Rebutting the Contention That Small Is Better for Banks

Richard E. Farley is a partner in the leveraged finance group of the law firm Paul Hastings and is writing “The Crisis Not Wasted - The Creation of Modern Financial Regulation During F.D.R.’s First Five Hundred Days,” a book on the creation of modern financial regulation during President Franklin Roosevelt’s first term of office.

The Dallas Federal Reserve Bank president, Richard W. Fisher, has again reignited the debate about what to do about “too big to fail” banks.

Five years after the financial crisis, it seems that the issue of bank concentration has never been resolved. In several recent speeches as well as a recent opinion article in The Wall Street Journal, Mr. Fisher expressed the view that it may be time to break up big institutions because “their privileged status places them above the rule of law.” He further argues that the Dodd-Frank financial overhaul that was supposed to help fix the problem didn’t.

Mr. Fisher has made many arguments in favor of limiting the size of banks. The first is that a larger size “emboldens a sense of immunity from the law.”

He acknowledges that he has borrowed this thought from the recent Senate testimony of Attorney General Eric H. Holder Jr., who claimed that when banks are too big to fail, “it is difficult to prosecute them” adding that criminal charges against a large institution could hurt the economy.

However, I challenge Mr. Holder (or Mr. Fisher) to pick up the business section of any major newspaper in any given week without reading about a government proceeding against a big bank. All these inquiries and actions have yet to dent economic growth or market performance, as witnessed by the new records that the major indexes seem to be setting daily.

Regardless of this, Mr. Fisher and Harvey Rosenblum, the executive vice president of the Dallas Federal Reserve, have proposed scrapping Dodd Frank in its entirety and replacing it with their three-prong plan to make all banks “a size that is too small to save.”

First, Mr. Fisher and Mr. Rosenblum suggest rolling back deposit insurance and access to the Federal Reserve discount window to only traditional banks and excluding nonbank affiliates of bank holding companies or parent companies of banks. Here, they are pushing against an open door: deposit insurance has never applied to anything other than deposits located at traditional banks (nonbank affiliates cannot even offer deposits backed by the Federal Deposit Insurance Corporation). The Federal Reserve already limits access to its discount window to “depository institutions” - insured banks, mutual savings banks, credit unions and savings associations.

Another step calls for having all customers, creditors and counterparties of all nonbank affiliates and parent holding companies “sign a simple, legally binding, unambiguous disclosure acknowledging and accepting that there is no government guarantee - ever - backstopping their investment.”

This part seems to be a red herring at best. There is not, nor has there ever been, a “legally binding” government guarantee of investments in banks. That is why bank bailouts are morally offensive to many - because there was no consideration given by recipients of the government largesse. A signed acknowledgment would never prohibit another bank bailout if future policy makers saw fit to undertake one.

The final argument presented is one that cannot so easily be dismissed: that megabanks can raise capital more cheaply than smaller banks because of an implicit belief they will receive some government assistance if they risk insolvency. This is undoubtedly true, and is actually quantifiable.

But is the answer to this unfair subsidy breaking up the banks Another possible remedy would be to require additional capital reserves or enact a surcharge to finance future bailouts if assets exceed a certain level. This approach would “even the playing field,” if that is the concern.

The size of the banks in the financial system is hardly the real issue. In relation to the economy it supports, the United States banking system is relatively small compared with those of other developed countries. As a percentage of G.D.P., total banking assets in the United States were about 117 percent in 2011 â€" less than in France (421 percent), Britain, (373 percent), Germany (332 percent) and even Canada (138 percent).

Second, the American banking system is less concentrated than the banking systems of most developed countries. By total assets, the five largest American banks held a smaller portion of G.D.P. in 2011 than in most other developed nations. The five big banks hold about 56 percent, compared with 309 percent in Britain and 116 percent in Germany. The United States banking industry is about as concentrated as Turkey’s (55 percent).

And let’s not forget the most important statistic in this debate: historically, small banks in the United States pose the highest risk of failure. During the Great Depression, more than 9,000 banks failed, nearly all of them small.

Because they were too small to save, panic led to the meltdown of the financial system, resulting in a nationwide bank shutdown and subsequent systemwide Federal Reserve bailout to enable the banks to reopen. Through this historical prism, banks that are “too big to fail” look to be a better example, and it is perhaps why the rest of the developed world doesn’t share our “big is bad” obsession.