New laws should be put in place that minimize the risk of companies becoming “too big to fail.” No single institution should be such a large part of the market that the effects of its failure threaten the whole banking industry, or the whole country’s economy. Instead, we should encourage a vibrant, diverse, stable banking system, made up of thousands of small and medium-size banks. Strong competition policy and antitrust laws will encourage financial institutions to invest in productive activity, instead of investing in changing the rules of the game or manipulating the market.

There are several reasons we need a stronger, scale-based competition policy for the financial-services industry:

A financial-services industry with a few major players is less stable than a financial-services industry with hundreds of small and medium-size banks.

The largest financial-services companies do not provide better services to consumers than small and medium-size banks.

The largest financial-services companies have not in fact been more “innovative” in a way that serves consumer needs (although they have been more innovative in ways that serve to confuse ratings systems and consumers).

The larger and more complex financial-services companies are highly bureaucratic and inefficient, and the instruments they create are more difficult to understand.

Large financial-services companies have disproportionate power over the political process. Concentrated financial power leads to concentrated political power; if you have a lot of cash, one of the most efficient uses of it to maximize profits is to petition the government to change the rules in your favor. Economies of scale work too well when it comes to influencing government.

Companies often grow too large even for themselves. As lawyers and economists have long understood, corporate managers often seek growth at all costs, even against their companies’ interests, in the pursuit of personal wealth, power, and prestige.

To respond to these serious, systemic risks, we need a fundamentally different set of laws governing financial institutions. The idea of a “systemic risk regulator,” currently popular in Washington, is distracting and potentially dangerous because it does not address the underlying problems. A systemic risk regulator would probably not be sensitive enough to new types of risks. It could suffer from the same complacency and overconfidence in models that helped lead to the economic crisis in the first place. It wouldn’t have the power to reshape a whole industry to make it more stable, and it could fall prey to the same risks as the Fed, such as those from cognitive limitations and ideological capture. Instead of a weatherman giving us warnings, we need new laws that would break up existing financial institutions and set a size limit on how big they can become.

Competition policy could prevent much of the systemic risk that has crippled our economy. By focusing on size and concentration, we might be able to avoid collapse, unplanned nationalization, and bailouts.

Here are some possible ways to get from where we are (an industry with increasing, dangerous concentration), to where we’d like to be, a diverse and stable industry made up of thousands of small and medium sized banks and credit unions.

  1. The broadest and more general solution is simply to limit corporate size. Size could be computed in several ways: revenue, profits, various and theoretically elusive conceptions of market share, and even the number of people employed by a company. The advantage of a simple size limit is that it would avoid vesting too much judgmental discretion in governmental agencies that might be subject to political pressure. The main disadvantage is that it is inflexible and can prevent the economic efficiencies that come with size, although we believe traditional economics overplays these efficiencies, and the evidence suggests that medium-sized banks perform better and are less risky. A law like this could be enforced by an expanded antitrust division in the Department of Justice, which already performs all the functions that would be necessary for this new law to work: investigations, review of mergers, and bringing enforcement actions to break large companies apart.
  2. Congress could expand and strengthen deposit caps and similar limits. A federal law currently restricts any bank from coming, through mergers, to hold more than 10 percent of the nation’s bank deposits. The 10 percent cap could be changed to 5 percent. It could apply to growth after mergers, or simply act as a rigid limit. Furthermore, what makes this law a sound principle for banks makes it a sound principle for related industries. Why not apply similar market-share caps to investment banks and the insurance industry?
  3. Tax law could be used to limit company size. Corporate taxes, which already distinguish between companies based on profits but might also be sensitive to revenue, could be used to further subsidize small companies or penalize large ones. For example, we could enact a radical increase of the corporate income tax for banks above a certain size, or provide subsidies for banks smaller than a certain size. The difficulty with using tax law is that there are often problems with enforcement, and there are fears that tax laws will drive companies out of the US. As a matter of political economy, large firms have been very successful in repealing tax burdens piecemeal and eviscerating the underlying force of tax laws. However, corporate taxation can be a flexible way to respond to the social costs and risks created by companies of different sizes.
  4. New congressional laws could support community banks and credit unions, actively encouraging the growth of small and medium-sized institutions. Laws might also pay attention to the ownership structure of banks and other financial institutions, favoring those that, like credit unions, are owned by their customers.
  5. Congress and state legislatures should consider more corporate-governance reforms. Last year, the OECD released a report concluding that problems in internal corporate governance played a large role in causing the economic crisis. The problems with corporate governance are complex, but the basic idea is easy to state: corporate managers are willing to take risks with other people’s money that people wouldn’t usually take with their own money. Because managers benefit from corporate growth more than other parties involved in corporations, including shareholders, greater governance-based review of corporate decisions to grow companies may be warranted. For example, laws might change the standard of review for managerial actions that sharply and rapidly grow enterprises, making it easier for shareholders to challenge these actions when they are not in a corporation’s interests.
  6. Congress could create stronger presumptions against mergers in the financial sector. Mergers and acquisition are a convenient moment for regulation to intervene, because they often depend on special statutory privileges that allow corporations to combine. We already evaluate mergers in terms of antitrust policy and in a variety of other ways. Reasonable expansions may include requiring greater affirmative shareholder approval to ensure sounder corporate governance, exclusion of mergers between companies larger than a certain size, or even prevention of it by default in certain industries.

A strong competition policy would probably use a blend of these methods, a mix of carrots and sticks, criminal and civil law and tax policy, all reinforcing our vision of a stable, diverse, boring banking sector.

The difficulty with many of these proposals is determining what counts as “size,” and how to measure size in a way that most closely tracks the underlying concerns, without leaving too much room for discretion (and therefore capture) in regulatory agencies. Any scale-based policy will have some unintended side effects, and perhaps, at the margins, have some negative effects. On balance, however, the value of having a stable economy far outweighs the value, often elusive, of having larger concentrated banks.

In the short term, there are some immediate steps that Congress should take, even while considering these broader proposals. In taking over distressed banks, regulators should look to break them up to advance competition-policy aims. For example, if the US does end up taking over Citigroup, it should break it into multiple pieces, ideally creating many decentralized community-based financial institutions. Federal regulators should exhibit a strong bias against shotgun marriages and combinations of banks in distress (e.g., Wells Fargo’s takeover of Wachovia) that significantly contribute to industry concentration. The long-term costs of industry concentration should presumptively outweigh any short-term emergency justifications for merger. Needing to act doesn’t imply needn’t to act dangerously.

Shawn Bayern, Assistant Professor of Law, Florida State University
Zephyr Teachout, Associate Professor of Law, Fordham University