A better way to reduce financial sector risk

The US administration has switched hesitancy for populism in proposing size and activity limits on America's largest banks. While details are still missing, possibly because no one really knows how to implement size limits or curbs on proprietary trading, the intent is clear - bankers must pay. It is hard to have much sympathy for the bankers, who have brought the public's ire on themselves through incompetence and then through an outrageous haste to pay themselves. Yet outrage is a poor guide to public policy. Beyond being punitive, will the administration's proposals help reduce financial system risk?

Consider size limits first. The idea is to ensure institutions are no longer too big to fail. But how to define size? Whether you use assets, capital or profits there will be problems - banks will try to economise on whatever measure is limited.

Crude asset size limits, for example, would probably ensure a lot of financial activity is hidden from the regulator, only to come back to light (and to balance sheets) at the worst of times. There are many legal ways to mask size. Banks can offer guarantees to assets placed in off-balance sheet vehicles, much like the conduits of the recent crisis. If, instead, capital is the measure, then we will be pushing banks to economise on it as much as possible, hardly a recipe for safety. And if it is profits, we will be inviting healthy banks to park profits elsewhere, while rewarding sickly ones by allowing them to expand indefinitely.

Even if we do settle on a definition, it is not clear that being large is necessary or sufficient for an entity to be a systemic risk. Bear Stearns would not be "large" by most calculations, though it was considered connected enough to be saved. But Vanguard, the mutual fund group, manages more than $1,000bn (€706bn, £616bn) in assets and would probably not qualify as systemic. Not all large financial entities are equally troubling; would we include the mutual funds operated by a bank in its size?

Also, being big has its virtues. Some larger banks are better at diversifying and attracting managerial talent (including risk managers). While a poorly managed $2,000bn bank creates immense problems for the system, the problems could be even greater with 100 banks of $20bn in size, each of which has taken similar risks. What is important is not size per se but the concentration and correlation of risk in the system as well as the size of exposures relative to capital.

Instead of imposing a blanket ban on institutions growing beyond a certain size, regulators should use more subtle mechanisms such as prohibiting mergers of large banks or encouraging the break-up of large banks that seem to have a propensity for getting into trouble. CitigroupWhile there are always concerns about whether regulators will use these sorts of powers arbitrarily, they are no more difficult for legislators and courts to oversee than are powers based on anti-competitive considerations.

Turning to activity limits, implementation will again be difficult. How does one tell proprietary trading from marketmaking or hedging? Moreover, isn't the real problem the banks' appetite for risk? Unless all forms of risk-taking are banned, will banks not find other ways to take on risk, including lending to dodgy customers?

In reality, proposing limits on size and activity is just an attempt to diminish the deleterious effects of another previous and now anachronistic intervention - deposit insurance. When households did not have access to safe deposits, deposit insurance made sense. With the advent of money-market funds, households gained access to near riskless deposits. Money-market runs can be eliminated by marking them to market daily; they do not need deposit insurance. To encourage community-based banks, deposit insurance may still make sense because small banks are poorly diversified and subject to bank runs. But for large, well-diversified banks, deposit insurance merely contributes to excess. We will bail out these banks anyway in a time of general panic. Why encourage the poorly managed ones to grow without market scrutiny by giving them deposit insurance along the way? Why not phase out deposit insurance as domestic deposits grow beyond a certain size? That would be far more effective in reducing risk than size or activity limits, and far easier to implement.

The writer is professor of finance at the University of Chicago's Booth School. His book Fault Lines will be published in May by Princeton University Press