Bipartisan Push For More Equity In Big Banks

By Simon Johnson

Proponents of the status quo in the financial sector just cannot catch a break.  Early August is supposed to be a time when regulators and markets slow down, or perhaps even take a break, but this year the news continues to be dominated by mismanagement or worse inside complex financial institutions.

It’s time for a new approach to bank capital.  As proposed by two U.S. Senators, this is not a panacea, but it would have a dramatic effect on big banks and how they operate.

Earlier this week, Standard Chartered, a large global bank (about $600 billion in total assets) based in the UK, was accused of breaking US law in its dealings with Iran and other countries with financial sanctions imposed by the US.  The complaint, lodged by New York’s Department of Financial Services, suggests that the bank’s executives deliberately intended to deceive regulators. 

“For almost ten years, SCB schemed with the Government of Iran and hid from regulators roughly 60,000 secret transactions, involving at least $250 billion, and reaping SCB hundreds of millions of dollars in fees. SCB‟s actions left the U.S. financial system vulnerable to terrorists, weapons dealers, drug kingpins and corrupt regimes, and deprived law enforcement investigators of crucial information used to track all manner of criminal activity.”

If these allegations are correct, someone was taking huge risks with the bank’s reputation by breaking the law.

StanChart, as the bank is sometimes known, is pushing back hard against these allegations.  This reminds me of Bob Diamond, the chief executive at Barclays who came under pressure and responded by attempting to take on the Bank of England – until he was forced out.  Bankers benefit from a great deal of state protection and subsidies.  It is unwise for them to break the rules and then turn on the people attempting to enforce the law.

Standard Chartered’s banking license in the United States could easily be revoked – and it should be revoked if the charges are correct.

At the same time, the near failure in recent days of Knight Capital further illustrates the risks inherent in running a complex securities trading operation.  Some sort of programming error resulted in the firm buying stocks that it did not want and quickly suffering large losses, put at $440 million .  The SEC, understandably, declined to let the firm have a “do over”, i.e., withdraw the trades.

Brad Hintz, a banking analyst at Sanford C. Bernstein & Co., drew one lesson.

“Knight Capital should remind investors how the investment banks became bank holding companies four years ago; markets froze, confidence was lost, funding dried up and a reluctant central bank was forced to step in to save the U.S. capital markets.”

Hintz is right that, “As investors learned in 2008-2009, the most significant risk to any major broker-dealer is a loss of confidence.”  But he then draws the policy conclusion that securities trading operations should remain inside megabanks, where they can be backed by essentially unlimited credit from the Federal Reserve.

But it’s precisely the prospect of unlimited and typically unconditional support from central banks that encourages moral hazard – meaning that bank management is not sufficiently careful.  If we increase the government backing and implicit subsidies for megabanks, will they take bigger or smaller reckless risks?  What would you do?

A much better approach would be to force large financial institutions to increase their equity funding relative to how to much they borrow.  When the business is riskier and when its failure would have more dire consequences for the economy, we want any potential bankruptcy to become much less likely.

Senators Sherrod Brown (D-Ohio) and David Vitter (R-La.) made this point in a powerful letter to Federal Reserve Chairman Ben Bernanke this week.  With regard to the Fed’s proposed rules for how large banks fund themselves, the Senators write,

“We urge you to revisit your proposed rule and modify it so megabanks fund themselves with proportionately more loss-absorbing capital per dollar of assets than smaller regional or community banks.  The surcharge on megabanks should be high enough that it will either incent them to become smaller or will help to ensure they can weather the next crisis without another taxpayer bailout.”

The letter is well argued and should be required reading for everyone concerned about financial sector stability.  “More capital” is sometimes used as a rhetorical smokescreen by people who actually do not want any reform; in contrast, Senators Brown and Vitter are pressing the Fed on the right specifics – and for amounts of equity funding that would really make a difference.

Highly leveraged financial institutions do not have the incentive to be careful – their executives get the upside when things go well, and the downside is someone else’s problem.  Executives and traders in megabanks are paid based on their return on equity unadjusted for risk.  As Anat Admati and her colleagues have been arguing, these executives want to have less equity and more debt – they don’t care about how this affects the rest of the financial system.

Bigger banks are more dangerous.  They should either have to fund themselves with much more equity or break themselves up.  Their executives can choose.

The financial sector should take up this issue because megabank behavior has become so bad that it damages everyone’s business.  Investor confidence has taken a beating precisely because highly leveraged financial institutions get into so much trouble.  As Dennis Kelleher of Better Markets put it on his blog,

“It’s not the fundamentals or computer trading or Wall Street misconduct or one scandal after another. It is the fundamentals and computer trading and Wall Street scandals and lots more. To ignore or deny the effect of the daily drumbeat of Wall Street mishaps and misconduct like the Knight Capital implosion, JP Morgan’s London Whale losses, the metastasizing Libor Scandal, HSBC and Standard Chartered criminal conduct, plus the Facebook and BATS listings debacles and high frequency trading incidents like the Flash Crash (not to mention the rot revealed by the 2008 financial crisis like no-accountability bailouts and Goldman’s Abacus deal) is to deny reality, how investors think and how markets work.”

“Fair or unfair, all of those incidents plus the lousy fundamentals combine to give people the impression or belief that the markets are a bad investment, that they are rigged, that the professional insiders have an advantage, that whoever has the fastest computer wins, and that individuals and ordinary investors just don’t stand a chance.”

As Senators Brown and Vitter suggest, we should increase the required equity funding for megabanks to make them safer, to improve their behavior, and to help restore investor confidence.

An edited version of this post appeared last week on the NYT.com’s Economix blog.  It is used here with permission.  If you would like to reproduce the entire post, please contact the New York Times.

9 responses to “Bipartisan Push For More Equity In Big Banks

  1. Lookout, the criminals are now trying to track the criminals. Why does the U.S. have such little respect for the world court? Oh yea, we are a driving society, FOR NOW!

  2. Thank you for the information. Now, what the H_LL do we do about Paul Ryan? Why are he and the right so fixated on dismantling the New Deal?

  3. Expecting large banks to increase capital requirements unilaterally is delusional, as this would impact profits. Also, the FED doesn’t seemed too inclined to do anything in the way of regulatory reform that would serve to curtail bank profits. Thus, it is not incorrect to say the relationship between the FED and the large institutions is one of collusion, mainly, and not one of securing the interests of investors, pensioners, stock holders, and others. The banks are the junkies, and the FED sits back at the pusher of the junk.

    Rob a bank teller of $2,500 in cash at the window and expect the fully monty…..local and state police, helicopters, police dogs, the FBI, and goodness knows who else. Launder billions in drug money, get caught doing so, and who goes to jail for it??

    You guessed it.

  4. ‘Bigger banks are more dangerous.’

    Prove it. JPMC just showed us how a large, diversified bank can withstand billions of dollars of losses in one dept and still report a quarterly profit.

    We learned in the 1920s and 30s just how dangerous a lot of small regional (and thus not at all diversified) banks can be. That’s the real underlying cause of the Great Depression; unit banking.

  5. That’s the general concensus: unit banking restrictions were one of the major contributors to the collapse of the Great Depression. Many of those failures happened in poorly-capitalized agricultural regions (the Deep South was especially hard-hit). States in which some limited form of branch banking fared better. However, none of those bigger banks had truly national scope, much less international reach. We have to be careful in applying these lessons to today’s situation. The question at hand is, what is an optimal size for a bank to ensure its stability and robustness to economic shocks, and what distortions in the regulatory and corporate governance systems now exist that hinder the evolution towards a more resilient banking system?
    We’ve seen the effect of too-small, weak unit banks. We’ve also seen the effect of undercapitalized, poorly incentivized and unwisely regulated megabanks grown beyond an optimal size. This is where @Per’s observations and proposals make a lot of sense.

  6. Chikni Chameli - Doing God's Work

    Simon boy, why does it take me just 5 minutes to catch your scam?

    Don’t you realize by now that you are not going to succeed? You should stick to teaching entrepreneurship.

    Huawei Technologies is not a bank. They violated iran sancitons. Of course, you are peddling this story that only ‘large banks’ violate sanctions. if you start speaking the truth, your books will not sell and you won’t be invited to speak on bloomberg tv.

    Also, when will you admit that Admait’s “work” is complete fraud. Have you read his paper on bank capital? The central argument is that REITs survived with 30% capital, so banks should. Mickey Mouse and Spiderman are interchangable.

    More importantly, US banks going from 10% to 30% capital is pure fantasy because it would completely undo the Fed’s QE program, which would raise interest rates which would give us another 20 years of depression. Admati’s 30% capital works well in a classroom, in disneyland.

    Brown and Vitter are addressing their local constituents: CEO’s of mid sized banks who feel they are not wealthy enough. Large banks have much better efficiencies and are intruding on thier market. This is an election year, the senators will do anything to stay in front of their local constituents. It is a shame (but not surprising) that you get caught up in election fever and perpetuate their scam.

    The best part is you have no downside when you lie. You are employed for life, you get healthcare for life and free ivy league education for the near and dear.

  7. Guys, guys, there’s only one issue right? Should the “banks”, and I use the term very advisedly, be forced out the door to fend for themselves like good capitalists? One way to have that happen is to make it too expensive for them to maintain their government guarantees. We actually have data points now to know how expensive that should be right?
    Since it took upwards of $17 trillion in equity to refloat these bloated hogs, that’s what we need to insure them for through proper equity requirements. Now if they can’t do that, they should get out from under the umbrella and go fend for themselves. It’s that simple. Now that will probably mean splitting in to pieces that are actually manageable without that sugercoated government teat.
    Here’s the quote that I’d like to respond to directly:
    “they don’t care about how this affects the rest of the financial system…” That’s because they don’t understand, no one does. In every age, people are behind the technological curve. The smartest guys in the room are no exception. They are incapable of putting it all together, of realizing that the world has fundamentally changed with the advent of automated trading and networked computing power.
    I honestly believe that many of them have no clue whatsoever about what goes on in the engine room, that their aren’t discrete corporate systems aren’t – either discrete or their private corporate assets. It’s simply one giant pool traded at hyper-speed with hair-trigger trading mechanisms that can and will bring the system down, and black-box analysis that enables you to figure out what the other guy is doing.
    Carry that thought to its logical conclusion and you come up with a real conundrum for the market-makers. So-called competition has too end up in complete collusion. Everything is, after all, wired together.
    I don’t know what it means, but it isn’t capitalism. You are, of course, absolutely correct to worry about the equity requirements given what Matt Taibbi has bluntly hammered home in critiquing the absurd NY Times piece by Steve Rattner, about “how insane it is for Rattner to call TBTF banking ‘one of our most successful industries’ when the business is now known all over the world to be so totally corrupt that nobody was even surprised when they found out that global interest rates were being manipulated. Or when basically the entire banking industry has been downgraded to near-junk status thanks to the widespread perception that their balance sheets are a travesty of phony accounting and unrealized losses.” That is to say, most of them are ill-liquid truth be told and the requirements would kill them off for good. That’s the gun at the head.
    Sullivan, as I’ve mentioned to you before, this narrative is now completely out of your hands. That’s just the way it is. If you can’t accept that then maybe you should find yourself another line of work. Sorry, that’s just reality.

  8. Christopher Holm

    Simon, this is some encouraging news, for both sides.

  9. If Anti Money Laundering is in full force, I think this can be lessened if not totally eradicated. Question is, is it in force? If it is, up to what extent?