13 Bankers: The Wall Street Takeover and the Next Financial Meltdown (36 page)

The third problem is that TBTF banks are bad for competition and therefore bad for the economy. Bond investors realize that megabanks have an implicit government guarantee, and therefore they are willing to lend them money at lower interest rates than their smaller competitors. This is why large banks could pay 0.78 percentage points less for money than small banks in the wake of the financial crisis, giving them a huge competitive advantage. Dean Baker and Travis McArthur calculate that this hidden subsidy was worth up to $34 billion for eighteen large banks in 2009, accounting for roughly half of their profits.
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This subsidy makes it harder for smaller banks to compete, deterring new entrants and only strengthening the long-term process of consolidation and concentration in the financial sector.

Where people disagree is what to do about the problem. The Obama administration initially put its faith in various technical regulatory fixes. One is to increase regulatory supervision of systemically important financial institutions. Another is to give the government “resolution authority” over holding companies that are too big to fail, similar to the power the FDIC currently has to take over and clean up insolvent banks.
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A third proposal is to increase capital requirements for large banks in an effort to make the most systemically dangerous institutions a little safer.
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A fourth idea floated by the administration is requiring large banks to raise “contingent capital”—debt that, in the event of a crisis, converts into equity capital at a predetermined trigger point.
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The legislation introduced in the House of Representatives and the Senate in fall 2009 largely followed the administration’s incrementalist approach.

These regulatory fixes make sense on paper, and it would be better to enact most of them than to do nothing. Resolution authority over holding companies would have given Treasury and the Federal Reserve another option during the financial crisis—the option to take over insolvent institutions, fire management, wipe out shareholders, and impose haircuts on creditors. Some experts insist that the government could already have used its negotiating power to obtain a similar result,
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but the proposed legislation would settle the question once and for all. The ability to impose some degree of pain on managers, shareholders, and creditors should have some deterrent effect on excessive risk-taking during a boom. (Contingent capital, however, might actually reduce the stability of the financial system, because reaching the conversion trigger point could itself cause a bank run; as
The Financial Times
’ Gillian Tett has pointed out, these instruments are called “death spiral bonds” in Japan.)
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However, the belief that these regulatory refinements alone will solve the TBTF problem and prevent the next financial crisis reflects excessive faith in technocracy. Crises, by their nature, are difficult to predict with any degree of precision. The first problem with increased capital requirements or with contingent capital is estimating how much capital will be enough in the next crisis. Both Bear Stearns and Lehman had sufficient capital on paper—five days before its bankruptcy, Lehman had a Tier 1 capital ratio
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of 11 percent
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—yet were overwhelmed by market fears about their viability. A month after the Lehman bankruptcy, the settlement auction for Lehman credit default swaps valued Lehman debt at only 9 cents on the dollar—meaning that liquidating the firm’s assets was only expected to yield 9 percent of the money needed to repay unsecured creditors.
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How much
more
capital would have been needed to prevent panic or to keep creditors whole—and how much capital will our banks need next time? The truth is that no one knows. And it is highly likely that any increases in capital requirements will be modest. In November 2009, Morgan Stanley analysts predicted that new regulations would result in Tier 1 capital ratios of 7–11 percent for large banks—still below Lehman’s pre-bankruptcy level.
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Resolution authority is also far from a magic bullet, especially in the global world of modern finance. Some of the most severe complications of the Lehman bankruptcy occurred not in the United States, but in other countries, each of which has its own laws for dealing with a failing financial institution. When a bank with assets in different countries fails, it is in each country’s immediate interest to have the strictest rules on freezing assets to pay off domestic creditors. For a resolution process to have any chance of succeeding, it must be cross-border in scope; yet there are strong political reasons to believe that such an international agreement will be difficult or impossible to achieve—and that countries would be unlikely to comply with it in a serious financial crisis.

More important, solutions that depend on smarter, better regulatory supervision and corrective action ignore the political constraints on regulation and the political power of the large banks. The idea that we can simply regulate large banks more effectively assumes that regulators will have the incentive to do so, despite everything we know about regulatory capture and political constraints on regulation. It assumes that regulators will be able to identify the excess risks that banks are taking, overcome the banks’ arguments that they have appropriate safety mechanisms in place, resist political pressure (from the administration and Congress) to leave the banks alone for the sake of the economy, and impose controversial corrective measures that will be too complicated to defend in public. And, of course, it assumes that important regulatory agencies will not fall into the hands of people like Alan Greenspan, who believed that government regulation was rendered largely unnecessary by the free market.

The technocratic approach assumes that political officials, up to and including the president, will have the backbone to crack down on large banks in the heat of a crisis while the banks and the administration’s political opponents scream about socialism and the abuse of power. Under the administration’s proposal, taking over a major bank would require a decision by the treasury secretary, consultation with the president, and the approval of two-thirds of the Federal Reserve Board of Governors,
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which means that it would be a political decision of the first order. Even leaving aside the issue of direct pressure from bank executives who happen to be major political donors,
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it would be politically difficult for any president to order a government takeover of an iconic American bank that was insisting through the media and its lobbyists that it was perfectly healthy. FDIC takeovers currently do not face this challenge because the banks involved are small and have little political power; the same cannot be said of JPMorgan Chase or Goldman Sachs.

Not only does the “better regulation” approach ignore the impact of politics, but it fails to solve the underlying problem—the existence of TBTF institutions. Even if the government were able to use resolution authority to take over a large bank, it is virtually certain that taxpayer funds would be necessary to finance the takeover, because of both the size of the bank and the urgency of the situation.
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Although the government might be able to impose small haircuts on creditors and counterparties, they would have to be small, since large losses would trigger the domino effect that has to be avoided at all costs, and taxpayers would be left bearing most of the losses. In short, this approach assumes that TBTF institutions must exist, and then attempts to deal with them as well as possible—and not very well at that.

The right solution is obvious: do not allow financial institutions to be too big to fail; break up the ones that are.

This is a controversial idea. It is a virtually unquestioned assumption in the American business world that bigger is better. Banking executives have spent the last twenty years making their banks as big as possible by entering new businesses, expanding into new geographic regions, and above all acquiring other banks. The idea that the United States, as the world’s largest economy, should also have its largest banks seems self-evident to most people.

Not surprisingly, the CEOs of large banks are not in favor of having their empires divided. In
The Washington Post,
Jamie Dimon wrote, “While the strategy of artificial limits may sound simple, it would undermine the goals of economic stability, job creation and consumer service that lawmakers are trying to promote.”
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In an interview, Lloyd Blankfein of Goldman Sachs said, “Most of the activities we do, and you can be confused if you read the pop press, serve a real purpose. It wouldn’t be better for the world or the financial system [to change the firm’s activities].”
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The Obama administration agreed. Diana Farrell, a member of the National Economic Council, said in an interview, “We have created [our biggest banks], and we’re sort of past that point, and I think that in some sense, the genie’s out of the bottle and what we need to do is to manage them and to oversee them, as opposed to hark back to a time that we’re unlikely to ever come back to or want to come back to.”
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Larry Summers said, “I don’t think you can completely turn back the clock.”
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Some economists and commentators recognized early on that breaking up the big banks was the only way to prevent a repeat of the financial crisis. Testifying before Congress in April 2009, Joseph Stiglitz said,

We know that there will be pressures, over time, to soften any regulatory regime. We know that these too-large-to-fail banks also have enormous resources to lobby Congress to deregulate.… Accordingly, I think it would be far better to break up these too-big-to-fail institutions and strongly restrict the activities in which they can be engaged than to try to control them.
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The Wall Street–Washington establishment at first attempted to portray this as a naive idea supported only by outsiders who didn’t understand the world of modern finance (even if some of them had won the Nobel Prize). However, cracks in the consensus began to appear in fall 2009. In testimony before Congress, Paul Volcker, the legendary Fed chair of the 1980s and an Obama administration adviser, said, “I would exclude from commercial banking institutions, which are potential beneficiaries of official (i.e., taxpayer) financial support, certain risky activities entirely suitable for our capital markets,” including internal hedge funds, internal private equity funds, and proprietary trading.
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In an October interview, he argued unequivocally for an updated version of the Glass-Steagall separation of commercial and investment banking. “People say I’m old-fashioned and banks can no longer be separated from nonbank activity,” he said. “That argument brought us to where we are today.”
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In October, Mervyn King, head of the Bank of England (the world’s oldest central bank), gave a speech arguing for the separation of the “utility” aspects of banking—processing payments and transforming savings into investments—which should be offered government support, from riskier activities such as proprietary trading, which should not. A key element of his argument was that regulation would be insufficient to keep banks from taking on excessive risk: “The belief that appropriate regulation can ensure that speculative activities do not result in failures is a delusion.”
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A stronger version of King’s position is
Financial Times
columnist John Kay’s proposal for “narrow banking,” which limits banks to taking deposits and processing payments and regulates them as utilities.
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Similarly, economics professor Laurence Kotlikoff has argued for “limited purpose banking,” a model in which banks are not allowed to borrow short and lend long, and all risky assets must be held in mutual funds.
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In November, Richard Fisher, president of the Federal Reserve Bank of Dallas, argued for getting rid of banks that are too big to fail: “This means finding ways not to live with ’em and getting on with developing the least disruptive way to have them divest those parts of the ‘franchise,’ such as proprietary trading, that place the deposit and lending function at risk and otherwise present conflicts of interest.”
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But the most surprising break with the conventional wisdom came from Alan Greenspan, who perhaps more than any other person had made the age of the megabanks possible. In an October speech, he said, “The critical problem that we have, which we’ve got to resolve, is the too-big-to-fail issue.” Asked how to solve this problem, he responded,

If they’re too big to fail, they’re too big. I—this one has got me. And the reason it’s got me is that we no longer have the capability of having credible government response which says, henceforth no institution will be supported because it is too big to fail.…

At a minimum, you’ve got to take care of the competitive advantage they have, because of the implicit subsidy, which makes them competitively capable of beating out their smaller competitors, who don’t get the subsidy. And if you don’t neutralize that, you’re going to get a moribund group of obsolescent institutions, which will be a big drain on the savings of this society.…