I think Henry Kaufman (in the WSJ) accurately outlines the public policy choice when it comes to financial reform: heavily regulated monster banks vs. a more decentralized, somewhat less regulated financial system TBTF creates a need for heavy regulation and less economic efficiency.
From what I could gather from a speech given by Fed Chairman Ben Bernanke at a conference sponsored by the Federal Reserve Bank of Boston a few weeks ago, the Fed favors constraining giant institutions to the point where they would become, in effect, financial public utilities. They might be required to increase equity capital and to limit their activities in proprietary trading and other risky activities.
But under this arrangement, these large institutions nevertheless would still command a vast amount of private-sector credit. And when markets became unstable in the future, other financial institutions would merge in order to come under the government’s protective too-big-to-fail umbrella.
If an overwhelming proportion of our financial institutions are deemed too big to fail, monetary restraint would fall heavily on institutions that are not. Pressure would sharply intensify on smaller institutions that mainly service local communities. Further consolidation would result, which in turn would reduce credit-market competition. At the same time, with increasing financial concentration, market volatility would increase.
All of this would narrow the gap between the Federal Reserve and the political arena. Taken to its logical conclusion, our market-based system of credit allocation would be replaced by a socialized financial system, and the Federal Reserve would become part of it.
A much better approach would be to prohibit any financial institution from remaining or becoming too big to fail. This would require that regulators downsize large financial conglomerates. In this process, the prime targets for divestiture should be financial activities that pose risk to the stability of the deposit function as well as operations that pose conflicts of interest.
Our financial system is at a crossroads. We can either succumb to the forces that are shifting markets toward greater government back-stopping and socialization. Or we can create a structure in which no institution is too big to fail, and a financial system that is supervised effectively by a modernized central bank.