Sunday, January 31, 2010

"Too Big to Fail" vs. "Too Small So We Failed"

. Sunday, January 31, 2010

A couple of weeks ago I argued that having "too big to fail" banks might actually be a good thing, or at least that the alternatives might be worse. Here's a few more reasons why this makes sense. First, because without large banks it's impossible to deal with many bank failures. How? Well, if you cap bank size, then who's going to buy the banks that fail?






In other words, imagine what the world would look like right now if JP Morgan couldn't/wouldn't buy Bear Stearns, or if Bank of America couldn't/wouldn't buy Merrill Lynch. It's a world with several other Lehman-type collapses, many more small bank failures (there was 140 in 2009, with potentially hundreds more still to come), and a broader systemic collapse. Either that, or a much larger public intervention than we actually had.

In fact, that's exactly what happened during the Great Depression:

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."

It's possible that the relationship between bank size and systemic stability is parabolic: at first there are increasing returns, then those flatten and eventually recede. But if that's the case, I've not yet seen an argument as to where the "socially optimal" margin lies, if such a thing could even possibly exist. As a rule, arguments in favor of shrinking the banks do not discuss unintended downside consequences. That is reason enough to be suspicious.


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