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The Big Bank Theory: Breaking Down the Breakup Arguments

The 2008 financial crisis threw into sharp relief the issue of “too-big-to-fail” (TBTF)?the challenge posed by financial institutions that were bailed out on concerns that their failure would cause damage to the rest of the financial system and the overall economy. Since then, policymakers and regulators have wrestled with how to address this problem.

The Dodd-Frank Wall Street Reform and Consumer Protection Act of 2010 (Dodd-Frank) put in place a series of measures to address the policy challenges of TBTF firms, including rules to enhance prudential supervision of individual institutions and reforms aimed at improving oversight of the overall financial system. Regulators have since agreed at a global level to yet-tougher prudential standards for large financial companies. Dodd-Frank also established a new legal authority to resolve a large and complex financial institution without the need for taxpayer support or further disruption to the financial system.

Have these sweeping reforms have gone far enough in addressing the policy challenge of large, complex financial institutions? If they have not, then further measures would be appropriate, including breaking up or shrinking the size of large financial institutions. Such efforts would aim to eliminate perceived government subsidies to large banks that might support their size, and thereby to lessen the purported negative impacts of problems associated with these institutions. But such actions would impose costs, on top of those already associated with the steps taken to date. These costs must be weighed against benefits in order to decide on the appropriate course of action.

This paper, a product of the Bipartisan Policy Center’s Financial Regulatory Reform Initiative, assesses those costs and benefits. What would be the consequences of breaking up the country’s biggest banks? What would dramatically shrinking their size mean for the financial sector, the U.S. economy, and the customers of these institutions? How would such a strategy work? This paper seeks to answer these important questions.

We conclude that the reforms undertaken since the financial crisis have gone a long way toward addressing the TBTF issue. Proposals to break up major financial institutions entail greater costs than the benefits they would provide and are potentially outright counterproductive. It would be better to allow Dodd-Frank and other U.S. and global reforms to work as intended, rather than to break up the largest banks. Indeed, if Dodd-Frank works as intended, then there is no need for a break up.

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