05/03/2010 05:12 am ET | Updated May 25, 2011

Dallas Fed President: Break Up Big Banks

We've cited Thomas Hoenig, president of the Kansas City Fed, a number of times on this blog for his calls to be tougher on rescued banks and to break up banks that are too big to fail. This has been a bit unfair to Richard Fisher, president of the Dallas Fed, who has been equally outspoken on the TBTF issue (although we do cite him a couple of times in our book).

reports that Fisher recently called for an international agreement to break up banks that are too big to fail. Here are some quotations, taken from the Bloomberg article (the full speech is here):

The disagreeable but sound thing to do" for firms regarded as "too big to fail" would be to "dismantle them over time into institutions that can be prudently managed and regulated across borders.

Given the danger these institutions pose to spreading debilitating viruses throughout the financial world, my preference is for a more prophylactic approach: an international accord to break up these institutions into ones of more manageable size. If we have to do this unilaterally, we should.

The existing rules and oversight are not up to the acute regulatory challenge imposed by the biggest banks. Because of their deep and wide connections to other banks and financial institutions, a few really big banks can send tidal waves of troubles through the financial system if they falter.

This is not the first time that Fisher has sounded this alarm. Last fall, he called too-big-to-fail banks a "the blob that ate monetary policy," arguing that they distorted the economy in ways that made it harder for the Fed to fight the economic downturn. This was the core of his conclusion:

To craft a smart solution to this vexing problem of banks considered too big to fail requires that we deal with the way people and businesses really are. To me this means finding ways not to live with 'em and getting on with developing the least disruptive way to have them divest those parts of the 'franchise,' such as proprietary trading, that place the deposit and lending function at risk and otherwise present conflicts of interest.

The TBTF debate is mainly between people like Fisher and Hoenig (and Paul Volcker and Mervyn King) who think that the problems posed by megabanks (implicit government guarantee, competitive distortion, etc.) cannot be regulated away, and people like Ben Bernanke and Tim Geithner who think that they can. (There are also a few people in free market fantasy land who think that the government can simply promise never to bail out another bank and that market forces will take care of the rest.)

Seen in an abstract light, we can have no assurance that any new regulations will actually work to prevent a financial crisis or defuse one, so the safer option (and isn't that what regulators should want?) is to break up the big banks. Most of the arguments against this course of action have something to do with international competitiveness (smaller U.S. banks would hurt American companies in the globalized world). I think those arguments are obviously flawed; globalization means that American companies can get their financial services from banks that happen to be headquartered anywhere in the world, not just U.S. banks. But even if we grant them for the sake of argument, the international agreement that Fisher suggests should take care of that issue. And the only way to get such an international agreement is for the U.S. to take the lead.

Politically, breaking up TBTF banks is something that should on paper be able to attract a bipartisan majority. Many progressives are in favor of cutting "Wall Street" down to size; so are some conservatives, on the grounds that TBTF banks enjoy an implicit government subsidy and would require a bailout in the event of a crisis. Thomas Hoenig is generally considered a relatively conservative Fed bank president, at least when it comes to monetary policy. (Of course, such a bipartisan majority would require some Republicans to vote for something that might be popular with the electorate, which might be impossible in the current political climate.)

For whatever reason, the administration and Christopher Dodd seem to be going for the other kind of majority -- one that cobbles together a least-common-denominator reform package that leaves the basic financial system intact. Even if they succeed, at best we will have lost our best opportunity for real change in decades.

Cross-posted from The Baseline Scenario.