If We Love the Banks, We Must Love Them Enough to Let Them Fail

Commenting on the health of big U.S. banks last week, former Fed Chairman Ben Bernanke wrote on his Brookings blog that “a lot of progress has been made (and more is in train) toward reducing the risks that large, complex financial institutions pose for the financial system and the economy.” Bernanke’s observation came after Minneapolis Fed president Neel Kashkari’s recent commentary about the need to reduce the alleged problem of “Too Big To Fail” within banking. Some readers could be excused for wondering why Bernanke would have any opinion on the matter at all.

Seemingly forgotten by Bernanke is that the Federal Reserve he once headed had regulatory responsibility over “large, complex financial institutions,” yet many of them ran into serious trouble of the bailout variety in 2008. Since Bernanke plainly didn’t see the financial crisis of 2007-2009 coming (if he possessed that kind of foresight he’d be a billionaire investor, not a former central banker hustling for speaking fees), why would anyone care about his present assessment of the banking system’s health? What could he possibly know?

So while Bernanke is probably not the one to be contemplating ways to fix banking, he correctly pointed out that financial institution size is an overrated basis on which to divine banking fixes. As he noted, Lehman Brothers was a third of the size of some of the largest U.S. banks. So true, but then he added that Lehman’s failure “almost brought down the global financial system.” It’s comments like that that make it exceedingly hard to take Bernanke seriously.

Lest we forget, Germans were reduced to living in caves after World War II, and their major commercial infrastructure was either destroyed or stolen. Japan was a vast mass of rubble, including two cities taken out by nuclear bombs. Both countries lost millions of their best and brightest. Yet within a few years of the war’s end Japan and Germany were once again among the richest countries on earth. If each country could bounce back from total devastation this quickly, is it really true that Lehman “almost brought down the global financial system”? Let’s be reasonable.

Lehman was only a major, market-shaking event insofar as investors were blindsided. A confused Bush administration, working in concert with a shaky Bernanke Fed, telegraphed a Lehman bailout (or private savior) right up to the point that the company filed for bankruptcy. Lehman was only a big, terrifying event insofar as investors were shocked. It was a surprise. But if Bear Stearns is properly allowed to go under the previous spring, Lehman arguably falls the following week without what was a near-term financial system crack-up.

Bernanke writes that large-scale financial institutions bring with them “benefits as well as costs,” which is the former Fed Chair’s assertion of that which is blindingly obvious. Businesses that are large have first and foremost frequently become that way because they’ve fulfilled an unmet market need, and they’re also frequently achieving economies of scale as he notes.

At the same time, the former Fed head’s post frequently mentions the “socially optimal” financial institution size as though banks were a sui generis concept requiring careful oversight from the wise. Not only are individuals like Bernanke (and his former Fed colleagues) totally unequal to the task of divining what banks should and should not be in terms of size, mission, level of risk, or anything else, implicit here is that banks are somehow different. But they’re not.

Everything Bernanke writes is rooted in the notion that banks can’t fail, but they can and should fail. Regularly. How else can banks evolve to meet the needs of the marketplace? Without failure, banks will soon enough be rendered extinct by outside sources of finance not hamstrung by limits on their ability to grow. They will become a protected class increasingly detached from serving customers and shareholders.

Rather than promote information-pregnant trial and error that has been the source of every other industry’s prosperity throughout the history of commerce (this no doubt included banking before it was captured by the political and central banking class), Bernanke lauds allegedly careful measures designed to shrink the odds of failure.  Remember, to a central banker still in thrall to the wholly false notion that the Great Depression was caused by weak banks (even then they accounted for much less than a majority of total lending in the U.S. economy), the economy- and industry-enhancing cleanse that is failure must be avoided at all costs.

Owing to Bernanke’s aversion to anything that might fell a bank, “higher required level[s] of capital” for larger institutions are cheered as a way of steeling them for the eventual bad times. The problem there is that capital is precious, and how unfortunate (and anti-big bank health) it is for regulations to sideline precious capital that could foster actual growth and innovation. Of greater importance, let’s not forget that a well-run bank never runs out of money simply because quality institutions can always pledge their assets for cash when near-term shortages materialize. As for the others that can’t, don’t we want to them to implode right away so that they can be acquired by their superiors? With banks, is small and inept somehow better than big and effective? Is Silicon Valley worse, or better off, now that theglobe.com, Webvan, and Friendster are no longer wasting precious resources?

In presuming that failure can wreck an economy or a financial system, Bernanke plainly misses the point. Failure is always healthy, and the bigger the better. We live in a world of limited capital, so it’s essential that poorly run institutions be relieved of their power to under-utilize limited resources so that more talented stewards can replace them. Bernanke plainly disagrees. He writes that “if major structural changes in the banking system are necessary to avoid another crisis, to promote financial stability, and to control moral hazard and excessive risk-taking, then we should all be for making the changes.” Again, he misses the point.

Neither Lehman, nor Goldman Sachs, or even the failure of J.P. Morgan could bring down the global financial system. On the other hand, what could certainly destroy the United States as a financial center is the view that any institution is too big to fail such that one or many require protected status. Indeed, once any business is classified as such by governments posing as protector, said business or businesses are no longer solely focused on achieving profits for their shareholders. Instead, they’re serving political masters who don’t care about profits, but who think of businesses as social concepts meant to fulfill political goals. We’re already seeing this right now.

As John Mack, former CEO of Morgan Stanley, told James Gorman (present Morgan Stanley CEO) in 2013, “your No. 1 client is the government.” Indeed. Thanks to the fear of failure among the politicians and central bankers so close to banks, U.S. financial institutions have taken their eyes off of the ball. Rather than focusing all of their energies on financial innovations meant to enrich customer and shareholder alike, a shaken, bailed out financial system cruelly victimized by “too big to fail” spends more and more time in Washington, D.C.

And while banks were already small in the big picture of total U.S. lending by the early part of the 20th century, a sixth of the way through the 21st, the news gets worse every day. Banks’ share of U.S. lending can be measured in the teens, and that number promises to drop with great speed. Since 2008 only one new banking company (A Bird In Hand Bank) has formed as regulations meant to strengthen the sector strangle it. Yet myriad non-bank lenders grow by the day. USAA is an insurer, but it performs many of the banking and lending functions handled by traditional financial institutions. Sam’s Club has taken to offering loans to its corporate customers, while LendingClub has become one of many Uber-like lenders, ably bringing together saver and borrower in much the same fashion as Uber helps drivers and passengers transact.

Ben Bernanke is in search of “a process that will help us find a solution” to the answer of “too big to fail,” but missed by the former central banker is the essential truth that the “process” and the misnomer “too big to fail” are unwittingly suffocating the very banking system they were meant to save.  Counterintuitive as it all may seem, an aversion to failure among banking cops has those same banks rushing toward extinction as relevant financial institutions. If banks are to revive themselves, they need much less Bernanke and his ilk and a great deal more of the failure that central bankers and politicians have attempted to banish. If we love the banks, we must love them enough to let them fail.