Are 19 banks “too big to fail?” Listening to Bloomberg radio, I heard that four banking firms control close to 50 percent of their industry’s assets, that the top 19 control 85 percent, and that the bottom 8000 control 15 per cent. An FDIC report from 2006 described a similar trend.
In a recent econtalk podcast, Gary Stern, past head of the Minneapolis Fed said that “too big to fail” distorts markets. Explaining why, he said that once creditors expect that an institution will be rescued, no matter how risky its behavior, its demand curve shifts lower than it should be for that institution’s securities. The result is “mispricing”. With borrowing less expensive, risky behavior is fueled with funds. Place that fund supply on steroids as before the 2007 panic and you have the potential for a “systemic” calamity. And, going full circle, if systemic calamity is possible, than those big enough to cause it, cannot fail. The challenge is to stop that cycle.
Is the solution smaller financial institutions? As happened during the late 1970s, when banks were prohibited from competing and growing freely, other financial firms took away the banks’ business with a better deal–a higher return and new financial products– for their customers. As a result, the attempt to preserve healthy institutions wound up threatening their survival. Today, we have an international financial community ready to offer “better deals” if we limit our banks. And, we also have an industry where new products, that regulators never imagined, surface daily. Is the solution new regulations? Enforce existing regulations better? Permit failure and let the market take care of itself? Your comments?
The Economic Lesson
Whenever banking is discussed, someone always refers to Glass-Steagall as a benchmark. Passed in 1933, Glass-Steagall is primarily associated with creating the FDIC and requiring banks to spin off their investment banking activities as separate firms. Repealed in 1999, actually, Glass-Steagall had gradually been unraveling since 1980.