There's a bank somewhere in this photo.

Photographer: Michael Nagle/Bloomberg

Two Right Answers in the Fight Over Big Banks

Noah Smith is a Bloomberg View columnist. He was an assistant professor of finance at Stony Brook University, and he blogs at Noahpinion.
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New York Times columnist Paul Krugman and Rolling Stone writer Matt Taibbi are having a debate over breaking up big banks. This is the key financial reform proposal of the Bernie Sanders presidential campaign, so it’s a very topical issue.

Krugman says that breaking up the banks isn’t a priority, and that the Sanders campaign isn’t critical:

The easy slogan here is “Break up the big banks”…But were big banks really at the heart of the financial crisis, and would breaking them up protect us from future crises?

Many analysts concluded years ago that the answers to both questions were no. Predatory lending was largely carried out by smaller, non-Wall Street institutions like Countrywide Financial; the crisis itself was centered not on big banks but on “shadow banks” like Lehman Brothers that weren’t necessarily that big.

Taibbi thinks otherwise:

Krugman neglects to mention the crucial role that big banks played [in the crisis]...The typical arc of [the mortgage lending] scam went as follows: Giant bank lends money to sleazy mortgage originator, mortgage originator makes lots of dicey home loans, the dicey home loans get sold back to the bank, the bank pools and securitizes the loans, and finally the bank sells the bad merchandise off to an unsuspecting investor...

When a company is not only too big to fail, but too big to prosecute, it’s too big to exist.

So who’s right here? Well, they both are.

Why are big banks bad? One reason is political influence -- a few large companies might be able to coordinate their lobbying efforts more effectively than a bunch of small ones, or might have monopoly profits that give them more to spend on lobbying. Outsized influence could allow banks to capture regulators and rewrite the laws of the land in their favor, as many accuse the big banks of doing. Krugman himself suggested this back in 2010. Since Sanders is very concerned with the political clout of large corporations, it makes sense for him to want to break up big banks for this reason alone.

A second reason is the so-called too-big-to-jail problem, which Taibbi talks about. Big, systemically important banks are probably better at evading prosecution for criminal activities, since the government will naturally be afraid that serving justice to large financial institutions would hurt them and potentially damage the economy. This is another good reason to break up banks.

Too Big to Fail

A third reason, which Taibbi indirectly references, is that big banks may be better at extracting rents from the economy than are small banks. Large, famous financial institutions have brand names that generate trust. That trust can serve as a cover for bad behavior, such as the brokering of assets that the seller knows are a bad deal for the customer. Reputation is one of the key mechanisms that overcomes asymmetric information in markets -- if big banks are more easily able to abuse their reputation to rip off clients, then that’s more evidence they should be broken up.

So Taibbi is right -- Sanders isn’t crazy to want to break up the banks. But Krugman also is right, when he says that Barack Obama’s financial reforms have already addressed much of the problem.

The Dodd-Frank Act of 2010 imposed extra regulation of systemically important financial institutions (i.e. big banks), requiring them to create so-called living wills that make it easier to put them in bankruptcy instead of bailing them out, should another crisis occur. That removes some of the moral hazard that let bankers take excessive risks knowing they won’t be punished. Under another recent reform, these banks are not allowed to use as much leverage, or borrowing, as smaller competitors.

It’s that latter rule that may end up solving the big bank problem even without Sanders-style reforms. Leverage is what turbocharges profits in the finance industry and restricting its use may well force big banks to get small. So the days of the megabanks may already be numbered.

Krugman is also right that breaking up banks, whether it’s good or not, isn’t enough to fix our financial system. We have a lot bigger problems than size alone. Excessive leverage is the big danger to the stability of the economy no matter the size of the banks. And the financial system is also probably extracting rents (unearned profits) from the economy in a variety of ways, such as when dishonest financial advisers get away with knowingly selling bad products to unsuspecting customers.

As Vox’s Matt Yglesias notes, the Obama administration is quietly addressing a number of these issues. Smart regulators are squeezing one source of financial profits after another, implementing a rule that makes the interests of retirement savers paramount, cracking down on certain kinds of tax avoidance and beefing up bank capital requirements that limit leverage.

It would be nice if a Sanders administration -- or a Hillary Clinton administration -- were to continue smart, targeted efforts like these (and it would be even nicer if Republicans weren’t set on rolling back recent reforms). But if Sanders focuses only on the problem of large banks, he might ignore many of the other tasks of financial reform. Krugman is right that a monomaniacal focus on punishing big banks would detract from the broader need to overhaul finance.

This column does not necessarily reflect the opinion of the editorial board or Bloomberg LP and its owners.

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