Break up the Big Banks for the Right Reasons

By Bob Gerecke

The size of banks and their (excessive) trading in derivatives are two different problems and require different solutions.

End of the year legislation to fund the federal government included an unrelated provision to let banks buy more derivatives.  This generated a call by some to break up the big banks.  That, however, is the wrong strategy for the particular problem of derivatives.

Because almost all banks buy and sell derivatives to one another and to other parties, and because derivatives require that for every winner there is a loser, the total volume of derivatives in proportion to the total capital of all banks is more important than the size of particular banks.  If a black swan financial event occurs, banks holding derivatives will be clobbered, regardless of size.  The winners probably won't be able to collect from the losers, so they will all go down together, regardless of size.

An instructive event occurred on Black Monday in 1987.  On the Chicago futures exchange, the price of S&P500 futures collapsed.  On behalf of the winners (who had sold short), the exchange could not collect from many of the losers (who were long and were unable to meet their margin calls).  The exchange was in danger of going bankrupt and failing to open on Tuesday morning.  The members of the exchange - those who owned the seats on the exchange - were obligated to supply the missing money in order to keep the exchange solvent.  They were holding back, each waiting to see if the others would put money in, because if they put money in and the others didn't, the exchange would fail anyway and they'd simply be out of the money they put in.  Alan Greenspan, who was chairman of the Federal Reserve, telephoned a friend who was chairman of a large Chicago bank that owned seats on the exchange.  He asked that the chairman tell his people to put the money in, and he promised that he would somehow make it up to the bank if the exchange failed anyway.  The bank put its money in, via computer hook-up.  When other seat-holders saw it, they put their money in, and the exchange was saved.

The total amount of financial derivatives has exploded since then, it has continued to explode since 2008, and the recent legislation permitting banks to buy derivatives with depositors' money will make it explode even further.  In a black swan event, the margin calls will be huge, and the exchange's seat-holders will be unable to cover them.  In addition, many derivative deals between financial institutions are now off-exchange, so there will be no exchange members to cover them.  The government will have to bail the system out.  This will happen because of the huge volume of derivatives, not because a few banks are too big to fail.  The banking system itself is too essential to fail, and the FDIC will be unable to cover the failures, because they will be widespread.  The G20 - the wealthiest countries - are considering adoption of a rule which will make bank depositors take some of the losses.  The general public, as depositors and taxpayers, will pay the price.

Therefore, that the strategy must be to reduce the ratio of all banks' derivatives exposure to their capital, rather than reduce the size of the largest banks.  No bank should hold an exposure to loss from derivatives in excess of its capital.  A campaign to convince the public of this may be more successful than one to cut down the size of the big banks.  Everyone can understand this, and a counter-argument should be difficult to frame.  Also, it will appeal to conservative voters, many of whom have savings in banks.

That recommendation regards only the issue of derivatives.  There are other reasons why we should not allow a few big banks to be so dominant.  But making them smaller won't eliminate the enormous risk from gambling in derivatives.  Instead the risk from derivatives in a system with many smaller banks will simply affect a larger number of banks, i.e., the pieces of big banks which were broken up and the medium-sized banks which will take advantage of the opportunity to pick up some of the big banks' business.  If more banks go under, it will cause more panic.