Credit: David Shankbone/Wikipedia

Simply breaking up the big banks won't be enough

Senior Fed policymaker Neel Kashkari wants to end 'too big to fail', but it will take more than that to avert the next financial crisis.

by Adam Gale
Last Updated: 17 Feb 2016

The bigger they are, the harder they fall. That was the apparent lesson of the financial crisis of 2008-9. Since Lehman collapsed and governments took on immense debts to bail out the likes of RBS and Lloyds, ‘too big to fail’ has been repeatedly and convincingly argued to be a fundamental problem with our financial system.

Neel Kashkari knows a thing or two about this. He was deeply involved in the US government’s bail-out during the crisis, and is now the president of the Minneapolis Federal Reserve, one of the 12 ‘regional’ offices of the US central bank. In a speech at the Brookings Institution, he said the major banks were still too big to fail (which will surprise no one), and suggested the option of breaking them up (which perhaps will).

‘A very crude analogy is that of a nuclear reactor. The cost to society of letting a reactor melt down is astronomical. Given that cost, governments will do whatever they can to stabilize the reactor before they lose control,’ he said.

To the nuclear option of splitting the banks into ‘smaller, less connected, less important entities’, he also added the suggestion of ‘turning large banks into public utilities by forcing them to hold so much capital that they virtually can’t fail’ and ‘taxing leverage throughout the financial system to reduce system risks wherever they lie’.

Kashkari believes that there will inevitably be another financial crisis (because risks cannot always be foreseen), that financial crises pose a much greater risk to the wider economy than collapses in other industries and that therefore more drastic action is required to insure against such a crisis than merely the stress tests and hikes in capital and liquidity ratio requirements we’ve seen so far.

That’s all very well, but would breaking up the banks (or rather ‘financial institutions’) actually make us any safer? One huge bank collapsing has dramatic consequences because they all lend to each other. When Lehman went down, it was followed by a vicious credit crunch that disrupted trade the world over. But if the financial system as a whole is still exposed to the kinds of risks that took Lehman down, then what’s the difference between one big bank falling and a dozen smaller ones with the same collective assets?

It’s arguable that the ‘too big to fail’ safety net means banks will take risks that they wouldn’t otherwise do. But bank bosses don’t exactly fancy the professional humiliation (not to mention the annihilation of their stock options) of a government bailout either. Collapse is disincentive enough for reckless risk-taking – the problem inevitably comes when they don’t realise they’re taking such risks until it’s too late.

It’s really the financial system itself that should be too big to fail, and that depends on the way risk is built into the system. During the crisis, businesses that hadn’t knowingly taken risks with the US housing market were effectively exposed to them because the banks were.

Ensuring low-risk finance (which is essentially what the economy depends on to function day to day) is insulated from high-risk finance would seem therefore to be what’s most required. That way, financial institutions that are exposed to higher risks could indeed fail without bringing everyone else down with them.

In practice, this is less about making sure there are no big banks per se (there are advantages in scale, especially in a globalised world), but separating retail and commercial banking from investment banking. Beyond that, Kashkari’s other suggestions of even higher capital requirements and taxing leverage would also help safeguard the system, but it’s really a question of how far you want to take the trade-off. Let’s not forget that finance provides opportunities as well as risks.

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