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It's not enough to simply break up large US banks
By Simon Johnson |
October 30, 2012, Tuesday
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Print Edition
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THE columnist George F. Will recently shocked his fellow conservatives by endorsing Richard Fisher, president of the Federal Reserve Bank of Dallas, to be US Treasury secretary in a Mitt Romney administration.
Fisher's appeal, in Will's eyes, is that he wants to break up the largest US banks, arguing that this is essential to re-establish a free market for financial services. Big banks get big implicit government subsidies and this should stop.
Will's endorsement was on target: The true conservative agenda should be to take government out of banking by making all financial institutions small enough and simple enough to fail. As Will asks, "Should the government be complicit in protecting - and by doing so, enlarging - huge economic interests?"
But Will could have gone further. Fisher should be considered for a top administration post regardless of who wins the presidency on November 6. He also should be a strong candidate to become chairman of US the Federal Reserve Board when Ben Bernanke's second term ends Jan. 31, 2014.
Unfortunately, Fisher's views on "too big to fail" banks draw the ire of powerful people on Wall Street, and he almost certainly will remain in Dallas. That is, until the next crisis.
Policy rethink
Fisher and Harvey Rosenblum, executive vice president and director of research at the Dallas Fed, have laid the groundwork for a comprehensive reassessment of finance and banking - and the effects on monetary policy. The closest parallel is the rethink that happened during the 1930s, as the gold standard broke down and the world descended into depression followed by chaos. But their approach is also reminiscent of the way that monetary policy was reoriented in the early 1980s, as Fed Chairman Paul Volcker and others brought down inflation. The world and the US economy have changed profoundly. We need to alter the way we think about the financial system and monetary policy. Fisher and Rosenblum have expressed, separately and together, three deep ideas since the financial crisis erupted in 2008.
First, very large banks are too complex to manage. "Not just for top bank executives, but too complex as well for creditors and shareholders to exert market discipline," they wrote in a Wall Street Journal op-ed in April. "And too big and complex for bank supervisors to exert regulatory discipline."
Complexity, they say, magnifies "the opportunities for opacity, obfuscation and mismanaged risk." This is a problem in other industries, too, though market forces compel US businesses to reconfigure their organizational structures all the time. There are large implicit government subsidies available if your financial institution is perceived as too big to fail. These subsidies - in the form of implicit downside protection or guarantees for creditors - drive up size and exacerbate complexity.
Second, too-big-to-fail banks do actually fail, in the sense that they require bailouts and other forms of government support. This is exactly what happened in the US in 2007 through 2009, and it is what is occurring in Europe today.
Breaking up
For anyone who finds the phrase "break up" hard to swallow - for example because you believe the government shouldn't take on this role - Fisher and Rosenblum argue: "Though it sounds radical, restructuring is a far less drastic solution than quasi-nationalization, as happened in 2008-09."
Third, monetary policy cannot function properly when a country's biggest banks are allowed to become too complex to manage and prone to failure.
Fisher and Rosenblum pointed out in 2009 that cutting interest rates doesn't work when systemically important banks are close to insolvency. The funding costs for banks go up, not down, as a crisis develops. As banks come under pressure, the Fed may cut its policy rate but the interest rates charged by banks to customers may actually go up, and it becomes harder to get a loan. This is what happened in 2008 and 2009.
Or think about what happens during any attempted economic recovery - such as the one we are in now.
"Well-capitalized banks can expand credit to the private sector in concert with monetary policy easing," Rosenblum wrote with Jessica J. Renier and Richard Alm in the Dallas Fed's "Economic Letter" of April 2010. "Undercapitalized banks are in no position to lend money to the private sector, sapping the effectiveness of monetary policy."
If you want monetary policy to become effective again, you need the largest banks to be broken up. Equity capital also must increase, relative to debt, throughout the financial system.
Simon Johnson is also a senior fellow at the Peterson Institute for International Economics. The opinions are his own.
Fisher's appeal, in Will's eyes, is that he wants to break up the largest US banks, arguing that this is essential to re-establish a free market for financial services. Big banks get big implicit government subsidies and this should stop.
Will's endorsement was on target: The true conservative agenda should be to take government out of banking by making all financial institutions small enough and simple enough to fail. As Will asks, "Should the government be complicit in protecting - and by doing so, enlarging - huge economic interests?"
But Will could have gone further. Fisher should be considered for a top administration post regardless of who wins the presidency on November 6. He also should be a strong candidate to become chairman of US the Federal Reserve Board when Ben Bernanke's second term ends Jan. 31, 2014.
Unfortunately, Fisher's views on "too big to fail" banks draw the ire of powerful people on Wall Street, and he almost certainly will remain in Dallas. That is, until the next crisis.
Policy rethink
Fisher and Harvey Rosenblum, executive vice president and director of research at the Dallas Fed, have laid the groundwork for a comprehensive reassessment of finance and banking - and the effects on monetary policy. The closest parallel is the rethink that happened during the 1930s, as the gold standard broke down and the world descended into depression followed by chaos. But their approach is also reminiscent of the way that monetary policy was reoriented in the early 1980s, as Fed Chairman Paul Volcker and others brought down inflation. The world and the US economy have changed profoundly. We need to alter the way we think about the financial system and monetary policy. Fisher and Rosenblum have expressed, separately and together, three deep ideas since the financial crisis erupted in 2008.
First, very large banks are too complex to manage. "Not just for top bank executives, but too complex as well for creditors and shareholders to exert market discipline," they wrote in a Wall Street Journal op-ed in April. "And too big and complex for bank supervisors to exert regulatory discipline."
Complexity, they say, magnifies "the opportunities for opacity, obfuscation and mismanaged risk." This is a problem in other industries, too, though market forces compel US businesses to reconfigure their organizational structures all the time. There are large implicit government subsidies available if your financial institution is perceived as too big to fail. These subsidies - in the form of implicit downside protection or guarantees for creditors - drive up size and exacerbate complexity.
Second, too-big-to-fail banks do actually fail, in the sense that they require bailouts and other forms of government support. This is exactly what happened in the US in 2007 through 2009, and it is what is occurring in Europe today.
Breaking up
For anyone who finds the phrase "break up" hard to swallow - for example because you believe the government shouldn't take on this role - Fisher and Rosenblum argue: "Though it sounds radical, restructuring is a far less drastic solution than quasi-nationalization, as happened in 2008-09."
Third, monetary policy cannot function properly when a country's biggest banks are allowed to become too complex to manage and prone to failure.
Fisher and Rosenblum pointed out in 2009 that cutting interest rates doesn't work when systemically important banks are close to insolvency. The funding costs for banks go up, not down, as a crisis develops. As banks come under pressure, the Fed may cut its policy rate but the interest rates charged by banks to customers may actually go up, and it becomes harder to get a loan. This is what happened in 2008 and 2009.
Or think about what happens during any attempted economic recovery - such as the one we are in now.
"Well-capitalized banks can expand credit to the private sector in concert with monetary policy easing," Rosenblum wrote with Jessica J. Renier and Richard Alm in the Dallas Fed's "Economic Letter" of April 2010. "Undercapitalized banks are in no position to lend money to the private sector, sapping the effectiveness of monetary policy."
If you want monetary policy to become effective again, you need the largest banks to be broken up. Equity capital also must increase, relative to debt, throughout the financial system.
Simon Johnson is also a senior fellow at the Peterson Institute for International Economics. The opinions are his own.
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