Monday, November 24, 2014

Truth from the Top

WASHINGTON, DC – It is unusual for a senior government official to produce a short, clear analytical paper. It is even rarer when the official’s argument both cuts to the core of the issue and amounts to a devastating critique of the existing order.

In a speech delivered on February 24, Thomas M. Hoenig, Vice Chairman of America’s Federal Deposit Insurance Corporation (FDIC), did exactly that. These four pages are a must-read not only for economic policymakers around the world, but also for anyone who cares about where the global financial system is heading.

Hoenig, former President of the Federal Reserve Bank of Kansas City, has spent his career working on issues related to financial regulation. He communicates effectively to a broad audience – and understanding the technicalities of finance is not needed to grasp his main points.

One of those points is that the world’s largest financial firms have equity that is worth only about 4% of their total assets. As shareholders’ equity is the only real buffer against losses in these corporations, this means that a 4% decline in their assets’ value would completely wipe out their shareholders – taking the companies to the brink of insolvency.

In other words, this is a fragile system. Worse, the current regulatory treatment of derivatives and of funding for large complex financial institutions – the global megabanks – exacerbates this fragility. Perhaps we are moving in the right direction – that is, toward greater stability – but Hoenig is skeptical about the pace of progress.

As he points out, the relevant studies show that the megabanks receive large implicit government subsidies, and this encourages them to stay big – and to take on a lot of risk. In principle, such subsidies are supposed to be phased out through measures being taken as a result of the 2010 Dodd-Frank financial-reform legislation. In practice, these subsidies – and the politics that makes them possible – are firmly entrenched.

The facts may startle you. In 1984, the US had a relatively stable financial system in which small, medium, and – in that day – what were considered large banks had roughly equal shares in US financial assets. (See Hoenig’s chart for precise definitions.) Since the mid-1980’s, big banks’ share in credit allocation has increased dramatically – and what it means to be “big” has changed, so that the largest banks are much bigger relative to the size of the economy (measured, for example, by annual GDP). As Hoenig says, “If even one of the largest five banks were to fail, it would devastate markets and the economy.”

The Dodd-Frank legislation specifies that all banks – of any size – should be able to go bankrupt without causing massive disruption. If the authorities – specifically the Federal Reserve and the FDIC – determine that this is not possible, they have the legal power to force the banks to change how they operate, including by reducing their scale and scope.

But the current reality is that no megabank could go bankrupt without causing another “Lehman moment” – that is, the kind of global panic that resulted in the days after Lehman Brothers failed in September 2008.

In particular, experts like Hoenig who have thought about the cross-border dimensions of bankruptcy emphasize that it simply would not work for a corporation the size of JPMorgan Chase ($3.7 trillion in assets), Bank of America ($3 trillion), or Citigroup ($2.7 trillion).

“Panic is about panic,” Hoenig says, “and people and nations generally protect themselves and their wealth ahead of others. Moreover, there are no international bankruptcy laws to govern such matters and prevent the grabbing of assets.” I would add that the chance of bankruptcy courts cooperating across borders in this context is nil.

As a result, the Federal Reserve and the FDIC should move immediately to force the megabanks to become much simpler legal entities. Current corporate structures are opaque, with the risks hidden around the world – and various shell games allowing companies to claim the same equity in more than one country.

Breaking down the components of banks into manageable pieces makes sense. The Federal Reserve has recently taken a step in that direction by requiring that global banks with a significant presence in the US operate there through a holding company that is well-capitalized by US standards.

This is not about preventing the flow of capital around the world. It is about making the financial system safer. Anyone who disputes the need to do this – and much more – should read and respond to Hoenig.

Simon Johnson is a member of the FDIC’s systemic resolution advisory committee, an unpaid position. The views expressed here are his alone.

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    1. CommentedGerald Yu

      In the chart "Consolidation of the Credit Channel", which covers the 28-year period from 1984 to 2012, I think Mr. Hoenig should adjust the Asset Size Group divisions over time, either by adjusting for inflation, or by, say GDP. $100m today isn't worth as much as in 1984. So there is no wonder the group that had assets below that size shrunk by 72%. Not adjusting for inflation or size of economy makes this chart biased and thus not illustrative of his point.

    2. CommentedStephan Ong

      Although perhaps also not fast enough, the development of a worldwide Legal Entity Identifyer (LEI system) would/should help in getting to insight in cross-border entities and activities. Just getting the legal structures of these mega banks in view would be a step forward.


    3. Commentedblueskybigstar Blyth

      Didn't the Sherman Antitrust Act use to do all of what is now so desperately needed very well. Let's bring it back and enact a Progress and Truth Amendment that will guarantee that all laws must state their reason for being with well researched data 1. proving the laws need 2. proving it is the best solution for the determined need and 3.guaranteeing that law is not made that provides extraordinary benefits and/or extraordinary penalties to the few; enact an organization committed to ensuring that for government to regulate the economy it must remain separate from business by having the power to eliminate and keep fascistic relations out of government; expand the definition and penalties for treason; enact consequences for politicians, government and business officials who are dishonest to the public regarding issues important to the democracy; make law that guarantees independent media where investigative journalism is subsidized for crimes never brought to justice; fund research into practicable methods to take money/bribery out of politics; ensure the freedom and access to speech and power of regular people; lower the criteria for impeachment and removal of politicians and government officials; increase penalties for defamation and/or framing others for crimes; make it illegal with serious consequences for politicians to repeal laws that have long well served the protection of the public; enact independent organizations committed to transparency and empowered with RICO laws for the purpose of investigating corruption in government; and reserve the death penalty for those who have abused power and/or privilege to such a great extent as to endanger the whole nation.

    4. CommentedProcyon Mukherjee

      Hoenig’s third point, “ the use of long-term assets to secure highly volatile short-term wholesale funding”, and the fifth, “the unfinished business is the assignment to assure that the largest, most complicated banks can be resolved through bankruptcy in an orderly fashion and without public aid”, is so apt as banks and the shadow banking system continue to elude a plethora of banking norms that were built in the first place for creating the much needed resilience to fend off critical points in the rather bouncy moments of upturns and downturns. On the contrary the arrangement appears to be like a conservatorship of the system by the government as implicit guarantees and subsidies approach epic proportions taking moral hazard to the hilt.

      Such an arrangement could be spilling to other areas of the economy when companies with huge debt and with eroding net worth would have to take the onerous burden of the increase in interest rates eventually.

    5. CommentedRalph Musgrave

      There is a simple solution to all this: just force banks to be funded 100% by shareholders rather than by depositors and bondholders. That way bank insolvency is plain impossible. If a bank performs badly, all that happens is that it’s shares drop in value: no big deal.

      As for the fact that the above policy would raise interest rates a bit, that’s immaterial. The existing banking system is subsidised, and subsidies no not make economic sense. In contrast, the above 100% system requires no subsidy, thus it does make economic sense.

        CommentedGerald Yu

        Being 100% funded by equity does not make sense. One of the main (perhaps the only) function for banks is to be an intermediary -- to take deposits from depositors and make loans to borrowers. When a bank takes deposit, it is being funded by debt (debt to the depositor). A "bank" that is 100% funded by equity means that it does not take deposit, in which case it is just a debt investor and loses the function of being an intermediary / a bank, that helps to bring savings to investments.
        So, a higher reserve ratio should be sufficient. Going all the way to 100% doesn't make sense, as it means to ban banks altogether. That is impossible, as the consequences would be a depression more severe than the Great Depression.