Making Banks Small Enough And Simple Enough To Fail

By Simon Johnson

Almost exactly two years ago, at the height of the Senate debate on financial reform, a serious attempt was made to impose a binding size constraint on our largest banks. That effort – sometimes referred to as the Brown-Kaufman amendment – received the support of 33 senators and failed on the floor of the Senate. (Here is some of my Economix coverage from the time.)

On Wednesday, Senator Sherrod Brown, Democrat of Ohio, introduced the Safe, Accountable, Fair and Efficient Banking Act, or SAFE, which would force the largest four banks in the country to shrink. (Details of this proposal, similar in name to the original Brown-Kaufman plan, are in this briefing memo for a Senate banking subcommittee hearing on Wednesday, available through Politico; see also these press release materials).

His proposal, while not likely to immediately become law, is garnering support from across the political spectrum – and more support than essentially the same ideas received two years ago.  This week’s debacle at JP Morgan only strengthens the case for this kind of legislative action in the near future.

The proposition is simple: Too-big-to-fail banks should be made smaller, and preferably small enough to fail without causing global panic. This idea had been gathering momentum since the fall of 2008 and, while the Brown-Kaufman amendment originated on the Democratic side, support was beginning to appear across the aisle. But big banks and the Treasury Department both opposed it, parliamentary maneuvers ensured there was little real debate. (For a compelling account of how the financial lobby works, both in general and in this instance, look for an upcoming book by Jeff Connaughton, former chief of staff to former Senator Ted Kaufman of Delaware.)

The issue has not gone away. And while the financial sector has pushed back with some success against various components of the Dodd-Frank reform legislation, the idea of breaking up very large banks has gained momentum.

In particular, informed sentiment has shifted against continuing to allow very large banks to operate in their current highly leveraged form, with a great deal of debt and very little equity.  There is increasing recognition of the massive and unfair costs that these structures impose on the rest of the economy.  The implicit subsidies provided to “too big to fail” companies allow them to boost compensation over the cycle by hundreds of millions of dollars.  But the costs imposed on the rest of us are in the trillions of dollars.  This is a monstrously unfair and inefficient system – and sensible public figures are increasingly pointing this out (including Jamie Dimon, however inadvertently).

American Banker, a leading trade publication, recently posted a slide show, “Who Wants to Break Up the Big Banks?” Its gallery included people from across the political spectrum, with a great deal of financial sector and public policy experience, along with quotations that appear to support either Senator Brown’s approach or a similar shift in philosophy with regard to big banks in the United States. (The slide show is available only to subscribers.)

According to American Banker, we now have in the “break up the banks” corner (in order of appearance in that feature): Richard Fisher, president of the Federal Reserve Bank of Dallas; Sheila Bair, former chairman of the Federal Deposit Insurance Corporation; Tom Hoenig, a board member of the Federal Deposit Insurance Corporation and former president of the Federal Reserve Bank of Kansas City; Jon Huntsman, former Republican presidential candidate and former governor of Utah; Senator Brown; Mervyn King, governor of the Bank of England; Senator Bernie Sanders of Vermont; and Camden Fine, president of the Independent Community Bankers of America. (I am also on the American Banker list).

Anat Admati of Stanford and her colleagues have led the push for much higher capital requirements – emphasizing the particular dangers around allowing our largest banks to operate in their current highly leveraged fashion. This position has also been gaining support in the policy and media mainstream, most recently in the form of a powerful Bloomberg View editorial.

(You can follow her work and related discussion on this Web site; on twitter she is @anatadmati.)

Senator Brown’s legislation reflects also the idea that banks should fund themselves more with equity and less with debt. Professor Admati and I submitted a letter of support, together with 11 colleagues whose expertise spans almost all dimensions of how the financial sector really operates.

We particularly stress the appeal of having a binding “leverage ratio” for the largest banks. This would require them to have at least 10 percent equity relative to their total assets, using a simple measure of assets not adjusted for any of the complicated “risk weights” that banks can game.

We also agree with the SAFE Banking Act that to limit the risk and potential cost to taxpayers, caps on the size of an individual bank’s liabilities relative to the economy can also serve a useful role (and the same kind of rule should apply to non-bank financial institutions).

Under the proposed law, no bank-holding company could have more than $1.3 trillion in total liabilities (i.e., that would be the maximum size). This would affect our largest banks, which are $2 trillion or more in total size, but in no way undermine their global competitiveness. This is a moderate and entirely reasonable proposal.

No one is suggesting that making JPMorgan Chase, Bank of America, Citigroup and Wells Fargo smaller would be sufficient to ensure financial stability.

But this idea continues to gain traction, as a measure complementary to further strengthening and simplifying capital requirements and generally in support of other efforts to make it easier to handle the failure of financial institutions.

Watch for the SAFE Banking Act to gain further support over time.

This is an updated version of a post that appeared in the’s Economix blog on Thursday morning.  If you would like to reproduce the entire post, please contact the New York Times.


30 thoughts on “Making Banks Small Enough And Simple Enough To Fail

  1. I applaud this, but I can’t help thinking that a tax on size, rather than an outright ban, would be a better approach – it would have softer edges, and an obvious justification as an insurance policy against systemic collapse.

    It would also make sense to tax size across the whole economy, to recover negative externalities of regulatory capture, antitrust, and other undesirable behaviors of large organizations.

  2. I second the applause. Watch out for the emotionally-potent oversimplications the financial lobby will spue to the sheeple and muppets to prevent this legislation from passing, however. Simon – it would be beneficial for all if you could front-run some of the arguments they will be making against passing this legislation.

  3. Glass-Steagall Act of 1933 — “An Act to provide for the safer and more effective use of the assets of banks, to regulate interbank control, to prevent the undue diversion of funds into speculative operations, and for other purposes.” What a novel idea to separate commercial and investment banking! In 1933! Wonder what Simon thinks about re-enacting this?

  4. Considering after the death fo the Keynesian wage-inflation price model died in 1975, the fire sector has been the key road to growth in the neo-liberal era. With decreasing laws and concentration. More importantly, declining innovation, which is the key for capitalism.

    If the system collapses, so might America into a dictatorship. Innovation has slowed way down, so far down the availability of new capital is not there at the level to finance new capital projects. It is a nice explanation why banks became enamoured with the mortgage market after the computer revolution’s capital dried up. Considering they are in the act of making money, money making is what they did and still try to do.

    Unlike what Ron Paul thinks, you can’t just force every laborer to lose their wealth and that “crisis” is going to spur innovation as desperation overcomes capital. It is like Paul banging a capitalist’s head against a rock and screaming damn you ‘innovate’ damn you to hell, please innovate. Alot of the innovation was publicly financed Ron. You live so far into your intellectual world you don’t even understand American history, you intellectualize it. Even Calvin Coolige saw it.

    The replacement of fire as the main economic requires major public reinvestment and that is something every economic school should accept. If they don’t, they will lead the country into dictatorship as people would find something to survive. Replacement of the JPM’s of the world as major capital allocating bodies is quite easy and historically done time after time. A reset indeed.

  5. Forcing the banks to downsize should have been the FIRST move during the crisis. Common sense tells you that to protect the citizens and the banking system itself, there should be no such thing as TBTF. TBTF is EVIL, TBTF is institutionalized moral hazard.

  6. What you suggest – slamming down the lid of the bottomless public cash box on the fingers of the global elites who benefit from the status quo – makes perfect sense.

    I hope that it happens, but will be amazed if it does.

    These “American” banks, are multi-national corporations with global controlling interests. The psychopaths who instruct them have nearly limitless resources available to crush all those who threaten the system. They are thisclose to getting everything they’ve set out to accomplish, and a lot what they can do to suppress dissent is now actually legal, at least in the U.S.

    I think most people who seek change don’t understand the raw power of what they are facing. It’s ALEC on steroids. There has simply never been anything like this before in recorded history.

    Four years after the crash – and nearly four years after the election of the person we thought was on Main Street’s side – and what has changed in any meaningful way? The debate today centers on the merits of austerity, not the reasonable lengths of prison sentences for the principals behind the criminal enterprises that created and continue to perpetuate this disaster upon mankind.

    That is the power of what we are facing here.

  7. Wouldn’t be wise to define our medium of exchange that the making of smaller banks hopes to protect? Money has, for 10,000 years, been represented by a physical medium of one sort or another. Software today is money coded to zip around the planet at light-speed. This is a new game. For the past thirty years, software-driven money has been the counterfeiter’s dream. To define money today, we must define the computer. Using the money-excuse to define the computer would usher in a common-sense beginning to safer banking, via making the counterfeiting of money a little more difficult than it is right now.

    Keep in mind, relative to the state of counterfeiting money, that the two billion dollars that JP-Morgan just lost, was taken home by others who did not add an ounce of value to Our Nation’s economic best interest.

  8. They did not add value by taking the money, but if that money eventually is spent in that nation, it will have been part of the 70% economic spending consumer that makes up the economy. How they were able to de-swipe the money does not add to our best interests though. But just the same as congressmen making laws to make it easier for the rich to become richer at the hands of the middle class is not in the middle classes economic interests, for me, it is a toss up as to which is a worse situation.

  9. And how could I not agree with “capital requirements… that do not depend on the problematic risk-weights used in Basel II”? I have been saying so since before Basel II was approved… and in Baseline since its first day.

    But now again my concern is that this statement proves that these “experts” have not yet fully understood what has happened, as a result of the additional layer of risk discrimination that was put on top of the anti-risk-bias that already existed in the market…and that according to Mark Twain make bankers lend you the umbrella while the sun shines and want to have it back when it seems it could rain.

    We do not need higher basic capital requirements for what is perceived as risky, like lending to small businesses and entrepreneurs, the current Basel II’s 8 percent will do. What we do need is to eliminate all those lower than basic capital requirements which apply to all what is officially perceived as absolutely not risky.

    And that requires increasing dramatically the capital requirements for banks when lending to the infallible sovereigns, and who are in fact the number one cause the banks have insufficient capital… and this requires a very long and careful transition period… unless you want to stop the economy completely.

  10. @Per – I think it is safe to say that Basel is delighted with the *unintended consequences* of Basel I, hence II and III. They’re not suffering, are they? They always had the vaccine against the virus…

    For anyone dreaming about USA becoming a dictatorship – you don’t get out much, do you?

    I would, however, send out a memo to can the talking point that without the investments of Wall Street, we’d all be still sitting in a cave. However, you know where they’ll be hiding soon…

  11. @Annie. No way! Having been on this since 1997, like few, or any, I am absolutely sure that Basel is not “delighted with the *unintended consequences* of Basel I, hence II and III”.

    They are just caught in their own mental spider-web, desperately unable to get out, since that requires them to internalize how guilty they really are for what has happened… something which really is not easy for anyone… I almost pity them.

    But, history will catch them… hopefully sooner than later, and so that we can get an end to this crazy regulatory discrimination against what is perceived as “risky”

  12. The simplest thing would have been when the banks failed and were “bought” by the US government, would have been to fire the people who ran the banks and unequivocally proven that they did not understand banking, risk, truth, or honesty.
    Oh, and that thing called profit and LOSS could have been allowed – where stupid or unattentive investors LOSE money for having imprudent CEO’s run the banks.

  13. And to fire bank regulators who proved conclusively they did not know what bank regulation was all about… and still do not know.

  14. Then of course we could turn them all in to weather forcasters for a day, with their numbers they can stretch it out till the end of time, which by the way, is not to far away.

  15. I exist because numerology is the great equalizer of evil, you exist to trap others in their conspiracy so they can be judged as to weather they are fit enough to even live. No joke, instead of just say no to drugs, it will be just say no to suzy.

  16. If the government is on both sides of this issue by guaranteeing non traditional mortgages and insuring deposit liabilities, would it be simpler to get out of guaranteeing mortgages and to turn deposit insurance over to the private sector? Removing an implied government bank guarantee would force the banks to have capital of approximately 20 percent, based on 19th century history, and reduce the financial services’ lobbying strength.

  17. “would it be simpler to get out of guaranteeing mortgages and to turn deposit insurance over to the private sector”

    Then you’d be putting yourself in the position for another AIG where AIG essentially “insured” too many CDSs. It would also create another private sector entity to do lobbying and undoubtedly become an integrated service of the same banks it would be insuring. A for profit entity would also have a vested interest in doing “extend and pretend” on banks to avoid having to make payouts.

  18. I did a simple calculation of a bank’s total debt to its market cap to see how “indebted” various banks were. Most big US banks had debt 6-8 times market cap, except for Wells Fargo where the debt was only slightly more than the market cap. Certain banks, such as US Bank, and Bank of Oklahoma, Northern Trust and Bank of the Ozarks, especially, had debt lower than market cap. It is a rough but quick test of how leveraged a bank is.

  19. Yes Chris… it is a much better indicator than that crazy risk-weighted assets to capital where no one has any idea on the validity of the risk-weights.

  20. The liberal Sen. Brown – both of them, actually – are imbeciles, and this is a malicious, garbage piece of legislation. You people have no understanding of banking, yet you constantly spew bile against the banks and insist that you have a right to strangle them. If you don’t like being on the hook for banks, you need to advocate the separation of government and banking instead of whining like little crybabies about the “big” banks you obviously envy – and it is obvious. It really is unbecoming for supposed grown-ups to throw an envious hissy fit over a large American business.

  21. @WM: “you need to advocate the separation of government and banking instead of whining…”

    The issue of regulatory capture is only an obstacle to solving the actual issue – a sufficiently large bank cannot be allowed to fail, lest it bring down most of the economy with it and cause untold pain and suffering. Regulations can either 1. Attempt to reduce the risk of a bank failure or 2. Reduce the effect a failure has on the economy. Of the two, #2 is much more easily accomplished.

  22. Reducing size is extremely helpful for reducing regulatory capture as well. A huge bank can recoup considerable remuneration from their individual lobbying efforts. Small banks face a commons problem – they have to organize before they can engage in large-scale lobbying, so the incentive to free ride naturally limits their activity.

  23. @Bolt – why do you believe this? It makes no sense – LOOK at the damage saving them caused. An argument can be made for LESS suffering for MORE people if it had come down all at once.

    you said, “The issue of regulatory capture is only an obstacle to solving the actual issue – a sufficiently large bank cannot be allowed to fail, lest it bring down most of the economy with it and cause untold pain and suffering. Regulations can either 1. Attempt to reduce the risk of a bank failure or 2. Reduce the effect a failure has on the economy. Of the two, #2 is much more easily accomplished.”

    Sorry, you just don’t have any $$$$ left for perpetual war making without declaring war on the entire planet using BANKING as the threat.

  24. Dear WM…
    I’ve got horrible news for you. No one in the banking industry … wait a second, you’re not part of that group are you? … or in regulation has any understanding of the sort of “banking” they’ve been doing. That’s because the gambling hall where the proprietary stuff has been taking place is filled with trap doors. It’s a fools’ game and you’re the fool, at least until you get your minions in Congress to bail your a$$ out.

    I take it you’ve not been in on conversation so why don’t you try this on for size:

    As for Sherrod Brown, he has a better handle on this than you or any of your deluded cronies. You don’t have a clue what you’re doing, and I’d be glad to stand up at any public meeting and challenge you on it.

  25. …WM
    As a follow up to my previous comment, please chew on this quote from the above linked paper:

    ‘…A(rbitrage) P(ricing) T(heory) makes several conventional assumptions upon which everything else depends: ‘‘perfect competition, market liquidity, no-arbitrage and market completeness’’. Crucially, this adds up to the implicit assumption that trading activity has no feedback on the dynamical behaviour of markets. And indeed, in the APT-fuelled boom time that preceded the bust, APT seemed to be very successful. In its imaginary world, market failures are caused by regulatory carelessness, resulting in a focus on creating institutional arrangements that seek to guarantee the premises upon which APT is based. To the contrary, Caccioli and colleagues argued that APT is not a “theory” in the sense habitually used in the sciences, but rather a set of idealized assumptions on which financial engineering is based; that is, APT is part of the problem itself.’

    Haldane and May go on to detail the existence of singularities – state transitions – that can bring the house of cards down on itself. In the limited world of statistical modelling, none of that happens, because you’re dealing with the microscopic parts of the process, not the macroscopic dynamics of the overall marketplace. That’s a serious, serious misunderstanding of the field your playing on.

    I repeat, neither you nor any of your buddies on the trading board have any idea what you’re doing. The quants should have broadened their resumes with some dynamical systems theory. And you can tell them that for me.

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