Naked Capitalism on Our Shaky Banking System

SheriffWarren

Mr. Market Says Dodd-Frank Isn’t Working

Posted on May 11, 2015 by

Yves here. While I am not convinced that breaking up big banks solves the “too big to fail” problem. Hedge fund LTCM nearly brought down the financial system in 1998. The comparatively small and simple by modern standards #4 bank in 1984, Continental Illinois, took seven years to resolve. Nevertheless, it would be a big step in the right direction. One of the advantages isn’t just reducing the size of firms but increasing their diversity. Andrew Haldane of the Bank of England warned that one of the big sources of instability in our modern financial system is a monoculture, in which the biggest firms are pursuing virtually identical strategies and using similar risk models (not just VaR, but FICO in their retail businesses) and trading approaches. Similarly, having more specialized players also means more contested regulatory demands as players with different customers and products jockey for regulatory advantage.

By Alexander Arapoglou, a professor of finance at the University of North Carolina’s Kenan-Flagler Business School, who been a derivatives trader and head of risk management worldwide for various global financial institutions, and Jerri-Lynn Scofield, who has worked as a securities lawyer and a derivatives trader

The objective of the 2010 Dodd-Frank legislation and other post-financial crisis regulatory reforms was to make the too big to fail banks so safe that they could not fail. Has this goal been achieved? The rating agencies answer no. If these agencies were convinced that the plethora of new rules– including increased capital requirements– had led big banks to achieve unquestioned credit standing, their bonds would be rated AAA.

Instead, bond ratings for the top 5 US financial institutions now hover around single A. These ratings scream to anyone who’s listening that the too big to fail institutions may indeed, fail. Mr. Market agrees: debt issued by too big to fail banks currently trades at prices consistent with their credit ratings.

Reforms undertaken since the demise of Bear Stearns and Lehman Brothers have failed on several fronts. The too big too fail banks are not fail-safe. They are more brittle and unable to act as shock absorbers than they were before. Holders of their shares are not deploying capital efficiently and small business is starved of financing. Where did regulatory policy take a wrong turn?

The missteps began during the financial crisis, when regulators were faced with two choices. The first would have turned back the clock on deregulation and re-erected walls between securities sales and trading, asset management, and commercial and retail banking. After such restructuring, smaller, more specialized financial firms would pose little risk to the rest of the economy if any failed.

The alternative approach– the one that was followed– was to accept that there were institutions that were too big to fail. Making these giant institutions safer became the regulatory priority. New rules were enacted and more aggressive and intrusive regulatory scrutiny mandated so, it was hoped, to prevent financial institutions from shooting themselves in the foot.

As a result, bank examiners have moved into the offices of many financial firms full time. They attend board meetings and drive business priorities by asking questions. Decisions are scrutinized lest they encourage untoward risk taking. The list of good intentioned ideas goes on and on. But to what end?
This matters because since 2008, too big to fail institutions have become much larger, posing an even greater risk to the economy than they did before. Bigger banks continue to increase their market share, the number of community banks has declined by 40%, and since June 2010, 500 of these have failed outright.

As banks have got bigger, many market participants— including at least one bank CEO– have conceded that these behemoths have become too big to manage. Goldman Sachs has reported that even JP Morgan Chase, one of the most profitable big banks, would be worth more broken into parts than kept whole– as is true with many conglomerates. The profitability of smaller, more narrowly-focused financial institutions usually exceeds that of institutions that follow a universal banking model, partly due to requirements that systemically important institutions maintain extra capital and overhead.

So how are we left? Dodd-Frank has sidestepped dealing with the central problem – a concentration of systemic risk that hangs over the real economy. Bank shareholders are worse off. Excessive capital requirements have burdened the economy without any offsetting increase in safety. The benefits to the broader economy of greater competition and better distribution have been forfeited without any offsetting gain. The corporate bond market has lost liquidity, adding costs and risk to the overall system for financing jobs, pensions, university endowments and insurance. And the decline of community banks has fallen hardest on small businesses, America’s biggest employer.

If regulators continue to to stumble down the wrong regulatory road, their next step might be to limit competition further, raising prices to guarantee bank profitability. This approach would certainly be safe, yet it would be costly, not only in terms of the cost of bank services, but it would also stymie new business formation.

There is an alternative: not to turn the clock back blindly, but to examine first what it was that made the Depression-era Glass-Steagall financial structure so robust. The regulators of that time quite rightly focused on preventing conflicts of interest and financial contagion. Their solution was to prevent the otherwise inevitable consolidation and oligopoly that follows when single firms are allowed to offer universal banking services by instead splitting up the largest financial firms and confining them to separate lines of business. More modern experts on regulation, such as Senator Elizabeth Warren, just last week again endorsed the general Glass-Steagall approach.

That framework wasn’t perfect; while it separated the domestic securities business from domestic banking, large banks continued to have securities operations in London and Tokyo. Yet while such regulations were firmly in place, the broader economy was insulated from boom-bust financial cycles generated by bank failures.

A modern version would be more far reaching. The most important banking function is the clearing function. If the financial system crashes, paychecks and payments for industrial and other supplies are “lost” and the entire economy would grind to a halt. Thus, as a first step, clearing and custody functions should be separated from everything else. They must be protected and restructured so as to best survive any future systemic shock.

But reform must go further. Trading of derivatives, securities and foreign exchange involves significantly more risk than the rest of banking. These operations should also be segregated — and more completely than in the watered-down Volcker rule that the Federal Reserve has more or less indefinitely deferred. Likewise, asset management activities should be conducted in distinct companies to avoid self-dealing. Brokerage functions should be spun off to avoid conflicts. Here, Eliot Spitzer well understood more than a dozen years ago that allowing one firm to undertake investment banking and sell securities sparked practices that inflated the firm’s bottom line at the expense of its brokerage customers. Many current regulators still have failed to absorb this lesson. Mergers and acquisitions activity should be made apart from lending decisions.

Breaking up the biggest banks would eliminate the too big to fail problem. Yet that wouldn’t be the only gain. If Goldman is right, this approach would benefit bank shareholders as well. A better plan where everyone benefits…. What’s not to like?

GoldmanSachs-3

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