Neel Kashkari, the new president of the local Federal Reserve bank, shows great energy in his campaign to break up big banks and other financial institutions designated as “too big to fail.” The most recent move was a star-studded conference here on April 4, with experts on both sides of the issue presenting their cases.
Kashkari’s basic premise is that, despite the Dodd-Frank Act of 2010, our economy remains vulnerable to the failure of very large financial institutions. The collapse of one or a combination of these could throw the U.S. economy into the situation we faced in early 1933, with output down by a third and unemployment over 30 percent. The solution, he and others argue, is not more detailed micromanagement ala Dodd Frank, but rather breaking up of the big institutions.
Let me state at the outset that I agree with this view and have been arguing it since 2009. I am not alone, economists far more distinguished than me, or non-economists like Kashkari for that matter, have made the case very well. Moreover, the Minneapolis Fed was sounding the warning trumpet on “too big to fail” as early as the 1990s, with then-president Gary Stern being particularly articulate on the issue. At that time, he and others did not necessarily advocate breaking up large institutions as the best response, but the warning of the danger of too-large institutions proved correct in the financial debacle of 2007-2009. So understand I am not neutral on this.
The financial sector, particularly big Wall Street firms, joined most Republicans in Congress in opposing Dodd-Frank. These politicians long have argued for its repeal and replacement with “common-sense legislation.” But like the promises to “repeal every word of Obamacare” and replace it with similar “common-sense,” no concrete plan has ever emerged.
GOP officials continue to snipe at particular features of the bill, in particular the Consumer Financial Protection Bureau that they rightly associate with Democratic Sen. Elizabeth Warren. But more importantly, the financial sector has moved on. Its leaders clearly think there are many worse evils than the new status quo, so Dodd-Frank, particularly as gelded in the legislative process to its final version, is the mast to which they will cling.
Enter Tim Pawlenty, the former Republican governor of Minnesota and now the financial sector’s public voice as the head of the Financial Services Roundtable; he laid out their views on Tuesday, the day after Kashkari’s forum.
Despite some questionable economic policies during his administration and brief 2012 presidential campaign (remember the “magic asterisk” of assuming unachieveable 5 percent economic growth?), Pawlenty is otherwise a thoughtful and articulate guy who eschews the bomb-throwing aspects of others in his party. This reasonableness is the strength that makes him such an effective industry representative. And the Dodd-Frank innovations that he reminded us of — and now defends — including higher capital requirements and the pre-planning and legal authority to tidily wind down failing firms, are concrete improvements to the financial sector.
On the negative side, the legislation also created enormous regulatory requirements that sap economic efficiency. This aside, the key question remains: Are the measures Pawlenty presented as adequate counters to Kashkari’s proposal really substantial enough to weather any future financial panic? Kashkari and others doubt that.
Simon Johnson, now professor at MIT and a former chief economist at the International Monetary Fund, spoke at Monday’s forum. He proposes a ceiling on the assets of any particular bank at 2 percent of GDP. That would be about $330 billion right now; the assets of Goldman Sachs at the end of 2015 surpassed $860 billion.
Yet even at the Minneapolis Fed, Patrick Kehoe, a long-time Research Department star, argues that these proposed measures are highly disproportionate to the danger posed. Others argue large banks achieve economies of scale that represent real efficiencies in how we use resources and that are passed along to clients.
The devil is always in the details and the details of breaking up the existing mega-banks are daunting. Aaron Klein, from the Brookings Institute, focused on these practical considerations. Just as farmers offered a subsidy to idle crop land always choose the least productive fields, so banks ordered to downsize will want to shed their least profitable operations. That may involve closing bank branches, hurting mom-and-pop customers and employees such as tellers but not really stemming the risk. Some communities will have less competition or even no local banking services at all, he argues. And large multinational corporations such as 3M or Medtronic may experience difficulty moving money as needed if the banks that service them are limited in size.
Eugene Ludwig, a banker and comptroller of the currency under Bill Clinton, offered the traditional economist’s advice that more study is needed.
Allow me a few academic comments. First, the economies of scale argument is a classic fallacy of composition. Just because a large bank, in itself, can use resources more efficiently and pass lower costs to its clients does not mean that a nation with many large banks is more economically efficient, especially when one considers the risk to the whole financial system engendered by extreme market concentration. Furthermore, the financial sector is much more concentrated now than it was only 20 or 25 years ago. Corporations were not burdened by inadequate services in 1995, when the market shares of even the largest firms were much smaller than now, nor was the overall economy measurably less productive.
Accept the warning of possible harm to retail customers skeptically. When farm subsidies are threatened, ag groups always trot out the specter of Ma and Pa Kettle being forced off their 80 acres when, in fact, the large bulk of federal dollars flow to a limited number of wealthy producers. And banks would have you believe that if Goldman Sachs or Citigroup are broken up, Archie and Edith won’t have any place to keep their $2,000 savings account.
Remember that we are blessed with a vibrant independent banking sector with many small- and medium-sized community and regional banks. Comparing these to Goldman Sachs in terms of large scale risk is apples to oranges, asset sizes aside. Also remember that technology is making physical location less important. There are many ways that adequate financial services can remain available in all communities even if the 41 or so largest banks get split up. In fact, ending TBTF would make community banks more viable because right now they struggle against bigger banks having a competitive edge in drawing deposits simply because of the implied government protection.
We should thank Bernie Sanders for making TBTF an issue in the presidential campaign. Unfortunately, his understanding of the issues is not deep. Simply putting a new cover sheet on the Glass-Steagall act passed eight decades ago and re-introducing it in Congress isn’t going to work. And while he can argue that there is some thin statutory authority for the Fed and Treasury to break up big banks without any new legislation, as a practical matter this will only happen if Congress passes legislation to do it. Good luck with that in today’s world.
Kashkari is brash and energetic, but understand that he has no power at all beyond his soapbox. Federal Reserve district presidents like him do get to take their turns as voting members of the monetary policy-setting Federal Open Market Committee. But decisions on Fed regulatory strategies are set by the seven-person Board of Governors in Washington. Full stop. District presidents can propose, but the Board disposes and only to the extent that Congress allows it to.
Former comptroller Ludwig is right. This needs more study. But the fact that breaking up the big institutions is on the table for discussion is a heartening development.