Break Up the Wall Street Banks. Now

Break Up the Wall Street Banks. Now

By Jonathan Macey - April 20, 2010

Chris Dodd and the other politicians working on financial reform claim that their proposed legislation will end the long-standing U.S. policy which posits that the biggest financial institutions are "too big to fail" and therefore must be bailed out every time they find themselves in financial distress. At the core of the "Dodd bill" is the premise that regulators need yet more discretion, more power, and more regulatory tools if they are to succeed at last in exorcizing long-entrenched too big to fail strategies from the heart of our regulatory canon. The Dodd bill is fundamentally flawed because it fails to address the basic fact that the "too big to fail" is a political problem, not an economic problem. The only way to eliminate too big to fail as the regulatory solution of choice is to break up any financial institution that is or becomes too big to fail. Unfortunately, the Dodd bill does not break up existing banks.

In a modest feint in the right direction, by proposing to cap banks' size, the Dodd bill does reflect an appreciation of the fact that the moment a bank becomes too big, it simultaneously becomes too big to fail. Specifically, the proposed law bars existing banks from acquiring or merging with competitors if the resulting entity's liabilities would exceed 10 percent of the total U.S. banking system (unless, of course, the regulators decide to make an exception).

On the one hand, this indicates that the gnomes in Washington finally realize that size has gotten to be a problem for bank regulators. But the bill ignores the painful but embarrassing fact that there are around a dozen financial institutions that are already way over the too-big-to-fail threshold.

If we have learned anything from the modern history of bank regulation it is that the government is incapable of making a credible commitment to refrain from bailing out financial institutions of any kind (insurance, investment banking, commercial banking) once they have grown to a certain size. There have been plenty of previous efforts to reign in "too big to fail." Ever since 1984 when then-Comptroller of the Currency Charles Conover told Congress that the top eleven banks in the country were too big to fail, politicians and regulators have been trying to put an end to this toxic public policy. All of these efforts have failed and this one will too. In the ongoing crisis, there were plenty of legal impediments to using taxpayer funds to bailout companies like AIG, Citigroup, and Goldman Sachs, but none of them was successful. The political fallout and perceived economic disruption from the failure of any of these financial behemoths is too much.

In light of these assumptions, and given the massive contingent liability that this regulatory system poses for the U.S., in a forthcoming article in the Yale Law Journal, Jim Holdcroft and I argue that good public policy requires that the largest U.S. financial institutions be broken up into pieces that are sufficiently small that they can be allowed to fail.

This proposed "Macey Rule," simply operationalizes the adage, once popular among regulators, but never implemented, that "any financial institution that is too big to fail is too big to survive." What this means, as a practical matter, seems obvious: we must determine what size constitutes "too big to fail" and we must dismantle those institutions into smaller sizes that can be wound up in a dissolution process if they become insolvent in a way that does not require government intervention.

Under the proposed rule, no financial institution could amass aggregate liabilities in an amount greater than five percent (5.00%) of the average of the targeted value of the FDIC Deposit Insurance Fund ("DIF") for the previous three-year period. The FDIC's target for the DIF is expressed as a percentage of FDIC insured deposits, and is therefore an objective and easily ascertainable number that is not subject to manipulation and is immune from political influence.

We derived the five percent threshold figure by analyzing the size of the FDIC insurance fund and determining the size of the loss from the failure of a single financial institution that we think the FDIC can tolerate both economically and politically.

The FDIC is empowered by the Federal Deposit Insurance Act to use its judgment to set the target value of the DIF taking into account any economic factors that it deems appropriate, but must select a target value of not less than 1.15% of aggregate insured deposits but no greater than 1.50% of aggregate insured deposits. This standard has a very practical protection against being relaxed for political reasons. If the target value is increased to allow banks to become bigger, then the banks will have to pay higher assessments into the DIF. This has two benefits: greater reserves for possible resolutions, and, higher costs for banks which will temper their fervor for greater growth. By way of illustration, the current targeted value for the DIF is equal to one and 15 hundredths of one percent (1.15%) of total insured deposits, the Macey Rule would not allow any bank to have total liabilities in excess of 0.0575% of total insured deposits, or approximately, $3.096 billion.

The Macey plan would, in practice, lead to the dismantling of only about 3 percent of the nation's banks. But these banks do all of the risky trading. They hold 100% of the derivatives that remain on banks' balance sheets, 100% of the trading liabilities, and over 80% of all bank liabilities. This data is not surprising because banks that are too big to fail have a huge competitive advantage over their smaller rivals because the customers of the biggest banks know that the government will bail them out if they get into trouble.

Like Odysseus trying to sail past the deadly and seductive Sirens on his journey back to Ithaca after the Trojan War, the government must find a way to protect itself from succumbing to the temptation to bailout companies when they fail. Odysseus's well-known strategy was to order his crew to plug their ears with beeswax and then to bind him securely to the mast, and make sure that he remained bound to the mast until they were out of earshot of the Sirens' island home.

Breaking up the nation's biggest financial institutions is the only way that we can sufficiently commit to refraining from bailing out our biggest financial institutions time and time again. I say we put Odysseus in charge of regulatory reform.

Jonathan Macey is a law professor at Yale and a member of the Hoover Institution Task Force on Property Rights. He can be reached at

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