As bank reform continues to grind through Congress something sorely lacking so far is concentration on safely managing down "points of risk" from Too Big Too Fail business models. We are awash in anger but remain devoid of constructive action. Perhaps it's because finding better basis for the role that big banks play in the U.S. economy is so important that we are paralyzed? And in this I'm including both the government and industrial side of the fencing. We all know this is the next step in the evolving theater so why aren't we infusing this latest round of legislation with constructive guidance and authorization to put the U.S. on a path to a solution? Possibly because we need someone to define a better mousetrap. Here's my stab at thinking about what that might be.
I've been observing with great interest the Johnson and Kwak hypothesis about limiting maximum bank size as a function of risk to U.S. Gross Domestic Product (GDP). The thesis is that we need to somehow cap TBTF exposure so that it's no more than 4% per business entity. It's an intriguing thought that causes me to wonder - as many other people are - about how one might go about slicing up the population of TBTF's to achieve this in a way that does not trigger unwanted side effects to the remainder of the economy in the process.
Over the years IRA has piled up mountains of data on banks and I've designed tools to support all manner of what-if modeling for acquisitions and divestitures. Some of these tools were used to confirm that the objectives of the Move Your Money initiative would indeed be positive contributors to the economy before we committed to donating our support to this cause. The tenets of building solutions strategies that are stable and achievable are central to my own comfort zone going all the way back to my Cold War days as a strategic military analyst. These cautions apply even more so when it comes to turning screws on the nuclear devices of finance, the TBTFs.
So the thought hit me that it might be interesting to ponder the stoichiometry - the math behind the chemistry - of the TBTF rebalancing issue. Butchering mastodon into chewable portions along logical lines turns out to be a rather complex process of avoiding unintended consequences. It's clear that doing careful impact analysis on things like regional competitiveness and market share up and down the national to local strata of the economy is critical. We do not want "machete-scale" TBTF action at the high end to cause undue damage to other parts of the banking and finance system.
For instance, parametrically slicing any one of the big banks is probably a combination of separating lines of business, dividing operating geographies and in some cases further dividing share within over dominated specific markets. The appropriate sizes and lines of business combinations are in turn driven by the landscape of incumbent competitors, large and small as well as healthy and stressed, within the affected sub-markets. Because we still do want to improve economic system efficiency not degrade it, there remains an overarching need to preserve whatever economies of scale and technology leverage have been gained from these big banks' combined corporate learning curves.
While the populist thinking is to send these banks to the gallows, that's not necessarily the safest or even achievable approach to furthering long run U.S. economic stability. Note that one does not necessarily need to legally slice up the institution to accomplish many of these risk management objectives. In fact, in some cases, it might be strategically counter-productive, causing a disastrous series of "knee jerk" responses further destabilizing the system. What's important to consider here is what's in the best "national interest".
As the nation ponders bank reform, I suggest that opening a line of discussion about a series of stringent rules imposed on banks that are either over a certain size or if they engage in certain combinations of lines of business. Such a discussion would say that they must set up set up certain new "walls" between segments of their business and run them as silos might be enough to bring some aspects of net risk to GDP per institution into better alignment. In other aspects of the process, forcing the creation of true arms length separations might be more appropriate.
I also believe that both government and banking need to be exploring this, if not together, then certainly in parallel. TBTF banks can make it proactive corporate policy to set up internal controls so that no single silo within their business can generate a "bail out" triggering risk. Banks within a certain exposure class can do the right thing and elect to disclose more transparent data so their combined systemic risk exposures can be tracked by both regulators and markets to emphasize promoting - as opposed to hiding - earlier warning and avoidance of future broad crisis conditions. Just like we did with things like Sarbanes-Oxley give them a fixed number of years to change, instruct the regulators to track the changes and adjust the regulations during that period to take advantage of what's learned during the process, then make the resulting more stable rules mandatory. Anyone who resists the tide? That's what liquidation is for. Now you've got a true carrot and stick enforcement strategy with a specific and actionable set of objectives. Better mouse trap.
Only in this way can government once again begin to operate as a guiding hand instead of a slapping one. If we don't do this we're going to break something. This is industrial engineering on a grand scale no less far reaching other great things in America's history. It cannot be done by the seat of one's pants or the smell of one's nose. But it can be done.
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