Among the final questions hovering over the Congress as it rewrites the rules of finance is this: If banks that are too big to fail are a big part of the problem, will anything short of busting them up suffice?
Treasury Secretary Timothy Geithner, White House economic guru Lawrence Summers, Federal Reserve Chairman Ben Bernanke, Nobel laureate Paul Krugman and the majority of the U.S. Congress (so far) say breaking up big banks is somewhere between useless and counterproductive.
U.S. Bank Capital Rules Get Weaker
But a loud contingent—MIT economist and blogger Simon Johnson, Nobel laureate Joseph Stiglitz, former Treasury Secretary George Shultz and, to varying degrees, veteran central bankers Paul Volcker, Alan Greenspan and the U.K.'s Mervyn King—counters: If banks are too big to fail, they are too big. Break 'em up, or at least handcuff them.
The problem is easier stated than solved: When everyone believes a bank is too big or too intertwined with others for the government to allow it to fail, investors will be too willing to lend it money. The bank then borrows more and takes more risks than the market would otherwise allow, raising odds of failure and taxpayer bailout.
The precedent-shattering rescues of Bear Stearns and American International Group, the catastrophic consequences of the Lehman Brothers bankruptcy and the subsequent taxpayer rescue of the entire banking system breed expectations that, no matter what it says, the government will bail out big banks the next time, too. And having fewer bigger banks—one result of the crisis—doesn't exactly cure the problem.
The approach Mr. Geithner and allies are pushing aims to make big banks less prone to failure by better arming regulators to force them to borrow less, build bigger capital cushions to absorb losses in the future and maintain more liquidity to fight financial fires. It also attempts to make it easier for the government to let a big one go by devising a mechanism other than bankruptcy (Lehman) and bailout (AIG) to deal with a collapsing financial institution, one that would, unlike recent bailouts, nick creditors as well as shareholders.
Their critics are pressing the Senate-House conference to either shrink the banks (an unlikely outcome) or sharply restrict businesses in which banks can engage (possible). "There is little in the current legislation that would change the behavior or reduce the size of the nation's six megabanks," said lame duck Sen. Ted Kaufman (D., Del.), who unsuccessfully sought on the Senate floor to cap the size of banks. "Instead this bill invests its hopes in two ideas: First that chastened regulators—who failed miserably in preventing the crisis—will this time control these megabanks more effectively....And second that a resolution authority designed to shield the taxpayers from yet another bailout will be able to successfully unwind incredibly complex megabanks engaged across the globe."
By a 37-7 margin, economists surveyed by The Wall Street Journal this week, many from Wall Street, said the pending bill doesn't do enough to address too-big-to-fail, sometimes abbreviated TBTF. "It doesn't end it, it institutionalizes it," said Stephen Stanley of Pierpont Securities, a young broker-dealer that is too small to save.
Protesters in Washington, top, proclaim their views Wednesday on bailouts as Tim Geithner, bottom, and others ponder future regulations.
In part, the differences are diagnostic. The Geithner camp doesn't believe that big banks are actually more prone to collapse and does believe that scale and scope bring economic benefits to the U.S. in a global economy marked by ever-bigger companies, though it allows that a big-bank collapse can do a lot of damage to others. In contrast, Richard Fisher, president of the Dallas Federal Reserve Bank, argued last week: "The dangers posed by institutions TBTF far exceed any purported benefits." The world needs big banks, he said; it doesn't need "a few gargantuan institutions capable of bringing down the very system they claim to serve."
The Geithner camp thinks forcing banks to return to the business of taking deposits and making loans would simply force a whole lot of riskier business to less regulated institutions and solve little. The other side argues that only restoring rules in place between the 1930s and the 1980s can restore that era's stability of the banking system.
In part, the differences are principled. The Geithner camp sees no alternative but to trust regulators. The other side is deeply skeptical of regulation, arguing that only the brute force of legislation can succeed. The Geithner camp believes it imprudent to forswear taxpayer bailouts at all times, even moments of global panic. The other side says any emergency-only clause will create expectations of bailouts that will inevitably be realized.
And, in part, the differences are practical. Gary Stern, the former president of the Minneapolis Fed who was shouting about too-big-to-fail before most, says "bust 'em up is a nice slogan," but dismantling Citigroup or Bank of America would be "daunting," and probably impossible. The other side counters that Citi (already shrinking itself under pressure from regulators), Bank of America and J.P. Morgan Chase—and perhaps Wells Fargo, Goldman Sachs and Morgan Stanley, too — have grown too-big-to-save and too-big-to-manage so the wisest course is to break them into smaller pieces.
In the legislative fight, Geithner & Co. appear to have thwarted those who would shrink the banks, but they're still wrestling with those who would substantially restrict banks from trading for their own profit or dealing derivatives. But they haven't won the public argument, at least not yet.