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Financial Myth: Saving TBTF Banks

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After Sec. Paulson, Pres. Bush’s Treasury Secretary, dumped billions of dollars into the nation’s six largest banks to stabilize the financial system and thereby the economy, many economists, financial writers and Fed officials are now saying it’s time to break up those banks. Simply put, they do not serve the commonweal. On the contrary, these exceptionally large banks pose both a moral and economic hazard to the country.

Speaking to the U.S. Chamber of Commerce summit in Washington, Thomas M. Hoenig, president of the Federal Reserve Bank of Kansas City and the current longest-serving regional Fed chief, said,

“In a 1999 speech on financial megamergers, I concluded that, ‘To the extent these institutions become ‘too big to fail,” and … uninsured depositors and other creditors are protected by implicit government guarantees, the consequences can be quite serious. Indeed, the result may be a less stable and a less efficient financial system,” he said. “More than a decade later, the only thing I can change about this statement is that the government guarantees are no longer just implicit. Actions during the financial crisis have made this protection quite explicit.”

“This framework has failed to serve us well,” he said. “During the recent financial crisis, losses quickly depleted the capital of these large, over-leveraged companies. As expected, these firms were rescued using government funds from the Troubled Asset Relief Program (TARP). The result was an immediate reduction in lending to Main Street, as the financial institutions tried to rebuild their capital. Although these institutions have raised substantial amounts of new capital, much of it has been used to repay the TARP funds instead of supporting new lending.”

Small banks, on the other hand, continued to lend. “In 2009, 45 percent of banks with assets under $1 billion increased their business lending,” Hoenig noted.

Hoenig explained how Too Big To Fail helps the nation’s biggest financial firms.

“TBTF status provides a direct cost advantage to these firms. Without the fear of loss to creditors, these large firms can use higher leverage, which allows them to fund more assets with lower cost debt instead of more expensive equity. As of year-end, the top 20 banking firms held Tier 1 common equity equal to only 5.1 percent of their assets. In contrast, other banking institutions held 6.7 percent equity.

“If the top 20 firms held the same equity capital levels as other smaller banking institutions, they would require $210 billion in new equity or reduced assets of over $3 trillion, or some combination of both.

Note that Hoenig stated that while these TBTF banks have not returned to lending, instead investing in proprietary trading and derivatives (again!), regional and small banks and credit unions with under $1B in assets have increased business lending since 2009 by 45%.

The economics blog Naked Capitalism, adds:

And Fed Governor Daniel K. Tarullo said in June:

The importance of traditional financial intermediation services, and hence of the smaller banks that typically specialize in providing those services, tends to increase during times of financial stress. Indeed, the crisis has highlighted the important continuing role of community banks…

For example, while the number of credit unions has declined by 42 percent since 1989, credit union deposits have more than quadrupled, and credit unions have increased their share of national deposits from 4.7 percent to 8.5 percent. In addition, some credit unions have shifted from the traditional membership based on a common interest to membership that encompasses anyone who lives or works within one or more local banking markets. In the last few years, some credit unions have also moved beyond their traditional focus on consumer services to provide services to small businesses, increasing the extent to which they compete with community banks.[…]

Specifically since Glass-Steagall was repealed in 1999, the giant banks have made much of their money in trading assets, securities, derivatives and other speculative bets, the banks’ own paper and securities, and in other money-making activities which have nothing to do with traditional depository functions.

The obvious conclusion is, if you believe that the primary purpose of banking – as opposed to hedge funds, traders, etc – is to act as the lending arm of the economy, and business in particular, then these six TBTF banks serve no useful function for the commonweal.

There is a general consensus among economists and financial writers that these TBTF banks must be reduced to a manageable, non-critical size.

Simon Johnson, formerly chief economist at the IMF, currently MIT economics professor, adviser to Congress, and co-creator of Baseline Scenerio (an economics blog) is not fan of the current Dodd proposal to create a resolution authority, consisting of the very same authorities that failed to see or do anything about the 2008 financial meltdown.

In a Bloomberg book review of 13 Bankers: The Wall Street Takeover and the Next Financial Meltdown which Johnson co-authored:

Unless these too-big-to-fail banks are broken up, they will trigger a second meltdown, the authors write.

“And when that crisis comes,” they say, “the government will face the same choice it faced in 2008: to bail out a banking system that has grown even larger and more concentrated, or to let it collapse and risk an economic disaster.” […]

Drawing parallels to the U.S. industrial trusts of the late 19th century and Russian businessmen who rose to economic dominance in the 1990s, the authors apply the term to any country where “well-connected business leaders trade cash and political support for favors from the government.”

Oligarchies weaken democracy and distort competition. The Wall Street bailouts boosted the clout of the survivors, making them bigger and enlarging their market shares in derivatives, new mortgages and new credit cards, the authors say.

Dodd’s bill contains a provision to manage the TBTF banks by creating a resolution authority which, while it sounds good, is essentially made up of the very regulating authorities that missed the last crisis. As Johnson writes on his blog,

The question of the day can be framed as the classic, “Who will guard the guardians?” Or you can just ask, loudly, “Where the heck were the people charged with the safety and soundness of the system over the past decade?”

It would be sheer folly to rely on “smart regulation” going forward – yet Larry Summers and Tim Geithner seem to be taking that approach. Just answer this, preferably in public: What happens when another president with the philosophy of a Reagan or a Bush starts to make appointments?

Or just think about this. The New York Fed is run by a senior executive of Goldman Sachs. At the same time, the former head of the New York Fed holds a top position at Goldman – where he is responsible for interacting with regulators around the world. And the practices, if not the explicit rules, of the New York Fed apparently permit its board members to buy stock in companies that the Fed oversees. Please explain exactly how this web of arrangements will help keep regulation strong and effective moving forward.

So, here’s the deal with this new regulatory panel, The Financial Stability Oversight Council, as envisioned by Dodd, consists of:

Expert Members: A 9 member council of federal financial regulators and an independent member will be Chaired by the Treasury Secretary and made up of regulators including: Federal Reserve Board, SEC, CFTC, OCC, FDIC, FHFA, the new Consumer Financial Protection Bureau. The council will have the sole job to identify and respond to emerging risks throughout the financial system.

Here’s the makeup and behavior of those agencies in 2005:

FSOC Board - 2005 votes

Now imagine that each of these members, sometime in the future, developed an ideology that said the banks can manage themselves without regulation or oversight. Would it not be possible for their attitudes, as exemplified in this 2005 chart, to return to crash the financial markets again as a direct result of allowing these TBTF banks to exist?

Since the relationship between Wall St and Washington is so symbiotic that regulatory capture and potential conflicts of interest occur so easily, imagine the kind of scenario put forward by Mike Konczal in Rortybomb blog in which a Goldman Sachs management group decides, in corporate Soprano-style, to take out one or more of the council’s players to its benefit. All it takes is for a TBTF bank to lobby for a couple of “friendly” regulators and the whole economy can go bust again.

Here’s the prescription put forward by Johnson that’s gaining consensus across the economics board. Rather than continuing with TBTF banks:

No financial institution should be allowed to control or have an ownership interest in assets worth more than 4 percent of U.S. gross domestic product, or roughly $570 billion in assets today. A lower limit should be imposed on investment banks — effectively 2 percent of GDP, or roughly $285 billion.

Long story short, Dodd’s bill does not protect either the economy or the financial system from these six TBTF banks. Instead, his bill offers a recipe for yet another financial meltdown of even greater proportion.


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