Former Federal Reserve Chairman Ben Bernanke said Friday that breaking up the big banks “doesn’t seem to be a smart way” to promote financial stability.
Bernanke, in a blog post previewing his appearance Monday at a Minneapolis Fed symposium, said that a lot of progress has been made toward reducing the risks that large, complex financial institutions pose to the financial system, but that thoughtful debate is still necessary because “it’s really important to get this right.”
Bernanke, the world’s most powerful banker during the financial crisis, will lend an air of authority to the second forum in Minneapolis Fed President Neel Kashkari’s effort to come up with a proposal by year’s end to end too big to fail, the notion that some banks are so large and important that their failure would create an economic crisis.
Kashkari has floated such ideas as breaking up the big banks, raising capital requirements, or taxing their leverage to encourage them to take on less risk.
Bernanke signaled Friday that he doesn’t think breaking up the biggest banks is the right call.
Reforms since the financial crisis — including the Dodd-Frank Act and the Basel agreements — have set in motion stronger incentives for banks to shrink or otherwise restructure themselves to reduce the risk they pose, he said. Only dramatically reducing the size of banks could be on the table, he said, given that the firms at the center of the financial crisis weren’t the largest ones.
“Modest size reductions are not going to accomplish much,” he wrote. “After all, Lehman Brothers was only about a third the size of the largest banks when its failure in September 2008 nearly brought down the global financial system.”
The ex-chairman, who is now a fellow at the Brookings Institution, said he sees two important drawbacks to breaking up the large banks.
First, there are good business reasons for large banks. They enjoy economies of scale, can spread fixed overhead costs over vast operations, and have global reach. His comments in this respect echoed those of JPMorgan Chief Executive Jamie Dimon, who said last month that large banks are an important part of the U.S. economy and crucial to its global leadership.
“Even putting aside the short-term costs and disruptions that would likely be associated with breaking up the largest banks, in the long run a U.S. financial industry without large firms would likely be less efficient, providing fewer services at higher cost,” Bernanke wrote. “From a national perspective, this strategy could also involve ceding leadership in the industry, and the associated jobs and profits, to other countries.”
The second drawback is that financial panics can happen in systems dominated by small banks, Bernanke wrote. This was the case with the Great Depression in the United States. Canada, which has only large banks, fared better in both the 1930s Depression and 2008 recession than the United States. Complexity, opacity, illiquidity, and interconnectedness with other firms helped make Lehman’s collapse catastrophic in 2008, he said.
“A more nuanced approach to ensuring financial stability and ending TBTF should take size into account, but other factors as well,” Bernanke wrote, using the acronym for too big to fail.
Bernanke said he is reassured about the stability of the financial system by reforms that raise capital requirements for banks, subject them to “tough” stress tests, and enforce higher standards for liquidity and risk management. He also believes the development of a new failure resolution regime, which lays out the ways a large bank should be wound down when it’s on the brink of failure, has been useful.
All of this is a work in progress, he said, but it is progress toward changing the incentives for banks, and it’s more important than the public appreciates. The unresolved debate about the adequate level of capital for a bank is also important, he said, and regulators need to coordinate more with foreign regulators to make sure multinational firms can be wound down safely.
But banks and their shareholders better understand their reasons for size and complexity than regulators do, and regulators should use that knowledge, he said.
“My takeaway is not that the problem is solved … but rather that the current approach amounts to a process that will help us find the solution,” Bernanke wrote.