Why not Baby Banks?

January 25, 2010

The President is right to target firm size if he wants to insure no financial firm can cause a system failure. Yet despite clear evidence that banks are already too big, Obama’s proposal won’t cut them down. It would only limit future growth by acquisition.

Specifics are being worked out, but what is clear is that Paul Volcker’s “size” proposal will limit future growth by acquisition only. It won’t force existing firms to shrink nor limit their ability to grow organically.

But if Obama wants to end the too-big-to-fail paradigm, if he wants to eliminate the possibility that one firm’s failure could cause a cascading financial collapse, he needs to engineer a system with more circuit breakers. Shrinking banks is crucial.

Like the power grid, the financial system is huge, dynamically complex and interconnected. A single point of failure can cause a cascading collapse. In 2003, some overgrown trees in Ohio were enough to cause a blackout that hit 55 million from Ontario to New York. In 2008, the failure of any one of a handful of financial firms could have plunged the economy into Depression.

True, size isn’t the only factor contributing to systemic risk. Yet despite thousands of bank failures during the savings and loan crisis, there was never a risk of systemic collapse because no bank was large enough to crash the system.

Another counter-argument is that gross balance sheet size isn’t by itself an indicator of risk. Certainly some balance sheets are riskier than others, but there remain 10 to 20 in the United States, of varying risk profiles, that are systemically dangerous.

Some argue that shrinking big banks would eliminate efficiencies. While size may have first order benefits, recent events show these are outweighed by second order bailout costs.

Nor do we need large banks to finance large deals. Big loans can be handled via syndication.

No doubt it would be tough to break up big banks, but we’ve done something similar before. Standard Oil and AT&T were split into Baby Oils and Baby Bells. Why not figure out a way to split too-big-to-fail financials into Baby Banks?


We welcome comments that advance the story through relevant opinion, anecdotes, links and data. If you see a comment that you believe is irrelevant or inappropriate, you can flag it to our editors by using the report abuse links. Views expressed in the comments do not represent those of Reuters. For more information on our comment policy, see http://blogs.reuters.com/fulldisclosure/2010/09/27/toward-a-more-thoughtful-conversation-on-stories/

The argument at the time of the crisis was that the big banks could not be put into resolution as they should have been by law because the resources were not available for a task of that size. That should be the definition of “too big.” If we are going to have a capitalistic system in the US, the legal and regulatory system needs to be able to enforce the law and regulations. Otherwise, there is lack of accountability, and when this happens there is lack of responsibility and an increase of cheating, eventually undermining the system.

What’s so hard to get about this? Oh ,I forgot, all the corporate cash that got us here in the first place.

Posted by Tom Hickey | Report as abusive

[…] At one time Standard Oil was too big to break-up.  Time for the big banks to shrink.  (Rolfe Winkler) […]

Posted by Tuesday links: news reading machines Abnormal Returns | Report as abusive

too sensible and simple ! and for added measure , lets just establish a naational limit on leverage at all banks to say 10×1 . Then they can’t start growing on steroids again .

but then Obama can’t whip up anti-bank sentiment among the looney left and there is no way that Congress gets to milk this idea for money ( ie no new taxes ) so it’ll never see the light of day .

Posted by divvy trader | Report as abusive

[…] At one time Standard Oil was too big to break-up.  Time for the big banks to shrink.  (Rolfe Winkler) […]

Posted by Tuesday links: news reading machines | Financial engineering resource center | Report as abusive