Friday, November 21, 2014

Too Big To Handle

WASHINGTON, DC – In the discussion of whether America’s largest financial institutions have become too big, a sea change in opinion is underway. Two years ago, during the debate about the Dodd-Frank financial-reform legislation, few people thought that global megabanks represented a pressing problem. Some prominent senators even suggested that very large European banks represented something of a role model for the United States.

In any case, the government, according to the largest banks’ CEOs, could not possibly impose a cap on their assets’ size, because to do so would undermine the productivity and competitiveness of the US economy. Such arguments are still heard – but, increasingly, only from those employed by global megabanks, including their lawyers, consultants, and docile economists.

Everyone else has shifted to the view that these financial behemoths have become too large and too complex to manage – with massive adverse consequences for the wider economy. And every time the CEO of such a bank is forced to resign, the evidence mounts that these organizations have become impossible to manage in a responsible way that generates sustainable value for shareholders and keeps taxpayers out of harm’s way.

Wilbur Ross, a legendary investor with great experience in the financial services sector, nicely articulated the informed private-sector view on this issue. He recently told CNBC,

“I think it was a fundamental error for banks to get as sophisticated as they have, and I think that the bigger problem than just size is the question of complexity. I think maybe banks have gotten too complex to manage as opposed to just too big to manage.”

In the wake of Vikram Pandit’s resignation as CEO of Citigroup, John Gapper pointed out in the Financial Times that “Citi’s shares trade at less than a third of the multiple to book value of Wells Fargo,” because the latter is a “steady, predictable bank,” whereas Citigroup has become too complex. Gapper also quotes Mike Mayo, a leading analyst of the banking sector: “Citi is too big to fail, too big to regulate, too big to manage, and it has operated as if it’s too big to care.”Even Sandy Weill, who built Citi into a megabank, has turned against his own creation.

At the same time, top regulators have begun to articulate – with some precision – what needs to be done. Our biggest banks must become simpler. Tom Hoenig, a former president of the Federal Reserve Bank of Kansas City and now a top official at the Federal Deposit Insurance Corporation, advocates separating big banks’ commercial and securities-trading activities. The cultures never mesh well, and big securities businesses are notoriously difficult to manage.

Hoenig and Richard Fisher, the president of the Federal Reserve Bank of Dallas, have been leading the charge on this issue within the Federal Reserve System. Both of them emphasize that “too complex to manage” is almost synonymous with “too big to manage,” at least within the US banking system today.

George Will, a widely read conservative columnist, recently endorsed Fisher’s view . Big banks get a big taxpayer subsidy – in the form of downside protection for their creditors. This confers on them a funding advantage and completely distorts markets. These subsidies are dangerous; they encourage excessive risk-taking and very high leverage – meaning a lot of debt relative to equity for each bank and far too much debt relative to the economy as a whole.

Now these themes have been picked up by Dan Tarullo, an influential member of the Board of Governors of the Federal Reserve System. In an important recent speech, Tarullo called for a cap on the size of America’s largest banks, to limit their non-deposit liabilities as a percentage of GDP – an entirely sensible approach, and one that fits with legislation that has been proposed by two congressmen, Senator Sherrod Brown and Representative Brad Miller.

Tarullo rightly does not regard limiting bank size as a panacea – his speech made it clear that there are many potential risks to any financial system. But, in the often-nuanced language of central bankers, Tarullo conveyed a clear message: the cult of size has failed.

More broadly, we have lost sight of what banking is supposed to do. Banks play an essential role in all modern economies, but that role is not to assume a huge amount of risk, with the downside losses covered by society.

Ross got it right again this week, when he said:

“I think that the real purpose and the real need that we have in this country for banks is to make loans particularly to small business and to individuals. I think that’s the hard part to fill.”

He continued,

“Our capital markets are sufficiently sophisticated and sufficiently deep that most large corporations have plenty of alternative ways to find capital. Smaller companies and private individuals don’t have really the option of public markets. They’re the ones that most severely need the banks. I think they’ve kind of lost track of that purpose.”

Hoenig and Fisher have the right vision. Tarullo is heading down the right path. Ross and many others in the private sector fully understand what needs to be done. Those who oppose their proposed reforms are most likely insiders – people who have received payments from big banks over the past year or two.

Read more from our "The Big Bank Battle" Focal Point.

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    1. CommentedKevin Remillard

      “Everyone else has shifted to the view that these financial behemoths have become too large and too complex to manage.” Really? Your Citi vs. Wells Fargo example is one to study. GLB created the former and the latter went successfully on with the meat and potatoes of banking. Avoiding concentration of risk (assets) and exposure to capital markets combined with liquidity are central issues. Our government seems to misinterpret their role leading to exacerbation with the likes of HUD, Freddie, and Fannie and with laws like Dodd/Frank that strangle small banks with regulatory burdens. Is this article social commentary or a business one?

    2. CommentedRajarshi Samuel Betha

      Simon, excellent article. Simply put, I'd ask this - would you like your stockbroker to use your money to trade on their account? How is it very different when banks expect deposit taking divisions to provide capital/collateral for financial securities operations and trading... This doesn't look like a storm in a teacup, and we have been through one real-life stress test already that required bailouts...

    3. CommentedTony Phuah

      Not too big to manage, not too small to scale. Be moderate.

    4. CommentedElizabeth Pula

      "I think they've kind of lost track of that purpose."

      This paragraph has got to be the UNDERSTATEMENT of the year, if not the last few years!

    5. CommentedZsolt Hermann

      The article says:
      "...In any case, the government, according to the largest banks’ CEOs, could not possibly impose a cap on their assets’ size, because to do so would undermine the productivity and competitiveness of the US economy. Such arguments are still heard – but, increasingly, only from those employed by global megabanks, including their lawyers, consultants, and docile economists..."
      And this is actually true. The present expansive, constant quantitative growth economic model needs the banks to provide constant, unceasing money injections, since the whole system is built on expansion beyond means, building bubbles hoping for the best, taking credit on top of credit.
      This attitude and lifestyle led to the unsustainable and critical credit, debt burden individuals and nations are buried under today.
      The banks are not the problem, they simply assisted the process and thus became the "celebrities" on constant growth.
      Thus bank regulations will not solve the problem, only a complete system change can.
      If the socio-economic model reduces itself back to a natural, necessity and available resource based system, the banks would automatically reduce back to their original assisting role, as the article itself writes:
      "...More broadly, we have lost sight of what banking is supposed to do. Banks play an essential role in all modern economies, but that role is not to assume a huge amount of risk, with the downside losses covered by society.
      Ross got it right again this week, when he said:
      Comments“I think that the real purpose and the real need that we have in this country for banks is to make loans particularly to small business and to individuals. I think that’s the hard part to fill.”..."
      Finally we need to see that partial solutions, being lost in the details cannot help us solving the crisis. We are facing a system failure and the solution also has to be systematic, a complete paradigm change.

    6. CommentedMarten Klein

      The United States lack an ordoliberal tradition, they are unable to prevent capture of the state because their officials lack ethos and revolving door is widely accepted. That is why their antitrust is a petting zoo.

    7. CommentedFrank O'Callaghan

      Too complex or too big to manage is a euphemism for too dishonest. These are only the excuses for the total failure of society to bring these institutions to heel.

      We need a complete reworking of the post crash world. Our productive capacity is greater than ever and can be deployed to create a comfortable life for everyone on the planet in a sustainable economy. This is not possible with a system of casino banks, rising inequality and wasted resources.

        CommentedA. T.

        @Mark Pitts, depends on what a flatter distribution of wealth would do for economic growth and purchasing power. Mind you, it's not something that's been tried with communism – that stupid system keeps almost everyone poor, but the party bosses rich indeed.

        CommentedMark Pitts

        Divide total world GDP by the number of people. You get about $9,000 per person per year. Whether or not that provides a "comfortable life for everyone" is questionable.

    8. CommentedProcyon Mukherjee

      Dan Tarullo’s speech covers broadly all the elements of systemic risks that fall in the ambit of regulation, but two of his references are worth mentioning, 1) shadow banking and related credit intermediation with excessive leverage involving maturity transformation, which has collateralization channels that could impact the mechanism through which money velocity works 2) bank capital adequacy, which even through the structure of capital surcharge that can offset precisely the systemic risks, is yet to be established.

      We have now the situation that while new credit creation is being initiated through Fed actions, the channels through which it would move (in the shadow banking system) have the issue of contraction in collateralization (as reported by Manmohan Singh at IMF), which unless solved has an overall money velocity problem. I do not know the solution to such problems has anything to do with regulation or de-regulation.

      Procyon Mukherjee

    9. CommentedStamatis Kavvadias

      Why is every response to a problem in capitalism, doomed to address only symptoms and not the causes?

      Why is it out of discussion that, not only is there a mechanism available to private lending institutions, to collect interest based on the expectation that our money can work for us, but they are also allowed to leverage their assets and take over the process of money creation out of the reach of control of the central banks (which, by the way, only model banks as "intermediaries" or not at all, as if they were lending existing money)?

      Why the twofold pitfall of removing private banks' need to be solvent, by having full reserves, and allowing them to create the currency? Why is virtually all currency created as debt to banks and the economy run on "liquidity" (later removed from circulation), and these private institutions are allowed to inflate the money supply based on market fallacies or with tricks, and with no real risk?

      Assessment of the value of banking business, by rating agencies is a way to say that society and state trusts the private sector to care that the financial system will work correctly. This is a fundamentally misplaced expectation. Private companies do not care about the economy, and do not have any liability to society, and of course no democratic accountability.

      Banks are supposed to be supervised, but there is no real evaluation of the credibility of their borrowers or the soundness of their investments, and that would be OK if they were working as all other companies, with liabilities to other legal entities. For banks, the risk of lending previously non-existing money is passed to the taxpayer. This would not be a problem if they were public! But, if "bank deposit" is in fact *a loan* to a bank, where the "depositor" risks loses, then banks need to be public, so that there can be democratic accountability. The two cannot be mixed. It is imperative that this will change.

      Currently, private banks do not simply have their money work for them, but they actually have non-existing money work for them. They usually place part of their gigantic profits, made with virtually no risk other than closing the bank, to the gambling economy. This alone is proof not of ability, but of scam by pure usury (well, scam is a form of well respected ability, it seems)!

      The first problem is collection of interest and the expectation of money working for us, without appropriate redistributing taxation to both bankers and the use of "financial instruments" in the gambling economy. Money placed in the gambling economy, without being taxed, is a way to allow banking business to grow in size, regardless of simplification of "financial instruments", and increase inequality, as well as their influence to politics, or even directly to government if they get large enough, interfering with democracy.

      Second, for banks to remain in the private sector, they need to (a) be liable to depositors (i.e. full-reserves), and (b) borrow the currency they lend from the state (e.g. a state-managed central bank), or use their owned assets. Currency creation policy target must be handled by the state and assigned to the central bank (central bank retains instrument independence).

    10. CommentedJohn Brian Shannon

      Hi Simon,

      Thank you for capturing the situation exactly as it is.

      I have no problems with the size of banks. I feel that smaller banks are easy pickings for larger banks, corporations and could be vulnerable in the case of foreign banks, corporations or governments.

      Large, well-run, capable and stable American banks should be the minimum standard, except for community-based banks and credit unions.

      Perhaps small banks should have a 'parent bank' arrangement with the super-jumbo sized banks to assist and protect them, in the case of predation by international banks, companies and corporations.

      I have serious concerns with the recent bailouts and wonder if regulatory controls are stringent and modern enough to prevent banking calamities.

      Not that banks, or any company, corporation, or NGO, should have heavy-handed and over-bearing burdens placed on them by regulators -- but there has got to be a balance somewhere, so that we don't re-visit the same sort of fiasco that we have seen in recent years.

      What's past is past, but stronger and better regulations must prevent another catastrophic banking calamity.

      Best regards, JBS

    11. CommentedCharles Broming

      Ross is right:

      We appear to be reliving the era of such large, diversified industrial conglomerates as ITT and Gulf & Western. The conglomerate model failed due to the failure of conglomerates to increase profitability through more effective management and reduced risk as advertised. One lesson we seemed to learn is that complexity is expensive because it requires intensive management and lots of managers. In industrial companies, the erosion of profitability is a long, slow process that can result in a "death-by-a-thousand-cuts" outcome (bankruptcy is a single, surprising event, frequently, but, getting there takes a lot of time - years) or mitigated by selling off business units as managers destroy their value, usually at a discount from the original purchase price.

      In financial companies (note that I don't have to distinguish between banks and non-banks anymore), a few big mistakes can wreak havoc in a very short period, in particular because of their high financial leverage. Their supposed diversification is an illusion because their markets are highly correlated with each other and their supplies of non-deposit funds are highly correlated with each other as well as with their markets, too. Thus, if the entire holding company is leveraged highly (relative to the deposit-taking side), then, its demise will be quick and painful--and these large banks are very highly leveraged. One of the virtues of Glass-Steagall was that it kept the leverage of deposit-taking, lending institutions in check. Now that "diversified" multibank holding companies can leverage their non-bank assets almost without limit, the entire structures have become more leveraged when you view them as a whole. The net effect that the bank side of the business is riskier than before and the trading side is the same as before. Bank executives use hedging strategies to disguise this increased risk, pretending that they are reducing risk.

      If it wasn't so costly, our failure to learn from history would be amusing. Lending money to companies (including offering trade finance) that can't access the public credit or equity markets is one the two functions (taking deposits is the other) that justify the existence of commercial banks. All of those other functions (trading, IPOs, secondary offerings, etc.) belong somewhere else.

    12. CommentedPaul A. Myers

      How about changing some tax incentives?

      Allow for the deductibility of dividends up to one-half of taxable income, while limiting the deductibility of interest expense on nondeposit liabilities to some percentage of capital or dividends paid.

      Preference should be given to a self-regulating scheme to promote desired behavior.

    13. Commentedradek tanski

      increasing complexity is the only degree of freedom had by the adaptable to differentiate and protect themselves from the un-adaptable.

      Calling that complexity should be given up - is like telling the clever to hold back so that the less clever can catch up.

      This line of thinking of too big too handle is just a socialist rally to protect relative group interests. But the hypocrisy of the majority tends to drown out the inconvenient responses.

        CommentedA. T.

        Complexity can only be equated to "adaptability" or "cleverness" if it can be demonstrated to create (rather than extract or even simply consume) value. Complexity that creates no value is just chaos, which has a natural tendency to occur.

        CommentedVivek S

        There is no problem with greater complexity, if the losses from that complexity is not to be borne by everybody every few years. The problem is the banks are using greater complexity to socialize losses, so your argument is backwards. Its the banks who are being socialist (not the other side), when they require govt support to bail them out.

        The call isn't merely to reduce complexity for its own sake, but to prevent the need for bailouts of those who can't manage the complexity. Let the clever do whatever they want to do, but without creating systemic risk.