Smaller institutions may pose less risk

Smaller institutions may pose less risk

The financial crisis is forcing regulators to encourage the creation of bigger, more interconnected institutions. In the short term, this may serve a useful purpose by allowing healthier banks such as BNP Paribas SA, Barclays Plc., Banco Santander SA and Wells Fargo and Co. to shore up weaker ones.

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The basic problem is, in the argot of Wall Street, excessive concentration of risk—or, in laymen’s terms, the placing of too many eggs in too few baskets. For the moment, it’s easy to see why regulators have encouraged this.

Supervisory acquisitions such as JPMorgan Chase and Co.’s of Washington Mutual Inc. and Bear Stearns Companies Inc., and Bank of America Corp.’s of Countrywide Financial Corp. and, to a lesser degree, Merrill Lynch and Co.—are a common tactic regulators use in times of severe credit distress to spread capital across the banking system to fill in the weak spots.

Yet, it’s creating some real monsters. In the UK, a combined Lloyds TSB Group/HBOS would have 29% of the mortgage market. Meanwhile, each of the three big US predators—Bank of America, JPMorgan and Wells—may be close to busting through the regulators’ 10% cap on any one bank’s share of total US deposits. Watchdogs might well show temporary forbearance, and later force banks to sell off deposits. But for now, a failure of any of the three would almost certainly wipe out the current reserves of the Federal Deposit Insurance Corp.

Because they have tendrils in so many other, riskier businesses—among them investment banking, private equity and servicing hedge funds through prime brokerages—these mega institutions pose risks to the financial system that could be beyond regulators’ ability to contain.

Indeed, Lehman Brothers Holdings Inc.’s failure showed that even smaller firms can be so interlinked through capital markets—particularly their more opaque corners such as credit default swaps (CDSs)—as to approach systemically critical status.

The worry is that the biggest banks, because they are deemed too important for governments to let them go under, could develop risk-taking cultures unchecked by the full discipline of a free market. This is something akin to what happened, and could conceivably happen again, at Fannie Mae and Freddie Mac. It’s also one reason some investors have called for Citigroup Inc. to be broken up.

In a nutshell, the institutions that regulators are now willing to see get too big to fail, and even to save, need, before long, to be changed so they’re either super-safe or too small to matter much. Regulators are preoccupied with sorting out the current mess. But even now, they shouldn’t forget to think about how they’ll address big concentrations of risk once the financial system looks more stable.

As Bernanke stated last week, the broad outlines of reform would include more robust regulation to make sure giant banks do not take advantage of their too-big-to-fail status. Second, financial infrastructure needs strengthening. A central clearing house for CDSs, for example, would make that market less complex and more transparent.

Finally, Bernanke wants a clear mechanism to handle the failure of non-bank financial institutions such as Lehman. The Federal Deposit Insurance Corporation Improvement Act provides a blueprint for handling the collapse of banks. But the bankruptcy process is not well suited to an orderly winding down of a securities firm with operations around the world.

All of Bernanke’s ideas make sense. But the most effective way to minimize the chance that institutions are too big to fail would be, well, to make them less big—and more to the point, less interconnected.

Regulatory carrots and sticks would help. One approach would be to increase the cost of deposit insurance for banks that engage in practices deemed risky. Another would be to raise capital requirements in such a way as to force riskier businesses, possibly even entire divisions such as fixed income, currencies and commodities trading, into separate, ring-fenced subsidiaries that are highly capitalized—or even make it worth banks’ while to hive them off altogether as hedge funds.