Sorry Paul, but the Bailout WAS about the Banks

Paul Krugman claims that "Many analysts concluded years ago" that the big banks were not at the heart of the financial crisis and that breaking them up would not protect us from future crises.  Incredibly, his claim is linked to an article by ... Paul Krugman.  Maybe a Nobel Prize comes with a license to cite oneself as Gospel authority, but I don't believe that Krugman's Nobel Prize was for his expertise on bank regulation. 

So what's wrong with Krugman's claim?  Let's go piece by piece. 

Claim 1.  "Predatory lending was largely carried out by smaller, non-Wall Street institutions like Countrywide Financial."

Wrong.  The actual loan origination was generally not carried out by Wall Street institutions.  It was carried out by mortgage companies, mortgage brokers, and commercial banks (I can only think of only two large commercial banks that are "Wall Street institutions--Citi and JPMorgan).  But this is silly.  It's like saying that the banks didn't do the origination, their loan officers did.  The mortgage companies, mortgage brokers, and commercial banks were just origination agents for a Wall Street-based securitization machine.  The Wall Street institutions provided the funding for the predatory lending--warehouse lines of credit from commercial banks and then the ultimate funding from securitizations organized by Wall Street.  Absent securitization there just isn't that much predatory mortgage lending.  The proof is the disappearance of all of the subprime mortgage companies with the implosion of the securitization machine.  And for the cherry on top, let me note that Krugman ignores the direct ownership of some of the mortgage companies and commercial bank originators by Wall Street institutions.  Lehman, Bear Stearns, Goldman, AIG...all owned origination entities.  

Claim 2.  "The crisis itself was centered not on big banks but on 'shadow banks' like Lehman Brothers that weren't necessarily that big."

Wrong.  This is semantics.  Krugman seems to equate "bank" with depositary (which is not consistent with equating "banks" with "Wall Street").  That's not right.  For starters, many investment banks owned depositaries.  But more to the point, when people talk about breaking up the "banks," they aren't referring to "depositaries" but to large financial institutions of any stripe. The reason is two-fold.  

First is that if a large institution fails, the impact is greater than if a small one fails.  Breaking up large institutions means that any individual failure is less costly.  (There's a question about whether large institutions are less fragile, but that's a separate issue.) 

Second is a political reason with which Krugman and other opponents of a 21st Century Glass-Steagall refuse to engage (and I suspect it's because they don't have an answer.) Large financial institutions wield out-sized political power.  They use this political power to stymie their regulation in the first instance, and then, when they get into trouble, to force the government to bail them out. If we want to be able to regulate the financial industry we must clear the decks politically for regulators to do their work. Because of the political constraints on the system regulators have to resort to Rube Goldberg devices to achieve the ends they want--living wills, FSOC designation, and litigation settlements and non-binding "guidance" in lieu of rule making. Ultimately this is not good for our political system writ large. 

Krugman also implies that the "big banks" were separate from "shadow banking."  That's just nuts.  Lehman, Goldman, Morgan Stanley, etc. all had substantial exposures to MBS, CDOs, and various mortgage derivatives.  They also made markets in these products.  In other words, the big banks were not separate from "shadow banking", but were at the heart of shadow banking. 

Krugman also equates "crisis" with the failure of shadow banks.  But the crisis wasn't about the failure of some fly-by-night subprime originators or even the failure of larger thrifts like Countrywide and WaMu.  Nor was it about some hedge fund getting its position wiped out.   The only real non-bank entity at the center of the crisis was AIG, and AIG's counterparties were all...banks. The crisis was because a whole range of investment banks and commercial banks had gorged on securities and derivatives that in one way or another were linked to the housing market and that exposure presaged their failure.  The exact extent of these institutions' exposures to the housing market were unclear, as was the extent of their exposure to each other.  But there was good reason for their counterparties to think that some might be illiquid or insolvent, and that was sufficient to trigger run or panic conditions.  

The real crisis was the possibility that "serious" Wall Street institutions would fail--AIG, Goldman Sachs, Lehman Brothers, Morgan Stanley--and there was a run on these institutions until the federal government stepped in:  Wachovia and Citi both experienced depositor runs, and AIG and Lehman had counterparty collateral runs.  Indeed, according to Sheila Bair's account of the crisis--and she's someone who should know--the major driver of the government response was concern about the impending failure of Citibank.  Last time I checked, Citi is, well, a Wall Street bank.  The bail out--which is where the real problem of too-big-to-fail lies--was undertaken to protect Wall Street institutions because they are so heavily intertwined with commercial banks and the payment system and thus systemically important, as without payment systems the entire economy stops working.  The little mortgage banks were allowed to fail because they were unimportantly systemically...as were homeowners.  

Breaking up the big banks alone will not prevent all future crises.  And no one is claiming that. But by breaking up the big banks there will be the political room to regulate the financial system more effectively.  Too-big-to-fail is too-big-to-regulate.  And that alone makes breaking up the big banks an important goal.