This is part of a series on The Hearing called “Making Financial Regulation Work.” The guest post is from Shawn Bayern, assistant professor of law at Florida State University, and Zephyr Teachout, associate professor of law at Fordham University.

Two weeks ago, the Obama administration put forward a set of proposals to reform the financial industry. As others have pointed out, it’s a fairly mild response to the most severe financial failure since the Great Depression.

One of the biggest gaps in the proposal is that it fails to address the problem of scale in the financial sector. Mega-banks, with massive power, made a series of massive mistakes—and then were bailed out because, the logic went, if they went under, the entire economy would go with them.

Unlike the administration, we think it is essential that new laws be put in place that minimize the risk of financial companies’ becoming too big. Elephantine banks cause far too much risk, with far too little benefit.

There are many reasons that laws should target size. The problem isn’t just interconnectedness or complexity. A financial services industry dominated by a few major players is simply less stable than a financial services industry made up of thousands of small and medium-size banks.

Moreover, mega-banks don’t even serve us well. Ordinarily, an advantage of large size is efficiency, but large financial services organizations don’t seem to be more efficient, or to provide better services, than smaller ones. The largest financial services companies
have not been innovative in efficient ways; instead, their innovations have hurt consumers, undermined ratings systems and led to economic instability.

Companies often grow too large even for themselves. As lawyers and economists have long understood, many corporate managers tend to seek growth at all costs, even against their companies’ interests, in the pursuit of personal wealth, power and prestige.

And there’s one more critical reason we need to limit scale — it relates to the political-economy argument that Simon Johnson, James Kwak and Joseph Stiglitz have so persuasively made in examining the root causes of this crisis. Large financial services companies have disproportionate power over the political process. The massive
influence of the banking sector on policy is what led to deregulation, which in turn led to greater growth.

In response, the Obama administration’s proposal relies too heavily on “oversight” and not heavily enough on substantive reform. Regulators are unlikely, on their own, to be sensitive enough to new types of risks, and they are likely to suffer from the same complacency and overconfidence in models that helped lead to the economic crisis in
the first place.

So how do we limit size and promote financial diversity? Here are six ideas to get from where we are (an industry with increasing, dangerous concentration) to where we ought to be: a diverse and stable industry made up of thousands of small and medium-size banks and credit unions:

1) Expansion of antitrust. The broadest and most general solution is simply to limit corporate size outright. Size can be computed in several ways: revenue, various and theoretically elusive conceptions of market share and even the number of people employed by a company. A simple size limit would avoid vesting too much judgmental discretion in governmental agencies that might be subject to political pressure. It may be inflexible and could prevent the economic efficiencies that come with size, but we believe traditional economics overplays these efficiencies, particularly in the financial sector. A new scale-based law could be enforced by an expanded antitrust division in the Department of Justice, which already performs all the functions that would be necessary for this new law to work: investigations, review of mergers and bringing enforcement actions to break large companies apart.

2) Lower deposit caps. Congress could strengthen deposit caps and similar limits that apply to banks. A federal law currently restricts any bank from coming, through mergers, to hold more than 10 percent of the nation’s bank deposits. The 10 percent cap could be changed to 5 percent, or it could be shifted to reflect absolute assets, instead of a percentage. It could apply to growth after mergers, or simply act as a universal limit.

3) Draconian tax laws. Corporate taxes, which already distinguish
between companies based on profits but might also be sensitive to revenue, could be used to further subsidize small companies or penalize large ones. A sharply progressive increase in the marginal income tax rate for banks above a certain size might be beneficial, even despite fears of enforcement problems or corporate migration away
from higher tax rates.

4) Carrots for community banks. New laws could support community banks and credit unions, actively encouraging the growth of small and medium-size institutions. Laws might also pay attention to the ownership structure of banks and other financial institutions, favoring those that, like credit unions, are owned by their customers.

5) Corporate-governance reforms. Congress and state legislatures
should consider further corporate-governance reforms. Last year, the OECD released a report concluding that problems in internal corporate governance played a large role in causing the economic crisis. Corporate managers are willing to take risks with other people’s money that people wouldn’t usually take with their own. Because managers benefit from corporate growth more than other parties involved in
corporations, including shareholders, greater governance-based review of corporate decisions to grow companies may be warranted. Laws might adjust the standard of review for managerial actions that sharply and rapidly grow enterprises, making it easier for shareholders to challenge those actions when they are not in a corporation’s
interests.

6) Anti-merger presumptions. Congress could create stronger presumptions against mergers in the financial sector. Mergers are a convenient moment for regulation because they often depend on special statutory privileges that allow corporations to combine. We already evaluate mergers in terms of antitrust policy and
in a variety of other ways. We could also require greater affirmative shareholder approval to ensure sounder corporate governance, exclude mergers between companies larger than a certain size or even prevent it by default in certain industries.

A strong competition policy would probably use a blend of these methods, a mix of carrots and sticks, criminal and civil law and tax policy, all reinforcing a stable, diverse, boring banking sector.

— Shawn Bayern, law professor at Florida State University, and Zephyr Teachout, law professor at Fordham University