Tuesday, May 25, 2010

The Goldman Sachs hearings missed the point - PART 5

Okay...sorry for another extended delay. It's been difficult knowing when to jump into the mix here when the financial reform package was still being hashed out. It has now passed the Senate and will be molded together with the House bill in the next few weeks. But before I talk about that at all...let's discuss this issue of 'Too Big To Fail'.

As I mentioned in the last post, I see two major categories for reform: 1) Increasing the transparency of financial transactions from the credit-card consumer-level to the hedge fund-level, and 2) breaking up the "Too-Big-To-Fail" banks. In my mind, both are absolutely critical and one is nearly useless without the other.

I know the phrase 'Too Big To Fail' has been thrown around A LOT lately (almost to the point of becoming cliché) but what exactly does it mean? Again, let's go to my current favorite book (13 Bankers):
Certain financial institutions are so big, or so interconnected, or otherwise so important to the financial system that they cannot be allowed to go into an uncontrolled bankruptcy; defaulting on their obligations will create significant market losses for other financial institutions, at a minimum sowing chaos in the markets and potentially triggering a domino effect that causes the entire system to come crashing down.
No one in their right mind would ever argue for the existence of financial institutions that are Too Big To Fail. Fixing this problem was the rallying cry from nearly everyone in the financial world (both financiers and regulators) at the time of the near-collapse in late 2008. The reason that everyone appeared on the same side was because the problem caused by Too Big To Fail institutions was such a blatant affront to the very foundation of the free market that no one in their right mind would argue for their existence. And the consequences of bailing out Too Big To Fail banks was clear as day to everyone in late 2008: the mega-banks get the benefits of all of the risks that they took over the preceding years and the taxpayer bears the enormous cost of these risks once they exploded. It is privatized gains and socialized losses. Essentially...if you think Obama's health reform plan was socialistic, then this is even at another level beyond that (at least in a socialistic system, the taxpayer gets the gains as well as the losses).

And once an institution realizes that they are Too Big To Fail, they now have the perverse incentive to take more risks because they are implicitly backed by the federal government. This gives them an enormous competitive advantage over smaller banks who do not have this implicit government backstop. It is completely unfair and antithetical to everything that capitalism stands for.

One of the big rallying cries of the right during the financial reform debate has been to get rid of Fannie Mae and Freddie Mac (the government-supported entities that create liquidity in the housing market). And I completely agree with that argument for the reasons I discussed above. Fannie and Freddie are Too Big To Fail. But in order to stay intellectually consistent, those same people who argue for the dissolution of Fannie and Freddie should also be for breaking up the mega-banks for the exact same reason. Essentially, Fannie and Freddie are explicitly backed by the federal government and the mega-banks are implicitly backed by the federal government. There is zero difference when it comes to their power to corrupt our economic system.

This is why this is so frustrating. This should not be a left vs right issue. This is clearly not an example of the free market working as planned. But those against reform are buying the completely bogus piece of propaganda from those interested in keeping the status quo: "This is a government takeover of the financial sector!" Good sweet Lord...it's just amazing to see and hear the financial sector make this argument. The mega-banks have been holding the American government and taxpayers hostage for years and they are the ones crying about being taken over? Give me a friggin' break.

Another way to address the Too Big To Fail issue is through a re-implementation of the Glass-Steagal Act which was enacted during the Great Depression in 1933 to formally separate the plain-vanilla commercial banks (like the one where you have your checking or savings account) from the speculative and inherently riskier investment banks. The idea is to have the safer commercial banks backed up by the federal government [through the Federal Deposit Insurance Corporation (FDIC)] to protect against a bank run and conversely have the riskier investment banks not backed up by the government. However, this perfectly reasonable separation provision was quietly repealed back in 1999 as the market for complex financial products was just starting to go into full swing.

Along the same lines, another proposal is to eliminate proprietary trading, which is when banks use their own money for trading financial products to gain profit as opposed to using their customers money. This is better known as the Volcker Rule. More details can be found here.

So why do we need hard and clear rules on the size and type of banks instead of just relying on regulations?

Banks will inevitably find loopholes and ways to have their activities exempted because of their enormous and unrelenting power over the political world. If you don't believe me, just look up the source of campaign contributions for nearly every politician with any significant say in financial legislation. That's one of the benefits to running a Too Big To Fail firm; you have lots and lots of money just lying around to pay lobbyists to push legislators to do just about anything in order to fund increasingly expensive re-election campaigns. This political power is also quite potent with the regulators (known as regulatory capture). All in all, it has really turned our political-economic system into something more resembling an oligarchy.

So the only way to play ball with the mega-banks is to implement clear and decisive rules that would essentially break them up into smaller less politically powerful institutions.

But what about the argument that we need big banks to compete in an international market full of other enormous banks? Well, it turns out that, yes, we are not the only country with enormous financial institutions. Some countries have banks that are better dubbed Too Big To Bailout (this is part of the reason that Europe is in their current economic crisis). But even with that admission, there is still no credible evidence to suggest that we (as a country and as players in the market) need Too Big To Fail financial institutions. The megabanks are currently at such a bloated size that the usual economies of scale no longer apply. They really only got uber-huge (relative to GDP) in the last 15 years and back then they could still compete quite well. Also take this argument from Simon Johnson:
Even the biggest nonfinancial companies do not, under any circumstances, want to buy all their financial services from one megabank.  They like to spread the business around, to use different banks that are good at different things in different places – in part to prevent any one bank from having a hold over them.  Playing your suppliers off against each other to some degree is always a good idea.
There is just no evidence for having these megabanks around. They are enormous liabilities!

Okay, so what about the financial reform package? Well, I think I'll save more of a discussion on it after it passes both houses but things do not look all that great. It is still largely a technocratic fix...i.e., they really are only addressing the regulation side of things and nothing really structural (e.g., the size of banks...Too Big To Fail). I'm afraid that we really missed a huge political opportunity in early 2009. Some of the new rules will surely help but we are still poised for another situation where a future President decides between two awful choices: A) another massive bail-out of Too Big To Fail banks or B) collapse of the financial system leading to another Great Depression.
UPDATE: Just so everyone is clear on what exactly a megabank is, Johnson and Kwak would like to start with a limit of 4% of GDP for all banks and 2% of GDP for investment banks. That would make the following banks "mega-banks" and definitely Too Big To Fail:

  • Bank of America (16% of GDP)
  • JPMorgan Chase (14%)
  • Citigroup (13%)
  • Wells Fargo (9%)
  • Goldman Sachs (6%)
  • Morgan Stanley (5%)

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