In addition to being a jaw-droppingly superficial idea overall, here’s another reason why breaking up the banks and capping their size would be a titanic mistake. Everyone seems to agree that normal, non-TBTF banks can be resolved without causing a meltdown in financial markets. This is, in fact, the justification given for capping bank size — it would make all banks “small enough” to be resolved smoothly, which means that no single bank failure would pose systemic risks. Mission accomplished! Of course, this argument quickly breaks down when you think for more than 15 minutes about how the FDIC resolves failed banks.

The FDIC resolves the vast majority of failed banks through what’s known as “purchase and assumption” agreements, or P&As. P&As are transactions in which a healthy bank purchases some or all of the assets of a failed bank and assumes some or all of the liabilities, including all insured deposits. P&As are much less disruptive to both communities and financial markets than straight deposit-payoffs by the FDIC. The FDIC has used P&As to resolve 163 of the 187 failed banks since the beginning of 2008. The JPMorgan/Bear Stearns deal was also a form of P&A (which was entirely intentional), with the Fed playing the role of the FDIC.

Now imagine that we cap bank size at, say, $100bn in assets. What happens if a bank with $99bn in assets fails? The way the FDIC resolves failed banks smoothly is through P&As, but the only banks big enough to buy the $99bn failed bank would surely be over the $100bn cap if they agreed to the purchase. So the choice is effectively between (1) a disorderly liquidation by the FDIC, which would pose exactly the kind of systemic risks that proponents of capping bank size are trying to avoid; or (2) granting an acquiring bank (or banks) a waiver from the $100bn cap and proceeding with a P&A. (The FDIC could technically use a conservatorship, but these are extremely rare, and no regulator has the capacity to manage a $99bn conservatorship.)

But think about how potential acquiring banks would respond if the FDIC approached them and offered them a waiver on the $100bn cap in exchange for agreeing to a P&A. They would think:

“Well, the government begged JPMorgan to buy Bear and begged BofA to buy Merrill, but then the government turned around and forced JPM and BofA to break themselves up a few years later! So thanks but no thanks, Sheila, we’re not interested in buying a bank that you’re just going to force us to divest in a couple years.”
So with a cap on bank size, P&As would likely be off-the-table for the largest bank failures. But if the FDIC can’t use P&As, then it can’t ensure that the largest banks will be resolved smoothly—and thus pose no systemic risks—even with a cap on bank size in place! And if the FDIC can’t ensure that the failure of the largest banks won’t pose systemic risks, then what was the point of the cap on bank size in the first place?

See how easy it is to knock down this silly “break up the banks” idea?


Anonymous said...

Or, the nature of systemic risk that Simon Johnson cannot seem to wrap his sorry head around.

Look buster, I have copyrighted "when you add them all up, they're no longer small enough to fail", and you are raining on my future royalty income.

Kid Dynamite said...

but EOC - if the bank who is blowing up had $100B in assets instead of $1T in assets, how can you argue that it wouldn't be LESS disruptive to the system if there were a blowup? the Fed could warehouse the risk if need be.

Seems clear to me that it's less systematically catastrophic to liquidate a smaller portfolio, and that if we prevent the portfolios from getting to LTCM size and scope, then we're clearly reducing systematic risk.

still, yet again, i think LEVERAGE is more important than gross notional size.

Matthew said...

A hard cap would have problems, both the one you mention and the simple question of what you do about organic growth. However, some kind of growth disincentive where insurance or other costs increase non-linearly as the size of the bank increases would seem viable.

If there are services that only a very large bank can provide, then they can charge what is required to make the fee viable. If not, they will have reason not to get so big.

Anonymous said...

The FDIC would run a "bridge bank" in that situation. That's what it did for 6 months at IndyMac, which had ~$30 billion of assets as I recall. It strained the FDIC but was definitely do-able. And it would be possible, if barely, to bridge a $100B bank but not at all one the size and complexity of the trillion+ banks that exist today.

Anonymous said...

You guys are basically arguing that a room full of 100 midgets and no giants is less susceptible to the plague than a room with full of 50 midgets and 5 giants. No, it's not.

Economics of Contempt said...

KD - My point was simply that capping bank size doesn't in any way eliminate the TBTF problem, because under a cap there's no P&A option for the largest banks, which, ironically, makes them TBTF again.

Also, LTCM only had about $95bn in assets when it nearly failed, and it was considered TBTF. Similarly, Continental Illinois only had $40bn in assets, and it was also considered TBTF. So clearly the failure of a bank with less than $100bn in assets can pose unacceptable systemic risks. (And in the extremely unlikely event that a cap on bank size was actually imposed, it would undoubtedly be closer to $300bn.)

In any event, I'm not arguing that the failure of a $100bn bank would be more disruptive than the failure of $1T bank. Nor is that even the relevant question. The relevant question is whether the disorderly liquidation of a $100bn bank would be less disruptive than a P&A-like, FDIC-managed resolution of a $1T bank. Would it? Obviously, it would depend on the particular circumstances. But it's a closer call than people like to think.

I totally agree that leverage is the real issue though.

rufus mcbufus said...

Wow! EOC and KD agreeing and I actually think you're both right. And by the by, I think TBTF can be completely dispensed with if we all just allow the F. Period..full stop...just Fail. The F is what will teach everyone about the true danger of leverage. And that lesson will hold for 80 to 100 years until the next set of generations must learn once again. Let's do the F, I say, I can take it.

Kid Dynamite said...

Rufus - i think EOC and I see eye to eye on most stuff - I like his blog (what I've read so far at least) - which is why i spend time commenting here.

as for Anon with the comment about midgets and giants - the question is, what if Plague is more prevalent in tall trees ??!!!! the giants ARE more susceptible to it!

Anonymous said...

KD - that is not the point. You are deceiving yourself if you think systemic threats only take one bank at a time, or only big banks, or that size is an immunity against systemic threats at all. It only looks that way when there are some very large, top-of-the-food-chain banks under threat (current situation.) It seems logical that the systemic threat would vanish if the threatened banks were smaller - more numerous. No, the systemic threat is not diminished one bit by that gambit. A systemic threat eats kibbles. It east bits. It eats kibbles'n bits. And it will eat all of them.

We are far better served by people who are talking about the means by which we can kill systemic threats when they arise, and then we can have banks that are fully competitive in the global marketplace instead of the neutered peep squeaks being envisioned.

David Smith said...

All industries that depend upon the representatives and agents of the US government to treat them with minimal sanity -- which in this day and age is all industries, full stop -- have to go through exactly this kind of analysis. It would be negligent of any bank with public shareholders not to think precisely along the lines you have described.

Jamie Dimon and Lloyd Blankfein rue the day they ever allowed their banks to take down the TARP capital.

It's as if Uncle Sam had become manic and unpredictable in his old age. You have to jolly him along, and when he's on the verge of going berserk deal with him as you would any other lunatic with a trunkful of loaded guns . . . veeeeeeeeeery caaaaaaarefully.

Name names? I'd rather not. The House in particular has many such people. Some of Barack Obama czars come across this way.

Finn said...

The central premise - that P&A agreements are necessary to ensure orderly liquidation - seems wrong, as Anonymous 1/26 10:03 points out.

Y = X said...

Is your argument valid if "$100 billion" is replaced by x where x is any number less than 100 billion? It seems absurd to me that capping bank sizes at $1 million would lead to a systemic failure if a bank of this size failed.

It also seems to me that resolving a problem at a $100 billion bank is much easier than in a $1 trillion bank. I get that a $100 billion bank can be in such a position that it is still too big to fail but it won't be too big to bankrupt the nation or hold the nation hostage. Isn't this the real point about the TBTF legislation?

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