If an institution is too big to fail, then it must not be allowed to take innovative risks because the potential consequences for the economy are dire.

Innovation entails risk. Any profitable business venture that is widely known to be successful is rife with competitors, so profit margins compress until nobody sees an opportunity worth exploiting. New profit centers are created by innovation, but innovation carries a heavy cost as most innovative start-ups fail.

When an institution becomes large, it becomes very difficult for them to innovate. Bureaucratic inertia, entrenched ideas, and groupthink all tend to stifle innovation. Usually it’s safer for large companies to innovate by purchasing a small, successful start-up and scaling their idea.

When an institution becomes so large that it’s becomes too-big-too-fail, it becomes too big to take on the risk of innovation. In fact, as a society, we don’t want too-big-too-fail institutions to innovate because if they fail, they might take down our entire financial system—like they nearly did with their failed mortgage and securitization innovations of the 00s.

This isn’t some abstract concept only of passing interest to economists, academics, the financial elites, and the politicians they own. You pay for failed mortgage innovations with your taxes and your home. Whether you support Bernie Sanders or not, I think most would agree with his assertion that banking should be boring and stable. Too-big-too-fail is too-big-to-innovate as well.

By Alain Sherter, April 8, 2016, 8:24 AM

After Sen. Bernie Sanders drew fire this week for failing to detail just how he would break up big U.S. banks in an interview with the New York Daily News, Hillary Clinton suggested he lacks the policy expertise to fulfill his vow to reform Wall Street. But Sanders may have accomplished a more important feat: shifting the debate from how to police the nation’s biggest banks, long the preferred remedy among most Democrats and Republicans, to how to break them up. …

Ever since the passage of Dodd-Frank, the political left has been on the defensive. This is a mistake. The bank bashing must continue until the too-big-to-fail banks crumble to dust.

“No single financial institution should be so large that its failure would cause catastrophic risk to millions of Americans or to our nation’s economic well-being. No single financial institution should have holdings so extensive that its failure would send the world economy into crisis,” Sanders said…. “The only way to contain the Street’s excesses is with reforms so big, bold and public they can’t be watered down — busting up the biggest banks and resurrecting Glass-Steagall,” Sanders said, alluding to the Depression-era law that, until it was struck down in 1999, barred financial institutions from engaging in both commercial and investment banking. “In 1999, I strongly opposed the repeal of this important legislation. I predicted then that such a massive deregulation of the financial services industry would seriously harm the economy. I would give anything to have been proven wrong about this, but unfortunately what happened to the economy during the financial collapse of 2008 was even worse than I predicted.” As of 2013, the world’s 28 biggest global banks had average assets of $1.8 trillion, up from $1.35 trillion in 2006, according to industry data. …

So eight years after the too-big-too-fail institutions nearly toppled our economic system, these institutions are actually bigger? WTF?

Even after Dodd-Frank, the 2010 financial reform law passed in wake of the housing crash, big global banks retain two features that make them dangerous, said Admati, an influential voice on Capitol Hill.First, these institutions are opaque, making it hard to spot possible risks lurking within their balance sheets. Second, they’re deeply interconnected with other major actors in the international financial system. In such a tightly bound system, disease in one sector can quickly metastasize. A particular concern, according to Admati and other Wall Street critics, is that large banks are today even bigger users of derivatives, which most experts agree worsened the damage from the subprime meltdown, than before the crash. As of 2015, four Wall Street firms — Bank of America (BAC), Citigroup (C), Goldman Sachs (GS) and JPMorgan Chase (JPM) — had total notional derivatives exposure of nearly $190 trillion. The U.S. economy is worth $18 trillion. “It’s a big house of cards,” said Admati, who favors barring government-insured banks from using derivatives. “The minute something goes wrong in these markets, there’s going to be a monumental collapse. The derivatives market is where fragilities hide.” …

So now we have too-big-too-fail banks that are even larger than before, and we allow them to gamble with derivatives that could easily allow them to take on risk far in excess of their ability to cover their bets if a black swan event happens. This is a crisis waiting to happen.

Sanders thinks one goal of financial reform should be to “make banking boring again.””The function of banking should not be about making as much profits as possible gambling on derivatives and other esoteric financial instruments,” he said. “The function of banking should be to provide affordable loans to small businesses to create jobs in the productive economy. The function of banking should be to provide affordable loans to Americans to purchase homes and cars.” …

My guess is that the big banks see it differently. They see their job as extracting as much money out of the economy as possible by exploiting their too-big-to-fail status and political clout.

Sanders agrees that Dodd-Frank has failed to adequately rein in big banks and safeguard the banking system. “I voted for Dodd-Frank, but let’s not fool ourselves. Dodd-Frank was a very modest piece of legislation,” he said, noting that the country’s six largest banks control 90 percent of all financial derivatives and hold over 40 percent of all bank deposits. “Dodd-Frank did not end much of the casino-style gambling on Wall Street. In fact, much of this reckless activity is still going on today.”

The bailouts of the too-big-too-fail banks irritated me (and many others). I would have far preferred to see the architects of the financial catastrophe of 2008 lose their jobs, their wealth, their social status, and be demonized for their atrocious behavior. Instead, we bailed them out, allowed them to keep their ill-gotten gains, and put them back in charge of our financial system. It wasn’t right then, and with the inevitable moral hazard influencing decisions at the too-big-too-fail banks today, the next bailout will be even larger.

“Gentlemen, I have had men watching you for a long time and I am convinced that you have used the funds of the bank to speculate in the breadstuffs of the country. When you won, you divided the profits amongst you, and when you lost, you charged it to the bank. You tell me that if I take the deposits from the bank and annul its charter, I shall ruin ten thousand families. That may be true, gentlemen, but that is your sin! Should I let you go on, you will ruin fifty thousand families, and that would be my sin! You are a den of vipers and thieves.” — Andrew Jackson

Rather than killing the evil banks as Andrew Jackson did, we bailed them out. This flawed policy was sold to Americans as a necessary evil; ordinary people were “saved” by bailing out the 1%. Since there is no way to test alternate realities, we have no choice but to accept their contention.

Personally, I think they’re full of shit.

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