Wednesday, December 2, 2009

How to keep banks small

Mark Thoma has consistently advocated that banks be broken up so that they are not too big or interconnected to fail. See, for instance, his cross-post on Moneywatch - How to Prevent the Next Financial Crisis:

We also need to make sure that financial firms are not too big or too interconnected to fail. And if it turns out that somehow a troubled financial institution is more interconnected than we thought and hence systemically dangerous, despite our efforts to make sure that doesn’t happen, we need to have the plans and the legal authority in place to deal with insolvent financial institutions, something that was very much needed but missing in the present crisis.

The fact that banks became big could have been a result of the evolution of firms as they adopted technology (e.g. ATMs, databases, etc.) that exploited economies of scale. This desire to expand so as to adopt new technologies resulted in the need to merge with other banks or to access public capital via equity offerings. Another reason that banks became big was so that they could be large enough to finance or back their own trading operations or mergers and acquisitions for their own profits. As they became bigger and fewer the more interconnected they became. (This is all conjecture.)

One way to keep banks small may be to deny them access to equity markets or keep them as partnerships. In addition, they would also be regulated in the activities that they could participate in e.g. branch banking with loans less than $100,000 or only M&A with no bond trading, etc. In a special report on the future of finance by the Economist magazine on January 24, 2009, the article "Playing financial chicken" states:

Firms also built up their capacity to trade in the secondary market, at first so they could make markets and later to earn profits on their own account. As the demand for capital grew, the partnerships were tempted to list their shares. ... partnerships really were easier to run, because the firms were small and their business was straightforward.


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