Should “Too Big To Fail” Banks be Broken to Pieces ?

Neel Kashkari was an important member of the team that finalized the details of the Troubled Assets Relief Program (TARP). This program has been more commonly referred to as the bailout package following the subprime mortgage debacle that plunged the entire financial world into a crisis. He was instrumental in ensuring that the financial system of the United States stays afloat post the Lehman debacle.

He recently shocked the financial world by saying that he is of the opinion that it is dangerous for an economy to have banks that are too big to fail. These banks should therefore be made less connected, less important and smaller in size. Kashkari has supposedly ordered his best researchers to create a proposal for breaking the banks and may supposedly present it to higher authorities after carefully evaluating it himself.

The average person feels it is ironical that Kashkari who oversaw the big banks getting even bigger on his watch has now made a complete “U-turn” on the issue. It is even more ironical given the fact that his stellar performance during the TARP was what has seemingly propelled him to be the chairman of one of the regional Feds.

In this article we will have a closer look at Kashkari’s analysis of the too big to fail banks.

The Moral Hazard Issues

Kashkari stated that he was sad that he helped in bailing out the banks. This is because the executives at these banks have no real reason to be afraid. They usually take excessive risks. If the payoffs turn out to be in their favor, they take home handsome bonuses. However, if their bets go south, the government picks up the bill. Since they never really suffer the consequences of their actions, executives have no reason to be careful creating what is commonly referred to as “moral hazard”

Kashkari says that he has seen several executives who took high risks survive and even thrive in the years following the subprime mortgage crisis. This is in stark contrast with the average person who suffered losses and faced economic hardships thanks to the actions of these executives!

Solution – Breaking Up the Banks

Kashkari believes that the government is forced to bailout the banks because they are too big to fail. Not bailing them out could cause the economy to plunge. Therefore he believes that the government does not make a conscious choice to help Wall Street but instead is held ransom by it.

Hence being too big to fail is the root cause of reckless decision making in these banks. Kashkari believes that if banks were right sized to such a size that they would have to face the good and bad consequences of their decisions on their own without causing a systemic crisis, the system would become far more sustainable and periodically recurring crises would stop.

Fact: The Biggest Banks Did Not Cause the Crisis

However, if we analyze Mr. Kashkari’s decisions, he does not seem to be aware of the facts of the very bailouts that he helped finance. Firstly, the 2008 crisis was not caused by too big to fail banks. Lehman Brothers did not even feature on the top 10 list when it caused the crisis!

True, that it was a big bank with interests across the nation and across the world. Yet it would still be inaccurate to say that the bank was too big to fail. Similarly Bear Sterns, Wachovia or Washington Mutual did not feature on the list of United States banking behemoths. Instead the big guys were the ones that saved the day. Had it not been for JP Morgan Chase, Bank of America and Citibank, the global crisis could not have been averted that easily.

Fact: Small Banks Caused the Great Depression

Mr Kashkari is making an underlying assumption when he calls out to break the banks. He believes that smaller banks mean a more stable system. However, history would beg to differ with his analysis. The Great Depression i.e. the worst economic situation ever known to man was started from the collapse of a large number of very small banks and financial institutions. Back then there were no behemoths at all! However, smaller banks going down one after the other created a catastrophe, the likes of which has not been seen by the world till today.

Where to Stop?

Another big issue with Neel Kashkari’s plan is that there is ambiguity as to where the government should stop breaking these banks. Banks like JP Morgan Chase and Bank of America are so huge that even if they are broken into several pieces, each of these banks are still going to be so huge that they will pose systemic risks. The important question therefore is not whether to begin the process of breaking up the banks but instead at what point should the process be stopped?

Who Will Finance the Megaprojects ?

Mr. Kashkari also seems to have forgotten that it is these big banks who have the wherewithal to finance megaprojects that have become American landmarks. If the system was made up of only small banks, they would not be able to take huge risks themselves. Big projects will therefore only be financed by a consortium of banks and it will become very difficult to mobilize funds quickly and without too much bureaucracy.

Mr. Kashkari’s analysis therefore seems to be lopsided. Time and again analysis has proven that breaking the big banks will not change much about the system. However, the idea of breaking the banks keeps raising its head over and over again.