The Absurdity of Too Big to Fail Banking

In this very political season, lobbyists for the too-big-to-fail banks are quietly holding briefings for congressional staffers, Obama administration members and hopeful Romney campaign economic advisors. The lobbyists are arguing that the rise of TBTF banks and the 1999 repeal of Glass-Steagall were actually good for the country. 

The points these TBTF'ers make are threefold.  First, large U.S. companies need world-class banks because, if banking size in the U.S. is limited, American companies will replace their U.S. banks with larger European, Japanese or Chinese banks. 

Second, the lobbyists claim, the consolidation of commercial and investment banking had nothing to do with the financial crisis.  The Glass-Steagall repeal is merely a scapegoat. That outdated law would not have restrained Bear Stearns, Lehman, AIG, Washington Mutual or Ally – all of which played a role in the panic. 

Lastly, the megabank representatives cry that all the chatter about TBTF ignores the tremendous “social utility” of the large banks to add value and to be a source of strength to bail out other institutions during times of crisis.  

It is a testament to the TBTF lobbyists' prowess that they are taken seriously in urging our policymakers that we emulate European banks. Woefully undercapitalized, those banks are a leading challenge to the Euro itself.  Does anyone really need to be reminded of the nationalization of the certain British banks, the entire Irish Banking system, the German state banks and the Spanish provincial banks, to name only a few recent era headlines?  The French and Italian banks are also under intense market scrutiny.  The ultimate irony is that the European-U.S. dollar funding crisis would be far worse if not for support from the U.S. money market funds and the Federal Reserve via the European Central Bank. 

Now, the TBTF'ers argue that the next place our big corporations would flee is the Japanese banks.  Do we really want to emulate a banking system that has been the primary cause of two decades of lost economic growth? 

Finally, perhaps the most laughable example given from what should be a group of uber-capitalists is that the Chinese banking system should serve as a model for us. I suspect that most U.S. corporations would stick with their American banks over those controlled by the largest Communist party in the world.

The Glass-Steagall repeal was not the sole cause of the financial crisis but certainly a contributor.  There is no doubt that Citigroup and Bank of America needed their extraordinary added TARP funds and FDIC guarantees, judging from their exposure to investment banking activities.  A fair read of the contemporaneous concerns regarding Citi and Bank of America would lead to no other conclusion.  In the case of Bank of America, the worries about the bank's own legacy mortgage holdings – and those of Countrywide – came months later. 

But there is a deeper concern as well.  It was not merely the technical repeal of Glass-Steagall that was a contributor to the crisis, but rather the permission regulators gave to the banks for the “cultural consolidation” of commercial and investment banking.  Even before Glass Steagall was repealed, the Fed permitted banks to engage in investment banking (up to certain limits), finding that these activities were “incidental” to commercial banking. Frankly, these activities are not necessary to run a successful bank or even a successful large bank.  U.S. Bank is one example of a large bank that has done well with hardly any underwriting or trading operations (most of what it does in this area is wealth management or stock brokerage).

Lastly, the TBTF'ers argue that the big banks create value for the economy, which is of course true.  The question is whether a better structured banking system would create far more value and additional jobs through effective financial lubrication of the economy.  Small and medium-sized banks are more effective at making loans to the small and medium-sized companies, which are the primary job creators in the U.S.  Large banks need to homogenize their approach to smaller companies, which is understandable and more efficient for big banks.  But what is good for the big banks is not necessarily good for the economy and the growth of jobs.

If policymakers can get the structure of the banking system right, there will be less of a need for the volumes of devilishly complex regulations, which are being created almost weekly, as I recently described at the TEDx Wall Street conference. 

Once the election is decided and Congress gets back to work, fixing the banking system and reinstating Glass Steagall should be the highest priority.

Scott A. Shay is a founder and the chairman of Signature Bank in New York.