Opinion: Making Banks Too Small to Succeed?

(Jan. 22) – On Thursday, the Obama administration introduced its proposal for dealing with the "too big to fail" problem for banks. "Too big to fail" refers to the idea that big banks are such an important part of a complex interconnected economy that the government doesn't dare let them fail. And how does President Obama propose to deal with this problem? By letting them fail? By not subsidizing them when they take risks and lose? Nooooooo. Obama plans to deal with it by not letting them get too big.

His plan would limit both the size of banks and the kinds of assets they are allowed to invest in. In other words, the government would take one the most regulated industries in the country – and regulate it more.

Unfortunately, this plan, if implemented, would go against much of what economists know about the value of size. Moreover, it would do nothing to address the real problem: "moral hazard."

As Columbia University financial economist Charles Calomiris pointed out last fall, when it comes to banks, size has its advantages. A bank that wants to deal in a large international market is better off if it's big. Those who deal with it are also better off because, to the extent that there are economies of scale, some of the cost savings make their way to customers. Also, all other things equal, the larger the bank, the more diversified it is. The more diversified it is, the less likely it is to fail.

Indeed, one of the major contributors to bank failures during the Great Depression was the National Banking Act of 1864. That law, according to monetary historian Jeff Hummel, an economist at San Jose State University, banned any branching (interstate or intrastate) by nationally chartered banks, except for a few grandfathered banks. Because banks during the Great Depression were so small, they were undiversified. So when the agriculture sector went under, in part because of the Smoot-Hawley Act that attacked free trade, many rural banks failed. Call it "too small, so we failed."

Had they been allowed to be big, many fewer would have failed. It's worth noting that in Canada, which also had a downturn in its farm sector, the banks were larger and not one failed during the Great Depression.

To be sure, Obama is going after a real problem: that banks often take too many risks in their investments. Wouldn't it be nice if we could go after that problem while not destroying the benefits of having large banks?

We can. And the best way to do that is to give those closest to banks a strong incentive to make sure the banks aren't taking undue risks.

One way to do that would be to get rid of deposit insurance. Until Dec. 31, 2013, if a bank fails and you have up to $250,000 in that bank, the Federal Deposit Insurance Corp. will make you whole. We depositors, therefore, don't have an incentive to monitor banks: it's called "moral hazard." Moral hazard, as you can see, has little to do with morality, but much to do with incentives. With little monitoring by depositors, banks are freer to take risks with "other people's money."

We could also repeal another restriction that prevents any one entity from holding more than a small percentage of ownership in a bank. Allowing concentrated ownership so that one firm or hedge fund could own, say, 10 or 20 percent of a bank's shares would allow the owners to kick out bank managers who are not doing well for shareholders.

If President Obama wants to avoid "too big to fail," he should focus on giving those closest to banks a stake in preventing failure in the first place.
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David R. Henderson is a research fellow with the Hoover Institution and an economics professor at the Naval Postgraduate School. He is the editor of The Concise Encyclopedia of Economics, Liberty Fund, 2008. He blogs at http://econlog.econlib.org.