Break Up The Big Banks? Seven Reasons Why That’s A Bad Idea
In recent months, many politicians and policymakers have grown more aggressively vocal in their call to break up large and systemically important U.S. banks as a further measure toward preventing another global financial crisis. We suggest they reconsider for several reasons.
- Regulations are already helping. Since the crisis in 2008–2009, we have seen a wave of improvements in bank regulation and supervision, from the application of Basel III enhanced capital and liquidity requirements to much of the Dodd-Frank Act, robust stress testing and the move to greater transparency in bank risk disclosures. Also, several large banks have shrunk their balance sheets and reduced their operational complexity in recent years in the context of the emerging “living will” resolution frameworks that require banks to plan ahead for a worst-case scenario.
- A breakup could prompt another credit crunch. At least in the short term, we could expect any move to break up big banks would be disruptive to those banks and to many of their peers, and that disruption could easily spill into reduced lending activity. The operational challenges and costs around a breakup would be daunting, to say the least, and that distraction would likely encourage even greater risk aversion in lending practices, at least through the transition.
- Smaller banks are not necessarily less risky. The risks to the financial system of a large bank failing are obviously greater than of a small bank failing. However, while the new smaller banks might be less exposed to funding shocks, they would still be exposed to all the correlated risks that always plague banking systems: property bubbles, commodities bubbles, excesses in corporate leverage, etc. And with bank regulators now needing to supervise so many more banks, would the supervisory regime be sufficiently robust to manage these correlated risks?
- Bank bail-ins are already a reality. The premise that large systemically important banks must be broken up is founded primarily on the argument that bondholders could not tolerate being “bailed in” in the event of a shock to a number of large banks. This argument, however, ignores the revolution in the way the market perceives bank credit since the 2008–2009 crisis. Most bondholders today recognize that the new bail-in regime is a reality, in part because any bailout of bondholders (instead of bail-in) would be politically toxic, and in part because bondholders have already suffered a series of important, if contentious, bail-ins in European banks.
- Bondholders would be wary of new entities. At present, the vast majority of the roughly $950 billion in bonds issued by the eight largest U.S. banks are issued out of their respective parent holding companies (source: Bloomberg). If the banks are broken up, which part of the bank is responsible for the existing debt? The new entities that would house the investment banking operations of the legacy big banks would require substantial wholesale funding, so they would require the bulk of the existing bond funding. But they could also be by far the weakest of the post-breakup new entities, with ratings that barely qualify as investment grade.
- We could see less capital in the system. At present, large and systemically important banks are required to run with significantly more capital than their regional bank brethren. With good reason, the largest G-SIBs (global systemically important banks, as determined by the G-20 Financial Stability Board) are required to run with a capital ratio of 10.5% versus just 7.0% for the larger super-regional U.S. banks. In addition, the G-SIBs have to carry an additional 9.5% of their risk-weighted assets in loss-absorbing bonds that can be bailed in if needed. The smaller non-G-SIB banks, however, have no requirement to carry loss-absorbing debt.
- There could be a potential increase in counterparty risk. The financial system is now far less susceptible to a major bank failure than it was in 2008, largely thanks to better risk management around derivatives counterparty exposures, especially the shift to centrally cleared derivatives. However, large portions of the derivatives market still rely on old-fashioned bilateral counterparty relationships. To minimize counterparty risks, though, most market participants look for a parent-level guarantee when they trade with the derivatives arm of a large bank. If a subsidiary entity is shorn away from the parent, there would suddenly be significantly more counterparty risk in the system.
At PIMCO, we agree that some of the biggest banks are not at their optimal size. Yet while further measures to encourage simpler and smaller balance sheets and operations may be needed, policymakers need to keep a close eye on their unintended consequences, no matter how politically appealing the measures may seem.
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With thanks to Del Anderson, Richard Hofmann and Matthieu Loriferne who assisted in preparing this note.