By Simon Johnson
On Friday, Senator Bob Corker (R, TN) took to the Senate floor to rebut critics of big banks. His language was not entirely senatorial: “I hope we’ll all come to our senses”, while listing the reasons we need big banks. And Senator Chris Dodd (D, CT) rose to agree that (in Corker’s words) reducing the size of our largest banks would be “cutting our nose off to spite our face” and that by taking on Wall Street, “we may be taking on the heartland.”
Unfortunately, all of their arguments in favor of our largest banks remaining at or near (or above) their current scale are completely at odds with the facts (e.g., as documented in our book, 13 Bankers).
The senators led with the idea that our nonfinancial sector needs huge, complex, global banks in order to remain competitive internationally. But this is completely untrue – in fact, Senator Dodd conceded as much to Ezra Klein recently when he said that he had heard the arguments of 13 Bankers against big banks also from “CEOs” (presumably of nonfinancial companies).
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.
Senator Corker also argued that entrepreneurs need today’s megabanks. Please find me a single entrepreneur who would agree with that statement – keeping in mind that I work with a lot of entrepreneurs in my day job (professor of entrepreneurship, among other things, at MIT, with a particular focus on entrepreneurs working globally). Of course entrepreneurs need access to capital and they need investors who are willing to back risk-takers in the nonfinancial sector, but if you can find a link between that productive activity and what Goldman Sachs is accused of doing by the SEC, write it up.
Senator Corker also stressed that businesses need to be able to hedge risks, e.g., regarding their input prices. This is a fair point but it is completely unrelated to how large our biggest banks should be. This is instead an argument for allowing the existence of derivatives market – like Gary Gensler of the CFTC, we take the view that requiring all derivatives to be traded on exchanges would not only reduce system risk, it would also be completely consistent with all legitimate and productive derivative-related transactions, and it would reduce the size of the largest broker-dealers (who currently have a great deal of market power when so much of derivatives trading is over-the-counter).
Both Senator Corker and Senator Dodd stressed that the biggest US banks are not the biggest banks in the world. But what does that have to do with anything? The largest European banks are again in seriously trouble this weekend – because they piled on exposure to the eurozone periphery in an irresponsible and frankly dumb manner. The largest Chinese banks are a complete mess in terms of governance and ability to make a sensible loan. And the biggest Canadian banks are underwritten by government guarantees of a nature and scale that make Fannie Mae and Freddie Mac look respectable during the go-go years (which they were not) – we have taken these points up at the highest levels within the Bank of Canada and they get this. So why would anyone think that any of these global banks is an appealing model for the United States to follow?
Senator Corker is opposed to any “arbitrary limit” on bank size. Senator Dodd’s support for Senator Corker on Friday is striking and surprising because, at least nominally, the Dodd financial reform bill as it came out of committee does cap bank size – see Section 620, “Concentration Limits on Large Financial Firms”:
“Subject to recommendations from the Financial Stability Oversight Council, a financial company may not merge or consolidate with, acquire all or substantially all of the assets of, or otherwise acquire control of, another company, if the total consolidated liabilities of the acquiring financial company upon consummation of the transaction would exceed 10 percent of the aggregate consolidated liabilities of all financial companies at the end of the calendar year preceding the transaction. The Council recommendations will be included in a study of the extent to which the concentration limit under section 620 would affect financial stability, moral hazard in the financial system, the efficiency and competitiveness of United States financial firms and financial markets, and the cost and availability of credit and other financial services to households and businesses in the United States. The intent is to have the Council determine how to effectively implement the concentration limit, and not whether to do so. The Council will have six months to write the study, and the Board of Governors of the Federal Reserve will have nine months in which to issue regulations that reflect the recommendations and modifications of the Council.
This is obviously very weak, in part because at best it only applies to acquisitions. This is a significant watering down of the Second Volcker Rule, which read in January:
“2. Limit the Size- The President also announced a new proposal to limit the consolidation of our financial sector. The President’s proposal will place broader limits on the excessive growth of the market share of liabilities at the largest financial firms, to supplement existing caps on the market share of deposits.”
Unfortunately, for whatever reason, the White House appears to have completely folded on the substance. Larry Summers now claims (inaccurately) “most observers” think breaking up big banks would be a bad idea because,
“Most observers who study this believe that to try to break banks up into a lot of little pieces would hurt our ability to serve large companies, and hurt the competitiveness of the United States.”
“But that’s not the important issue, they believe that it would actually make us less stable. Because the individual banks would be less diversified, and therefore at greater risk of failing because they wouldn’t have profits in one area to turn to when a different area got in trouble.
“And most observers believe that dealing with the simultaneous failure of many small institutions would actually generate more need for bailouts and reliance on taxpayers than the current economic environment.”
The Brown-Kaufman SAFE banking act would cap banks, as a practical matter, between about $100 billion and $450 billion in total assets – depending on their exact risk profile. What exactly is the diversification that you can do at $2 trillion that cannot be done at $100 billion?
The Corker-Dodd-Summers view follows closely the line from Hal Scott, a Harvard law school professor (and a director of Lazard) who strongly favors the big banks – for example, he testified against any form of the Volcker Rules when we both appeared before the Senate Banking Committee in February. Scott runs the Committee on Capital Markets Regulation, which recently stated,
“As with the Volcker Rules, the Committee does not believe that size limitations will reduce systemic risk. An institution does not pose systemic risk because of its absolute size, but rather because of its debt, its derivatives positions, and the scope and complexity of its other financial relationships. Because the problem is not size but interconnectedness, reform should focus on reducing the interconnections so that firms can fail safely. Furthermore, even if size were the right issue, the Senate Banking bill would not require any existing bank to shrink; it would only prevent further growth by consolidation or acquisition. Assuming size is the source of systemic risk, we should presumably be concerned about it whether it is the result of acquisition or organic growth.”
Of course the issue is about system risk. Risk is about many things, including the ability of banks (at any size) to circumvent regulation. But risk is also partly a function of bank size – smaller banks are not too big to fail and this affects the incentives of management and directors (as well as traders, depending on the compensation system).
And if you don’t think our largest banks have completely captured the hearts and minds of their regulators – both prior to September 2008 and perhaps even more subsequently – read 13 Bankers and tell us where we got that part of the story wrong.
If you still really don’t want to cap bank size, take a long hard look at the UK, where RBS had a balance sheet of roughly 1.5 times the UK economy when it failed. When it failed in fall 2008, Citigroup had total liabilities around $2.5 trillion. Would our problems now be better or worse if Citi had had $5 trillion in assets – or if it had been the size of RBS relative to the UK economy, i.e., roughly $20 trillion?
As for why exactly Senators Corker and Dodd really support big banks, it seems increasingly likely that this is all about campaign contributions.