Don't Fetishize Small Banks

A friend and source in the finance industry in New York has repeatedly made the argument to me that regulators focusing on the size of banks are missing the point.

"Small banks did the worst in this crisis," he once wrote to me. "Making banks smaller would not have changed a thing. If you have 100 little banks with the same portfolio as one giant bank, how are those little banks any more acceptable as failures? If they all go, we're in the same position. In fact it's worse, because it's disorganized and disaggregated."
I've been torn on this question. On the one hand, if largeness confers implicit and distorting powers to banks (this is the worry behind Too Big to Fail), then by allowing banks to grow without bound, we encourage them to take on cheaper risk. On the other hand, we've had small bank calamities before (the Savings and Loan crisis, for example). Lehman Brothers was not a huge bank and its collapse triggered a worldwide financial catastrophe.

My NY friend will be gratified to see this piece from Vox that warns: "A world with only small and domestic banks is no safer. The key benefit of multinational banks - being able to mobilise funds across countries - could still be extremely useful for maintaining stability in times of distress."

A view shared by many has gradually emerged during the crisis, that a world with relatively small domestic banks is safer than one where large global institutions are also important players. This is understandable, given that many of the financial firms that had to be bailed out or supported with public funds in 2008 and 2009 in Europe and in the US were multinational banks and that the size and the scope of the activities of these banks have partly been at the root of the systemic nature of the financial turmoil (see for example Gros and Micossi 2008).

But this would be a superficial view of the current events. Institutions with regional or national frameworks of action also had to be supported because of bad investment policies. Examples include Nothern Rock in Britain and WestLB in Germany. Moreover, the key "raison d'être" of multinational banks - i.e. being able to mobilise funds across countries - could in principle be extremely useful to support global operations in times of distress and not necessarily be a cause of instability.

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Derek Thompson is a senior editor at The Atlantic, where he writes about economics, labor markets, and the entertainment business.

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