After reading about Obama’s proposals for limiting the size of banks, it has occurred to that there may be a more nuanced way to prevent banks becoming ‘too big to fail’, without having to put an explicit cap on their size or market share. Banks currently have to keep a certain percentage of their deposits in the form of safe capital (effectively cash or government bonds), and the percentage of deposits that banks are required to hold in low-risk assets like these are known as capital requirements. It’s generally accepted that higher capital requirements mean that banks are more stable, but conversely when banks have to put more of their deposits in safe capital, there’s less to fund lending elsewhere. Over the past few decades capital requirements have gradually shrunk, increasing the ability of banks to lend, but making them more susceptible to financial shocks, like the one we’ve experienced over the past couple of years. Unsurprisingly, many are now calling for capital requirements to be increased considerably, to try to prevent future crises.
Which leads me to my question for those with more knowledge of financial regulation than I do; why not make capital requirements non-linear with regard to the size of the bank? Or, in more simple terms, why not force bigger banks to keep a higher percentage of their deposits in safe assets than smaller banks do? The reasoning for this is fairly straightforward; small banks can have a relatively high failure rate without posing systemic risk to the wider financial sector, whereas the fall of a single large bank can be catastrophic for the entire economy (hence the phrase ‘too big to fail’). The structure of capital requirements could be rejigged such that small banks would have modest capital requirements, and as bank size increases, so do their capital requirements. This could be continued to the extent that once a bank became ‘too big to fail’, its capital requirements would be almost 100% (making it in effect a narrow bank), meaning it would become, in theory at least, ‘too stable to fail’.
Unlike an across-the-board increase in capital requirements, such a system of non-linear capital requirements would give smaller institutions the capacity to continue with a healthy level of lending, while still ensuring that the largest banks are sufficiently stable. Furthermore, it would have the advantage of not requiring an explicit cap on the size of banks (which in fact already exists in the US, but has been repeatedly breached over the past couple of decades). Instead, the market itself would settle the appropriate sizes for banks, balancing between the needs of stability and lending capacity.
Intersting perspective on the theme of Obama’s proposals. I would take the view that the financial meltdown of 2008 provides a great oppurtunity for policy makers worldwide to take a fresh look at the role banks occupy in an economy. Currently banks undertake a mass of services including; retail banker and lender, property and commercial underwriter, insurance and re-insurance, asset management, risk management, security services and fx liquidity. Now is the time to “down size” our banks, seprate all of these functions into smaller comapnies independant of one and other. This will reduce risk to an economy in an instance of financial shock, thereby making redundant the phrase “too big to fail”. This if implemented would take a lot of “profit” from banks and indeed an economy. This would reduce the influence of banks, at the same time however, infuriate some very powerful men.
If any policy maker has the courage or strength of character, a window exists to take a deep and penetrating look at the policy of fractional reserve banking, which gave rise to your blog in the first intance!
Capital Requirements are negatively correlated with profitability during the bulk of an economic cycle. Forcing larger banks to have a larger capital requirement puts them at a significant competitive disadvantage compared to smaller banks.
You would end up with a large population of small banks taking large correlated risks. When they collectively fail, this would cause as much disruption to the financial system as a few large failures.
Large banks already have a significant competitive advantage, however, due to the implicit guarantee governments give to ‘too big to fail’ institutions. Requiring them to hold higher quantities of low-risk capital would impact their profitability, but this would be canceling out the advantage they already have, rather than putting them at a particular disadvantage. That said, there is an argument for making large banks competitively disadvantaged, both to prevent the TBTF scenario as well as to discourage the development of monopolies in particular banking services.
Correlated risks amongst small banks would still be a problem, I’ll admit. I don’t quite know how to deal with that, aside from simply more effective monitoring of systemic risk by regulators.