By Simon Johnson, (13 Bankers, out tomorrow)
Some people at the top of the administration begin to understand that it makes both economic and political sense to impose binding constraints on our largest banks. But even the clearest thinking among them still has a problem – breaking up banks seems too much at odds with the way they saved these same banks in 2009. At best, this would be most awkward for the individuals involved on all sides.
“We’ll achieve the same general goal by imposing capital requirements that increase with the size of the bank” (not an exact quote) is the administration’s latest whispered idea, and in principle this has some appeal. If done properly, this could level the playing field – and therefore should be supported politically by small banks. By increasing the buffer against future losses, it would put in place greater protection for taxpayers against too big to fail (TBTF) institutions. And it would push TBTF firms to break up if they really have nothing better than cheap funding – based on implicit government subsidies – to support their continued existence.
But this “let’s do it with capital requirements” proposal is deeply flawed and completely unacceptable. From different perspectives, Paul Volcker, Elizabeth Warren, and Ted Kaufman all agree, we cannot rely on our existing regulations (and regulators). We need new law.
Setting capital requirements involves a delegated decision, i.e., Congress indicates some parameters in general terms and the executive branch has to implement. The broad authority is in the hands of top people at the White House/Treasury, while the mind-numbing details fall to the regulators (subject to political pressure). So how do you write the capital requirements legislation that has the “end TBTF” outcome?
The bottom line is that you would have to trust the White House and myriad regulators. But neither have credibility on this front, as Senator Ted Kaufman insists. Given their track record, they might promise to raise capital enough, but once the moment of political attention is over, they’ll likely just roll over for the big banks again.
Accommodating the interests of big firms – if that is what you want to do – is made all the more easy by the complexity of the issues involved. What is the level of capital requirements for the largest banks that would really level the playing field? Would 20 percent get it done? Why not 30% – which is more like the average of pre-1913 capital-asset ratios, i.e., before the era of modern bailouts? No one knows – and a good deal of assertive experimentation would be required.
On top of this, the international part of capital requirements runs through the Basel Committee, which (a) takes a long time, (b) is highly technical, and (c) is murky without any real accountability – i.e., by the time someone writes a front page WSJ article on what went wrong, it’s 5 years too late. A key function of international organizations, not subject to disclosure like US public institutions or discovery like US private organizations (facing lawsuits), is to hide all kinds of dubious actions – there is by definition no sunlight. You can shred all the documents you want at an international organization; no one on the outside will ever get you for this.
Any approach that puts heavy emphasis on capital requirements comes down to trusting the Obama administration’s economic team to be suitably resilient in the face of heavy pressure from big banks. But when these same people had the choice of being tough or nice to big failed bankers, by their own admission they went overboard on the niceness – no one on the board of directors of Citigroup was even embarrassed by what happened in early 2009. This tells us something about preferences, style and how our top officials see the world– whether you want to call this non-confrontational, highly deferential to the financial sector, or awe of Jamie Dimon.
How can any reasonable person trust the administration to get capital requirements right – i.e., so as to force TBTF banks to make themselves smaller – particularly when the Europeans have serious fiscal-financial problems, will want to paper over their own capital deficiencies, and are much more comfortable using implicit government guarantees to back banks than the US is (or should be)?
There is no substitute for new law here – just as Elizabeth Warren argues (and we discuss further in 13 Bankers). And the only law that will really deal with massive banks is law that effectively constrains their size – the point that Paul Volcker has been making and will likely reiterate tomorrow.
The Baseline Scenario 
—->one day<—— turning the page on the past and bookmarking into the future – sound bites it may be….
A view from Europe: Simon, you keep charging on
European regulation and institutions like B.I.S.
Through B.I.S we can know that European banks have lent
258 billion dollars to Greece, while they have lent
671 billion dollars to Spain. This is not worthless information, even if they seem asleep at the wheel, and its head, Jaume Caruana, famously discreet, last stated that “more regulation will mean less credit”,
an argument I read in the speeches of Dutch bankers, lol
As you may well know, even more since the Financial Crisis, in Europe the relation between banks and governments has been tightened, for bad and for worse.
It is not a secret that two of the biggest French banks, BNP-Paribas and SocGen are under the Basel ratios, imho, that’s why the French managed to land Christian Noyer as the 3 year-term chairman to “cover
up” on the potential cliffs of the balance sheets.
How do you think France finances its exports of weapons or airplanes ? Through the banks
Additionally, you could dedicate an entire post on Deutsche Bank, equally ‘toxically loaded’and rumoured to be leveraged at 50..
The solution is not that difficult: carve out their proprietary activities and regulate derivatives. Then, place tight restrictions on mortgage originations, whether done by banks or non-banks. Finally, put some teeth into the regulation of securitizations. In other words, regulate the liquidity mechanisms that have the potential to create a bubble.
Your right, the regulatory system can’t be trusted and political reforms (like publicly funded elections) that would allow us to regain that trust are unlikely.
So we MUST have:
1) a strong form of Glass-Steagall (complete separation), or
2) the Volcker Rule (a mild form of Glass-Steagall) and size limits.
Personally, I’d rather have #1 because the Volcker Rule still relies on the regulators and I don’t think that bankers should be allowed to find creative ways to leverage bank balance sheets or hold us hostage with our own money (and payment systems that allow us to move our money).
Its also easier to constrain and regulate derivatives exposures of a bank than an investment bank.
What really makes capital requirements the wrong way to go is that they’ll go out the window whenever someone like Mexico needs to be bailed out, or whatever new and sudden need for a big chunk of money rears its head.
1. In Leonhardt’s NYTMag piece he repeatedly mentioned downsides to fixed rules, but never said what those downsides were. Do you think they’re significant? (And what are they?)
2. Would you write up for us the law(s) you would propose? I would much value it. Pseudocode is fine, but as specific as possible. (Where the devil is…)
Thanks,
Steve
“Setting capital requirements involves a delegated decision, i.e., Congress indicates some parameters in general terms and the executive branch has to implement. The broad authority is in the hands of top people at the White House/Treasury, while the mind-numbing details fall to the regulators (subject to political pressure). ”
Otto von Bismarck wrote:
“Laws are like sausages. It’s better not to see them being made.”
(1815 – 1898)
I fear, that for all the spin and perjuries of Geithner
and Bernanke of late in their public hearings, The Treserve will try to weigh of all its weight-plus the
bank lobbyists- to keep the regulation within their hands and we have already seen the “results” of such ‘regulators’ or ‘arsonists’, Best wishes to Paul Volcker, the winds are turning nevertheless..
I asked once short while ago; “So can you tell me what I can do about all this?” Of course there seems to be no answer to what single me in American can do.
So how about Regulation that can be explained to me.
Penalties instead of bonus buyouts for not complying.
Seems to me jail time and forced sell-off of assets in noncompliance would take care of some of the size problem.
JustMe
Systemic risk: how to deal with it?
Paper by Jaime Caruana, General Manager of the BIS
February 2010 – excerpt
“The international financial crisis has made us all think much harder – not only about what systemic risk means, but also about what it means for policy. Systemic risk was underestimated across the board before this crisis. We were faced with the unthinkable when a number of very large institutions failed, despite their previous reputation for balance sheet strength and leadership in risk management. Coming to grips with systemic risk is vital because the aggregate risk facing the system is much higher than the simple sum of the individual risks attending financial institutions, products and markets.”
http://www.bis.org/publ/othp08.htm
It is not that difficult to force the issue on banks statutorily if the law can be passed. Simon mentions the rules of pre 1913. OK, go for it. All national associations and state banks must maintain Treasury and cash reserves of 25 % of all deposits and other subordinated debt that is specifically defined as not permanent capital. Permanent Capital is perpetual preferred and common positions. Going even further, the Bank Holding Company must mimick the national associations they own in having as high a permanent capital for all it’s holdings as it does for national associations. Then let’s go for the magic hated word in laws. Deem all debt of the BHC as being invested in the National Associations and thus coming under the NA reserve holding requirements.
Lastly, the BHC may not guarantee any subsidiary debt. Each subsidiary will fail on it’s own without entangling other units. You loan to subsidiaries with statutory exclusion from looking to other entities. This will get mighty expensive. Going even further. All long term borrowings require sinking funds as in days of yore before 1913. To provide liquidity all long term secured debt is in bearer form as it generally was in 1913.
At this point the big BHC concept is hog tied.
There would be immense consequences in frozen ability of banks to lend to anyone. By freezing 25 % of loans to the NA and BHC both directly and indirectly that means interest rates on the 75 % would have to make up for the 25 % held as reserve assets. It would get very expensive to borrow money.
Today, the real problem of banks is that the income levels of US retail borrowers is insufficient to service the loan interest and amortize the loan and create increased demand out of the same income.
All this can be examined in detail, as concepts, by studying the big company financial statements from around 1880-1910.
Oops, I meant all long term debt in securitized form. That would go for Mortgage Bonds and Debentures. Also, to clarify, Bonds and debentures are one issuer to many buyers. Example. United States Steel Bonds and Debentures issued when the Steel trust was created. What Carnegie and Frick took back for doing the deal.
Another point. Sinking funds usually wound up putting their payments in a sinking fund deposit controlled by the likes of Morgan or Schiff. The bonds traded bearer and were redeemed all at once for the total lent. The coupons handled the interest.
Yes. It would be nice if you could answer Leonardt point for point. This help us the readers get some clarity better than when all of you guys are talking past each other.
Why ‘Buy & Hold’ Investing Is Dead And Recessions Are The New Normal
http://tinyurl.com/yj9mgaq
I should add to my post above I would force the ‘sale of the cream’ and force retention of the garbage.
The Supreme court will rule it all null and void. Their assets and pensions are bullet proof.
I am reading “The Big Short” by Michael Lewis while I wait for your new tome to arrive from Amazon in about a week. I am struck by the fact that apparently none of the really big TBTF’s understood the nature of their own derivatives and the marketplace until kind of late in the game, and by that time a huge number of absurd subprimes (and I do mean totally absurd, like on mobile homes) had been securitized, tranched, and sold all over the world. The CDS market was active, but mostly in the area of corporate debt, and then they were tipped by those outside their doors who understood the complete fallacy of their bogus bonds and CDO’s. Wow, what a story.
It is so very much time to completely stomp out the Bondfires of Vanity that have for so long lit the worlds of the economic Wallstreet elites. The only way to do it is to pass a law or laws which make playiing their games illegal and unteneble. Like opening all derivatives to public trading and scrutiny, like separating traditional from investment banking, like having tough consumer regulations that come from an independent source not associated with anyone responsible for the fiscal health and stability of banks, like large whistle blower awards for reporting on those who violate the laws and the public trust in addition to heavy fines and very extensive criminal penalties, like a sliding scale of capital requirements (larger percentages for larger institutions), like … (fill in the next few yourself). This issue is so important, and the anti-Wallstreet political climate so strong, that now is the right time to really get something meaningful done. In fact, if it isn’t done, this will prove that our Congress is unalterably captured by the financial elite oligarchy and is participating the an American plutocracy which rivals anything that Soviet Russia ever had.
There was never any question in my mind that if you set up a skewed system of capital requirements based on perceived risk and then appoint just a few agents to be the perceivers, sooner or later something was going to go seriously wrong. The fact that the members of the Basel Committee and of their public relation agent the Financial Stability Board never even saw it is more than enough evidence that the most serious financial regulatory problem we confront is the inappropriateness of the current bunch of regulators.
Come on, they did not even debate what the purpose of the financial sector really should be, they just imposed their own boudoir dreams of a world with no bank defaults… as if that´s it… and then imposed their concoctions that they thought so brilliant.
Change all regulators or if that´s impossible, ignore the Basel Committee and the FSB.
“Oh but that you cannot do… they are the experts!” Sorry, look out the window and you must know that is not true. They might be financial experts… but that does not make them good regulators.
And while you´re at it request from all major universities to provide proof of them having warned about the consequences of the financial regulations and or of any impending crisis. You got some cleaning work to do there too! http://bit.ly/P4m
And just in case I am far from being the only one warning in a timely fashion.
There is not one single word on the paper that a good regulator should not have known before this crisis… and that is probably the scariest part of it all. If this total regulatory failure would had occurred in any other area the regulators would have been long gone.
Simon concludes with “the only law that will really deal with massive banks is law that effectively constrains their size”
And I would agree with that but only after you have eliminated all current regulatory bias that helps the banks to grow massive. If you do not start with that, you might very well mess it up even further having a bunch of almost massive banks creating one single massive crisis.
“But this “let’s do it with capital requirements” proposal is deeply flawed and completely unacceptable. From different perspectives, Paul Volcker, Elizabeth Warren, and Ted Kaufman all agree, we cannot rely on our existing regulations (and regulators). We need new law.”
You don’t need a new law. Modern culture needs to learn how a control language does its job. double-entry book-keeping is the only control language in existence that can control today’s financial services community. The double-entry language is 670 years old. The formal language fell into disuse 40 years ago because it has never been programmed into software. Because language is by nature experiential, since it is not being used even intelligent advocates such as Simon and James don’t know that it is missing. The software developers who write the poorly written software in use today have never had experience with the formal language either.
Nothing will be fixed until the book-keeping framework of rules is properly programed into code and used as a control language that governs the financial services community and all of commercial trade.
It is simple, not one among them knows anything about business and they are too busy trying to take the free market over!
http://americaspeaksink.com/2010/03/tyrannical-government-no-longer-theory/
Right so!
They insist with their myth of rational regulations without even changing the regulators after the greatest regulatory failure ever. At least the “irrational” market, in similar situations, usually calls in a new CEO or the bankruptcy court.
Have you noticed how often names of banks and bankers have been named here in pejorative terms, often deserving it, but not once have the regulatory schemers in the Basel Committee who unwittingly seeded this AAA-bomb in our financial system and which then exploded, been mentioned by their names… might they all be buddies of Simon? http://bit.ly/gNemy
“Today, the real problem of banks is that the income levels of US retail borrowers is insufficient to service the loan interest and amortize the loan and create increased demand out of the same income.”
Completely agree with this. More important than any of the financial reform proposals currently being considered is the declining income of retail borrowers, which translates into less aggregate demand. Thirty years of stagnant wages have left consumers overly reliant on debt. Until some way is found to address the widening divergence between productivity growth and wage growth financial reform is little more than the rearranging of deck chairs on a sinking ship.
Simon Johnson asks “How can any reasonable person trust the administration to get capital requirements right – i.e., so as to force TBTF banks to make themselves smaller – particularly when the Europeans have serious fiscal-financial problems, will want to paper over their own capital deficiencies, and are much more comfortable using implicit government guarantees to back banks than the US is (or should be)?”
And the answer is that you can never be sure getting it right… but when different capital requirements were imposed on different assets based on risk perceptions by the credit rating agencies then you should have been absolutely sure that was the kind of regulatory arbitrary interference that guaranteed the “doing harm” and getting it exponentially wrong.
So for a start, the regulators who came up with the current nonsensical capital requirements should be banned for life!
How does France finance its exports of weapons . . . Just to be clear, the only reason Western Europe is in the news at all is because it looks bad. Greece has degraded it.
European finance, culture, politics are so important to Americans. The only countries in the headlines are China and Iran (sometimes), although, financially, China is a very small player. Yet I can go to the NY Times front page, read nothing about Britain or Europe, and see the word China seventeen times. Ever.