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?