Thursday, August 20, 2009

Let's put a cap on the size of banks

Large, complex financial institutions are lethal to the financial system. They can fail and when they do, they wreak havoc on the economy.That's why they have to be rescued- as we have seen in the present crisis. We also saw what happens when they are not rescued, as in the case of Lehman Brothers when confidence in the system evaporated.

I do not believe that the present two-pronged approach, which consists of a regime for winding down such institutions in the event of failure and higher capital requirements, will suffice. You have to tackle the root cause of the problem, the bigness of the bank itself. I cannot see how any CEO can manage risks in institutions with over a trillion dollars or so in assets. Ask any bank CEO with, say, $10 bn in assets and he will tell you he is fully stretched.

I elaborate on this in my ET column, Banks that can be run by idiots. I propose a ceiling a bank size- say, 5-10% of GDP. For a large economy, we should be closer to the lower end of the range; a smaller economy could be at the higher end. In addition, regulators should keep in mind some absolute size limit beyond which financial institutions become impossible to manage. In the process, we will also have less concentration and more competition.

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