We Don't Need "Too Big To Fail" Institutions

I've been traveling a lot in recent weeks and had the pleasure of meeting policymakers in a number of countries. Perhaps the most interesting of those meetings occurred in a small workshop attended by a couple of policymakers who had worked with Timothy Geithner to bail-out Wall Street. Let me just say that these were intelligent guys with their hearts in the right places. While they probably did not think they were doing “God's work” (as the Vampire Blood Sucking Squid put it), they certainly did think they were operating in the public interest. They shared a view that what we experienced back in 2008 was the mother of all liquidity crises. As one of them put it, the crisis boiled down to this: the world missed a payment, then all hell broke loose. To summarize this view, we had a highly leveraged and interdependent financial system that relied on extremely short-term borrowing (overnight) to finance positions in assets. A key link in the liquidity chain was the money market mutual fund, which essentially promised close substitutes for bank deposits, but without the government guarantee. MMMFs purchased very short term debt issued by the shadow banking system (held as assets). When it looked like forces would “break the buck” there was a massive run on the money markets which made it impossible for the MMMF's to continue to provide overnight funding to the shadow banks. This is a $3 trillion uninsured “deposit-like” market that the government had to guarantee dollar-for dollar. All told, the bailout of Wall Street amounted to more than $29 trillion (that is the “flow” number; the outstanding stock maxed at perhaps $8 trillion—still a very big number). That is what happens when the world “misses a payment”. While this is not the topic for this blog, just think about the possibilities if $8 trillion (leaving to the side $29 trillion) had been devoted to bailing out Main Street rather than Wall Street. We'd be fully employed, driving brand new SUVs, and making payments on our overpriced MacMansions. All that is too obvious to require any explication. Now, I think these guys are wrong. Dangerously so. What we actually had (and have) were massively insolvent Wall Street shadow banks, so their short term liabilities were trash. The run on MMMFs was not an irrational liquidity run, but rather a rational run on institutions that were holding garbage as assets. The federal government made that garbage as sweet smelling as roses, by intervening in the biggest bailout in human history, by several orders of magnitude. And it did not have to be that way. Let us instead deal with a “what if”. Suppose we had decided not to bailout the MMMFs and let the insolvent shadow banks go down. What if we had not handed bank charters to Goldman Sachs and Morgan Stanley (the last two investment banks standing)? What if we had simply closed down what my colleague Bill Black calls “systemically dangerous institutions”? What if we had let the market “work”—in its wisdom it wanted to close down the biggest financial institutions and to rid the world of shadow banking. What if we had let that happen? We know the view at the Treasury: from Rubin to Paulson to Geithner the view is that we'd have no economy at all. Forget about a financial system—we'd be back to bartering coconuts for fish. That was the claim made by Paulson when he went to Congress and demanded nearly a trillion dollars to bailout his Wall Street buds, with a gun to his head and threatening to pull the trigger. What if we had borrowed a line from Clint Eastwood: “go ahead, make my day”? Blow your own stupid head off. Here's a hypothesis. We'd be MUCH better off today. The banksters would all be gone—retired to their offshore islands with whatever riches they had been able to hide away. We'd still have, oh, about 4000 banks, mostly honest, mostly making loans to firms and households, and with reasonable compensation and no special power over Washington. This ain't just my hypothesis. In a very interesting (and to my mind, convincing) article, Robert G. Wilmers, chairman and chief executive officer of M&T Bank Corp. (MTB) made the case for me. Indeed, his piece is so good that I cannot possibly improve upon it. Let me provide a few key (and somewhat long) excerpts. The whole piece is here: Small Banks, Big Banks, Giant Differences: Robert G. Wilmers First, Mr. Wilmers rightly notes the long term transformation of banking away from lending and to trading:

Community banks have given way to big banks and excessive industry concentration; profits are increasingly driven by risky trading; leverage is taking precedence over prudent lending; compensation is out of control. This toxic combination leads to continued taxpayer risk and threatens long-term U.S. prosperity. To understand the change, first consider history. Banking once was a community-based enterprise, relying on local knowledge to guide the process of gathering customer deposits and extending credit. Done well, this arrangement ensures that deposits are deployed into a diversified pool of investments, while providing depositors with liquidity and a return on their savings. Over the past generation, however, the financial services industry changed dramatically. In 1990, the six largest financial institutions accounted for 9 percent of all U.S. domestic deposits. As of Dec. 31, 2010, the six biggest banks accounted for 36 percent of deposits.

Amazing analysis, from a banker. The big banks have virtually no interest in lending. They use deposits to finance their trading activity; and when the trades go bad they ask Uncle Sam to bail them out.

Such concentration raises the concern that poor decisions at such outsized institutions can lead to systemic risk. But this risk is greatly magnified by the new way in which the major banks, those deemed too big to fail, are doing business today. The largest and most profitable bank holding companies have moved away from traditional lending and come to rely on speculative trading in all types of securities, derivatives, credit default swaps, mortgage-backed securities and other, even more complex and exotic financial instruments -- many of them associated with high leverage. Such trading now is the engine of income. In 2010, the six largest bank holding companies generated $56.1 billion in trading revenue, or 74 percent of their $75.7 billion in pretax income. Trading revenue at these institutions distinguishes them from traditional commercial banks, which aren't typically involved in such speculative endeavors. The Big Six institutions earned more than 93 percent of the trading revenue generated by all American banks during the past two years. To say these large institutions are the same species as traditional commercial banks is akin to describing dinosaurs as reptiles -- true but profoundly misleading.

In reality these institutions are what my colleague Bill Black calls control frauds. Their sole purpose is to enrich top management with outsized bonuses. Trading is the preferred activity. First because they can screw the suckers. But more importantly, because trading profits can be whatever you want them to be. You buy my trash at outlandish prices, and I buy your trash at ridiculous prices. We book profits and pay ourselves bonuses. So long as regulators look the other way, there is quite simply no limit to how much we “earn”. Just ask Hank and Bob—whose rich rewards were due to trading activity.

Consider that in 1929 compensation for employees in the financial-services industry was just 1.5 times that of the average nonfarm U.S. worker. By 2009 employees in the securities and investments sector, which includes investment banks, securities brokerages and commodities dealers, earned 3.4 times as much as an average U.S. worker. The average 2009 investment banking compensation at four of the top banks was at least six times that of an average American worker -- while employees in the traditional commercial bank sector earned just 1.2 times the average nonfarm employee. The chief executive officers at the top six bank holding companies were paid an average of $26 million in 2007, or 516 times the U.S. median household income. Indeed, those bank CEOs are paid 2.3 times the average total CEO compensation of the top Fortune 50 nonbank companies.

The bailout of Wall Street was, by design, an effort to keep those bonuses flowing. Oh, who designed it? Well, Hank, Bob and future Goldman Sachs employee Timothy. And who guaranteed the bonuses? Uncle Sam. What is the consequence? Destruction of the real banks—those that still make loans.

The major Wall Street banks operate under the taxpayer-backed umbrella of the Federal Deposit Insurance Corp. and, as we saw in 2008, the Treasury Department and the Federal Reserve. To pay for the cost of such protection, legislators and regulators have forced thousands of Main Street banks like the one I run to absorb a larger, more expensive set of regulatory costs, including higher capital and liquidity requirements. This threatens to deny small-business owners, entrepreneurs and innovators the credit they need and on which the economy relies. Such, I fear, are the bitter fruits of a financial services industry unmoored from its traditional role in the commercial economy and a regulatory regime that protects outsized compensation tied to trading. Regulators have failed to distinguish between trading activity and traditional banking, or to recognize that the activity of an institution, not its form, should be the proper focus of oversight.

We know what happened to “reform”—it got captured by Dodd-Frank, legislation overseen by two of the most conflicted legislators the US has ever seen. Worse, President Obama has in recent days renewed his love affair with Wall Street, returning with open arms to rebuild bridges. After all, he wants at least $1 billion to conduct his next campaign. All that drives home the fact that true reform is impossible so long as these “too big to fail”, systemically dangerous institutions are kept on Washington's life support. Wilmers offers an unassailable agenda for policy makers:

Main Street banks are heavily regulated -- and have been for generations -- to ensure their safety, soundness and transparency. A new generation of regulation must now be applied to what has become a virtual casino. All the players must be included -- Wall Street banks, investment banks and hedge funds. Complex derivatives and credit default swaps must be brought out of the shadows and into public clearinghouses, so that markets can know their magnitude and extent. Those financial institutions that engage in trading should live and die by the pursuit of their fortunes, rather than impose a burden on the whole economy. It's time to disentangle the trading of big financial institutions from their more traditional commercial banking operations and put an end to this unsafe business model.

Unfortunately, I am not optimistic. First we will need another global financial collapse—probably one bigger than what we experienced in 2008—to make this policy politically feasible. Second, we must close all the big, systemically dangerous institutions. They control policy-making and they have an unfair advantage over community banks. The subsidy offered to Goldman alone (in the form of insured deposits plus an obvious backstop that will prevent Goldman from failing no matter how bad its trades go) is worth tens of billions of dollars. Community banks cannot compete with that. There is no hope so long as Goldman et al remain in business. Sometimes the best answer is “TINA”: there is no alternative. To shutting down the biggest banks. The next crisis—which could come any day now—will offer that opportunity. It would be foolish to waste another crisis.