The Answer Is Not Breaking Up the Banks

Pretty much everyone (that is sane or not rent seeking) believes that too big to fail is a bad thing. Some will argue that we could have worse problems and that it would be better to prevent systemic failure by protecting TBTF banks even if that means them getting a competitive advantage because of the distinction. But even there, those are arguing from a position of necessary evil. By and large, the agreement is that banks considered too large, complex, and interconnected to the system to be allowed to fail is problematic.

One solution is to just accept TBTF and work around that. But this only perpetuates a problem. Another solution is to forcibly break them up, trust busting style. And so write Nomi Prins for The Daily Beast:

Any 5 year old who plays with Legos or blocks could address the issue of “too big to fail” with more logic than most of Washington. What do you actually do about things that are too big and could fail? Well, if you build too high a Lego tower, it has a greater chance of collapsing. So you divide the tower into smaller parts. Same blocks. Different construction. Less crash risk. Simple.

No. Not so simple. The thing is, what if you want to build a tower? Smaller parts, same blocks, different construction does not mean same end product. The value of five small towers may be lower than the value of one big tower. Any 5 year old can tell you that too. Who is to say what the child can build with his blocks. They are his Legos. The tower is his vision. It might fall. He might choose to limit his risk on his own by stopping the height of the tower, but having the babysitter come in and tell him what to build eliminates something very important: the child’s investment in his own creation.

Similarly, with Wall Street firms, if you limit the profitability of firms, you just drive people away from the business. What other industries do we have with ceilings on the limits of success? We will destroy so much value in this country by breaking up TBTF firms and limiting others from reaching that threshold.

And that is why the third solution is preferable: transfer risk. The babysitter needs to step away from the Lego tower and make it clear to the child that if the tower falls, no one will catch the pieces, no one will him him put the tower back together. The risk is on the 5 year old. And most kids can understand that logic. It changes their mindset and building plans.

When it comes to Wall Street, it is a little more complicated than the government just walking away. There is a whole host of regulatory change that must come about. There are a series of government policies that create bad incentives. And there are a lot of good ideas for regulatory reform on the table aside from systemic risk that should be looked at (overhauls to banking and insurance regulation being two of them).