A free-market case for ending Too Big to Fail

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In the first debate between President Barack Obama and Governor Mitt Romney, the former Massachusetts governor asserted that regulations are necessary for a free market to function: “You can’t have a free market work if you don’t have regulation. As a business person, I had to have — I needed to know the regulations. I needed them there … you have to have regulations so that you can have an economy work.”

Implicit in Governor Romney’s remark is the sense that regulations provide a level legal playing field for businesses; regulations make clear what the rules of the game are, and businesses are able to adapt their strategies in response to these rules. When they are clearly developed, regulations provide a kind of stability to the market. This stabilizing tendency is perhaps one of the strongest reasons why even the most ardent free-market capitalists might defend the existence of some kind of government regulation. A market dominated by fraud and a sense of radical uncertainty will be one that minimizes innovation, distorts capital flows, and undermines the basic trust necessary for a marketplace.

The large financial institutions christened “Too Big to Fail” (TBTF) threaten this sense of stability. According to the Federal Reserve Bank of Dallas, the top five banks held 17% of total industry assets in 1970; by 2010, the top five held 52% of industry assets. The 100 biggest banks in 1970 held 54% of industry assets, but in 2010 they held 84% of industry assets. The proportion of capital held by about 12,500 small banks in 1970 is exceeded by the proportional holdings of the five biggest banks in 2010. This is a massive change in the concentration of capital. The odds of 12,500 banks failing at the same time are pretty small. The odds of five banks failing at the same time are much greater. Indeed, the failure of a single one of the largest banks in the USA now would be equivalent to the failure of thousands of banks in 1970.

This new concentration of capital and the leveraging of this capital by these banks lead to new risks for the economy. The bank bailouts of 2008 were premised on the idea that certain financial institutions really were too big to fail, so these institutions (often headed by individuals with close connections to the federal government) were rescued. Some of the big players were saved, while others were left to go bankrupt and twist in the wind. The president’s signature financial reform legislation, Dodd-Frank, officially swears off TBTF, but it has not yet proven to be able to end TBTF: big banks continue to grow and take on more risk, even as Washington creates more and more regulations under the auspices of Dodd-Frank. Thus, it appears the financial system remains exposed to the systemic risks posed by TBTF, and another panic could easily ignite another round of bailouts for the politically connected.

Some on the right have suggested that the appropriate antidote to TBTF is not to break up the large banks but instead to allow them to grow bigger and bigger and, if they collapse, let them fall. This approach is understandable, and at least it would avoid the moral hazard of our current regulatory regime. However, I fear this approach does not take fully into account the psychology of politicians. Most politicians are not rigid ideologues — and that is not entirely a bad thing — but instead are immediate pragmatists, focused on the short-term, real-world consequences of an action.

There was at least a small chance that not bailing out the big banks in 2008 could have led to a broader systemic collapse, so Washington immediately acted to prevent this crash. No congressman, senator, or president wants to be facing voters who believe he or she could have prevented a crash but didn’t. If future panics happen (and history suggests that they will), there will still be at least a small chance that a TBTF fall could cause a broader financial Armageddon, so Washington will be very likely to intervene. Due to the imperatives of democratic governance, the continued existence of TBTF makes it far more likely that government will continue to bail out certain vested financial interests. Ideology may suggest that a TBTF bank should in fact be allowed to fail, but ideology only has so much force in the face of the ballot box.

So if conservatives are interested in preventing further bailouts not just as a matter of rhetoric but also as a matter of policy, making sure that banks are small enough that they can fail without raising concerns about a systemic collapse could be an important step. Precisely what steps should be taken to make banks small enough to fail is up for debate. Revising capital requirements/leverage limits, splitting up bank activities (for example, restoring certain aspects of Glass-Steagall), or more aggressively cutting down the size of various banks remain possible solutions.

The impetus for ending TBTF would not be to punish Wall Street but to restore it. In the current situation of opaque and indefinite government support, no one knows who’s going to be the next Lehman Brothers (a big bank that was allowed to fail). Some well-connected players may feel free to gamble under the belief that Washington will back them if those bets go bad, but one or more might be wrong in that assumption: their lucky firm could be the one Washington decides is to be the sacrificial lamb before bailing out other big banks. The liquidation of that firm could wipe out the wealth of its shareholders and also cause many traders to lose their jobs. If this bank had not assumed that it would have government protections, however, it might have acted more prudently. Fear of failure is one of the greatest sharpeners of prudence in a capitalist marketplace; by putting the safety net of government bailouts under certain banks, we at once encourage them to be more reckless and to make less sound investments. This is a bad outcome from both a civic and an economic perspective.

Republicans would benefit politically from ending TBTF. Such an enterprise would appeal to popular dissatisfaction with the banking system. But there is an even more pressing reason for trying to achieve this aim: ending Too Big to Fail would be a defense of the free market. In 2008/2009, the banking system came closer to being socialized than at any time since the Great Depression. If we are interested in ensuring a market-oriented banking system, we must apply the principles of the market to the banking system. As Harvey Rosenblum noted in the 2011 Dallas Fed annual report, “freedom to succeed and freedom to fail” provide a foundation for capitalism. In a functioning market, risk is diversified among a number of economic actors, ensuring that the failure of one firm does not pose a danger to the market as a whole. Regulations clarify capital flows and business structures so that all operate on a level playing field. Too Big to Fail combines the uncertainty of the Wild West with the moral hazard of corporate welfare — the inverse of what a functioning free market should be.

Fred Bauer is a writer from New England. He blogs at A Certain Enthusiasm, and his work has been featured in numerous publications.