The Dodd-Frank Act, passed in 2010 in response to the financial crisis, was touted as ending the policy of “Too Big To Fail.” The law’s proponents claimed that it curtailed the Federal Reserve’s emergency lending powers and ensured that banks could not get big enough to pose a risk of taking down the economy. Six years after the law’s passage, the big banks are as big as ever and the banking industry continues to consolidate as more and more small banks go out of business. So if Dodd-Frank failed to break up the big banks, why not go in with some new law and break up the big banks?
It all boils down to one thing: the reason the big banks have gotten so large is because the banking industry in the United States was purposely designed to be a highly concentrated oligopoly. High barriers to entry and burdensome regulations mean that not everyone who wants to can enter the banking industry. Banks got protection from competition from the government in exchange for agreeing to purchase government debt. It’s a quid pro quo that’s been going on for centuries.
Then there’s the Federal Reserve System, created to cement the dominance of Wall Street over the rest of the country’s banks, which is why the President of the New York Fed maintains a permanent seat on the Federal Open Market Committee. Existing banks get both implicit and explicit subsidies from the government, ranging from federal deposit insurance backstopped by the US Treasury, discount window and emergency lending from the Federal Reserve, and sometime just banking regulators looking the other way as banks do things they’re not supposed to do. Breaking up the banking industry requires not more regulation, but deregulation.
Deregulation means actual deregulation, removing existing regulations, not passing new legislation to counteract existing regulations or the negative effects of existing regulations. That means that both the barriers to entry that keep new entrants out and the subsidies that support existing banks need to be done away with. Think of the banking sector as a table supported by two very high legs. You want to reduce the height of the table, which is where the big banks are. The barriers to entry are one leg of the table, the government subsidies are the other. If you knock out one leg, you leave the table unstable and it can come crashing down. Both legs need to be removed simultaneously.
As an example of what not to do, take the Gramm-Leach-Bliley Act, touted by both proponents and opponents as an example of banking deregulation. That act eliminated the separation between commercial banking and investment banking. But because banks’ commercial activities were still subsidized by federal deposit insurance and access to the discount window, free capital from the commercial side could be used to trade on the investment banking side. It was hoped that risk could therefore be shifted onto the government. Access to additional capital could be gained through mergers with other banks to enlarge the deposit base. That’s why the banking system has seen so many mega-mergers and why these huge banks were so overexposed to risky loans during the financial crisis. One leg of the table (the separation between commercial and investment banking) was shortened but the other was left in place.
Breaking up the big banks through some sort of new legislation or regulatory action would only result in a temporary decrease in the size of banks. What would inevitably result is a raft of mergers as the “Baby Big Banks” begin to merge with each other or take each other over. It happened with Standard Oil, it happened with the Bell System, and it will happen with the banks. The baby banks would either merge amongst themselves, or merge with regional banks, or see themselves taken over by foreign banks. Well, put a cap on mergers, you might say. That already exists, the cap is set at 10% of nationwide deposits.
In order to reduce the size and influence of the big banks, it is absolutely necessary to reduce the barriers to entry that keep new and smaller entrants from being able to compete against the big banks. Subsidies need to be removed, such as federal deposit insurance with its US Treasury backstop. The Federal Reserve cannot retain any discount window or lender of last resort powers, banks must be totally responsible for their own operations through membership in privately-organized and -operated clearinghouses. Banking is like any other industry in that attempts at command and control by the government will be ineffective at best, but more likely harmful. Any solutions to fixing the banking system that fail to acknowledge and address the existing structural problems that have led to the development of megabanks will inevitably fail.
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