A simpler way to end Too Big to Fail

The Bloomberg editors joined in the chorus calling for a cap on bank liabilities as the way to end Too Big to Fail.

While the idea definitely has merit, the Bloomberg editors pointed out its biggest weakness:  where to set the cap given the existence of banks like JP Morgan.

Regular readers know that your humble blogger has suggested a much simpler solution:  require the banks to provide ultra transparency and disclose on an on-going basis their current global asset, liability and off-balance sheet exposure details.

With this disclosure, market discipline will be applied to shrink the banks.

First to go will be proprietary bets.  Every trader knows that if their positions are fully disclosed to the market the other market participants will engage in activities that minimize the profitability of these proprietary positions.

Second to go will be the 14,000+ subsidiaries that exist not to support the real economy but to arbitrage either capital requirements or taxes.

Simply eliminating gambling and subsidiaries for gaming the system dramatically reduces the risk profile of the banks.

However, that is unlikely to be where market discipline stops.

Third to go will be the risk of contagion.  Investors will use the information to assess the risk of each bank and adjust their exposure to each bank to what they can afford to lose given the risk of the bank.

With this adjustment, banks no longer are Too Big to Fail as it is assumed that they can fail and the investor will lose money if this happens.

Limiting banks’ size is a rare example of agreement among prominent Democrats and Republicans, who complain equally that U.S. banks have grown too big, too complex and too risky. 

They also agree that big banks benefit unfairly from an implicit government guarantee despite the authority Congress gave regulators in the Dodd-Frank Act to dismantle troubled banks. (Does anyone really believe Washington would let JPMorgan Chase & Co. (JPM) fail?) 

Agreement tends to end there, however.... 

So we read with interest about a new idea that has entered the mainstream, one that wouldn’t break up the big banks, which we’ve argued against, and instead would cap the size of their non-deposit liabilities. Such liabilities consist of borrowings from the Federal Reserve (FDFD), commercial paper and -- perhaps riskiest of all -- overnight repurchase agreements, or repos, in which banks pledge their securities as collateral for overnight loans.

Put simply, insured banks would have to limit such borrowings to a specific percentage of U.S. gross domestic product.  

A cap would force banks to shrink without government bureaucrats arbitrarily taking them apart.

One of the benefits of requiring the banks to provide ultra transparency.

It would also curb banks’ continued reliance on the overnight loans that leave them vulnerable to runs, which is what helped bring down Bear Stearns Cos. and Lehman Brothers Holdings Inc. 

Ohio Democratic Senator Sherrod Brown is proposing to limit non-deposit liabilities to 2 percent of GDP. Such a level would force the nation’s top five banks to shrink significantly -- possibly too much. 

A 2 percent cap would seriously crimp former investment banks such as Goldman Sachs Group Inc. and Morgan Stanley, which became commercial banks during the financial crisis and continue to rely almost entirely on non-deposit funding. 

A fee, instead of a cap, would be a more market- friendly alternative: Banks could be assessed a levy based on the size of their non-deposit liabilities.... 

Yet determining an appropriate cap could prove nettlesome. Why not 1 percent or 3 percent?

A fee would be better. Banks would be less likely to overborrow if they knew they would be charged a fee for every dollar of non-deposit liability. Such a levy would also bring money into the federal government at a time of fiscal strain. (A similar fee proposed by the Barack Obamaadministration as a way to recoup bailout costs was estimated to bring in about $90 billion over 10 years.) As with a cap, lawmakers would have to decide which liabilities to include and which deposits to exclude. 

Valid worries persist about the risks large firms pose to the financial system. The incentives must shift so banks are penalized, not rewarded, for bigness.

Actually, the incentives must shift so banks are penalized, not rewarded, for risk!  

The issue of concern is the risk the banks take and limiting the risk.  Formally breaking up the big banks (which isn't going to happen) or putting a cap on their size are complex, one-off solutions to address risk at the banks.

The simple, direct approach to reducing risk at the banks is to require them to provide ultra transparency.