Can governments avoid being trapped between the choice to let a big bank fail or increase banking concentration?

Question

The too big to fail situation in the banking system has been criticised multiple times, but banking concentration in the US and Europe is still rising. The problem is not only the systemic risk, but also the formation of oligopolies, in more than half of the listed countries the three top banks control more than 60% of the country assets.

Now the Credit Suisse crisis became an excuse to exacerbate the problem by enabling a merger between the two biggest banks in Switzerland. An operation that in normal conditions would probably have been rejected due to anti trust concerns. Furthermore the failure to address the too big too fail problem was censured once again, but the Swiss parliament vote was only symbolic.

In the last 30 year we already saw the collapse of many big banks, past experience shows that we cannot rule out it will happen again. In that case it is also possible that the financial institutions will take advantage of the situation to force the political world to accept further concentration. Until now the only alternative solutions adopted by some governments were unpopular nationalisations like it happened with ABN AMRO and Royal Bank of Scotland. But given the rise of government debts it is unlikely that they will be able to save again a collapsing bank by nationalisation.

Is there a way for governments to avoid to remain trapped between two evils? Increase banking concentration or risk a systemic failure.

Answer 1

The Glass-Stegall legislation was meant to prevent these types of situations.

The legislation puts a firewall between "commercial bank" and "investment bank" activities. There's even an amusing explainer from the HBO series The Newsroom on that.

Generally speaking:

• Commercial banks run traditional checking account for average consumers. We deposit our money in the bank and they use some of those monies to make relatively low-risk loans to other people in society (see 0:00 - 5:30). When they do trade in financial instruments, they are restricted to trading tightly-regulated, government approved, boring instruments.

• Investment banks do not run checking accounts at all. Their business consists entirely of helping their clients trade in complex, high-risk (but potentially higher-reward) financial instruments.

Under the Glass-Stegall legislation, banks have to choose to be either commercial bank or investment bank exclusively. The end result is that banks cannot take average people's desposit as commercial bank, then turn around to gamble those monies in high-risk trading as investment bank.

This way, if investment banks melt to the ground due to years of irresponsible trading, the governments don't need to bail them out because the average consumer's money are safely insulated in commercial banks.

This, however, is not our reality right now.

The Glass-Stegall legislation was repealed decades ago, and commercial banks immediately start merging with investment banks. This is now more or less the global standard, most banks dabble in both commercial AND investment bank activities simultaneously.

Proponents of these types of legislations argue that until governments reinstate a firewall between commercial and investment bank - and a financial collapse does happen again - then the banks can repeatedly hold people's deposits hostage in exchange for a government bailout - and the government will most likely give them what they want.

Answer 2

Is there a way for governments to avoid to remain trapped between two evils? Increase banking concentration or risk a systemic failure.

Yes. A few options come readily to mind:

1. Allow foreign banks not previously allowed to do business in a country to do business in a country, with some sort of government subsidy or encouragement (such as regulatory waivers), to help make it happen.

2. Nationalize the banking sector. This maximizes banking concentration but without the abuses associated with a private monopoly and the systemic risk associated with investor owned banks.

The question notes that:

Until now the only alternative solutions adopted by some governments were unpopular nationalisations like it happened with ABN AMRO and Royal Bank of Scotland. But given the rise of government debts it is unlikely that they will be able to save again a collapsing bank by nationalisation.

But, I don't think that the Royal Bank of Scotland move remained unpopular in the long run, even if it was momentarily. And, "the rise of government debts" isn't an obvious barrier since in insolvent bank is, by definition, cheap so the equity holders can be cut out entirely much as they were in the Silicon Valley Bank sale in the U.S. to another private bank. Ultimately, a national government can make more money if it must. Done too often or to too great an extreme, this can lead to hyperinflation, but that doesn't have to be the case for a one off bank nationalization.

3. Turn banking into a regulated utility. This also allows for increased banking concentration while mitigating the downside of this oligarchy.

4. Allow financial companies, like brokerages, investment banks, and insurance companies that aren't banks to buy troubled commercial banks to provide them with fiscal strength.

5. Place the failed bank under a receivership and reorganize it. In the U.S., the FDIC system comes close to this model.

6. Force one or more of the big healthy banks to break themselves in a manner similar to the way that U.S. anti-trust officials forced the break up of American Telegraph and Telegram (AT&T).

7. Rather than relying on a central bank, deposit most government funds into medium sized banks thereby making them into bigger banks.

Answer 3

The too-big-to-fail problem has two components, first the number of entities that are too big and second the expected loss if they need to be rescued. Both components can be limited with readily available means.

The number of entities too big can be reduced by anti-monopoly regulations, which includes but is not limited to controls of mergers or even forced breakup in the worst case. Anti-monopoly laws and agencies exist. For example in the US or in the EU.

The expected loss in case of a rescue action can be minimized by higher capital requirements on those bigger entities. See for example the Basel accords which have resulted in increasing amounts of equity needed. Governments additional supervise banks in an effort to keep the risk of a bank imbalance under control. See for example the Dodd-Frank act.

Specifically for your examples: Credit Suisse Bank's problems built up in the past and were at least partly known. The bank could have been broken up or higher capital requirements could have been imposed on it already in the past. Now, the merged UBS/CSB can still be broken up in smaller units to avoid problems in the future. Large losses like during the rescue of ABN Amro and Royal Bank of Scotland might not be possible anymore with the higher capital requirements in Basel III, compared to Basel I/II, which was valid back then when they needed to be rescued.