By James Kwak
Paperback On Sale February 12
"A major and timely contribution to a national debate that will only get more heated in the years ahead."
—Mohamed A. El-Erian, CEO of PIMCO
Our Other Book
By James Kwak
The administration is putting a lot of eggs in the resolution authority basket — the idea that, if it gets the power from Congress, it can take over large banks and wind them down, sell them off, or run them temporarily without taking the financial system down. I agree that taking over Citi last winter would have been preferable to what did happen. But I wrote somewhere (sorry, can’t find it now) that resolution authority has a political problem — if, say, JPMorgan Chase runs into trouble five years from now, how much confidence do we have that the government would actually invoke the power and take over the bank when push comes to shove? Even if a Democratic administration were in place, the executives at JPMorgan would scream bloody murder, as would the Republican Party, and the administration would have to decide if it wants to fight that political battle (“Socialism!!!”) before pulling the trigger.
To address the concept of ‘‘Too Big To Fail’’ with respect
to certain financial entities.
1 Be it enacted by the Senate and House of Representa-
2 tives of the United States of America in Congress assembled,
3 SECTION 1. SHORT TITLE.
4 This Act may be cited as the ‘‘Too Big to Fail, Too
5 Big to Exist Act’’.
6 SEC. 2. REPORT TO CONGRESS ON INSTITUTIONS THAT
7 ARE TOO BIG TO FAIL.
8 Notwithstanding any other provision of law, not later
9 than 90 days after the date of enactment of this Act, the
10 Secretary of the Treasury shall submit to Congress a list
1 of all commercial banks, investment banks, hedge funds,
2 and insurance companies that the Secretary believes are
3 too big to fail (in this Act referred to as the ‘‘Too Big
4 to Fail List’’).
5 SEC. 3. BREAKING-UP TOO BIG TO FAIL INSTITUTIONS.
6 Notwithstanding any other provision of law, begin-
7 ning 1 year after the date of enactment of this Act, the
8 Secretary of the Treasury shall break up entities included
9 on the Too Big To Fail List, so that their failure would
10 no longer cause a catastrophic effect on the United States
11 or global economy without a taxpayer bailout.
12 SEC. 4. DEFINITION.
13 For purposes of this Act, the term ‘‘Too Big to Fail’’
14 means any entity that has grown so large that its failure
15 would have a catastrophic effect on the stability of either
16 the financial system or the United States economy without
17 substantial Government assistance.
Introduced by Senator Bernie Sanders of Vermont. That’s the entire bill.
You hear a lot these days that banks need to be big to serve their clients. Charles Calomiris said this morning that we can’t run the global economy with “mom-and-pop banks.” Sure, I’m willing to concede that. But how that’s a silly debating tactic. More seriously, how big do they need to be?
Yves Smith, no friend of the mega-banks, says, “The elephant in the room is derivatives. The big players have massive OTC derivatives exposures. You need a really big balance sheet to provide OTC derivatives cost effectively.”
Surprise, surprise — GMAC needs more money. As you may recall, GMAC was the one institution that got a C- on the stress tests this spring that were impossible to fail. I imagine the analysts at the Fed really wanted to give it an F, but they couldn’t. In any case, it seems that GMAC is too big to fail, because of its importance to the auto industry. Yves Smith says, “The reason for more dough to GMAC is so GM and Chrysler can continue to finance auto purchases, not as a result of greater than expected losses on its existing portfolio. So this is cash for clunkers under another brand name.”
Again, not surprisingly, the government is treating the 50% ownership threshold as some sort of magic line. From the Times article:
“With all three helpings of federal aid, it is possible that the government could wind up owning at least half of the company. But GMAC and Treasury officials are discussing ways to structure the investment in a way that could limit the government’s ownership interests. One possible option would be to also ask some of its private preferred stockholders to convert their investments into common stock.”
Simon and Charles Calomiris were quoted on NPR this morning on the topic of the day — too big to fail.
I thought one of Calomiris’s examples was interesting. He cited Mexico, where banking was dominated by six families that wouldn’t lend to potential competitors. After the Mexican financial crisis and the entry of foreign banks, now it is easier for companies to raise money. It seems to me that story could be used by either side.
By James Kwak
One of the Free Exchange bloggers (some people know who is who by name, but I don’t — if anyone wants to enlighten me, I’m listening) admits choosing his bank because it was big, and staying there because it is big. He also links to James Surowiecki, who asks in the “notes” to his latest column,
“[W]hy, given the broader backlash against the big banks and the less-than-inspiring performance they’ve turned in over the last couple of years, are people still sticking with them? What makes this even more curious is that the big banks, which have historically offered their customers worse deals than smaller banks, have not changed their ways: they pay less for deposits, charge more for loans, make billions from overdraft fees, and have jacked up credit-card rates.”
Last week, Charles Calomiris wrote an op-ed in the Wall Street Journal arguing that big banks are better for various reasons. Simon wrote last week saying that Calomiris underestimated the political dimension, and that his proposed solution — a cross-border resolution mechanism for large institutions — is the policy equivalent of assuming a can opener.
I wanted to look at Calomiris’s specific claims. I think I’ve already dealt with the myth that banks “need to be large to operate on a global scale—and they need to do so because their clients are large and operate globally.” Calomiris also argues that there are economies of scope (it’s better to be big because you can play in multiple businesses). Here’s his evidence:
“True, some empirical studies in the field of finance have failed to find big gains from mergers. But those studies measured gains to banks only, and measured only the performance improvements of recently consolidated institutions against other institutions, many of which had improved their performance due to previous consolidation.
“Yet even unconsolidated banks have improved their performance under the pressure of increased competition following the removal of branching restrictions, which permitted the consolidation wave in banking. And when an entire industry is involved in a protracted consolidation wave, the best indicator of the gains from consolidation is the performance of the industry as a whole. One study of bank productivity growth during the heart of the merger wave (1991-1997), by Kevin Stiroh, an economist at the New York Federal Reserve, found that it rose more than 0.4% per year.”
Nate Silver thinks that financial regulation will be the big political issue of the first half of next year. And for better or for worse, he thinks the central political issue — the “public option,” if you will — will be TBTF and breaking up banks.
I have been skeptical of this. I have been following the conventional wisdom that public anger has receded into confusion, health care has taken over the stage, and no one can get interested in financial regulation — it’s just too boring. Also, I thought the fact that financial regulation doesn’t break down along party lines hurts its popular appeal. In particular, it leaves liberal Democrats very confused (conservative Republicans have an easier time — oppose anything Obama wants). But I suppose I could see breaking up banks — now that it’s come back from several months in the wilderness — becoming a rallying issue. And health insurance is intrinsically boring, too. In any case, Nate Silver knows politics a lot better than I do.
(Also, according to Silver, we are “Volckerists” and the other side are the “Summersists.” We could do worse.)
By James Kwak
Yves Smith has a long excerpt from testimony by Robert Johnson before the House Financial Services Committee on regulation of OTC derivatives. (Johnson’s testimony is not up at the committee site.) Johnson brings together the issues of too big to fail and derivatives regulation: “Absent a drastic simplification of derivative exposures and a transparent and comprehensive improvement in the monitoring of those positions when imbedded in large firms, complex derivatives render these behemoth institutions Too Difficult to Resolve (TDTR).”
In short, he argues that even if you give regulators the ability to “resolve” a Tier 1 financial institution in the event of a crisis, regulators will be afraid to pull the trigger as long as there is still this complicated web of non-standardized derivatives linking it to the rest of the financial system. In addition, this creates a bizarre incentive: if you think that you can escape being shut down by having an intimidatingly complex derivatives portfolio, then you will go out and create such a portfolio.
“If they’re too big to fail, they’re too big,” Greenspan said today. “In 1911 we broke up Standard Oil — so what happened? The individual parts became more valuable than the whole. Maybe that’s what we need to do.”
My jaw is still on my desk.
By James Kwak
At a panel discussion at the Pew Charitable Trusts (captured for posterity by Planet Money), Alice Rivlin floated the idea of breaking up big banks. Luckily for us, Scott Talbott of the Financial Services Roundtable (a lobbying group for big banks) was there to slap that idea down.
Talbott: “We need big companies, and they can be managed, and they are being managed …”
Alex Blumberg (Planet Money): “But why, why do we need big companies?”
Talbott: “They provide a number of benefits across the globe. We have a global economy, and these institutions can handle the finances of the world. They can also handle the finances of large, non-bank institutions like General Electric or Johnson & Johnson. They need these institutions [that] can handle the complex transactions. Simply breaking them up … then you’re discouraging a company from achieving the American Dream, working hard, earning money, producing products, and getting bigger.”
There are two things I object to strongly. The second is easy. The American Dream is for people, not companies. And people dream of working hard, being successful, making money, and having an impact on the world. The American Dream does not imply any particular company size. There are situations in which your products are just so much better than anyone else’s that your company becomes big as a result; Google comes to mind. But Citigroup is the product of no one’s American Dream. When Talbott says “American Dream,” what he really means is “American Bank CEO’s Dream” — because, as we all know, CEO compensation in the financial sector is extremely correlated with assets.
In 2004, Brookings published “Too Big To Fail: The Hazards of Bank Bailouts” by Gary Stern and Ron Feldman (paperback edition 2009). There is a great deal of sensible thinking in this book, as well as much that now seems prescient – particularly as they have been presenting and publicly debating these ideas at least since 2000.
Some of it also seems a bit dated, but in an interesting way that tells us a great deal about how far we have come.
On the basis of their qualitative assessment, reading of the regulatory tea leaves, and a deep understanding of the available data, Stern and Feldman construct several lists of banks that may be considered (in 2004) Too Big To Fail. The most interesting names and numbers are in Box 4-1 (scroll to p.39 in this Google Books link) (update: or look at this pdf version), entitled Organizations Potentially Considered Large Complex Banking Organizations.
Here’s this weekend’s competition. Continue reading
At a hearing of the House Financial Services Committee yesterday, Barney Frank nicely summarized where we are with regard to re-regulation of our largest financial institutions: some of them are definitely “too big to fail”, with the potential to present the authorities with what Larry Summers calls the “collapse or bailout” choice, but what exactly should be done about it?
On a five-person panel, I had the middle seat (as usual) and found myself agreeing with points made both to my left and to my right. Alice Rivlin is correct that we need to control leverage as well as increase capital requirements, and the Fed’s tools vis-à-vis leverage need modernization – your grandparents’ margin requirements would not suffice. Peter Wallison, a member of the new financial crisis investigation commission, stresses that capital requirements should be higher for larger banks. Paul Mahoney wants to change the bankruptcy code, to make it easier for courts to handle large financial firms in quick time; recent CIT Group events suggest this is a good idea.
And Mark Zandi was persuasive on the point that households had no idea what they were signing up to with option ARMs – even he has trouble with those spreadsheets. Effective consumer protection – including a new consumer safety commission – would definitely contribute to financial system stability.
What will Barney Frank and his committee do? There will be no “Tier 1 Holding Company” category of firms, if Frank has anything to do with it; this is too much like creating an implicit government guarantee. Frank is clearly drawn towards higher capital requirements or more insurance payments from firms that pose more system risk. I suggested total assets of 1% of GDP as a threshold, but we agree this should be essentially a progressive drag on profits – creating the strong market-based incentive for the biggest firms to downsize.
Other than that, watch this space.
My written testimony submitted to the committee is below. Continue reading
There are two views of the global financial crisis and – more importantly – of what comes next. The first is shared by almost all officials and underpins government thinking in the United States, the remainder of the G7, Western Europe, and beyond. The second is quite unofficial – no government official has yet been found anywhere near this position. Yet versions of this unofficial view have a great deal of support and may even be gaining traction over time as events unfold. Continue reading