November 20, 2012
I was pleasantly surprised to hear Federal Reserve Bank of New York President William Dudley say in a recent speech that solving the too big to fail problem may require breaking up big banks. He is in favor of trying the resolution authority granted in the Dodd-Frank legislation first, but this is an untested solution to the too big to fail problem that attempts to isolate and dismantle large, troubled institutions while protecting the rest of the economy.
If this solution doesn’t work, then he would be in favor of breaking large banks into smaller pieces. That wouldn’t fully solve the financial meltdown problem – we still had banking collapses in times when banks were much smaller – but it would reduce the economic and political power of individual institutions and lower the chance that the problems of a single firm will cause widespread harm to the economy.
Why not break the banks into smaller pieces as a precautionary measure? The main worry is that very large banks are needed to fully exploit economies of scope and scale, and that breaking them up would reduce efficiency and increase the cost of some types of financial transactions.
But the evidence on the size that a bank must attain to fully realize these efficiencies is not conclusive, and we don’t really know what the minimum size needs to be. My reading of the admittedly shaky evidence is that we could reduce bank size without losing efficiency, but that is not the approach that those in charge of the banking system have decided to take.
Banks are not the only systemically important firms in our economy. Any large, highly interconnected firm has the potential to produce large direct and indirect effects when it experiences problems. If an automobile company fails, for example, its suppliers are likely to fail along with it and the resulting domino effect can produce widespread negative effects that ripple throughout the economy. In fact, new research shows that a shock to a single large, highly interconnected firm can have a surprisingly large impact on the aggregate economy.
I believe strongly that we have paid too little attention to the growing economic and political power of our largest firms, and this concern is not limited to the financial sector. As The Economist noted recently, “the world’s biggest firms keep on getting bigger. In the past 15 years the assets of the top 50 American companies have risen from around 70 percent of American GDP to around 130 percent.”
The article goes on to note that “estimated cost functions suggest the limits of scale may have been reached for some very large firms, and that “antitrust authorities should be much more skeptical about mergers that claim to be justified because of economies of scale.”
I agree, and I’d go even further and break up firms that have the potential to impose large external costs if they fail, and are considerably larger than can be justified on efficiency grounds. In cases where economies of scope and scale clearly do justify large size, the firms should be subject to much stronger regulatory oversight than they are now.
At a minimum, these firms should pay for the costs they impose on the rest of us when they make poor decisions and fail. When financial firms, for example, failed as a result of the popped housing bubble the costs of the Great Recession fell on the entire economy. That is, the costs were largely socialized which is a bit ironic given how quick business leaders are to speak out against socializing anything.
One solution that has been proposed for the financial industry is to cover these costs through a tax on size. As Ken Rogoff states, “Financial systems are bloated by implicit taxpayer guarantees, which allow banks, particularly large ones, to borrow money at interest rates that do not fully reflect the risks they take in search of outsized profits. Since that risk is then passed on to taxpayers, imposing taxes on financial firms in proportion to their borrowing is a simple way to ensure fairness.”
But why limit this tax to large banks? Why not apply it to all large firms in the economy as a way of compensating taxpayers for the costs these firms impose when they fail, and to offset the benefits the largest among them enjoy from implicit taxpayer guarantees? Why shouldn’t all firms be asked to pay more as they grow larger?
The reality, of course, is that the political power these firms have is a large barrier to taxing their size, regulating them more aggressively, breaking them up, or anything else. But the acknowledgement of New York Fed President Dudley that solving the too big to fail problem may require breaking up banks is a hopeful sign that attitudes may be changing.
Let’s hope so, because the bigger they are, the harder they fall on the rest of us, and it’s long past the time to take a stand against the growing economic and political influence of our largest firms.