Business Insider

Peter Crabb: 'Too-big-to-fail' banks must be broken up

Are the banks really different this time?

Government support for the failing financial institutions of the United States continues this week in response to an ongoing financial crisis. The primary argument in favor of such support is potential systemic risk – these institutions are too big to fail.

Reportedly, a regulatory review indicates Bank of America needs another $34 billion to stay solvent. The U.S. government looked favorably on B of A’s earlier acquisitions of Merrill Lynch and mortgage lender Countrywide, but the massive size of this institution now puts it well in the too-big category.

From a historical perspective, this bank is extremely big.

An old story goes something like this: Banks throughout the country were foreclosing on mortgages, forcing people out of their homes and off their farms. At the same time, there was widespread unemployment in all regions of the country.

The place was the United States. The year was 1819.

The financial crisis of 1819 is not widely covered in our history books, perhaps because there was little to no official response to the panic.

The panic began as officials at the central bank of the day, the Second Bank of the United States, grew leery of the lending practices of many Western state banks. Bank of the U.S. called in the loans to these institutions, which in turn called in their loans.

These state banks had lent to land speculators who were unable to repay. Sound familiar?

The cause of the panic is no different this time, but the size of institutions pale in comparison.

In the years that followed, many banks failed and depositors were wiped out. These were tough economic times, but without any intervention, conditions improved just five years later.

The official response today is unprecedented. To meet their new regulatory mandates, the Bank of America will need to convert preferred stock shares currently held by the government to common shares.

All public corporations issue stock, but many firms issue both common and preferred stock. Preferred stock is a hybrid security between debt and equity. Preferred stock holders do not normally have voting rights like common equity holders, and unlike interest on bonds, preferred stock dividends are not tax-deductible.

With the conversion, the U.S. government will have a large vote in the operations of an important financial institution with a strong competitive position.

Questions continue to be raised as to why the government so adamantly opposes letting these large banks fail. According to a report this week in the Financial Times, the answer is politics.

The largest originators of subprime mortgages, including B of A’s Countrywide, spent almost $370 million in Washington over the past decade on lobbying and campaign donations. Both past and present administrations received millions in donations. Countrywide spent more than $11 million, beginning in 1998, and continuing through the start of the crises in 2008.

The nonpolitical answer is one of simple economic theory. When previously competitive markets become dominated by a few large firms, the market power of these firms leads to non-competitive outcomes. The banking industry is highly concentrated.

According to the most recent Federal Deposit Insurance Corporation (FDIC) tally, there are 86 commercial banks, out of 7,085 in the United States, with more than $10 billion in total assets. These 86 institutions hold more than 77 percent of all deposits.

In 1984, the percentage was only 34 percent. The market and political power of the large banks has more than doubled in the past two decades.

As it was in 1819 it is today. The mistake of speculative lending will never elude us, but the power of the speculative lenders can be reduced.

Signs of economic recovery abound – the stock market is rising and prices are stabilizing. However, without a breakup of large banks, through bankruptcy or receivership, competitive lending is unlikely to return.

The credit crunch remains as long as large, but financially weak, banks remain in power.

Since 2000, Peter R. Crabb has been a professor of finance and economics at Northwest Nazarene University in Nampa. He earned his doctorate in international and financial economics from the University of Oregon.