'13 Bankers': If The Megabanks Are Too Powerful To Regulate, Then They're Too Powerful To Shrink

06/26/2010 05:12 am ET | Updated May 25, 2011

Anyone who's taken an interest in financial reform this last year will recognize the massive dilemma at the heart of it: In order to regulate banks effectively, we may have to shrink them, because they could be too powerful to rein in otherwise. But if they're too powerful to regulate effectively, they're probably too powerful to shrink. After all, the banks would almost certainly oppose shrinkage even more vigorously than they'd resist regulation.

The great strength of Simon Johnson and James Kwak's compelling new book, 13 Bankers, is the clarity with which they drive home the first point. The great weakness is the ease with which they elide the second.

As Johnson and Kwak explain, the problem with too-big-to-fail institutions is threefold: The first is distributional-if and when these firms do fail, the ensuing bailout represents a huge wealth transfer from taxpayers to the firm's stakeholders. The second is the moral hazard problem-because a bank's creditors know they'll be made whole in the event of a meltdown, they have little interest in scrutinizing the behavior of bank executives, who place risky bets to pad their income. The third problem is that too-big-to-fail institutions are anti-competitive-they can borrow cheaply because of the implied government guarantee, giving them an unfair advantage over smaller rivals.

The response the administration and congressional Democrats have proposed is resolution authority: Give the government the power to take over a failing megabank--to fire its management, wipe out shareholders, sell off assets, and impose losses on bondholders. In theory, this would prevent big transfers of income from taxpayers to bank bondholders and shareholders. It would also make bondholders more leery of lending to large firms, particularly those who take outsize risks.

It's an elegant solution in principle. And, in practice, it would almost certainly be an improvement over the status quo, in which the government is basically committed to bailing out big firms but has no clear authority to wind them down. But, of course, authority to dismantle a firm and impose losses isn't the same as the will to use it. Like Johnson and Kwak, I have an easy time imagining a future Citigroup pleading that it shouldn't be resolved because it employs hundreds of thousands of people, many of whom will be thrown out of work. I'm sure such a bank would also point out that its employees have a habit of voting and donating large chunks of campaign cash.

Nor is it hard to imagine a future administration getting cold feet before imposing losses on creditors. Anyone can talk tough when markets are calm. But in the middle of a financial crisis--and you're almost by definition in a crisis if a megabank is wobbling--it takes a special breed of hard-ass to insist on haircuts, since no one can be sure that squeezing creditors won't shut down the entire bond market. Who wants to be the Treasury secretary who vaporized the financial system so that bond holders would only end up with 90 cents on the dollar?

Which is why the Johnson-Kwak solution seems like a no-brainer: Break up the banks in advance, and they won't be able to throw their weight around Washington once they're in trouble. They'll also have fewer liabilities, meaning the ripple effects from any haircut to bondholders should be small enough for a Treasury Secretary to sleep soundly at night.

How could anyone reject this logic? The explanation Johnson and Kwak come up with is intellectual capture. They write that, in the fall of 2008, "government negotiators came to the table largely in agreement with the bankers' view of the world." And, though George W. Bush presided over the first round of bailouts, they contend that Team Obama was no more imaginative in its thinking: "[E]conomic policy in 2009, just as in 2008, was set by a group of people who, despite their considerable intelligence, experience, and integrity, seemed to believe that ... each subsidy to the banking sector was justified."

I don't doubt there's a level of receptiveness to the banker's worldview in certain parts of the Obama administration. It would be hard not to have at least some sympathy for this view if you've spent years working on Wall Street, as several administration officials have. Or if you've never worked on Wall Street but spent years interacting with people who do.

On the other hand, based on my own conversations with Obama economic officials--including some of those same Wall Street refugees--I can tell you that most of them appreciate the dangers of overgrown banks, and many would favor breaking them up in principle (though views are more split on this question). As one Treasury official told me several months ago, the main reason to favor tough regulation rather than a break-up is that the latter would be much tougher to push through Congress. If a future Citigroup can resist a break-up the middle of a crisis-which is to say, when it's politically weakest-then the current Citigroup can almost certainly nix a break-up now, just after a $4.4 billion first quarter.

Here's how I see the tradeoff: If resolution authority passes, it will only be as meaningful as its first test-case. Somewhere down the road, a megabank will get in trouble, requiring Treasury and the FDIC to step in. If, at that point, the government has the nerve to make the resolution process stick, bondholders will thereafter price in the possibility of future losses, and we'll suddenly have a much safer, more competitive banking system. If, on the other hand, the government backs down and arranges another bailout, our moral hazard problem is here to stay. I give this between a 25 and 50 percent chance of working out the right way. (If bondholders agree with my assessment, they'll start discounting somewhat even before the test case.)

Those odds sound pretty lousy, I know. But then ask yourself how likely it is that the administration could break up the megabanks today, and I think you come up with something considerably less than 25 percent. Which is why I don't think you need to invoke intellectual capture to explain the administration's approach. You just need a hard-nosed assessment of its chances of success.