Solving Banking’s “Too Big to Manage” Problem

Jeremy Kress is Assistant Professor of Business Law at the Stephen M. Ross School of Business at the University of Michigan. This post is based on his recent article, forthcoming in the Minnesota Law Review.

One of the enduring ironies of the 2008 financial crisis is that nearly everyone now dislikes big banks, but no one can agree what to do about them. Policymakers as diverse as Bernie Sanders, Elizabeth Warren, John McCain, Newt Gingrich, and even President Donald Trump, have called for shrinking the largest financial firms.  In fact, both the Democratic and Republican parties endorsed breaking up the banks in their policy platforms for the 2016 election.

This apparent consensus in favor of breaking up the banks stems, in large part, from a perception that some U.S. financial institutions are “too big to manage” (TBTM). A financial institution is TBTM if its size prevents executives, board members, and shareholders from effectively overseeing the firm, leading to excessive risk taking and misconduct. Officials from both the Obama and Trump Administrations have cited the TBTM problem as a catalyst for the 2008 financial crisis. On this view, many of the largest U.S. financial companies collapsed because management was unable to monitor the firms’ risk profiles.

Despite this apparent consensus, policymakers have not settled on a solution to the TBTM problem. Scholars, legislators, and think tanks have proposed various strategies to break up the banks. Some big bank critics, for example, would institute a size limit on U.S. financial institutions. Others favor reinstating the Glass-Steagall Act, which would force financial conglomerates to separate their banking and nonbanking operations. Still others support a “soft break-up,” in which stricter regulations would incentivize TBTM firms to shrink. To date, however, none of these reforms has garnered significant political support, and prospects for future legislative action are dim.

In the meantime, the largest U.S. financial conglomerates have grown even bigger since the financial crisis. JPMorgan and Bank of America, for example, are more than 50 percent bigger today than they were in 2007. Scandal-ridden Wells Fargo, meanwhile, has more than tripled in size. Amidst this unprecedented growth, JPMorgan’s $6 billion London Whale trading loss, Wells Fargo’s fraudulent accounts scandal, and other misconduct by big banks have added urgency to solving the TBTM problem.

My new article, Solving Banking’s “Too Big to Manage” Problem, presents the first scholarly analysis of the TBTM issue. While scholars have addressed other aspects of the “too big” problem—asserting that banks are too big to fail, too big to jail, or too big to regulate—they have largely neglected the managerial implications of banks’ excessive size.

I contend that big banks face unique governance challenges—including extreme opacity, run risk, and weak market discipline—that expose these institutions to excessive risk taking and misconduct. Despite these managerial impediments, however, TBTM banks will not voluntarily break themselves up because they benefit from implicit government subsidies unavailable to smaller firms. Thus, while there are many reasons to believe that some banks are TBTM, there is little reason to trust that banks will solve the issue on their own. A public policy response is therefore necessary to fix the TBTM problem.

I argue that existing proposals to solve the TBTM problem suffer from critical shortcomings. Breaking up all of the largest U.S. financial institutions could have detrimental unintended consequences. Once broken up, for example, JPMorgan, Citigroup, and other U.S. firms might struggle to compete with their larger international counterparts. Similarly, shrinking the banks could reduce economies of scale, making large financial institutions—and the broader financial system—less efficient. Moreover, if policymakers were to reinstate the Glass-Steagall Act, financial institutions might become less diversified and, thus, less stable. In sum, even if it were politically possible, breaking up all large U.S. banks could create more problems than it solves.

My article proposes a better solution to the TBTM problem. I recommend that financial regulators use their existing statutory authorities to require a financial conglomerate to divest operations when it falls out of compliance with minimum regulatory standards. Regulators could use these authorities to compel a troubled financial conglomerate to sell certain subsidiaries, spin them off to shareholders as separately capitalized companies, or shutter them entirely. Regulators might, for example, order Wells Fargo to divest its scandal-plagued wealth management unit or notoriously troubled Deutsche Bank to cease its U.S. banking operations.

Forced divestitures are better than other plans to break-up the banks for four reasons. First, the threat of such a significant sanction would increase financial conglomerates’ incentives to operate prudently. Second, divestitures would safeguard the broader financial system by reducing the systemic footprint of banks that fail to comply with minimum regulatory requirements. Third, in contrast to more draconian break-up proposals, targeted divestitures would affect relatively few firms and thereby preserve economies of scale and scope for most financial conglomerates. Finally, unlike some politically infeasible break-up plans, no new legislation is required because Congress has already authorized regulators to mandate divestitures under existing law.

The financial regulatory agencies, in fact, have several underutilized authorities empowering them to order divestitures. The most promising of these authorities permits the Federal Reserve to compel a poorly managed financial conglomerate to discontinue its nonbanking subsidiaries. Historically, bank holding companies (BHCs) have been limited to engaging in traditional banking and closely related activities, such as taking deposits and making loans. In 1999, however, Congress authorized a new type of BHC—called a financial holding company (FHC)—to engage in an expanded range of financial activities, including investment banking and insurance underwriting.  To become an FHC and engage in these activities, a BHC and its subsidiary banks must be well capitalized and well managed, as measured by an annual supervisory examination. Under section 4(m) of the Bank Holding Company Act (BHC Act), if an FHC ceases to be well capitalized and well managed, the Federal Reserve may order it to divest its nonbanking subsidiaries.

The Federal Reserve has never exercised its divestiture authority under section 4(m), despite many opportunities. Indeed, nearly 40 percent of large FHCs do not currently satisfy the well-managed requirement to continue engaging in nonbanking activities. The Federal Reserve has not publicly explained why it declines to enforce section 4(m). I assert that the agency’s longstanding neglect of section 4(m) has become a self-fulfilling prophecy. Because the Federal Reserve has not invoked section 4(m) in more than 20 years, the agency now risks that its first use of section 4(m) will be perceived as arbitrary.

In the article, I urge the Federal Reserve to exercise its section 4(m) power in appropriate circumstances, and I propose a framework to put this authority into practice. I recommend that the Federal Reserve adopt a regulation requiring an FHC to divest its nonbanking operations if it fails to comply with the well-capitalized or well-managed requirement for more than two years. By implementing a regulation through notice-and-comment rulemaking, the Federal Reserve would combat perceptions of arbitrariness when it ultimately exercises its section 4(m) authority. Moreover, by increasing incentives for FHCs to comply with regulatory requirements, and by breaking up FHCs that fail to do so, this divestiture framework would finally help solve the TBTM problem.

The complete article is available here.

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