Sunday, April 20, 2014
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Big Banks’ Tall Tales

WASHINGTON, DC – There are two competing narratives about recent financial-reform efforts and the dangers that very large banks now pose around the world. One narrative is wrong; the other is scary.

At the center of the first narrative, preferred by financial-sector executives, is the view that all necessary reforms have already been adopted (or soon will be). Banks have less debt relative to their equity levels than they had in 2007. New rules limiting the scope of bank activities are in place in the United States, and soon will become law in the United Kingdom – and continental Europe could follow suit. Proponents of this view also claim that the megabanks are managing risk better than they did before the global financial crisis erupted in 2008.

In the second narrative, the world’s largest banks remain too big to manage and have strong incentives to engage in precisely the kind of excessive risk-taking that can bring down economies. Last year’s “London Whale” trading losses at JPMorgan Chase are a case in point. And, according to this narrative’s advocates, almost all big banks display symptoms of chronic mismanagement.

While the debate over megabanks sometimes sounds technical, in fact it is quite simple. Ask this question: If a humongous financial institution gets into trouble, is this a big deal for economic growth, unemployment, and the like? Or, more bluntly, could Citigroup or a similar-size European firm get into trouble and stumble again toward failure without attracting some form of government and central bank support (whether transparent or somewhat disguised)?

The US took a step in the right direction with Title II of the Dodd-Frank reform legislation in 2010, which strengthened the resolution powers of the Federal Deposit Insurance Corporation.  And the FDIC has developed some plausible plans specifically for dealing with domestic financial firms. (I serve on the FDIC’s Systemic Resolution Advisory Committee; all views stated here are my own.)

But a great myth lurks at the heart of the financial industry’s argument that all is well. The FDIC’s resolution powers will not work for large, complex cross-border financial enterprises.  The reason is simple: US law can create a resolution authority that works only within national boundaries. Addressing potential failure at a firm like Citigroup would require a cross-border agreement between governments and all responsible agencies.

On the fringes of the International Monetary Fund’s just-completed spring meetings in Washington, DC, I had the opportunity to talk with senior officials and their advisers from various countries, including from Europe. I asked all of them the same question: When will we have a binding framework for cross-border resolution?

The answers typically ranged from “not in our lifetimes” to “never.” Again, the reason is simple: countries do not want to compromise their sovereignty or tie their hands in any way. Governments want the ability to decide how best to protect their countries’ perceived national interests when a crisis strikes. No one is willing to sign a treaty or otherwise pre-commit in a binding way (least of all a majority of the US Senate, which must ratify such a treaty).

As Bill Dudley, the president of the New York Federal Reserve Bank, put it recently, using the delicate language of central bankers, “The impediments to an orderly cross-border resolution still need to be fully identified and dismantled. This is necessary to eliminate the so-called ‘too big to fail’ problem.”

Translation: Orderly resolution of global megabanks is an illusion. As long as we allow cross-border banks at or close to their current scale, our political leaders will be unable to tolerate their failure. And, because these large financial institutions are by any meaningful definition “too big to fail,” they can borrow more cheaply than would otherwise be the case. Worse, they have both motive and opportunity to grow even larger.

This form of government support amounts to a large implicit subsidy for big banks. It is a bizarre form of subsidy, to be sure, but that does not make it any less damaging to the public interest. On the contrary, because implicit government support for “too big to fail” banks rises with the amount of risk that they assume, this support may be among the most dangerous subsidies that the world has ever seen. After all, more debt (relative to equity) means a higher payoff when things go well. And, when things go badly, it becomes the taxpayers’ problem (or the problem of some foreign government and their taxpayers).

What other part of the corporate world has the ability to drive the global economy into recession, as banks did in the fall of 2008? And who else has an incentive to maximize the amount of debt that they issue?

What the two narratives about financial reform have in common is that neither has a happy ending. Either we put a meaningful cap on the size of our largest financial firms, or we must brace ourselves for the debt-fueled economic explosion to come.

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

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  1. CommentedParrain Boursorama

    The best model for expanding Alternative Energies and Environmental Protection globally is through using market equilibrium, whereas governmental subsidies and fiscal stimulus to be just supplementary

  2. CommentedAjit Kapoor

    what This is a perfect example of academia preaching to the world about common sense. However failing to address the Geo political control by the big banks on powerful governments. I agree with much of Prof. Simon's thesis, however, its not pragmatic as it fails to recommend solutions to take the politicians out of the grip of Big Banks. I hope this comment is not taken as socialistic viewpoint but would like to hear professor's view on this complex but untouchable topic.

  3. Commentedde Lafayette

    {SJ: After all, more debt (relative to equity) means a higher payoff when things go well. And, when things go badly, it becomes the taxpayers’ problem (or the problem of some foreign government and their taxpayers).}

    Well put, but if we must chose one of the other of the above scenarios, which is the more crucial to the nation? The well-being of banks or that of its citizens? I vote clearly for the latter.

    Which makes me wonder why we do not recognize the fatal error made when Clinton was ill-advised by Rubin and Summers (et al, namely a Republican Congress) to do away with the Glass-Steagal Act.

    There are, by their very natures, two banking sectors: One is Commercial Banking that is or should be risk-averse and Investment Banking that is risk-prone. Never the twain should meet in the same financial entity.

    Meaning quite simply, who in their right-mind can accept as fundamentally justified that the deposit funds of the former (meaning my and your account) should be employed to collateralize the risks of the latter?

    Yes, the FDIC is there to prevent any great loss from occurring should the deposits evaporate like the morning dew come the next banking calamity.

    But, the FDIC is nothing more than the Treasury, which is little more than the Fed – meaning that the Fed will print money in order to save our deposits (up to but not beyond the statutory limits).

    Which is what both bankers and politicians seem to think when it comes to managing total risk. That is, regardless of the consequences, the Fed will print money to reimburse the loses.

    Nice, comforting thought. But, still, I’d not care to have my money in an American bank when that happens.

    My point is this: Rather than the various measures taken to date to assure that “nothing can go wrong”, I would rather that the large banks be forced to dismantle and distribute further the inevitable risk of another debt-related catastrophe happening. And in the process, let’s put back up the firewall between the two banking sectors.

    Yes, the hue and cry from the Investment Bankers will be great. And it will as well be music to my ears …

  4. Commentedfrancesco totino

    the problems can come of course from the banks and the reforms that they need ... but the real problem is given from lobal finance rules
    If we want to have a long term balanced social developmente we need take the following actions

  5. CommentedRajarshi Samuel Betha

    Simon, I agree with you. But, isn't the real question "what it will take to make banks do what they are supposed to do?"...

    Corporates are hailed for executing to a plan or strategy, and abhorred for springing surprises... Unrelated diversification has generally proven to be unsuccessful (atleast it has not been a general panacea for success)... However, banks seems to be allowed to go on an empire building spree, diversify into multiple markets and market-making products such as CDS (a form of insurance!), and without necessarily ring-fencing capital?

    So to prevent banks from exceeding their mandate, they have to either voluntarily stay within it (which is evidently not the case) or be legally bound to it (read some form of Glass Steagall).

    So the underlying problem is then how to maneuvre through the existing situation of having to regulate large multinational banks (nearly the size of some economies) to remain focused on their original mission when the government and treasury themselves seem addicted to increasing remit/scale and debt?

    With a country addicted to cheap imports, governments relying on deficit spending, and a dependence on low interest rates to finance an increasingly unsustainable debt load, the government is no different from the banks in creating systemic risk through the illusion of a low cost of risk-free capital... Or is it not?

  6. CommentedRalph Musgrave

    A solution: bank failure under full reserve is impossible, so a country wanting to avoid bailing out mega banks could refuse to allow any bank (or bank division) to operate in its jurisdiction unless the bank/division was full reserve – or at least abided by enough of the elements of full reserve to make failure impossible.

    The crucial “element” here is that a bank owes no one any specific sum of money. That is, under full reserve, depositors who want their bank to lend on or invest their money foot the bill for any loses on those loans or investments. Easy.

  7. CommentedC. Jayant Praharaj

    Mr. Johnson needs to explain why he thinks putting a cap on the size of financial institutions will prevent debt-fuelled catastrophes. How does the microeconomics add up to the macroeconomics ?

  8. CommentedRocio L. Barrientos

    Would stronger monopoly and oligopoly related laws help as an alternative medium to control the size of banks that are "too big to fail", as a temporary solution until transborder agreements are reached? Just wondering....

  9. CommentedTony Phuah

    If it is too complex to understand (and hence manage), reduce the interconnections.

    It’s fine as long as not over. • Moderation • balance

  10. CommentedLiz Banker

    Why can’t the international financial regulatory bodies create their version of "The Hague" ["The Hague Justice Portal is a gateway to information, news and research on the Hague organisations in the fields of international peace, justice and security. It improves access to the Hague courts, tribunals and organisations and encourages academic debate."] - expand its purpose and role to include finance as a part of the global national security discussion and action. As long as TBTF is perceived as a necessity rather than a danger, little action will be done. Pundits often like to conclude in their articles, books, interviews and such that....these TBTF banks haven't learned their lesson as current market trends seem to headed toward another economic meltdown. I would argue that it's not that they haven't learned their lesson from 2008--very much to the contrary--they have learned their "lesson" but are, instead, choosing not to reform themselves. They see financial reform (aka government) as restricting their freedom and self-interest. It is a sad state of affairs, but it’s not something that can’t be overcome with a little creativity and hard work.

  11. CommentedProcyon Mukherjee

    If Simon is referring to the convergence of FASB & IASB then far from converging the battle lines are drawn around the 'incurred loss' model of IASB versus the sequestering of loss as early as possible (FASB) so that the books better reflect as of the current so that we mitigate the impact of surprises later; the essential difference lies in the principle that views books to reflect the potency of certain risk taking approaches which reflects in the higher yields that investors demand while taking those risks and books should not make them appear riskier than they actually are.

    The subsidy that banks enjoy cannot be uprooted by mere regulatory reform in the likes of Dodd Frank Act et al or Basel III norms, as we have seen even a solid bank like the Deutsche Bank have capital ratios that would just need 3% drop in equity to make matters look highly risky from its current position of risk.

  12. CommentedCraig Hardt

    Would it be impossible to create a regulatory system that accepts the systemic importance of some institutions ("Too Big to Fail") and still creates sufficient disincentives for banks to engage in behavior that would lead them to fail (without government bailouts)? While this would be a controversial step, regulations could stipulate that if a bank is forced to accept a government bailout in order to stay solvent, all its highest ranking employees would be fired or suspended without pay for as long as it takes to repay the bailout loan. This may not fix the problem, but it at least puts incentives for individual decision makers in large financial institutions closer to where they should be.