The Too Big To Fail Subsidy Debate Is Over

By Simon Johnson

No doubt there is still a lot of shouting to come, but this week a team at the International Monetary Fund completely nailed the issue of whether large global banks receive an implicit subsidy courtesy of the American government.   Is there a subsidy, is it large, and how much damage could it end up causing to the broader economy?

The answers, in order, are: yes, there is an implicit subsidy that lowers the funding costs for very large banks; the subsidy is big, with costs of borrowing for these banks lowered by as much as 100 basis points, i.e., 1 percentage point; and yet this large scale of implicit support is small relative to the macroeconomic damage that is likely to be caused by the high leverage and incautious risk-taking that the subsidy encourages.

If anything the IMF’s work provides a conservative (i.e., low) set of estimates.

Still, as I explain in my NYT.com Economix column, I’m a big fan of this work because the Fund’s report is very good on how to handle and reconcile the main alternative methodologies for getting at the issue.

The Fund offers an entirely reasonable approach that sets a very high quality bar. The Government Accountability Office (G.A.O.) is expected to produce a report on TBTF subsidies in the summer; their work now needs to be at least as careful and as comprehensive as that of the IMF. The same applies to the Federal Reserve and anyone in the private sector who attempts to dispute these numbers.

“All You Need for a Financial Crisis . . .

By James Kwak

. . . are excess optimism and Citibank.”

That’s a saying that someone, probably Simon, repeated to me a few years ago. Crash of 1929, Latin American debt crisis, early 1990s real estate crash (OK, that wasn’t a financial crisis, just a crisis for Citibank), Asian financial crisis of 1997–1998, and, of course, the biggie of 2007–2009: anywhere you look, there’s Citi. Sometimes they’re just in the middle of the profit-seeking pack, but sometimes they play a leading role: for example, the Citicorp-Travelers merger was the final nail in the coffin of the Glass-Steagall Act and the immediate motivation for Gramm-Leach-Bliley.

Citigroup is also the poster child for one of the key problems with our megabanks: the fact that they are too big to manage and, on top of that, the usual mechanisms that are supposed to ensure half-decent management don’t work. Around 2009, if you were to describe the leading characters in the TBTF parade, they were JPMorgan, the last man standing (not so much anymore); Goldman, the sharks who bet on the collapse; Bank of America, the ego-driven empire-builder; and Citi, the incompetent (“I’m still dancing”) fools.

Continue reading ““All You Need for a Financial Crisis . . .”

Goldman Sachs Concedes Existence Of Too Big To Fail

By Simon Johnson

Global megabanks and their friends are pushing back hard against the idea that additional reforms are needed – beyond what is supposed to be implemented as part of the Dodd-Frank 2010 financial legislation.  The latest salvo comes from Goldman Sachs which, in a recent report, “Measuring the TBTF effect on bond pricing,” denied there is any such thing as downside protection provided by the official sector to creditors of “too big to fail” financial conglomerates.

The Goldman document appears hot on the heels of similar arguments in papers by such organizations as Davis Polk (a leading law firm for big banks), the Bipartisan Policy Center (where the writing is done by a committee comprised mostly of people who work closely with big banks), and JP Morgan Chase (a big bank).  This is not any kind of conspiracy but rather parallel messages expressed by people with convergent interests, perhaps with the thought that a steady drumbeat will help sway the consensus back towards the banks’ point of view.  But the Goldman Sachs team actually concedes, point blank, that too big to fail does exist — punching a big hole in the case painstakingly built by its allies.  Continue reading “Goldman Sachs Concedes Existence Of Too Big To Fail”

Too Big To Fail Remains Very Real

By Simon Johnson

Prominent voices within the financial sector are increasingly insisting on one point: We have ended “too big to fail.” The idea is simple: through a combination of legislation (the Dodd-Frank legislation of 2010) and supportive regulation (particularly regarding how big banks would be handled in the event of “liquidation”), very large financial institutions are no longer perceived by investors to be too big to fail.

Unfortunately, while tempting, this idea is completely at odds with the facts. The market perception that some financial institutions are “too big to fail” is alive and well. If you want to remove that perception, you need to break up our biggest banks. Continue reading “Too Big To Fail Remains Very Real”

Jon Huntsman: Too Big To Fail Is Too Big

By Simon Johnson

The idea that big banks damage the broader economy has considerable resonance on the intellectual right.  Tom Hoenig, recently retired president of the Kansas City Fed, has been our clearest official voice on this topic.  And Gene Fama, father of the efficient markets view of finance, said on CNBC last year, that having banks that are too big to fail is “perverting activities and incentives” in financial markets – giving big financial firms, “a license to increase risk; where the taxpayers will bear the downside and firms will bear the upside.”

The mainstream political right, however, has been reluctant to take on the issue. This changed on Wednesday, with a very clear statement by Jon Huntsman in the Wall Street Journal on regulatory capture and its consequences.  Before the 2008 financial crisis: “The largest banks were pushing hard to take more risk at taxpayers’ expense.”  And now,

“More than three years after the crisis and the accompanying bailouts, the six largest American financial institutions are significantly bigger than they were before the crisis, having been encouraged to snap up Bear Stearns and other competitors at bargain prices. These banks now have assets worth over 66% of gross domestic product—at least $9.4 trillion, up from 20% of GDP in the 1990s. There is no evidence that institutions of this size add sufficient value to offset the systemic risk they pose.”

This message could work politically, for five reasons. Continue reading “Jon Huntsman: Too Big To Fail Is Too Big”

Too Big To Fail Under Dodd-Frank

By Simon Johnson.  This post comprises the first three paragraphs of my latest Bloomberg column; you can read the full column there.

Here we go again. Major shocks potentially threaten the solvency of some of the world’s largest financial institutions. Concerns grow over the ability of European leaders to shore up their banks, which are reeling from a sovereign-debt crisis. In the U.S., the shares of some large banks are trading at less than book value, while creditor confidence crumbles.

Private conversations among economists, regulators and fund managers turn naturally to so-called resolution powers — the expanded ability to take over and wind down private financial companies granted to federal regulators by the Dodd-Frank financial reform law. The proponents of these powers, including Tim Geithner and Henry Paulson, the current and former U.S. Treasury secretaries, argue that the absence of such authority in the fall of 2008 contributed to the financial panic. According to this line of thought, if only the Federal Deposit Insurance Corp. had the power to manage the orderly liquidation of big banks and nonbank financial companies, the government could have decided which creditors to protect and on what basis. This would have helped restore confidence, it is argued.

Instead, the government was forced to rely on the bankruptcy process, as in the case of Lehman Brothers Holdings Inc., or complete bailouts for all creditors, as in the case of American International Group. The FDIC already has limited resolution authority, which functioned well over many years for small and medium-sized banks.

To read the rest of this column, please click on this link to Bloomberg: http://www.bloomberg.com/news/2011-10-10/too-big-to-fail-not-fixed-despite-dodd-frank-commentary-by-simon-johnson.html

Big Banks Have A Powerful New Opponent

By Simon Johnson

As a lobby group, the largest U.S. banks have been dominant throughout the latest boom-bust-bailout cycle – capturing the hearts and minds of the Bush and Obama administrations, as well as the support of most elected representatives on Capitol Hill.  Their reign, however, is finally being seriously challenged by another potentially powerful group – an alliance of retailers, big and small – now running TV ads (http://youtu.be/9IUt-lY-XgM, by Americans for Job Security), web content (http://www.youtube.com/watch?v=DiKoFzS_lXs, by American Family Voices), and this very effective powerful radio spot directly attacking “too big to fail” banks: http://www.savejobs.org/audio18.html.

The immediate issue is the so-called Durbin Amendment – a requirement in the Dodd-Frank financial reform legislation that would lower the interchange fees that banks collect when anyone buys anything with a debit card.  Retailers pay the fees but these are then reflected in the prices faced by consumers.

The US has very high debit card “swipe” fees – 44 cents on average but up to 98 cents for some kinds of cards.  These fees are per transaction – representing a significant percent of many purchases but posing a particular problem for smaller merchants. This is estimated to be around $16-17 billion in annual revenue.

Other countries, such as Australia and members of the European Union, have already taken action to reduce interchange fees – because the cost of such transactions is actually quite low (think about it: the “interchange fee” for checks, which also draw directly on bank deposits, is exactly zero).  The United States severely lags behind comparable countries in terms of how consumers are treated by banks in this regard. Continue reading “Big Banks Have A Powerful New Opponent”

Agreeing on the Problem

By James Kwak

Over the past month, Simon and I have become very closely associated with the Brown-Kaufman amendment to break up big banks, and that’s an association I welcome, especially given the last chapter of 13 Bankers. The fact that the amendment came from basically nowhere and got thirty-three votes in the Senate is, to me, an encouraging sign. But while this solution looks like it is unlikely to pass in this session of Congress — and there is debate about whether it is the right solution to begin with — the more encouraging sign is the amount of agreement on the problem to be solved: a financial system that is too big, too concentrated, and too powerful.

I wrote a guest post for the Harvard Law School Forum on Corporate Governance and Financial Regulation, a group blog, on this broader issue and some of the other solutions that have been floated. As we’ve said many times, as long as debate moves in this direction, that’s progress.

The Oracle of Kansas City

By James Kwak

Many of you have probably already seen Shahien Nasiripour’s interview with Thomas Hoenig, president of the Federal Reserve Bank of Kansas City and the most prominent advocate of simply breaking up big banks. (Paul Volcker is more prominent, but his views are more nuanced; the famous Volcker limit on bank size, it turns out, would not affect any existing banks, at least as interpreted by the Treasury Department.) It largely elaborates on Hoenig’s positions that we’ve previously applauded in this blog, so I’ll just jump to the direct quotations:

On megabanks:

“I think they should be broken up. . . . We’ve provided this support and allowed Too Big To Fail and that subsidy, so that they’ve become larger than I think they otherwise would. I think by breaking them up, the market itself would begin to help tell you what the right size was over time.”

Continue reading “The Oracle of Kansas City”

“Break Up the Banks” – in the National Review

By James Kwak

“Big banks are bad for free markets,” economist Arnold Kling (who usually blogs at EconLog) begins in the conservative flagship National Review, and it only gets better from there. “There is a free-market case for breaking up large financial institutions: that our big banks are the product, not of economics, but of politics.”

Like other conservative economists, Kling uses Fannie Mae and Freddie Mac as an example of financial institutions that grew too large through a combination of lobbying expertise and government guarantees . . . and frankly I agree with him. But he is equally unsparing of other large banks that were supposedly “pure” private actors but turned out to have their own government guarantees.

Continue reading ““Break Up the Banks” – in the National Review”

Senator: Which Part Of “Too Big To Fail” Do You Not Understand?

By Simon Johnson

When a company wants to fend off a hostile takeover, its board may seek to put in place so-called “poison pill” defenses – i.e., measures that will make the firm less desirable if purchased, but which ideally will not encumber its operations if it stays independent.

Large complex cross-border financial institutions run with exactly such a structure in place, but it has the effect of making it very expensive for the government to takeover or shut down such firms, i.e., to push them into any form of bankruptcy.

To understand this more clearly you can,

  1. Look at the situation of Citigroup today, or
  2. Read this new speech by Senator Ted Kaufman. Continue reading “Senator: Which Part Of “Too Big To Fail” Do You Not Understand?”

Dallas Fed President: Break Up Big Banks

By James Kwak

We’ve cited Thomas Hoenig, president of the Kansas City Fed, a number of times on this blog for his calls to be tougher on rescued banks and to break up banks that are too big to fail. This has been a bit unfair to Richard Fisher, president of the Dallas Fed, who has been equally outspoken on the TBTF issue (although we do cite him a couple of times in our book).

Bloomberg reports that Fisher recently called for an international agreement to break up banks that are too big to fail. Here are some quotations, taken from the Bloomberg article (the full speech is here):

“The disagreeable but sound thing to do” for firms regarded as “too big to fail” would be to “dismantle them over time into institutions that can be prudently managed and regulated across borders.”

Continue reading “Dallas Fed President: Break Up Big Banks”

As Is?

The White House background briefing is that their proposals would freeze biggest bank size “as is” — this makes no sense at all.

Twenty years of reckless expansion, a massive crisis, and the most generous bailout in human history are not a recipe for “right” sized banks. There is a lot of work the administration hasn’t done on the details — this is a classic policy scramble, in which ducks have not been lined up. But we should treat this as the public comment phase for potentially sensible principles — and an opportunity to propose workable details.  The banks are already hard at work, pushing in the other direction.

It’s a big potential policy change, and my litmus test is simple – does it, at the end of the day, imply breaking Goldman Sachs up into 4 or 5 independent pieces?

By Simon Johnson

Welcome, Barack

So Barack Obama has come around to the idea that big banks need to be made smaller and that smarter regulation (contingent capital, enhanced capital requirements for large banks, resolution authority, etc.) just won’t cut it. Today he proposed limits on market share (measured by a bank’s share of total bank liabilities in the United States) and a prohibition on internal hedge funds, private equity funds, and proprietary trading.

This is great. It means that the administration is moving in the right direction–breaking up big banks–and the president is putting his name behind it. For more on why these are good ideas, see Mike Konczal.

OK, now for the caveats.

Continue reading “Welcome, Barack”

“All Serious Economists Agree”

The most remarkable statement I heard at the American Economics Association meeting over the past few days came from an astute observer – not an economist, but someone whose job involves talking daily to leading economists, politicians, and financial industry professionals.

He claims “all serious economists agree” that Too Big To Fail banks are a huge problem that must be addressed with some urgency. 

He also emphasized that politicians are completely unwilling to take on this issue.  On this point, I agree – but is there really such unanimity among economists? Continue reading ““All Serious Economists Agree””