Dec. 10 (Bloomberg) -- Here’s a puzzle to entertain your friends this holiday season. Why would a senior governor of the Federal Reserve System publicly ask a question to which he plainly knows the answer?
We are all familiar with the dark art of reading central bank communications as they pertain to interest rates. The opacity of former Fed Chairman Alan Greenspan was legendary; his successor, Ben S. Bernanke, and other current central bankers lean toward greater transparency and signaling their intentions.
But today’s puzzle isn’t directly about interest rates. It is about regulation in general, and the Fed’s policy toward big banks in particular.
In the bad old days -- before October -- the Fed would elide such issues more often than not. Officials would point out that there are many other bank regulators or that it was up to Congress to make the big decisions. Even the Dodd-Frank financial-reform legislation didn’t immediately inspire Fed governors to take up the role of thought leaders on the nature of systemic financial risk, and what to do about it.
Yet, in prominent speeches delivered Oct. 10, Nov. 28 and Dec. 4, the Fed governor responsible for bank supervision, Daniel K. Tarullo, seemed intent on asserting a leadership role for the central bank. The speech in October laid out a broad agenda and floated the idea of size caps on the largest U.S. banks.
In November, he sensibly proposed actions to ensure that the U.S. operations of foreign banks are capitalized separately. To borrow a phrase from the former Bank of England official Charles Goodhart, big banks live globally but die locally, and we should prepare accordingly.
Lawyers for the bankers reply that such arrangements will make cross-border resolution of failing banks harder. That argument makes no sense. In fact, the opposite is true; resolution would become easier. The Fed will prevail on this issue.
The most interesting speech was delivered last week, when Tarullo asked whether there are significant economies of scale or scope in global megabanks. In other words, is there a good reason not to force these institutions to shrink over time?
It is well established that there are no such economies. In fact, we know that the scale of public subsidies for these banks -- and the damage they can cause -- increases as the banks become larger.
So why did Tarullo ask the question? Here are three possibilities:
The first is that he isn’t aware of the careful studies on this issue. But Tarullo is, among other things, a leading academic expert on banking. And, just in case he is too busy, the Fed is full of really good economists who have read everything on this issue. There is zero chance that Tarullo has overlooked the work showing that big banks aren’t more efficient, and receive much larger implicit subsidies than smaller ones.
The definitive summary is the Oct. 25 speech by Andrew Haldane of the Bank of England, “On Being the Right Size.” In particular, study Chart 9, which demonstrates that there are no economies of scale when you adjust for the undeniable implicit subsidies received by megabanks.
For anyone on the Fed staff wanting to catch up on the literature, I also recommend: “The Implicit Subsidy of Banks,” by Joseph Noss and Rhiannon Sowerbutts, also of the BOE. Or have a look at “The Social Costs and Benefits of Too-Big-To-Fail Banks: A Bounding Exercise,” by John Boyd and Amanda Heitz, or “Too Big to Be Efficient? The Impact of Implicit Funding Subsidies on Scale Economies in Banking,” by Richard Davies and Belinda Tracey, or “Size Anomalies in U.S. Bank Stock Returns,” by Priyank Gandhi and Hanno Lustig.
And there is also a comprehensive soon-to-be-published book, “The Bankers’ New Clothes: What’s Wrong With Banking and What to Do About It,” by Anat Admati and Martin Hellwig. It isn’t officially available, though the galleys are a hot property.
The second possible way to explain Tarullo’s question is that he disagrees with the findings in this literature. But in his speech he didn’t mention any of the important findings or take issue with any of the authors and the substantive points they make.
However, he did cite a recent Clearing House study that claims big advantages in having humongous banks. Wisely, he didn’t appear to take seriously this lobbying document, which is based on claims that can’t be independently verified because they are based on “proprietary data” and “interviews.” Why would anyone take such propaganda seriously?
The main proposals on the table -- for example, the Safe, Accountable, Fair and Efficient Banking Act sponsored by Senator Sherrod Brown of Ohio -- would roll back the largest banks to the size they were in the mid-1990s. What great positive impact for the broader economy have we seen from the increase in bank size over the past 15 years? Tarullo didn’t claim any, because there are none.
The last possibility is that Tarullo and his colleagues understand the facts and agree that the largest banks are too big, and he framed his speech to send a signal. What is it?
The Fed agrees that the largest banks are too big. Eradicating the problem of too big to fail may be impossible, though we can move in the right direction by strengthening capital and leverage requirements (more equity for bigger banks), by putting in place a resolution regime that could work (but the cross-border problems loom large), and by removing the funding-cost advantage that big banks enjoy because their creditors know there is effective downside protection from the government.
Still, the Fed isn’t ready to move on this issue by itself. It wants to first stir the hornets’ nest, with angry comment letters from bankers and high-profile congressional hearings.
The Fed has the authority to cap bank size, but it wants to shift the consensus first. The banks will push back hard, which will expose the weakness of their arguments.
The major reform battleground for 2013 is a focused question with a clear answer: Are there economies of scale or scope in banking that outweigh the unfair, nontransparent and highly dangerous government subsidies that megabanks receive? No, there aren’t.
(Simon Johnson, a professor at the MIT Sloan School of Management as well as a senior fellow at the Peterson Institute for International Economics, is co-author of “White House Burning: The Founding Fathers, Our National Debt, and Why It Matters to You.” The opinions expressed are his own.)
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