Break Up the Big Banks?

71586.jpgPaul Volcker has suggested, as has Mervyn King, the Governor of the Bank of England (the U.K.'s version of the Federal Reserve), along the lines of the Public Utilities Holding Company Act or the Glass-Steagall Act, both passed in the 1930s and since repealed, that commercial banking (including lending by thrifts, and probably by money-market mutual funds as well) be separated from proprietary trading and other high-risk financial activities.

The reasons are several. One of course is the contagion of the kind that brought down Lehman Brothers; unless risky and safe activities are conducted in strictly separate subsidiaries--which is difficult to do without sacrificing whatever benefits flow from having both types of activity in the same enterprise--the assets involved in the safe activities will be available to the creditors of the risky activities. Not that banking can ever be completely safe, given that its essence is borrowing short and lending long, but it can be made much safer than it is.

Another reason for separating out commercial banking besides the contagion effect is the awkwardness of trying to merge disparate business cultures in a single firm. The combination is likely to be unstable if the different cultures have different risk profiles. A safe, conservative banking operation will attract a different type of executive from a speculative trading operation. The banker will be more cautious and, because of the positive correlation between risk and return, will be differently--and less munificently--rewarded. The greater profitability and more generous remuneration of the traders will nudge the bankers (or induce top management to pressure them) to increase the profitability of their own operations, which will require their taking greater risks. Thus the separation of commercial banking from other financial activities would automatically solve the problem for which limiting the amount or structure of compensation of financial executives is proposed as the solution. A career in a "safe" bank would not draw persons with a taste for risk.

There would be additional, and even greater, benefits to making commercial banking safe by forcing banks to divest their risky, nontraditional banking activities and thus creating a dike against inundation from a collapse of other parts of the financial system. Although nowadays commercial banks supply less than a quarter of the total amount of credit in the United States, they play a unique role. They provide essential financing for small- and medium-sized businesses (what is called "external finance")--businesses too small to meet their own financing needs out of retained earnings or by issuing bonds or commercial paper, or to be attractive to a lender that does not have an established relationship with the borrower which would enable the lender to evaluate the borrower's creditworthiness. If a bank fails, though other lenders remain, borrowers from the bank may find it difficult to establish the kind of personal relationship with a new lender that would reassure the lender that the borrower was creditworthy.

Relationship banking declined during the current depression not only because of fear of default and a fall off in demand for loans, but also because the relationships that sustain relationship banking had withered in banks that had embraced the new model of originating and purchasing securitized debt. Creating securitized debt for a fee, or buying securitized debt, involves no relationship with the debtor. (This is an argument for limiting securitization by commercial banks.)

Banks also provide standby lines of credit that provide emergency funding when other sources of credit fail, as happened when the commercial-paper market froze in the wake of the collapse of Lehman Brothers and the near insolvency of other broker-dealers that had been intermediaries in that market. (Issuers of commercial paper normally have standby lines of credit from commercial banks, should the usual purchasers of their paper defect, as Lehman did.) Banks thus back up the riskier lenders.

And they are the normal conduit by which the Federal Reserve pumps cash into the financial system in order to increase the amount of lending, whether by lending money to banks directly or more commonly by buying short-term Treasury securities from them (or lending money to the banks, taking the securities as collateral, by means of repossession agreements), thus increasing their lendable cash. (Put differently, the commercial banks are the instruments by which the Fed regulates the money supply--in normal times, at any rate.) It is easier for the Fed to recapitalize a bank than to recapitalize other types of financial institution. And the Federal Deposit Insurance Corporation has authority and expertise that enables it to close a failing bank and transfer its assets to another bank with minimal disruption of its business.

Were commercial banks forbidden to affiliate with other entities, the danger of a financial crisis that would engulf the commercial banking sector would be minimized. Even when a nationwide housing bubble bursts and mortgages are a significant component of the asset portfolios of most banks, with the result that the capital of most banks is impaired, the Fed can prevent their collapse by pumping cash into them. In fact the primary victims of the banking collapse of September 2008 were not commercial banks but other financial intermediaries.

Part of the reason is federal deposit insurance, which protected most commercial banks from the runs that brought down Bear Stearns and Lehman Brothers and would have brought down Merrill Lynch, Morgan Stanley, and Goldman Sachs within days of Lehman's collapse had the government not intervened by arranging the sale of Merrill to the Bank of America and the conversion of the other two firms to bank holding companies, which placed them under the Federal Reserve's regulatory authority and thus gave them access to the "discount window"--which just means, made it easy for them to borrow money from the Fed. This option reassured investors and stopped the run that was threatening to deprive the firms of the short-term capital that they needed in order to continue in business.

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Richard A. Posner

Richard Posner is an author and federal appeals court judge. He has written more than 2500 published judicial opinions and continues to teach at the University of Chicago Law School. More

Richard A. Posner worked for several years in Washington during the Kennedy and Johnson Administrations. He worked for Justice William J. Brennan, Jr, the Solicitor General of the U.S., Thurgood Marshall, and as general counsel of President Johnson's Task Force on Communications Policy. Posner entered law teaching in 1968 at Stanford and became professor of law at the University of Chicago Law School in 1969. He was appointed Judge of the U.S. Court of Appeals for the Seventh Circuit in 1981 and served as Chief Judge from 1993 to 2000. He has written more than 2500 published judicial opinions and continues to teach at the University of Chicago Law School. His academic work has covered a broad range, with particular emphasis on the application of economics to law. His most recent books are How Judges Think (2008), Law and Literature (3d ed. 2009), A Failure of Capitalism: The Crisis of '08 and the Descent into Depression (2009). He has received the Thomas C. Schelling Award for scholarly contributions that have had an impact on public policy from the John F. Kennedy School of Government at Harvard University, and the Henry J. Friendly Medal from the American Law Institute.

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