Explaining Southern California's economy

Small banks v. too-big-to-fail banks

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Bank of America, a big U.S. bank that's a symbol of "Too Big to Fail."

In a very aggressively argued essay by Harvey Rosenblum in the annual report of the Federal Reserve Bank of Dallas, the difference between Very Very Big Banks and small banks is blamed for the Federal Reserve's general inability to use monetary policy to "fix" the financial crisis:

The machinery of monetary policy hasn’t worked well in the current recovery. The primary reason: TBTF financial institutions. Many of the biggest banks have sputtered, their balance sheets still clogged with toxic assets accumulated in the boom years. 

In contrast, the nation’s smaller banks are in somewhat better shape by some measures. Before the financial crisis, most didn’t make big bets on mortgage-backed securities, derivatives and other highly risky assets whose value imploded. Those that did were closed by the Federal Deposit Insurance Corp. (FDIC), a government agency. 

Coming out of the crisis, the surviving small banks had healthier balance sheets. However, smaller banks comprise only one sixth of the banking system’s capacity and can’t provide the financial clout needed for a strong economic rebound.

The entire essay is worth reading, as a reminder that TBTF could justifiably be relabeled "Even Too Bigger to Fail," because the majority of financial assets in the U.S. are now concentrated in even fewer large banks than before 2008.

But the point that Rosenblum makes about small banks is worth carefully considering. It was all about risk. The small banks didn't make the crazy bets and earn the monster rewards. But their balance sheets aren't in ruins, either. The challenge will be to scale-up their example — without scaling it up too far! This leads to a politically difficult conclusion: Will it eventually be necessary to end TBTF by breaking up the big banks?

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