Last week, the Federal Reserve Bank of Minneapolis President Neel Kashkari shocked the financial world when he urged regulators to consider breaking up the nations largest banks. He envisions a world where large banks are transformed into boring utilities that "virtually can't fail."
Breaking up the big banks has become an increasingly familiar refrain. Senator Bernie Sanders wants to break up the big banks and re-instate Glass-Steagall, which separates commercial from investment banking.
Breaking up big banks might make some people feel safer. Unfortunately, it would not have prevented the 2008 banking crisis. It would not have prevented the Savings and Loan crisis of the 1980s. And it won't prevent another crisis in the future that could require taxpayer money to prevent contagion.
What is Required for a Banking Crisis?
A typical banking crisis has the following four ingredients:
1. Institutions make loans, but do not have sufficient capital to absorb losses.
2. These institutions make a lot of really bad loans.
3. The really bad, long-term loans are funded with "hot" short-term money that could disappear in a crisis.
4. The failing institutions are incredibly connected to other institutions all over the world. As a result, their failure would result in a domino effect that could prove disastrous for the economy.
When Lehman failed in 2008, it met all four conditions. First, Lehman did not have anywhere near enough capital. In 2007, Lehman had a leverage ratio of 30.7. Second, the loans were horrible. Lehman had invested aggressively in sub-prime mortgages. We are all now familiar with NINJA loans: "no income, no job and no assets." Third, although Lehman invested in long-term loans (often with 30 year terms), it financed itself with short-term money. Every day, Lehman had to raise billions of dollars to finance its operations. Once people started to panic, Lehman could no longer finance its daily operations and had to file bankruptcy. Finally, Lehman was so inter-connected to the global financial system, that its collapse caused panic throughout the world.
The S&L crisis shared a lot of similarities. The S&Ls had shockingly little capital. They made horrible loans. Most of the loans were 30 year mortgages, but the mortgages were funded with short-term deposits that could easily disappear in a crisis. And a collapse of the S&Ls could infect the wider financial system and spread to Main Street.
Governments often step in to stop panics from spreading. Financial institutions are like the veins of the country's nervous system. A single blockage can have unintended consequences throughout the system, often leading to failure. It is not so much the size of the institution that matters. Instead, you have to understand how critical the individual institution is to the entire system, and how likely it is to fail.
Why Breaking Up the Banks Won't Prevent Another Crisis or Bailout
Lehman was not a mega-bank. It did not combine commercial and investment banking. Yet it brought down the global financial system. Breaking up banks and re-instating Glass Steagall will not make the system safer, and would not have prevented the 2008 Great Recession.
Instead, regulators need to focus on capital and systemic risk.
The first line of defense against a banking crisis is capital. A popular post-crisis book called "The Banker's New Clothes" argued for a lot more capital.
The more capital a bank has, the more losses it can withstand. Since the crisis, capital requirements have been increased dramatically. Some institutions have been creating stronger balance sheets more aggressively than others. But it is ultimately a fortress balance sheet that will save an institution in a time of stress.
Systemic Risk - and Shadow Banking
Rather than looking at the size of a bank, regulators need to understand the systemic importance of an institution. If it fails, will dominos fall around the world creating panic?
Again, regulatory reform after the crisis has created a special designation for systemically important financial service companies. Because too many dominoes would fall if these businesses failed, the capital requirements have been increased even further.
The higher capital requirements make a lot of sense. But, these rules can have unintended consequences. Clever individuals will find ways of creating businesses that can avoid the regulation and capital requirements. This is called the shadow banking sector, and presidential candidate Hilary Clinton is right to focus on it.
Breaking up big banks may make some people feel feel better, but it won't make us safer.