How to Get Banks to “Right-Size” Themselves

As a reminder, Dr. Dunkelberg serves as Chairman of the Board of Liberty Bell Bank.

Assuming that regulators decide that banks are indeed too large, how might a reduction in size be accomplished? There is already in place a limit on the share of domestic deposits a bank may have (although recent “resolutions” of troubled banks have resulted in these limits being exceeded). But banks were able to grow using foreign deposits (not insured by the FDIC) and by issuing bonds (guaranteed by the FDIC until recently). To be more effective, setting a minimum level for the ratio of core deposits to assets would limit growth funded by bank debt or foreign deposits and reduce leverage. For community banks, this ratio is very high since few issue bonds or have foreign deposits.

Capital requirements should also be increased with asset size. This will discourage growth since it lowers the return on capital unless increased size really produces the cost economies or extra revenues that supporters of big banks argue are present. Federal Reserve research suggests cost economies disappear at around $10 million in assets, but there is disagreement. By increasing capital requirements, banks won’t grow unless it really pays.

FDIC insurance charges should be applied to assets (less capital) instead of core domestic deposits. It is the assets that put the deposits at risk, so the insurance tax should be applied there, and should be raised as the assets carried on the balance sheet of the bank become more complex and opaque.

Off-balance sheet and “repo” activities should be more transparent and better monitored, making them more difficult to execute, and therefore rarer. These can’t be used by banks to avoid compliance (for example, by temporarily offloading those “troubling assets” that might violate regulations in a repo in exchange for wonderful cash or Treasury securities).

These regulatory changes would raise the cost of getting large, force the capital increases needed as risk rises, and force banks to actually realize the cost savings or benefits allegedly produced by “bigness” so that the return on investment will not be compromised. Regulators would not need to arbitrarily set limits on bank size since the regulations would compel banks to raise capital as needed and realize alleged scale economies to maintain a competitive return on investment. With regulations like these in place, very large banks would either prove to be profitable while being better capitalized and less risky or they would have to shrink, reduce leverage and opacity to earn a competitive return for shareholders. This is just what the “regulator doctor” ordered.