Does a sophisticated modern society need too-big-to-fail banks?

No.

Banks today perform two distinct and unrelated functions: they facilitate payments and they create credit. Both are essential for contemporary society. Neither needs to be housed within a financial institution that extracts rents from the rest of us by being “too big to fail.”

It is the combination of the two activities that makes big banks so pernicious. There is no reason why a company that manages deposits, wire transfers, and debit/credit cards also needs to make long-term loans, much less underwrite securities or trade in the markets.

Yes, a company that focused only on payments would be less profitable than a contemporary TBTF bank but it would also be far safer. Such a company would never need to use the Fed’s discount window, never need bailouts, and never exacerbate financial crises. In other words, it would be a utility.

You could even have the entire payments system run directly by the Fed. One of the additional benefits would be a simplified monetary policy transmission mechanism.

The connection between deposit-taking and lending is an accident of history. Institutions that originally focused on payments wanted to make an extra profit so they decided to lend out the deposits using fractional-reserve banking. Nowadays, banks lend first and generate the reserves later, often by borrowing them from another institution. This works well enough most of the time and is understandably quite popular with bank owners and managers. Thus credit creation became linked with the payments system.

What if the bankers make bad loans? This is the real reason why they still take deposits. Bankers do not need your savings account (or money-market account) to support their more exotic activities. Hedge funds seem to do just fine without having regular people funding them. The big banks need your money so they can force the government to intervene on their behalf when things go pear-shaped. It’s one thing to let a casino go broke. It’s another to force Mom and Dad onto the streets because their nest egg was wiped out through no fault of their own.

Hence the creation of central banks to serve as “lenders of last resort.” In the U.S., the Fed was invented by Wall Street bankers shortly after the panic of 1907. Backstopped by the American taxpayer, the big bankers could take more risk while paying lower interest costs because of their guaranteed ability to borrow unlimited amounts from the Fed if they ever ran into trouble. This has done wonders for their profitability and led to much higher leverage ratios.

So there is a good argument for separating the payments system from the business of credit creation. This would limit bankers’ abuse of taxpayer generosity and remove the need for market distortions like the discount window and deposit insurance. In fact, James Tobin made this case back in 1987.

Now suppose that banks only focused on credit creation. Would they need to be so big that they could hold the nation for ransom? Would their failure automatically destroy the economy? The answer to both questions is “no.”

In 1983, a young scholar at Stanford named Ben Bernanke argued that bank failures in the early 1930s exacerbated the Great Depression. This was because the banks were specialists that researched investment opportunities to more effectively match savers with borrowers. As the banks failed, those who needed capital found it harder to connect with those who wanted to earn a return, sapping economic activity and making the downturn worse.

Does this logic apply today?

Not really. From the perspective of credit creation, big banks are just one kind of actor in the modern financial system. They borrow from one group of people and lend to another at a slightly higher rate—nothing more interesting or systemically important than a leveraged long-only bond fund. This is not a uniquely valuable activity.

Savers can participate directly in the credit creation process without dealing with banks by buying mutual funds or buying bonds in the capital markets. There are plenty of other institutions that create credit, including insurance companies, asset managers, pension plans, and hedge funds.

Some are enormous and others are small. The bigger ones have a harder time finding opportunities that others have missed. For a bank, the only advantage to size is lower funding costs but this is beneficial only for the owners and managers of the bank. They do not necessarily earn superior returns on their assets.

A small community bank with a keen sense for which local firms will do well is obviously different. This is the sort of intermediary that Bernanke found so crucial. Yet they are not considered systemically important compared to the megabanks, which hire other firms to originate loans and then sell those loans off to investors in the capital markets. Unlike the community banks or the hedge funds, the megabanks do not have the same incentives for checking whether their borrowers will actually pay them back. It is a recipe for repeated crises.

Moreover, businesses do not need credit to expand. They can also issue equity, which is much healthier from the perspective of systemic stability. Households currently cannot, but it arguably makes a lot more sense for students to finance their education through a claim on a share of future after-tax earnings rather than through usurious loans.

There is no need for gigantic banks that can demand unlimited bailouts whenever they are forced to face their own incompetence. The size and importance of the megabanks come from their control of the payments system, which can be addressed by cutting off the risk-takers from the utilities.

Contrary to what the megabanks might have you believe, this would not impair the financial system’s ability to match savers with borrowers. Big companies can already access funds through the capital markets. Households and smaller firms would be better off relying on specialists anyway, whether they are angel investors or community banks.

Those who say that this is impossible suffer from a failure of imagination. They are the same sorts of people who thought that the Europeans could not survive without their empires. Yet it turned out that they could not survive with them. Nor can a capitalist democracy long survive the reign of “too-big-to-fail.”

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About Matthew C. Klein
I write about the economy and financial markets for Bloomberg View. Before that I wrote for The Economist on a fellowship provided by the Marjorie Deane Financial Journalism Foundation. I have worked at the world's largest hedge fund and read every FOMC transcript since May, 1987.

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