The Economy Cannot Recover Until the Big Banks Are Broken Up

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Washington’s Blog

A lot of people still haven't heard that the economy cannot recover until the big banks are broken up.

In fact, virtually all independent economists and financial experts are calling for the big banks to be broken up, including:

  • Dean
    and professor of finance and economics at Columbia Business School,
    and chairman of the Council of Economic Advisers under President George
    W. Bush, R. Glenn Hubbard
  • The leading monetary economist and co-author with Milton Friedman of the leading treatise on the Great Depression, Anna Schwartz
  • Economics professor and senior regulator during the S & L crisis, William K. Black
  • Professor of entrepreneurship and finance at the Chicago Booth School of Business, Luigi Zingales

Why do these experts say the giant banks need to be broken up?

Well, small banks have been lending much more than the big boys. The giant banks which received taxpayer bailouts have been harming the economy by slashing lending, giving higher bonuses, and operating at higher costs than banks which didn't get bailed out.

As Fortune pointed out, the only reason that smaller banks haven't been able to expand and thrive is that the too-big-to-fails have decreased competition:

Growth
for the nation's smaller banks represents a reversal of trends from
the last twenty years, when the biggest banks got much bigger and many
of the smallest players were gobbled up or driven under...

As
big banks struggle to find a way forward and rising loan losses
threaten to punish poorly run banks of all sizes, smaller but well
capitalized institutions have a long-awaited chance to expand.

So the very size of the giants squashes competition, and prevents the small and medium size banks to start lending to Main Street again.

And as I noted in December 2008, the big banks are the major reason why sovereign debt has become a crisis:

The
Bank for International Settlements (BIS) is often called the "central
banks' central bank", as it coordinates transactions between central
banks.

 

BIS points out in a new report
that the bank rescue packages have transferred significant risks onto
government balance sheets, which is reflected in the corresponding
widening of sovereign credit default swaps:

The
scope and magnitude of the bank rescue packages also meant that
significant risks had been transferred onto government balance sheets.
This was particularly apparent in the market for CDS referencing
sovereigns involved either in large individual bank rescues or in
broad-based support packages for the financial sector, including the
United States. While such CDS were thinly traded prior to the announced
rescue packages, spreads widened suddenly on increased demand for
credit protection, while corresponding financial sector spreads
tightened.

In other words, by assuming huge portions of
the risk from banks trading in toxic derivatives, and by spending
trillions that they don't have, central banks have put their countries
at risk from default.

Now, Greece, Portugal, Spain and many
other European countries - as well as the U.S. and Japan - are facing
serious debt crises. We are no longer wealthy enough to keep bailing out
the bloated banks. See this, this, this, this, this and this.

Indeed, the top independent experts say that the biggest banks are insolvent (see this, for example), as they have been many times before. By failing to break up the giant banks, the government will keep taking emergency measures (see this and this) to try to cover up their insolvency. But those measures drain the life blood out of the real economy.

And by failing to break them up, the government is guaranteeing that they will take crazily risky bets again and again, and the government will wrack up more and more debt bailing them out in the future. (Anyone
who thinks that Congress will use the current financial regulation -
Dodd-Frank - to break up banks in the middle of an even bigger crisis is
dreaming. If the giant banks aren't broken up now - when they are threatening to take down the world economy - they won't be broken up next time they become insolvent either. And see this. In other words, there is no better time than today to break them up).

Moreover, Richard Alford - former New York Fed economist, trading floor economist and strategist - recently showed that banks that get too big benefit from "information asymmetry" which disrupts the free market.

Indeed, Nobel prize-winning economist Joseph Stiglitz noted in September that giants like Goldman are using their size to manipulate the market:

"The
main problem that Goldman raises is a question of size: 'too big to
fail.' In some markets, they have a significant fraction of trades. Why
is that important? They trade both on their proprietary desk and on
behalf of customers. When you do that and you have a significant
fraction of all trades, you have a lot of information."

Further,
he says, "That raises the potential of conflicts of interest, problems
of front-running, using that inside information for your proprietary
desk. And that's why the Volcker report came out and said that we need
to restrict the kinds of activity that these large institutions have. If
you're going to trade on behalf of others, if you're going to be a
commercial bank, you can't engage in certain kinds of risk-taking
behavior."

The giants (especially Goldman Sachs) have also used high-frequency program trading which not only distorts the markets
- making up more than 70% of stock trades - but which also lets the
program trading giants take a sneak peak at what the real (that is,
human) traders are buying and selling, and then trade on the insider
information. See this, this, this, this and this. (This is frontrunning,
which is illegal; but it is a lot bigger than garden variety
frontrunning, because the program traders are not only trading based on
inside knowledge of what their own clients are doing, they are also trading based on knowledge of what all other traders are doing).

Goldman also admitted
that its proprietary trading program can "manipulate the markets in
unfair ways". The giant banks have also allegedly used their Counterparty Risk Management Policy Group (CRMPG) to exchange secret information and formulate coordinated mutually beneficial actions, all with the government's blessings.

Again, size matters. If a bunch of small banks did this, manipulation
by numerous small players would tend to cancel each other out. But
with a handful of giants doing it, it can manipulate the entire economy
in ways which are not good for the American citizen.

Moreover, JP Morgan Chase, Bank of America, Goldman Sachs, Citigroup, and Morgan Stanley together hold 80% of the country's derivatives risk, and 96% of the exposure to credit derivatives. Experts say that derivatives will never be reined in until the mega-banks are broken up, and yet unregulated derivatives are one of the main risks to the economy.

In addition, as everyone from Paul Krugman to Simon Johnson has noted, the banks are so big and politically powerful that they have bought the politicians and captured the regulators. So their very size is preventing the changes needed to fix the economy.