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Too big to fail – 1984 version

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Aspen Institute: Overcoming Short-termism

Aspen Institute: Overcoming Short-termism

The first rule of a blog is to write about what people are interested in reading. So, in complying with that rule, here is more financial information that I suspect most people – and most certainly not this old bird – did not know about.

While reading Jennifer Taub’s abstract Enablers of Exuberance: Legal Acts and Omissions that Facilitated the Global Financial Crisis , I came across the case of Continental Illinois. I’d never heard of this company before. For all I knew it was a railroad company. But it wasn’t. It was a huge bank that failed during the Reagan Administration.

On May 9, 1984, Continental Illinois, Chicago’s largest bank and one of the top ten banks in the US, began a frantic battle to counter reports that it was on the brink of insolvency from a combination of bad loans and funding liquidity risk.

At the root of the crisis lay a massive portfolio of energy sector loans that had begun to turn sour on Continental when the US oil and gas sectors lurched into recession in 1981. The $33-billion asset bank had compounded its mistakes by lending large amounts to lesser-developed countries prior to the August 1982 start of the major LDC crisis of the 1980s.

With investors and creditors spooked by rumours that the bank might fail or be taken over, Continental was quickly shut out of its usual domestic and international wholesale funding markets.

By May 17, regulatory agencies and the banking industry had arranged billions of dollars in emergency funding for the stricken giant. And in a move that remains controversial almost 20 years later, the Federal Deposit Insurance Corporation tried to stem the bleeding away of the banks funds by extending a guarantee to uninsured depositors and creditors at the bank giving credibility to the notion that some banks should be considered too big to fail.
Ambit ERisk

To stem greater market risk which the Reagan Government and FDIC deemed far too great for the banking industry and the economy at large, the FDIC took over the bank, eventually owning 100% of the bank. After pouring millions into the bank, the bank, after more than 2 years, was sold to Bank of America which enabled B of A to expand its banking into the Midwest.

As noted in a case study by Wharton’s School of Finance (University of Penn), the federal government knew long before the 2008 financial collapse what the systemic risks were to the economy from a “too big to fail” financial institution. And those who’ve been in Congress for decades knew as well.

The collapse of Continental Illinois National Bank and Trust was a watershed event in modern banking history that holds lessons for both bank risk managers and regulators. It showed how quickly the revelation of credit problems at a well-regarded bank could turn into a liquidity problem that jeopardized not only the survival of the bank itself, but also, in the view of the US regulators, the financial system. It is widely, if controversially, cited as a prime modern example of systemic risk.

The run on Continental was global and began when traders in Tokyo refused to roll-over their inter-bank placements with Continental. By the time markets opened in the US, Continental Illinois was no longer a viable institution. The U.S. authorities improvised a series of increasingly desperate bail-out measures including the guarantee of uninsured depositors and creditors of the bank, but these measures failed to restore confidence in the institution. Continental remains the largest institution ever to have been rescued by the Federal Deposit Insurance Corporation. Indeed, during Congressional testimony surrounding the intervention in Continental, the regulatory authorities admitted that the ten other largest US banks were also “too big to fail.” The ultimate resolution of Continental Illinois – the so-called Continental divide – has become the prototype for numerous good bank/bad bank restructurings around the world.

What I find inconceivable to understand is why former-Senator Phil Gramm promoted the overturn of Glass-Steagall. I understand that Sen. Gramm is a free-marketer, but he was in the Senate long enough to understand the consequences of an unregulated investment industry when combined with commercial and retail banking.

In 1933, in the wake of the 1929 stock market crash and during a nationwide commercial bank failure and the Great Depression, two members of Congress put their names on what is known today as the Glass-Steagall Act (GSA). This act separated investment and commercial banking activities. At the time, “improper banking activity”, or what was considered overzealous commercial bank involvement in stock market investment, was deemed the main culprit of the financial crash. According to that reasoning, commercial banks took on too much risk with depositors’ money. Additional and sometimes non-related explanations for the Great Depression evolved over the years, and many questioned whether the GSA hindered the establishment of financial services firms that can equally compete against each other. We will take a look at why the GSA was established and what led to its final repeal in 1999.

Reasons for the Act – Commercial Speculation
Commercial banks were accused of being too speculative in the pre-Depression era, not only because they were investing their assets but also because they were buying new issues for resale to the public. Thus, banks became greedy, taking on huge risks in the hope of even bigger rewards. Banking itself became sloppy and objectives became blurred. Unsound loans were issued to companies in which the bank had invested, and clients would be encouraged to invest in those same stocks.

Effects of the Act – Creating Barriers
Senator Carter Glass, a former Treasury secretary and the founder of the U.S. Federal Reserve System, was the primary force behind the GSA. Henry Bascom Steagall was a House of Representatives member and chairman of the House Banking and Currency Committee. Steagall agreed to support the act with Glass after an amendment was added permitting bank deposit insurance (this was the first time it was allowed).

As a collective reaction to one of the worst financial crises at the time, the GSA set up a regulatory firewall between commercial and investment bank activities, both of which were curbed and controlled. Banks were given a year to decide on whether they would specialize in commercial or in investment banking. Only 10% of commercial banks’ total income could stem from securities; however, an exception allowed commercial banks to underwrite government-issued bonds. Financial giants at the time such as JP Morgan and Company, which were seen as part of the problem, were directly targeted and forced to cut their services and, hence, a main source of their income. By creating this barrier, the GSA was aiming to prevent the banks’ use of deposits in the case of a failed underwriting job.

Even though Glass himself later stated his Act “was an overreaction to the crisis” and the Act should be overturned, many in the financial industry pushed for it being overturned immediately, stating that they could effectively police themselves.

The limitations of the GSA on the banking sector sparked a debate over how much restriction is healthy for the industry. Many argued that allowing banks to diversify in moderation offers the banking industry the potential to reduce risk, so the restrictions of the GSA could have actually had an adverse effect, making the banking industry riskier rather than safer. Furthermore, big banks of the post-Enron market are likely to be more transparent, lessening the possibility of assuming too much risk or masking unsound investment decisions. As such, reputation has come to mean everything in today’s market, and that could be enough to motivate banks to regulate themselves.

Obviously, the profit motive, especially for short term gains and personal profit, over-rode the self-imposed industry policing effort. As the Aspen Institute stated in their paper of September 9, 2009,

We believe a healthy society requires healthy and responsible companies that effectively pursue long-term goals. Yet in recent years, boards, managers, shareholders with varying agendas, and regulators, all, to one degree or another, have allowed short-term considerations to overwhelm the desirable long-term growth and sustainable profit objectives of the corporation. We believe that short-term objectives have eroded faith in corporations continuing to be the foundation of the American free enterprise system, which has been, in turn, the foundation of our economy. Restoring that faith critically requires restoring a long-term focus for boards, managers, and most particularly, shareholders—if not voluntarily, then by appropriate regulation.

Steven Pearlstein, Washington Post Business Editor, reminds us

It’s been a year since the onset of a financial crisis that wiped out $15 trillion of wealth from the balance sheet of American households, and more than two years since serious cracks in the financial system became apparent. Yet while the system has been stabilized and the worst of the crisis has passed, little has been done to keep another meltdown from happening.

Even the modest regulatory reform effort launched with much fanfare back in the spring is now bogged down by bureaucratic infighting and special interest lobbying. And back on Wall Street, the wise guys are up to their old tricks, suckering investors into a stock and commodity rally, posting huge profits on their trading desks and passing out Ferrari-sized bonuses. The Wall Street Journal reports they’ve even cranked up the old structured-finance machine, buying up claims to life insurance proceeds and packaging them into securities.

The roots of this short-termism go back to the 1980s, with the advent of hostile takeovers mounted by activist investors. This newly competitive “market for corporate control” promised to reinvigorate corporate America by replacing entrenched, mediocre managers with those who could boost profits and share prices. In theory, the focus was on increasing shareholder value; in practice, it turned out to mean delivering quarterly results that predictably rose by double digits to satisfy increasingly demanding institutional investors. Executives who delivered on those expectations were rewarded with increasingly generous pay-for-performance schemes.

As fund managers grew more demanding of the short-term performance of corporate executives, investors became more demanding of the short-term performance of fund managers. To deliver better returns, managers responded by moving money from bonds and blue-chip stocks to alternative investments — real estate, commodities, hedge funds and private equity funds — where there was more risk, higher leverage and bigger fees. In time, the managers of these alternative investment vehicles began looking for new strategies to improve their results, and Wall Street was only too willing to accommodate with a dizzying new array of products.

At times, it seemed to work spectacularly. During the late ’80s, the late ’90s, and again during the recent boom, investors earned record returns and corporate executives and money managers earned record pay packages. But after the bubble burst in each cycle, the gains to investors turned out largely to have been a mirage, while the gains of the executives and the money managers remained largely intact.

It is all well and good to vow that compensation schemes will be changed so that executives and money managers sink or swim with their investors, but there is a limit to how far those incentives can be aligned. While these new and improved financial markets promise greater efficiency and liquidity — except, of course, when they don’t — it’s now clear that the benefits of all that efficiency and liquidity are captured largely by the Wall Street middlemen rather than their customers, or the economy as a whole.

The more fundamental problem, as the Aspen panel reminds us, is that the components of modern finance — the securities, the trading and investment strategies, the financing techniques, the technology, the fee structures and the culture in which they operate — are all designed to work together to maximize short-term results. And, in such a self-reinforcing system, it is very difficult to change any one feature without changing all the rest.

The problem we face regarding financial markets is not limited to Wall St investment banks. It is systemic. And it must be changed, both through better, more effective regulation and through the understanding of large investors – pension fund managers, etc. – that slower, sustained growth is preferable to market bubbles and quick profits that inevitably harm the overall economy.


Written by Valerie Curl

September 17, 2009 at 5:55 PM

One Response

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  1. Came here from your post on Taplin’s blog and glad I did. Very smart writing Val. Plan to be a regular.

    Ken Ballweg

    September 19, 2009 at 10:24 AM

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