Should Big Banks be Broken Up?
by Anat Admati
The Economist Debate, May 15, 2013
The largest 80 corporations in the world are all financial institutions, each controlling hundreds
of billions, even multiple trillions worth of assets. These megabanks are a particularly dangerous
part of a fragile and inefficient financial system that exposes millions to unnecessary risk and
distorts the economy. Making this system safer is possible and urgent, but current reform
proposals fail to do so. Among the many benefits of a safer and healthier system is reducing the
excessive subsidies that the megabanks benefit from. With fewer subsidies, the business model
of the megabanks may no longer be viable, and they may break up naturally.
When a bank's creditors believe that the government will not let it fail, they agree to lend to the
bank on favorable terms that do not reflect its true risk. Bankers and shareholders of "too big to
fail" institutions have a particularly large advantage. They enjoy a magnified upside, while
sharing the downside with creditors and taxpayers.
Paradoxically, explicit and implicit guarantees, and tax codes that encourage borrowing and
penalize equity funding, give banks incentives to borrow excessively and inefficiently, thus
increasing the fragility of the financial system and harming the economy. Worse, heavy
borrowing distorts banks' investment decisions, making some loans less attractive than riskier
investments that may be less beneficial to society. If banks become distressed, lending is
disrupted and the damage to the economy can be large and lasting. These effects have been
evident since 2007.
Implicit guarantees also perversely encourage and enable the large banks to grow excessively so
as to achieve and take advantage of the funding advantage that being considered "too big to fail"
confers. Evidence suggests that banks can grow "too big to be efficient", and there is little to
suggest that any true efficiency is attained by banks growing beyond $100 billion. Recent
banking scandals illustrate the challenge of governance and controls at the largest banks.
Nevertheless, just constraining banks' size would not address the key distortions of the system.
Even if individual banks are smaller, the system can remain too fragile and dangerous if banks
pursue similar strategies and fail at the same time, or if the failure of some banks weakens others,
imposing costs on taxpayers and harming the economy.
Attempts to break up banks by law or regulation must therefore consider the interconnectedness
in the system, and must be accompanied by other steps to reduce the fragility of the system. A
highly beneficial reform would be requiring banks to use much more equity funding than current
and proposed regulations allow. The Basel III proposals, which still allow banks to fund up to
97% of their assets by borrowing, are woefully insufficient and flawed. Transitioning to a system
where banks' equity levels are maintained between 20% and 30% is possible and would bring
about numerous benefits to society. Such levels are considered minimal for other businesses and
corporations, and they would allow banks to support the economy better than they currently do,
and with fewer distortions. Nothing about banking justifies the levels of indebtedness banks
choose and regulations allow. The choices benefit bankers and harm many others, including
diversified shareholders, creditors and the broader public.
In lobbying against regulation to impose higher equity requirements, bankers and others make
numerous flawed and misleading claims. In a recent book, The Bankers New Clothes: What's
Wrong with Banking and What to Do about It, Martin Hellwig and I debunk many of these
claims and outline specific policy recommendations that can be implemented immediately if the
political will can be found. For example, a pervasive and insidious fallacy is that bank capital is
something banks "set aside" like a rainy day fund. In fact, bank capital refers to equity funding
that is available for lending, and capital regulation does not restrict banks' investment.
Alternatives to equity, such as contingent capital (Co Cos), are problematic. And claims that it is
important to maintain a “level playing field” and worry about the global competitiveness of a
nation's banks are also invalid. The experiences of Ireland, Iceland and Cyprus illustrate that the
global “success” of a country's banks can be very costly to its citizens.
One advantage of having smaller and more focused banks is that regulations can be tailored to
their mix of activities. For example, global banks should be subject to particularly strict capital
requirements, because the difficulties of cross-border resolution procedures make their failures
particularly difficult to deal with and dangerous. Banks that can scale up their risk through
derivatives and other trading activities might be subject to different regulation from banks that
focus on making business loans.
Despite the enormous damage caused by the financial crises, beneficial reform of financial
regulation has been stymied by lobbying based on invalid claims and by political considerations.
The persistence of too-big-to-fail banks is a stark illustration of the failure of policymakers to
protect the public from a dangerous and distorted financial system. We deserve better.
George G.C. Parker Professor of Finance and Economics, Graduate School of Business, Stanford