Jonathan Macey, one of my favorite legal thinkers, and James Holdcroft Jr. have written a fascinating essay for the Yale Law Journal that calls for an “ersatz-antitrust approach to financial regulation.” In very broad outline, their argument is that because the federal government has proven incapable of regulating away financial crises (see the history of the last 150 years) and because a democracy can’t credibly make a no-bailout precommitment (voters will punish politicians who don’t to respond to a crisis in a dramatic fashion), the only solution is to break up the banks to the point where any discrete failure would pose no systemic risk. They propose a bright-line limit of total liabilities to 5% of the targeted level of the FDIC’s Deposit Insurance Fund in any given year. The idea is that the federal government could afford to wind down banks of this size. Note that this proposal envisions that there would be no need for any limits on the activities that banks undertake — it just places a limit on their size.
So why take this rather radical step? It comes down to politics:
(1) Smaller banks exert less political pressure;
(2) politicians and regulators have a track record of bailing out big banks and letting the small fry die, which creates a poisonous, self-fulfilling dynamic towards ever more risky bigness;
(3) and big banks behave like lemmings — it’s easy to follow what a small handful of competitors are up to, the returns to converging on the leader are high, the short-term cost of a contrarian strategy can be ruinously high for executives responsible to trigger-happy shareholders, etc.
Establishing a hard cap on size would reduce lemming-like behavior and excessive risktaking:
[I]f the largest banks are broken up, then cascade behavior will be far less likely because there will be no “leader of the pack” to follow. The cascade literature assumes that there is a leader, or at least a “first mover,” who may or may not have qualities that one normally associates with leadership. Simply put, if the big banks are broken up, there no longer will be first movers for the rest of the industry to follow. This, in and of itself, will make the banking system more resilient; the diminution in the current lemming-like behavior and increase in diversity of decisionmaking will translate into a diversification of strategies within the banking industry. This will lead to a significant reduction in systemic risk.
Thus, as long as we have big banks, we will have implicit insurance of large financial institutions and the culture of bailouts that such an insurance scheme brings with it. Our approach is to address the root cause of the problem, which is that the size of the largest institutions makes bailouts inevitable.
The essay contains a very effective critique of Dodd-Frank. And while it bears a superficial resemblance to the Volcker Rule, the authors argue that the Volcker Rule would be very difficult to implement because its risk-adjusted liability threshold is easy to game.
To defenders of Big Banks, the authors offer the following:
[I]f there is an advantage in having very large financial institutions, that advantage is not reflected in creating financial institutions that are stronger than financial institutions that are significantly smaller—at least without the generosity of Uncle Sam. If big financial institutions do in fact provide services and products to large corporate clients that only very large financial institutions can provide, or if big financial institutions enjoy an efficiency advantage due to superior scale, then it is reasonable to assume that they should be able to capture above-normal fees or profits from these activities. That, in turn, should lead to either a stronger balance sheet and capital position or higher compensation and higher dividends. The data show that, if these advantages exist, Big Banks have not used this advantage to build stronger capital positions. In other words, just as the government-sponsored entities, Fannie Mae and Freddie Mac, have done, the Big Banks have privatized the gains and socialized the risks of their businesses. To the extent that these advantages do not make a meaningful difference in the performance or financial strength of the Big Banks, claiming that these advantages justify the increased risk associated with these very large banks is similarly questionable. [Emphasis added]
Another interesting factoid: uninsured depositors disproportionately choose Big Banks, presumably a response to implicit TBTF “insurance.”
As crazy as this idea sounds, Macey and Holdcroft are really aiming at the socialization of risk. They want banks to be risk-bearing entities, not risk-shifting entities. There is an intuitive appeal to this idea, though I’m sure that there are many smart objections. I’ll keep an eye out for replies to their approach.