Wednesday, April 15, 2015

Breaking Up the Biggest Banks: The Impact on Moral Hazard

Citing the “slap on the wrist” culture at the U.S. Federal Reserve and the Securities and Exchange Commission (SEC), U.S. Senator Elizabeth Warren called on Congress in April 2015 to break up the big banks such as Bank of America, Citigroup, JPMorgan Chase, and Goldman Sachs.[1] She coupled the ‘break-up” approach to reducing the systemic risk with limiting the Fed’s ability to bailout individual banks. The synergy in Warren’s approach is worthy of further analysis.

The five largest American banks had seen their assets increase collectively by a third since the financial crisis of 2008. This further concentration of capital translates into higher systemic risk. It being at the very least open to debate whether requiring the bigger banks to hold more money in reserve would make much of a difference in fortifying them against short-sellers during a financial crisis, the increased systemic risk meant that the U.S. financial system was even more exposed in 2015. It makes  sense, therefore, that the five largest U.S. banks each be split apart—the systemic risk of each resulting parcel would of course be less.

So limiting the Fed’s ability to bailout banks so as to obviate moral hazard (i.e., risky behavior on the anticipation of being rescued if things go bad in a hurry) would not be a threat to the financial system as the collapse of Lehman Brothers had been. That is to say, knocking the biggest banks down to size makes it possible to reduce moral hazard without putting the financial system at risk.

For their parts, bankers at the biggest banks claim that the tremendous size allows for efficiencies, as from synergy and economies of scale, for instance. However, as Thompson suggests in his classic book, Organizations in Action (1967), the costs of internal integration rise disproportionally as an organization increases in size. In other words, it becomes increasingly costlier for an organization to function as it gets bigger. Especially in an age of computer technology, economies of scale in a service industry are likely to be overstated, and even used quite conveniently as an excuse to engage in “empire-building.”

Just as power within a bank doubtlessly plays a role in how large a bank becomes, the power of Wall Street in Congress is adept at keeping threats such as enforced downsizing at bay. Hence, Warren’s policy prescription would likely be “dead on arrival.” Even so, her coupling of splitting-up the banks with reducing their moral hazard is worthy of note.

[i] Reuters, “Elizabeth Warren Calls on Congress to Break Up the Big Banks, Change Tax Rules,” The Huffington Post, April 15, 2015.