Salient to Investors:

The New York Fed says investors are beginning to price in a higher risk of default on senior bonds issued by large institutions. Since the mid-1990s, banks have grown too big due primarily to non-deposit liabilities, not retail deposits. The five biggest US banks control more than half of all US banking assets versus 17 percent in 1970.

While big banks shouldn’t be broken up, the incentives must shift so banks are penalized, not rewarded, for bigness. Too-big-to-fail banks can borrow more cheaply than smaller banks, in essence get a government subsidy.

Capping non-deposit liabilities as a percentage of US GDP has merit. It would force banks to shrink without government arbitrarily taking them apart and would curb their reliance on the overnight loans that helped bring down Bear Stearns and Lehman Brothers. Princeton University economist Hyun Song Shin said that in March 2008, the five largest Wall Street investment banks were rolling over a quarter of their balance sheets every night.

Banks would be less likely to over-borrow if they knew they would be charged a fee for every dollar of non-deposit liability, and this would raise money for the federal government at a time of fiscal strain.

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