Structuring Finance to EnhanceEconomic Growth and Stability

by Douglas J. Elliott

Brookings Institution Press © 2013

getAbstract © 2013

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Take-Aways• America’s regulatory response to the 2008 crisis

ignored an opportunity to rethink the purpose andstructure of the financial sector.

• The finance industry’s purpose should be “to servethe real economy” by providing liquidity, acting asan intermediary and managing risk.

• Before the crisis, many large banks benefitted froman implicit government guarantee.

• Risk occurs when these too-big-to-fail institutionsteeter, but the failure of a significant number ofsmall banks can also pose a danger to the financialsystem.

• Capping the size of banks could lead to a reductionin overall economic benefits.

• Preventing banks from proprietary trading may notmake practical economic sense.

• Regulators are exploring “ring fencing” to isolatedeposit taking from riskier activities.

• The Volcker rule, which bans US banks fromproprietary trading, could cause them to withdrawfrom securities activities.

• Regulators must understand the economics ofscale and scope in the financial industry.

• If banks save money when they engage in bothbanking and the securities industry, restricting themfrom doing so could increase costs to society.

RelevanceWhat You Will LearnIn this summary, you will learn:

1.) How the structure of the financial industry and itsreform are intricately related,

2.) Why breaking up large banks and restricting theiractivities may not benefit the economy or society,and

3.) Why economic experts agree on the need for moreresearch.

RecommendationGovernments responded symptomatically to the 2008financial crisis and spent little time examining thestructure and rationale of the financial system and itsrelationship to regulatory reform. The Economic Studiesprogram at the Brookings Institution brought togetherexperts and analysts from the US Federal ReserveSystem, universities and the financial industry to discussfundamental issues related to the structure of finance.Among those participating were Daniel Tarullo, a memberof the Board of Governors of the Federal Reserve Systemand the leader of the Fed’s financial reform efforts;Martin Baily, former chairman of the President’s Councilof Economic Advisers; and Donald Kohn, former vicechairman of the Federal Reserve Board. Baily and Kohnare senior fellows at Brookings. They and other speakersexpressed a variety of opinions but all agreed on theneed for more extensive research about a range of fiscalissues. getAbstract recommends this informed discussion

to anyone who wants an overview of the debate about theUS financial industry and its reform.

SummaryPeculiarities and PurposeFinancial industry reform in the wake of the 2008 financialcrisis has centered on preventing what went wrong thenfrom happening again. But that response ignores anopportunity to ask basic questions about the properpurpose and structure of the financial sector. It fails todelve into what benefits finance should seek to achieveand how society can best organize the financial industry toachieve those goals.The financial industry is unique in the way its fortunesaffect the broader marketplace. Its purpose should be “toserve the real economy” by providing liquidity, acting as anintermediary between savers and borrowers, and helpingto manage risk. Most experts agree that it is not necessaryfor the government to support the industry for its own sakebut that this sector’s “proper working” is “critical for overalleconomic growth and activity.”Though no longer practiced widely, “industrialorganization” (IO) – the study of how industry structuresachieve specific business or social objectives – couldprovide important ideas on how the financial sector canbetter address socioeconomic needs. Organizing financemore effectively could lead to regulatory changes thatwould promote growth and stability while safeguarding theinterests of all members of society.For regulators to design effective laws, they mustunderstand the financial system’s economies of scale andscope: Large banks can be more efficient than smallerinstitutions and can provide individuals, households and

businesses with a wider range of cheaper products andservices. Take the question of whether it makes senseto restrict deposit-taking institutions from participating insecurities markets: If banks gain significant economiesfrom engaging in both spheres of activity, restrictingthem to one or the other could impose greater costs onthe public. On the other hand, if those economies existbecause large banks operate with the unfair advantage ofimplicit government support, then constraints on size andactivity would be rational remedies.In addition, IO would deal with the unseen dynamicsof the financial industry, such as the extent of thecooperation necessary among banks to ensure creditand market liquidity. The financial sector’s actions haveunintended ripple effects that spread throughout aneconomy. These “externalities” are another industrydynamic. “Mark-to-market accounting” forces banks torecognize losses on assets when prices are tumbling.Banks’ interconnectedness with one another, withother institutions and with markets in general promotes“contagion”: When panic occurs, fear spreads quicklyamong market participants, forcing selling that pushesmarkets even lower.“Societal Objectives”Some financial sector parties have lost sight of theindustry’s societal responsibility. The 2008 financial crisisrevealed many transactions and financial products with nounderlying commercial value; rather, they existed only “toenrich the participants.” Yet it is hard to judge where valueends and speculation begins: “Virtually all speculativetransactions have at least the theoretical advantage ofincreasing liquidity in markets by raising the volume andfrequency of activity.”

Whether any single speculative deal’s ability to improvemarket liquidity was worth the risk it brought to itsparticipants and to the marketplace is unknowable. Whatis evident, however, is that individuals who transact fortheir own gain eventually join with other participantsto “produce an overall good for society, a concept thatgoes back at least as far as Adam Smith.” But if theindustry’s structure promotes speculation at the expenseof economic stability, regulators and industry experts needto investigate and change what’s wrong with finance.More Questions than AnswersMeasuring the issues that affect financial institutions andtheir impacts on the economy is mostly conjecture; forinstance, even experts have no way to determine “how bigor how integrated financial firms need to be.” For now, thefield lacks empirical evidence that proves the need for arigorous reworking of the financial industry. However, moreresearch that incorporates an IO emphasis could beginto address what kind of and how much banking reform ismost effective.Other issues that require further study include the questionof whether it makes sense to divide firms according totheir lines of business, and how reducing the size of largerfinancial institutions would affect smaller ones. Wheneconomists discuss financial sector structural reform, theydiffer on whether banks are too big, but none think they’retoo small, although, in relative terms, banking in the US issignificantly smaller than in Europe and Japan.Large banks contribute significant economic advantages.A study by the Clearing House Association, an industrybody, suggests that big banks create national benefitsof between $50 billion to $110 billion annually througheconomies of scale, product offerings and financial

innovation. A Federal Reserve Bank of St. Louis studypoints out that capping the size of banks at $1 trillion, arelatively high level, could lead to a reduction of $79 billionin overall economic benefits.But other experts argue that finance plays too big a rolein the modern economy. The number of global bankingpositions more than tripled from 2000 to 2008. Somestudies point out “that economic efficiency declineswith rapid financial growth and high levels of financialactivity.” And new research also suggests that “rapidgrowth in financial intermediation is correlated with slowerproductivity growth in the wider economy.”Too Big to FailCertain financial service activities – for instance, deposittaking – are so vital to the future of the economy thatthe government should protect them with guaranteesor a safety net. Firms and households need a place todeposit their money safely without fearing bank insolvency.That is why the Federal Reserve expanded its safety netto include money market mutual funds during the 2008crisis: Even though these funds are neither regulated norprotected as deposit-taking institutions, consumers usethem like banks.In the period leading up to the financial crisis, largebanks profited from the view that the federal governmentimplicitly guaranteed them against failure. Without thatimplied faith, these too-big-to-fail institutions would nothave been able to borrow or would have had to borrow athigher interest rates. But estimating the monetary value tobanks of such guarantees is impossible.Debate continues on whether post-crisis financial reformsand regulations, such as the Dodd-Frank Act, couldmake government bailouts unnecessary. Title II of Dodd-

Frank authorizes the creation of an orderly liquidationmechanism for “systemically important” financialinstitutions. But Dodd-Frank might not go far enough.Under pressure from the finance industry, legislators havenot addressed many of the core issues at the heart of thecrisis.Because deposit-taking institutions might misuse theadvantages of a safety net, arguments abound forbreaking up the largest banks, through either compulsoryrestrictions or a system of incentives that would encouragemassive institutions to shrink. Those who contest thisassertion say that supporters of disassembling big banksoften exaggerate its benefits, and contend that even iflarger banks had broken into 20 smaller pieces beforethe financial crisis, the smaller units could have made thesame mistakes and incurred similar risks and failures.The public presumes that letting smaller financialinstitutions fail poses fewer risks for the system thanallowing large ones to collapse. History shows this maynot be true. Government policy makers may decidethat bailing out a significant number of small institutionsis necessary, even at considerable cost to taxpayers,because their group failure presents a threat to the overallsecurity of the financial system, as demonstrated in theUS savings and loan crisis.LimitsTo mitigate the too-big-to-fail risk and keep the systemfrom crashing all at once, government policy makersshould focus on practical ways of limiting banks’interdependence on each other. Dodd-Frank regulationsstipulate – and some Fed initiatives propose – that bankswith assets of more than $500 billion (the largest banks)should set limits on the exposure they have to each other

and to the rest of the financial sector. These “SingleCounterparty Credit Limits” (SCCLs) must balance effortsto “reduce the contagion risks” against “stifling usefulmarket activities.”Many proposals for restructuring the financial industrysuggest that regulators should prevent banking companiesfrom participating in the securities market or, at the veryminimum, restrict the scope of their activities. After theGreat Depression, the US Congress passed the Glass-Steagall Act that forbade deposit-taking institutions fromconducting securities transactions, thereby removing theconflict of interest that many then assumed was one ofthe causes of the 1930s crisis. Some economic historianstoday dispute that claim, and experts question whether thesimplistic remedy of limiting banks’ activities makes anyeconomic sense.“Ring Fencing”Constraining banks to conduct certain activities, likedeposit taking or derivatives trading, in separate legalvehicles essentially shields federally insured deposits andbank depositors from the losses or failures arising fromother riskier bank business. This ring fencing still exists inthe US, which never wholly repealed the Glass-SteagallAct; instead, Congress revoked Glass-Steagall provisionsthat prevented commercial banks from associating withsecurities dealers under the same holding company’scontrol. The law still precludes deposit-taking banks fromengaging in securities activity, although their subsidiariescan do so. Stringent rules govern the interactions betweenthe deposit-taking function and the securities affiliates ofbank holding companies.In Europe, two regulatory initiatives are attempting to dealwith these issues of safety through ring fencing. In the UK,

the Independent Commission on Banking, also called theVickers Commission, proposed to ring fence banks’ coredeposit taking from their other financial activities.The European Commission’s High Level Expert Groupsuggests that all securities trading – whether proprietarytrading or the market-making activities necessary tohandle client needs – should occur outside the ring-fenced deposit taker, an admission that regulators can’teasily distinguish between proprietary trading and market-making activities.Part of the Dodd-Frank Act includes the Volcker Rule,which “abolishes proprietary trading by banks and theiraffiliates.” But commercial banks are central to USfinancial markets, and loans and credit are synergisticallyrelated to underwriting securities. Regulatory confusioncould lessen the liquidity that enables markets to providecompanies with well-priced equity and debt. Manyexperts worry that strict adherence to the Volcker Rulecould cause market inefficiencies if large commercialbanks were to withdraw from market-making activities.In addition, derivatives have become central to the riskmanagement practices of firms, financial institutions andmarkets, so disentangling what are client-initiated tradesfrom bank proprietary trading is difficult, to say the least.Finally, if regulations were to compel large commercialbanks to withdraw from securities activities or restrict theirinvolvement in these activities, the government shouldprovide a period of transition to allow smaller firms to

develop the necessary culture, risk management systemsand counterparties to expand their trading.

About the AuthorDouglas J. Elliott is a fellow in economic studies at theBrookings Institution, a nonprofit public policy organizationbased in Washington, DC.