Krugman: "The idea that we can...let banks fail as long as none of them is big is just wrong."

[ProSense]

Failure Is A Failed Strategy

One thing that keeps coming up in comments, both here and on my column, is the widespread belief that all we need to do on the banking front is (a) break up the big banks, so that none of them are too big to fail (b) promise not to bail out any banks in the future. That way, the claim goes, bankers will know that they will face dire consequences if they misbehave, and market discipline will do the rest.

Dream on.

There are at least three things crucially wrong with this argument.

First, even when banks can fail, bank managers and/or owners have an incentive to make risky bets; after all, their downside is limited — at worst, the bank goes under — while their upside isn’t: if they can earn high profits for a few years, they can walk away with a lot. Remember that in the S&L crisis of the 1980s, quite a few people made out like bandits while running their banks into the ground.

Second, a wave of bank runs that brings down many small banks can do as much damage as the failure of a few big banks. The biggest banks didn’t fail in 1930-1931, when a generalized run on the system began with the failure of the 28th largest bank in America; nonetheless, the results were catastrophic. The idea that we can cheerfully let banks fail as long as none of them is big is just wrong.

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What is true is that there are bailouts and then there are bailouts. What has to be protected in a crisis are bank deposits and things like bank deposits — basically, bank-created money. Money market accounts and “repo” — very short-term loans in which businesses often park their funds — have to be protected to avoid 1930-31-type collapses. On the other hand, bank shareholders and long-term bondholders can be made to pay a price without collapsing the system.

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Georgia on My Mind

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I’m not sure how many people know that Georgia leads the nation in bank failures, accounting for 37 of the 206 banks seized by the Federal Deposit Insurance Corporation since the beginning of 2008. These bank failures are a symptom of deeper problems: arguably, no other state has suffered as badly from banks gone wild.

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What’s striking about the contrast between the Texas story and Georgia’s debacle is that it doesn’t seem to have anything to do with the issues that have dominated debates about banking reform. For example, many observers have blamed complex financial derivatives for the crisis. But Georgia banks blew themselves up with old-fashioned loans gone bad.

And for all the concern about banks that are too big to fail, Georgia suffered, if anything, from a proliferation of small banks. Actually, the worst offenders in the lending spree tended to be relatively small start-ups that attracted customers by playing to a specific community. Thus Georgian Bank, founded in 2001, catered to the state’s elite, some of whom were entertained on the C.E.O.’s yacht and private jet. Meanwhile, Integrity Bank, founded in 2000, played up its “faith based” business model — it was featured in a 2005 Time magazine article titled “Praying for Profits.” Both banks have now gone bust.

So what’s the moral of this story? As I see it, it’s a caution against silver-bullet views of reform, the idea that cracking down on just one thing — in particular, breaking up big banks — will solve our problems. The case of Georgia shows that bad behavior by many small banks can do as much damage as misbehavior by a few financial giants.

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[napi21]

1. Paul is right, there IS no single fix for the financial system. BTW, I did know that

Ga. lead the bank failures, but that's probably because I live in Ga. I know hombuyers won't like what I have to say, but the banksneed to go back to the day when i was harder to get a mtg, and harder to et a loan. They need to do their homework on a customer's credit viability. Even then, some loans will go bad, but at least they will be few.