Breaking Up Big Banks and Increasing Regulations

Breaking Up Big Banks and Increasing Regulations

I am an economist and a former employee at the Federal Reserve in the United States. I experienced first-hand the impact of 2008 economic crash across all sectors of the America’s economy. While many people are concerned about the rippling effects of the crisis, I am convinced that it is better to address the ailment rather than its symptoms. My extensive experience in the industry informs me that large banks are to blame for the economic woes. Therefore, there is no better solution for the government to restore the global economy on a positive growth trajectory than to break up big banks and to increase regulatory policies in the banking industry.

On average, the American banks have grown tremendously on an annual basis, though the total number of banking institutions has dropped drastically over the past decade. Statistics indicate that between 1986 and 2011, the average total assets in the US (adjusted for inflation) rose to $893 million from $167 million. During the same period of time, the average number of commercial banks in America dropped by 50%. Additionally, the latest federal data indicate a rise in the share of overall banking system assets that large financial institutions hold since 2008 financial crisis. For instance, in the year 2007, five of the largest banks in the United States held up to 30% of the assets in the banking system. Bank of America alone had approximately $ 552 billion worth of assets during the same year. Contrastingly, in the year 2012, a research conducted by the Federal Reserve indicated that the top 5 financial institutions in America held nearly 50% of the total assets in the system. Still, the percentage has risen sharply since then. In fact, it is estimated that four of the largest banks have total assets in excess of 1 trillion US dollars (Volcker et al. 12). Notably, JP Morgan and Chase had approximately 2 trillion dollars in 2012 (15% of US commercial banks’ assets).  

As a proponent of limiting the bank size, I argue that large banks pose a serious risk to the nation’s financial system. They bear potentially catastrophic consequences for the larger economy, so do the outdated federal policies that backstop such banks. On the surface, the 2008 financial crisis and the resultant recession in EU and US seem to bear this out, given that four of the largest American financial institutions such as Citibank, Washington Mutual Bank, Wachovia Bank, and Bank of America failed and were recipients of federal financial assistance to remain operational. On the other hand, only 5% of small depository institutions failed.

From my observations, the 2008 financial crisis shed light on how interconnected and close most of the world’s largest banks are. The revelation was even expounded by credit guarantees and provision of short-term financial remedies. In essence, such connections are attributable to systemic risk, especially in the case where a single large and complex bank fails (Volcker et al. 4). If this is the case, other global financial institutions connected to such entity could be brought down, thus threatening the survival of the broader financial system.

I watched closely as the financial crisis developed. Indeed, I witnessed how doubts surfaced as individual financial firms were unable to meet their contractual obligations by repaying their loans. As the crisis took a toll, there was a widespread pullback by the financial lending firms as the managers sought to protect the assets. Eventually, most of them moved their funds into safe assets such as gold and diamonds as currencies’ value dropped. Others resorted to cash reserves and US Treasury securities. Even worse, Lehman Brother’s bankruptcy in late 2008 reinforced the fears of other financial institution and lenders, hence intensifying the rush for safe liquid assets. At the same time, the pressure remarkably increased on the commercial paper market, the money market mutual funds and other segments dependent on continuous credit flows. 

            Furthermore, the governments are unwilling to allow large financial institutions to fail because the development can yield significant losses on other corporations. Consequently, the functioning of the financial system is impeded seriously, multiplying the risks to the larger economy. As a result, governments are obliged to treat large financial institutions as TPTF (Too Big To Fall). In the United States, for example, the government commonly commits public funds to cover debts of large banks when they are set to default. It is true that labeling large banks as TBTF prevent systemic risks, but there is a moral hazard to this policy.

Instances of moral hazard resurface when insurances encourage risk-taking to increase the chances of the insurance payout. For instance large banks can operate with greater leverage and borrow more, given that the government protection refrains creditors from making losses. The move will certainly raise their chances of failure as compared to when there is an absence of government backstop. While supervision by the government minimizes excessive risk-taking, studies indicate that federal deposit insurance is a guarantee that encourages large banks to engage in more risky business activities. Moreover, treatment of large banks as TPTF widens unlimited protections to depositors and creditors. In return, the bank gets more incentives and funding advantage but at a higher risk as compared to smaller banks.

Increasing Regulations in the Banking Industry

 In an effort to minimize risk-taking, the US government introduced Dodd-Frank Act in the year 2010 which imposes a renewed oversights and regulations on the financial institution (Acharya et al. 62). However, these regulations have proved ineffective, calling for the need to refine them to meet the changing needs of the volatile business environment. The amendments should end TBTF through the enactment of new processes to resolve failures of large banks in a manner that subjects the lenders of these financial institutions to losses. As a sharp critic of large banks, I contend for the enforcement of stricter limits on the size of particular financial corporations to eliminate the problem of moral hazard and to end TBTF policies.

Large financial institutions are conceived from the merger of smaller banks motivated by business synergies like economies of scale. In the United States, the main aim for large banks is to gain oligopolistic status. The move will profit the customers and the shareholders, but the counter-effects are equally highly risky. Breaking up large financial institutions is a deterrent to such economic failures as witnessed in the aftermath of 2008 economic crisis. In fact, the US economy is yet to fully recover from the economic disaster triggered by woes of large banks. Introducing rules and regulations that limit the size of banks encourages competitiveness in the market, hence jump-starting the ailing economies in Europe and the United States. The federal experts should assess the financial sector and set up the maximum ideal size that banks should be allowed to grow. On the other hand, the regulations must address the issue of mushrooming large banks that discourage market rejuvenations and the introduction of start-up financial institutions.

There are three perspectives to view the importance of regulatory policies. First, the oversight will not sacrifice economic efficiency of the lending institutions. If the laws offer directives for limiting the size of large banks, chances are that the US economy will be restored to its former glory and optimum level of performance as experienced more than three decades ago. Secondly, the policies and increased government regulations will positively affect the existent systemic risks by eliminating or minimizing them to allow for fair business practices and ethics in the banking industry. Lastly, the American government should shift the attention to the resultant political economy of limiting the size of large banks. While economic turbulence and a shake-up in the banking industry are likely to occur in the short run, the fruits of increased oversights and regulatory policies will be reaped in the long-run as the confidence of the citizens in financial institutions is gradually restored.

            FDIC insures nearly all large financial institutions in the United States. The firm gives large banks immunity over their unscrupulous dealings and risky business moves. Therefore, the regulatory authority is mandated to bar these banks from conducting trading operations for their accounts. In the past, government bailouts were effective, especially in the United States. However, America’s dominance of international trade and global economies has waned over time, thus blunting the effectiveness of financial bailouts of large corporations. In addition, globalization exposes large financial institutions to unprecedented levels of risks in the developing world outside of the United States. As the burden of bailouts become too much for the federal government to bear, tougher rules and regulations on large banks should be introduced instead as a replacement of this policy. In this way, it will be easier to monitor the behavior of large banks and to arrest instances that can trigger economic downfall.

Further, additional regulatory policies guarantee diversification in the banking sector’s portfolio such that when a single bank is on the brink of failure, the overall economy will still function normally due to the limited impact. Prudent investors always hold tiny positions in multiple securities to diversify their level of investment. If the legislation to increase regulation of large banks is done successfully, it will end the mentality of TBTF because unbiased perspectives will add sufficient credibility to the mindset of intelligent oversight (Walker 45). Therefore, I advocate for new reform legislations that will not be themed on punishing the bankers but enhancing financial stability in the modern America.

The 2008 financial crisis resulted in a new phenomenon that large banks are too complex to fail because, at the time, they required a significant financial boost from the taxpayers. Thus, the officials and regulators should show their commitment to reigning large banks through the application of numerous measures. Modestly, the federal government ought to consider setting up a special levy on strategically important financial institutions to provide funding for a crisis resolution facility. Some of the more sweeping regulations include restrictions on business lines at the banks, banning ownership of investment vehicles, and ring-fencing of the financial portfolios.

Bank regulations are prudential because they protect depositors by minimizing the risk exposed to the bank creditors. The measures lower the risk of disruption that often results from adverse trading conditions as witnessed during the financial crisis. Most commonly, such disruptions lead to major or multiple bank failures. Even worse, the damage is amplified in the case of large banks. Moreover, increased oversight and regulations check on bank misuse, hence eliminating the risk of a financial institution being utilized to fulfill criminal missions. A classic example of this is the laundering of crime proceeds by the top level managers or other staff members. The tightened policies will also instigate the large banks to exercise corporate social responsibility and to treat customers fairly as they seek to compete with other firms.

The probability of a bank failure is diminished greatly when stringent regulatory policies are put in place. Essentially, this can be attained if the regulator focuses on the probability of failure of large banks. In the American society, there is a misconception that large financial institutions minimize cases of asymmetric information between borrowers and lenders by monitoring developments using returns to scale. However, this is not the case in practical terms. Institutions cannot emerge and survive in volatile economic environments just because they are efficient in their operations. Banks exist and grow to become large institutions because they are profitable. Indeed, financial institutions are the transformers of economic maturity, but they can only be successful when their assets are diversified (Kregel and Kattel 321). As the bank grows, its influence towards the government plans and policies increases as well. Considering this, the government should turn the tables by tightening the regulations on banking institutions to tame them and to avoid instances where the bankers can exercise dominance over the government to push for personal agendas and interests.

Minimal requirements that regulators impose on banks are intended to promote the federal government and regulators. The rules on maintenance of minimal capital ratios in financial institutions should be tightened to sound an alarm in case a large bank is on a verge of collapse. In the US, banks are granted a leeway to choose their regulator and supervisor, but this should change. An overall oversight body should be enacted to monitor the activities of all financial institution at a centralized vantage point. In addition, the state should empower such a regulator to tax large banks as per their size to internalize the excessive cost inflicted. The strategy can be achieved by consideration of progressive capital requirements as per the size of the firm. Furthermore, the taxation neutralizes the effectiveness of political connectedness commonly observable between the Washington and the leaders of large banks.

In summary, financial crises are part and parcel of growing economies. However, mistakes that result in such economic losses should be highlighted and eliminated. While future crises cannot be overruled, rectification of loopholes in the banking industry addresses the current challenges that slow down the recovery process from the 2008 financial crisis. As a first step, the government should break up large banks because they were the main cause of the economic disaster in America, Europe and other parts of the globe. However, this cannot be attained unless the regulations are increased to limit the size of banks. I am convinced that if these recommendations are implemented, the impact of future economic crises will be less severe.

Works Cited

Acharya, Viral V., et al. Regulating Wall Street: The Dodd-Frank Act and the New Architecture of Global Finance. Vol. 608. New York: John Wiley & Sons, 2010: 1-66. Print.

Kregel, J A, and Rainer Kattel. Economic Development and Financial Instability: Selected Essays. , 2014: 320-327.Print.

Volcker, Paul A, William M. Isaac, and Philip C. Meyer. Senseless Panic: How Washington Failed America. Hoboken, N.J: Wiley, 2013: 1-54.  Internet resource.

Walker, Stephen. Understanding Alternative Investments: Creating Diversified Portfolios That Ride the Wave of Investment Success. New York: Palgrave Macmillan, 2014: 40-48. Internet resource.