The Break-Up-the-Banks Drumbeat Gets Louder. But Is It Just a Bunch of Hot Air?

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Conservative columnist George Will and liberal Ohio Senator Sherrod Brown don’t agree on much. So it was a little strange to see Will publish an article last week praising Brown’s legislative efforts to shrink America’s largest banks in order to remove any systemic threat that their failure might pose to the U.S. economy. But Will is not the only member of the right-leaning commentariat to write favorably of the idea of downsizing too-big-to-fail through legislative dictate, as The Wall Street Journal’s Peggy Noonan and the American Enterprise Institute’s James Pethokoukis have gotten in on the party as well.

There has always been support from a segment of the Democratic Party for legislating hard caps on the size of banks, with 30 Democrats in the Senate supporting the original iteration of Brown’s legislation — the Brown-Kaufmann Amendment — when the Dodd-Frank financial reform bill was originally being debated in the spring of 2010. But many on the right have been somewhat uncomfortable with Brown’s law — which would set restrictions on how large a bank can grow relative to other banks and to the economy as a whole — or similar legislation. After all, this would be an example of the federal government stepping into the private market, mandating that certain companies cannot gain too large a market share — in other words, not exactly an easy thing for limited-government types to support.

But as the aforementioned conservative writers have noted, there is something unique about the financial sector that might necessitate this sort of intrusion, specifically that the failure of a large-enough bank can precipitate the collapse of an entire financial system. We saw that possibility play out in real time in 2008, and more than four years later there has been no definitive resolution to this too-big-to-fail problem. Dodd-Frank’s solution is to create a financial stability oversight council, which can designate certain institutions as systemically important, and then put tougher capital restrictions on those firms. The law also arms regulators with more tools to wind down big banks in case of failure, but there are legitimate concerns as to whether the FDIC would be able to effectively resolve a failing institution the size of Citigroup, given its mammoth size, complexity, and global reach.

Throughout the debate over financial reform, the Republican party’s alternative to the Dodd-Frank resolution authority was to simply expand bankruptcy law and force failed banking behemoths to fail. Essentially, Republicans are arguing that there is no such thing as “too-big-to-fail,” and that if these institutions do fail, that it won’t have a negative effect on the rest of the economy. By credibly committing to doing nothing in a crisis, Republicans argue, banks would shrink in size as creditors would refuse to finance oversized banks.

The logic behind this position is that the government, through its implicit support of certain financial institutions, has actually encouraged those institutions to grow to the point where their failure could endanger the entire economy. By simply removing this implicit support, they maintain, too-big-to-fail is solved. Setting aside the issue of whether too-big-to-fail institutions can arise without government support, this policy ignores the simple fact that when the next financial crisis occurs, Congress can just change the law to allow the sort of bailouts we saw in 2008. After all, that’s what a divided government did in 2008.

In other words, if Republicans are really serious about ending too-big-to-fail, they need either to support a viable resolution framework, or to figure out a way to shrink large financial institutions down to a size where their failure wouldn’t pose such a risk. And since Republicans have legitimate concerns about Dodd-Frank’s ability to end too-big-to-fail, it seems that a strict law forcing the banks to shrink themselves down to size may be the strategy that employs the least amount of government power.