The Catch-22 of banking reform: We need big banks

We need big banks to bail out little banks, should they get into trouble.

By , Guest blogger

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    A small businessman isn't tall enough to reach the line qualifying him as "too big to fail."
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Krugman's piece today on banking reform offers several interesting ideas. I want to talk about this quote; "Here’s how I see it. Breaking up big banks wouldn’t really solve our problems, because it’s perfectly possible to have a financial crisis that mainly takes the form of a run on smaller institutions. In fact, that’s precisely what happened in the 1930s, when most of the banks that collapsed were relatively small — small enough that the Federal Reserve believed that it was O.K. to let them fail. As it turned out, the Fed was dead wrong: the wave of small-bank failures was a catastrophe for the wider economy."

Here is the irony. We know that banks would make "better" decisions if they knew that the government would not bail then out when things go bad. But, the 2008 precedent, their lobbying and ongoing research in macro economics (that argues that the financial sector influences the macro economy) all suggests that government is not willing to sit on its hands during a crisis.

In a strategic game between a bank and a government, if the government promises that there will be no bailout, then the bank will do a better job researching real risk exposure and will hedge risk through futures markets and will demand a big risk premium (a price discount) for taking on risk.

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Now suppose that Paul Volcker gets his wish and the big banks are broken up; here is the funny party. In the future when small banks experience a bank run (for whatever reason), this creates an arbitrage opportunity for a big bank to buy it and restore "confidence". Note that NO TAXPAYER $ is used here. The big bank steps in and like a sheriff in a Western restores order. The problem is that in this case we need "big banks" or there will be "big banks" as medium sized banks buy distressed banks and get bigger and eventually they will cross the Volcker line. So, the irony here is that competition and big fish buying up distressed small banks offers a way to minimize taxpayer involvement with this strange sector but if the government has a rule on bank size then this free market adjustment mechanism may vanish.

Now, I disagree with the relevance of Krugman's history lesson from 1930 for today. If a small bank in Los Angeles goes bust today, this doesn't mean depression for my home town. We now have a globalized capital market and low prices means there is an opportunity for a buyer (vulture?). Now, to avoid adverse selection problems (the bank is a lemon), we need regulatory laws so that banks must disclose their full balance sheet of assets so that potential buyers can value the risk and calculate how their correlation structure of assets will be affected by buying the distressed bank. In this age of strong computers, banks should hold more detailed information on the income and job categories of their borrowers so they can assess in real time how much risk their portfolio of loans really reflects. Banks should hire a few more applied microeconometricians and we could crunch the data in a few days to figure this out.

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