Too big to fail.” If there is one phrase that folks on Wall Street are sick of hearing by now, more than five years after the financial crisis began and just as major market indexes finally are revisiting their pre-crisis highs, that’s it. And it’s also the question that is proving hardest to resolve, as post-crisis efforts to prevent the financial system from another near-catastrophe continue.
Eric Holder, the country’s Attorney General, raised eyebrows nationwide as well as the blood pressure on Wall Street when he testified to the Senate Judiciary Committee Wednesday that he believes the size of the biggest global banks “made it difficult” to prosecute them for any misdeeds. What happens, he asked, if levying criminal charges means jeopardizing the national or even the global economy? Even more alarming, perhaps, is his suggestion that the size – and thus the influence – of the big banks is so immense that Wall Street can ensure investigations never bear any fruit. Too-big-to-fail banks, he said, may have “an inhibiting impact on our ability to bring resolutions” to situations that the government has investigated.
There is tremendous frustration on the part of some Washington policymakers that no Wall Street institutions have been held accountable for whatever crimes, misdemeanors or missteps they and much of the country believe led to the financial crisis. But while Holder may well have a point about the impact that gargantuan financial institutions – and their lobbying – can have on government, there is a broader issue that too often is lost amidst all the outrage: It has proved very hard, and sometimes impossible, to demonstrate that laws were broken. Two Bear Stearns hedge fund managers were acquitted of criminal charges, for instance; that may have done more to dampen the enthusiasm of prosecutors than any lobbying by Wall Street.
Comments like Holder’s may add to the pressure to break up the big banks, but the authors of a new report published by the Milken Institute, a think tank, come down against such a move, in large part because there is no evidence that it would make the system safer or more manageable. There is, on the other hand, a risk that it would be a destabilizing process, they write in the report, entitled Breaking (Banks) Up Is Hard to Do. Who decides what is too big? Or how a bank should be broken up?
The study avoids another important issue, however. Its authors cite the old Wall Street argument that it wasn’t big banks that were the problem in 2007 and 2008, but leverage. From there, runs on the institutions in the “shadow banking system” and a freeze in liquidity caused the full-blown crisis. That argument ignores the fact that it was Wall Street’s behavior that made possible the growth of the shadow banking system and that provided fuel for the fire that consumed Bear Stearns and Lehman Brothers and nearly annihilated other major institutions as well.
Of course, as the Milken Institute report points out, there is no way to determine in advance which kind of Wall Street institution will become a systemic threat. The most serious threats to the financial markets previously had come from fraudulent accounting, or from flawed risk management at hedge funds such as Long-Term Capital Management. The size of the institutions themselves was no determinant of how serious the threat became to the stability of the financial markets. Even in the case of Long-Term Capital, the fund itself was tiny compared to the banks. What mattered was the leverage and counterparties involved.
To the extent that a Wall Street institution is not only big but involved in every kind of financial transaction, the odds increase that it will be caught up in whatever kind of crisis erupts next. As the reports about the JPMorgan Chase “London Whale” trading losses indicate, size can make it harder for risk managers to crack down and for CEOs to know what is going on. True, size made it possible for JPMorgan to swallow that loss and move on. But just as size may not dictate whether an organization is automatically a bigger threat to the system, keeping banks small can’t be seen as a panacea.
It is the behavior of banks, not their size, that we should be focused on, and to that extent Holder hit the nail on his head in his testimony. If the size of banks gives them the ability to fend off regulators or investigators, that’s far more of a threat to the system than anything else. Just look at the way that banks influenced policymaking in the years that led up to the financial crisis.
The goal here shouldn’t be for Washington’s policymakers to declare that any bank whose deposits top a certain percentage of the country’s GDP should be broken up. Rather, they should be looking at whether the regulation is capable of reining in excesses and bad behavior, and holding bankers and other Wall Street participants – regardless of the size of their institution – responsible for their misdeeds. The purpose must be to ensure the stability of the system, not enshrine some hypothetical perfect size.