Illustration by Bloomberg View
Illustration by Bloomberg View

In the U.S. Senate on Friday, legislators will try yet again to answer a question of great concern to the country: How did JPMorgan Chase & Co., a bank large enough to bring down the U.S. economy, rack up losses of $6 billion in a unit that was supposed to be managing its excess cash and mitigating risk?

Allow us to suggest a follow-up question: Why should any bank be big and threatening enough to bring down the U.S. economy?

In recent editorials, we’ve explained how recurrent bailouts have encouraged banks to become as large and scary as possible. The more damaging their failure would be, the more certain they and their creditors can be that the government will rescue them in an emergency. This certainty allows the biggest banks to borrow at lower rates than their competitors -- a subsidy from taxpayers worth tens of billions of dollars a year.

JPMorgan is a prime example of where the too-big-to-fail policy has gotten us. Under international accounting standards, it is the largest bank on the planet: Its total assets stood at almost $4 trillion as of mid-2012, according to an estimate by Federal Deposit Insurance Corp. Vice Chairman Thomas Hoenig. That’s equal to more than a quarter of the country’s entire annual economic output. The bank’s tangible equity, the bedrock capital available to absorb losses, amounted to just $121 billion, or 3.1 percent of tangible assets. In other words, a decline of 3.1 percent in the value of JPMorgan’s assets could be enough to render it insolvent and necessitate a taxpayer bailout.

Growing Support

Lately, the idea that we should stop paying banks to become dangerous has garnered support on both ends of the political spectrum. Notably, the American Conservative Union has invited a major proponent of caps on bank size, Dallas Federal Reserve Bank President Richard Fisher, to address its annual conference this week outside Washington, D.C.

The essence of Fisher’s solution is twofold. He would impose an asset limit on banks that, according to Bloomberg News, could force some of the biggest banks to shrink their consumer and commercial-lending units by more than half. He would also roll back government subsidies from banks’ trading and investment-banking operations by requiring them to be walled off from the units that take deposits and make loans.

Size constraints of some form could significantly reduce the subsidy enjoyed by the largest financial institutions. If a bank has $250 billion in assets instead of $4 trillion, it’s much easier to believe that the FDIC could take it over and wipe out some of its creditors without triggering a systemwide crisis. As a result, creditors would be less likely to count on bailouts.

Problem is, making banks smaller doesn’t necessarily reduce the chances that they will fail -- and many failures happening at once could be just as threatening and bailout-worthy as a single big one.

To make the whole system more resilient, banks need to get a larger share of their funding in the form of equity from shareholders, as opposed to loans from depositors and other creditors. We have advocated $1 in equity for each $5 in assets, a level that would absorb a 20 percent drop in the value of a bank’s investments, compared with JPMorgan’s 3.1 percent. The latest global banking rules require only $1 in equity for each $33 in assets, and use a lenient approach for measuring the ratio.

Higher equity requirements reduce taxpayer support to banks in a different way, by making them less likely to require bailouts. The added discipline would also put natural pressure on banks to shrink: Once shareholders fully realized how poorly the largest banks perform in the absence of subsidies, they would have more incentive to demand that they be broken up into smaller, more profitable units.

That said, size constraints can be useful to augment the desirable effects of equity, guaranteeing that banks get down to a manageable scale. Think of it as a dual containment system for too-big-to-fail institutions: One measure deals with the “big,” while the other deals with the “fail.”

To contact the Bloomberg View editorial board: view@bloomberg.net.