The great too-big-to-fail debate: stick with Dodd-Frank or break up the banks?

• Author: Berry, John M.

You would never know it from the nasty presidential election year debate over too-big-to-fail, but nine years after the horrific financial crisis began in 2007, the U.S. financial system is in fine shape. Collectively, banks and savings institutions earned roughly $150 billion last year, only eight of 6,200 institutions failed, and most were small. Bank lending, hammered during the crisis, has largely recovered, albeit with more prudent underwriting standards. And banking regulation and supervision are far more stringent than they were a decade ago, particularly for the largest institutions. Nevertheless, memories of the crisis, the bailouts of institutions regarded as too big to fail, or TBTF, and the sense of unfairness those generated are playing a key role in the presidential nomination campaigns.

Senator Bemie Sanders of Vermont, seeking the Democratic nomination, insists in all his stump speeches that we must "break up the big banks" to ward off collapse of a TBTF institution that could trigger another crisis and perhaps another round of bailouts, and in the process bring Wall Street to heel. He brushes aside any thought that federal regulators implementing the Dodd-Frank Act have made enormous strides in reducing the risk of such a failure. Senator Ted Cruz of Texas, in his campaign for the Republican nomination, said all the big banks that got bailouts during the crisis should have been allowed to go broke, disregarding the devastating impact of a collapse of the financial system on the economy. Of course, he also touts the supposed virtues of a return to the gold standard.

In an interview with editors of the New York Daily News, Sanders would not say how large a bank would be okay or whether new legislation would be needed to force banks to shrink. He would let the banks themselves decide how to go about doing it.

Nowhere in the political wrangling is there any sense that breaking up the banks might create havoc in the country's financial system. For instance, a proposal by economist Simon Johnson of the Sloan School of Management at the Massachusetts Institute of Technology to limit bank assets to no more than 2 percent of U.S. GDP, or about $360 billion, would require the nation's three largest banks, JPMorgan Chase, Bank of America, and Citibank, to shed about one-third of the $16 trillion in all the nation's banks. That would require tens of millions of American households and businesses to find a different bank. Longstanding banking relationships would be obliterated. It would produce chaos and likely throw the economy into a tailspin. Is that sort of cost worth it to avoid the possibility of a TBTF failure? Banks and their financial intermediation services are a critical element in a healthy modem economy, which Sanders seems not to understand.

Meanwhile, Neel Kashkari, the new president of the Minneapolis Federal Reserve Bank, startled his Federal Reserve colleagues by making it plain that he, too, wants to break up the banks. Kashkari acknowledges the strides regulators have made in dealing with TBTF institutions, but said he doubts that officials would in fact be willing to take a chance that any large failure would not take the whole system down. At a seminar at the Brookings Institution earlier this year, Kashkari, a senior aide to Treasury Secretary Henry Paulson during the crisis, said his bank will host a series of symposiums this year to discuss the issue. And before the year is out, the Minneapolis Fed will formulate a plan for "transformational" policies that could eliminate all TBTF risk, Kashkari promised. Among the possibilities would be "breaking up large banks," he said.

Actually, most of the financial institutions that are regarded as TBTF are already shrinking as a result of major changes in banking regulations that have made it substantially more costly to be really big.

Dodd-Frank created the Financial Stability Oversight Council, or FSOC, comprised of representatives of ten major financial regulatory agencies, to deal with TBTF institutions. It is led by the secretary of the Treasury and it determines which institutions are TBTF. Officially, they are labeled global systemically important banking organizations, or GSIBs. A number of tough mies and costly regulations apply only to them.

As Federal Reserve Chair Janet L. Yellen...