Why Rescue Big Banks?

3. Big banks can trade in size in global capital markets. Small and medium-sized banks cannot keep up with the large scale and quick tempo of international capital markets. Only large banking institutions can maintain ongoing relationships with giant counterparties including multinational corporations, central banks or other government agencies, and sovereign wealth funds. With the United States running chronic balance-of-payments deficits, it is in the national interest to have banks large enough to maintain such relationships in order to facilitate large capital inflows.

4. Big banks are in the derivatives business, small and medium-sized institutions are not. Admittedly, this does not sound like a recommendation, given how many large financial institutions have gotten in trouble recently through mismanagement of their derivatives units. But derivatives are not going away -- credit default swaps, for instance, offer immense benefits to users because they vastly reduce the cost of managing portfolios of corporate bonds, mortgage-backed securities, and other securitized instruments. In the future, counterparty risk will be taken far more seriously, which will mean more in-depth vetting of trading partners. This process is often possible only with big institutions, because it takes highly trained specialists to pore over the numbers and ask the right questions about the financial health of major counterparties.

5. Big banks run big IT operations. There are immense economies of scale in niches such as corporate cash management, credit-card back office, mortgage servicing, securities custody, and performance attribution. They will not disappear. Studies that seem to show a lack of economies of scale in banking are not wrong, just badly designed. Although there are not many economies of scale in credit analysis, only a handful of large banks with global reach can perform highly computerized back-office servicing functions.

The above points explain why financial institutions grew so large and why that was and remains a generally good thing for the economy as a whole. But what about arguments that the government should never again allow such firms to grow "too big to fail"?

There are indeed problems with massive bailouts, particularly the danger that they will create "moral hazard" -- an incentive for institutions to behave recklessly in the future on the assumption that the government will bear the losses if anything goes wrong. But the appropriate way to prevent such behavior is not to limit the size of financial institutions, but rather to reform their corporate governance.

Board members of banks have been treated more strictly than board members of other corporations since 1991, when the Federal Deposit Insurance Corporation Improvement Act was passed to overcome the abuses that led to the savings and loan crisis of the 1980s. For example, members of boards of depository institutions are limited in the number of boards they can serve on, and they must accept personal liability for the decisions of a failed institution. Since then, the system has worked reasonably well for smaller banks (but not for larger institutions, where most board members are simply ill-equipped to stay on top of the immense amount of detail involved)..

Further improving board oversight of bank management must be a top priority in any attempt to construct a safer and sounder financial system. The current category of independent directors, which brings to the boardroom people of diverse backgrounds and business experience, is not necessarily bad. But it is not enough. There should be a second kind of independent board member, as well -- essentially, a category of "professional directors" -- who are elected directly by shareholders. These directors would chair the three most important board committees -- audit, risk management, and compensation.

Such a reform could materially strengthen the ability of banks and other important financial institutions to move ahead without stumbling into new risks. That is because professional directors -- unlike even well-intentioned amateur ones -- would have both the skills and incentive to execute their duties with a high level of care. If they performed haphazardly or casually, they would risk losing the stature necessary to continue to serve on boards of other companies. Their livelihoods would depend, in other words, on their willingness to understand exactly what a bank is doing, what risks it is taking, and how proficient top management is in running a complex business.

Whatever else the Obama administration focuses on in its regulatory reforms, it should not waste time or effort trying to limit financial institutions' size. Responsible board oversight and governance is much more important.