TBTF

Larry Summers thinks US banks should maybe be a little bit bigger

July 28, 2013
July 28, 2013
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Summers seems to have fixed his gaze on the Fed’s top job.Reuters / Jonathan Ernst

Larry Summers now seems to be the front-runner to become the next head of the US Federal Reserve.

If he gets the job, he’ll be both the guardian of monetary policy and one of the most important financial regulators in the country. As such, we figured it was worth digging through some of Summers’ recent statements to try to get a sense of what kind of regulator he would be.

Summers is sometimes queried on his role in the Clinton-era deregulatory push, which peaked with the passage of the Gramm-Leach-Bliley Act in 1999. As the cognoscenti cog-know, that law removed protections that had previously separated commercial banks from Wall Street trading houses. And many, such as Elizabeth Warren, now a senator from Massachusetts, argue that the repeal of those protections “mattered enormously” to how the crisis played out.

Summers begs to differ. He tends to deflect criticism with a couple of arguments. He points out that some of the highest-profile financial failures of the crisis—Bear Stearns and Lehman Brothers—were individual Wall Street investment banks. In other words, they would have been allowed to exist even before Gramm-Leach-Bliley was enacted. “If you look at the big failures, Lehman and Bear Stearns were both standalone investment banks,” he told a British interviewer back in early 2012. “Perhaps if they had been combined with banks they would have been in a more healthy situation.”

Strictly speaking, that may be true, but it’s a limited way of looking at the financial crisis. The collapse of Bear and Lehman really only mark well-known peaks of the financial crisis. Major “Main Street” financial institutions also either collapsed or provoked panicked, last-minute rescues, including what was once the largest US mortgage originator, Countrywide Financial, and the country’s largest-ever bank failure, Washington Mutual. (Update: Though to be fair, those failures of large old-school banks were brought on pretty much by traditional lending practices, where standards had become recklessly low, not by new investment-banking and trading operations allowed under Gramm-Leach-Bliley.)

And it’s not as if Bear and Lehman failed and that was the end of the problem. The collapse of Lehman set off a panic that threatened to take down US megabanks such as Citigroup and Bank of America. Those deposit-taking institutions were vulnerable because they had large trading divisions that had grown in size and importance after the Depression-era restrictions were removed. And it ultimately took a system-wide bailout funded by the US taxpayer to quell the panic.

But another way Summers tends to parry questions about his record as a deregulator is more interesting. He brings up Canada (at 11:20 in the video) and its heavily concentrated banking system:

What country has been the best probably at weathering this financial storm, of the major countries? It’s probably Canada, which has only five major banks in the whole country, which are very broad in the set of activities in which they engage. So no, I was not favor of the regulation that separated entirely banking and investment banking activities because I recognized the importance of diversification.

Doesn’t it sound like Summers is arguing that the US financial crisis was a result of having banks that were too small, rather than too large? Summers seems to make a similar argument in this July 2012 interview with NPR (at 11:00):

I also think it’s a mistake to assume that somehow breaking up the banks would be a panacea. The lesson that was drawn from the S&L crisis was that the financial system was excessively fragmented. That was the lesson that was also drawn from the Depression. The other lesson that most experts have drawn from recent experience is that Canada, which has a much more robust system of regulation than other countries, has been a model. But it has a financial system that is heavily consolidated.

Now, Summers has a point. The Canadian system does suggest that a banking system isn’t necessarily doomed to instability if it is dominated by large, complex institutions. Canada’s largest are both commercial and Wall Street-style investment banks. But Canadians are stricter on their banks than Americans.

In the run up to the financial crisis, Canada’s single banking regulator, the Office of the Superintendent of Financial Institutions, “proved tougher than in the United States, mandating higher capital requirements, lower leverage, less securitization, the curtailment of off balance sheet vehicles, and restricting the assets that banks could purchase,” according to economists (pdf) who have studied the difference between the US and Canadian systems.

The idea of simply allowing the US banking system to become as concentrated as Canada’s is nuts. The US has proven time and again that it doesn’t have the regulatory chops to keep American banks from periodically blowing themselves up—along with large chunks of the real economy.

If Summers is tapped to run the Fed, confirmation hearings will likely zero in on his seemingly favorable views on the concentration of the banking system. It would be useful to understand what exactly he is suggesting. Given Summers’s love of debate, that could make for a lively back-and-forth, as a bi-partisan break-up-the-banks bill has been on the move lately.

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