Banks That Are “Too Big to Fail” Need Competition

Policy Reports | Financial Crisis

No. 378
Friday, December 11, 2015
by John Berlau

The federal government’s response to the 2008 Financial Crisis resulted in an unofficial “too big to fail” doctrine. Large financial institutions received generous bailouts in the wake of the crisis, whereas other industries in the past were forced into bankruptcy.

Executive Summary

The government has not provided adequate answers as to why. The policy hampers competition, which hurts consumers and small businesses alike. Proponents argue that special treatment of the financial sector had to do with its “interconnectedness.” But they fail to acknowledge that most sectors of the economy are also interconnected. Favoring finance over nonfinancial firms led to bailouts and the subsequent Dodd-Frank legislation, which together entrenched “too big to fail” policy.

By saving financial institutions, the government artificially propped up failing banks and prevented new, perhaps better managed institutions, from entering the market. Whereas Netflix replaced Blockbuster as the more efficient and cost-friendly business model, those financial institutions that should have failed remain because of government intervention. The Dodd-Frank Act only entrenched their power. For example, a component of Dodd-Frank, the Volcker Rule, puts limits on proprietary trading which small banks rely on to hedge against risk. As a result, some simply had to close. The burdensome and expensive regulations then prevent new community banks from even opening. In fact, only three new banks have opened in the United States since 2010.

Decreased competition leaves American communities with fewer banking options, hurting both consumers and small businesses. Meanwhile, big banks can absorb the cost of new, expensive regulations and policies that essentially protect them from collapse.

Theoretically, major corporations like Walmart could offer other banking options as competition against the big financial firms. However, the Bank Holding Company Acts of 1956 and 1970 prohibit the mixing of banking and commerce. Since 2010, there has been some innovation in the financial services industry — such as technologies to pay and collect payments by credit card over smartphones, new options in prepaid debit and credit cards, and online peer-to-peer platforms for lending and borrowing. But these innovations have come largely outside of the banking sector, and are limited by their providers’ nonbank status.

Other countries have taken a different path by actively encouraging nonfinancial firms to enter the financial sector. The Milken Institute notes that the United States is the only country among the G20, the largest developed economies in the world, that opposes mixing of banking and commerce. In the United Kingdom one out of eight pounds withdrawn from an ATM are taken from the cash machines of Tesco Bank, a division of retail giant Tesco. Similarly, in Canada and Mexico, one of the most powerful new entrants in the banking industry is Walmart, which operates a bank that issues credit cards in Canada and until recently ran a full-service bank in Mexico.

Some U.S. commercial banks — industrial loan companies (ILCs) — are owned by nonfinancial firms. The Milken Institute found the safety and soundness of these banks exceeds that of the U.S. banking sector as a whole. ILCs, in total, have a much higher ratio of capital to assets (16.7 percent) than banks as a whole (11.3 percent). ILCs owned by nonfinancial firms also have the lowest share of troubled assets in the banking sector (2.35 percent).

Ending the “too big to fail” doctrine and promoting competition will require the U.S. government to reform current legislation. Among the needed legislative changes:

  • Congress should require new procedures for regulatory agencies that mandate a specific time limit on approval or denial of new bank applications.
  • Congress should exempt small banks from the regulatory burden of Dodd-Frank.
  • Congress should eliminate the Financial Stability Oversight Council, which implicitly guarantees banks that are “too big to fail.”
  • Congress should repeal the Bank Holding Company Acts of 1956 and 1970, so that nonfinancial companies can enter the banking industry.
  • Congress should repeal the Volcker Rule in Dodd-Frank that restricts proprietary trading.

These changes are the first step toward what economist Joseph Schumpeter called “creative destruction” in the banking industry by bringing in the competition from new entrants that exists in every other industry.

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