Break Up The Banks: Part 2
My my.
The heat has turned up around this issue. Maybe there’s something in it.
As I wrote yesterday I am a firm believer in reducing the scale of our banks. In a nutshell my view is premised on the ability big banks have to destabilize the economy and on their associated ability to exert undue influence on our legislative process. in short I see mega banks as anti-social and anti-democratic.
Extending this little bit: the big banks represent the only aspect of our economy where we, the people, have an interest in preventing failure as a matter of course. This aversion to failure does not flow through to all banks. On the contrary we allow small banks to fold up an a regular basis: nearly 100 small and medium sized banks have been allowed to fail this year and their assets have been dealt with by the FDIC according to well established and easily implemented guidelines. It is only the large banks who operate with carte blanche freedom to screw up royally and yet be bailed out. This is moral hazard writ large – egregiously large – and must end.
Why?
Because the banks know they will not be allowed to fail. So they can indulge in all sorts of gambling activities with impunity. The managers and traders can arrange to pay themselves vast bonuses safe in the knowledge that they have no ultimate responsibility for their actions. The behavior of Goldman Sachs and AIG should be adequate warning to us all in this regard. The one is larded with astonishing hubris – its CEO yesterday claimed that increased income inequality produces social benefits in the long run, to which I can best respond by paraphrasing Keynes: ‘in the long run we are all dead’. The second seems to be stuffed with an unreconstructed rentier class attitude which motivates its managers – that might be too generous a term given the obvious lack of management at the place over the past decade – to develop a sense of entitlement: they are aghast that we might find multi-million dollar bonuses for failed portfolio managers and traders somewhat galling.
As long as these organizations are allowed to persist they will always exert an extraordinary and disproportionate effect on policy makers. This means that monetary policy will be tilted towards avoidance of failure for these banks as a priority over other policy options that could benefit us all. Whilst policy makers live in fear of the results of the incompetence that seems to pervade Wall Street we cannot expect them to act on our behalf. they will protect the banks first. And the devil can take the hindmost – that’s you and me.
Which raises the non-economic issue: the very existence of private organizations large enough to wreck the way of life of all of us disturbs the balance of our democracy. They can, and do, act as oligarchs. They expect legislative bias in their favor. The flood the legislative process with cash – corruption by any other name. In times of crisis they expect to be at the front of the queue for government aid and bailouts.
This is decidedly unhealthy were it to persist for too long. My view is that it already has thus persisted.
So the question now becomes what to about anti-social and anti-democratic organizations.
My solution, as you know, is to get rid of them.
This is not an unknown or untried solution. Standard Oil is the obvious case in point. Economically the break up of Standard Oil was probably a wash: the resultant smaller organizations all did well for their shareholders and this gain offset any lost rent seeking that the larger quasi-monopoly can be presumed to have had. Socially America at large was much healthier subsequent to the break up: a huge source of political disruption was neutered and its corrupting influence watered down. More to the point, by breaking up Standard Oil we ended up with a more competitive and more vigorous oil industry – there were more players in the market so the public had more choice and costs were forced down accordingly.
Others are far more cautious and seem committed to protecting the banks integrity.
Daniel Tarullo, a Governor of the Federal Reserve Board, came out yesterday and opposed the ‘provocative’ idea of breaking up the banks. In particular he doesn’t see any advantage to splitting the gambling and lending activities apart in the way that the old Glasss Steagall Act did. His objections all seem very weak to me:
First, he argues that no one has offered up how we would break the banks apart, and so the idea remains a ‘provocative idea’ not a ‘solid proposal’. That’s bureaucrat speak for ‘we don’t have a plan yet so nothing exists’. Apparently only things that are planned for can be discussed. That’s just silly of course. The whole point of floating the idea is to elicit responses and start to planning process. the notion that the idea should be killed simply because we have no current plan is absurd. Let’s make a plan.
Second, he argues that separating the gambling and lending parts will not eliminate risk of losses. Duh. No one said it would. This is what we call a red herring. Of course it won’t eliminate lending risks. But it will isolate the two forms of banking risks from one another and prevent them from compounding each other. Moreover, since we are now acutely aware of the huge volatility in gambling risk, we should act fast to stop that volatility from undermining the capital base of the lending risk and thus freezing up the flow of credit into the economy. The objective of pulling the two risks apart – into what I call separate commodity and gambling banks – is to minimize the ability of the gamblers to stall the economy.
The social purpose of banking has to be pre-eminent in our regulatory attitude. That purpose is to allocate scarce capital against competing end requirements. Banks are the mechanism that we have for that allocation. Privately owned banks are better than publicly owned banks – they are supposedly immune to political favoritism – and so our regulatory regime should ensure the safety and soundness of the private banking sector. But only insofar as it performs its social task well. Once it wanders off into other activities – gambling on securitized or obscure derivative products that do not assist the allocation of capital, but exist only to generate bank profit – then our regulatory interest should drop to zero. We simply shouldn’t care if Goldman Sachs blows itself up by taking too much risk – what they do mostly doesn’t touch regular people at all, so why should regular people bail it out?. But we should care if Citicorpscrews up and doesn’t keep making those credit card or small business loans. Pulling out the gambling bits of Citicorp and selling them off to private gamblers makes sense in this case.
So the defense of social purpose is a big driver of our need to limit banks to specific types of banking: that way we can limit the extent of our underwriting.
Third, Tarullo argues that hiving off the gambling would simply move the problem and not resolve it: there would still be ‘too-large-to-fail’ gambling banks like Goldman cluttering up the regulatory space.
Not necessarily.
Once we start untangling the web of counter-parties and deliberately convoluted subsidiary relationships that the banks have put in place to reduce their tax payments – nice corporate citizens that they are – I think we will find that the bulk of the bloat is fiction. All banks could be much smaller if they were prevented from trading at the pace they do. Current bank balance sheets are pumped up in size by the constant inter-bank trading of gambling products. This activity generates profits and thus bonuses, but doesn’t n=move capital into the real economy. It stays within the financial sector. By putting a fence around the gambling banks we can force them, to pay the full cost of the underwriting insurance of their gambling activities – we can withdraw our support completely. The margins on this churn of gambling products is usually wafer thin, if the banks then had to price in the underwriting cost – private bail-out insurance – the profitability would be eliminated and the volumes collapse back to those derivatives and securitized packages for which there is a social value: futures on commodities for example. So separating the gamblers from the lenders is just the first step I envisage. It enables the second: the elimination of any public support for the gambling activities.
The irony is that most defenders of the banks espouse free market principles. All I am arguing is that we should force the gamblers like Goldman Sachs, whose managers constantly spout their pride in being tough players in tough markets, to play in markets that are, in fact, free. In particular they should play in markets free of government support. If they do well, then great. If they sink, then great too. I love the democratic power of markets. What I don’t love is the hypocrisy of managers who talk tough and play soft – while paying themselves as if they were playing tough.
So Tarullo’s whole speech seems to me to be a hurried attempt to throw up a few ill thought through roadblocks. That he felt the need to do so is re-assuring. It means the break up argument is worrying the establishment.
Speaking of which: today’s Wall Street Journal carries an op-ed piece by Professor Charles Calomiris arguing against break up also – I doubt the WSJ would carry a pro-break up piece, but that’s another argument. As I would expect the professor makes a much more nuanced and better case than Tarullo’s more political version.
But he still misses the main point.
Calomiris focuses his defense of mega banks on their ability to operate and provide services across global markets. Breaking them up might jeopardize this ability. Plus, he says, the scope advantages of the huge banks enables them to mix products and package them attractively for those same customers. Finally he cites research that shows the cost of equity underwriting has fallen significantly since the abolition of Glass Steagall.
But none of these arguments defends against my main attack: the political power of mega banks to disrupt democratic determination of economic policy.
His preferred solution to the ‘too-big-to-fail’ problem – and he acknowledges that it is a problem – rests on our ability to legislate powerful restraints on bank activity – by adding capital requirements, raising transactions costs, limiting affiliations etc. Since all these regulatory actions would represent a threat to the personal gain of the managers now running the mega banks – profits would be reduced – the professor seems, naively in my view, to assume that the banks would not resist. Or that they could not derail such legislation. Or that they could simply re-locate enough of their operations to lax regulatory regimes and thus avoid the restrictions of American law. They already avoid tax laws this way, why not regulatory restrictions too?
I think the professor misses what has happened during the past year. The administration has trodden very politely around any strong regulatory measures. Regulators seem to ape the opinions of the banks. People like Geithner spend more time on the phone with top bankers than they do talking with non-bank experts. In short there is no evidence that the banks would fail to stop strong legislation.
Calomiris’ solution presumes a compliant industry. There is no evidence of such compliance. On the contrary there is ample evidence of corruption and undue influence. And that simply serves to support my claim that they are already disruptive and so need breaking up.
As for the global arguments: on paper they seem strong. In reality they melt. Even a trimmed Citicorp could manage its global clients. And, surely, the increased competition represented by the existence of more banks, as would be the case after the break up of the mega banks, would add to and not diminish, the cost and innovative advantages that Calomiris attributes to the existing structure. It is contorted pleading to argue that advantages of scope and scale will inevitably outweigh the advantages of more free market competition. Economic theory – screwed up as it is – is not something we can cherry pick to support our arguments. It either works or it doesn’t, in its entirety. If this is true then the professor needs to explain why market forces – something he teaches about every day in his academic life – suddenly appear frail in the face of mega banking.
On the topic of theory: Calomiris sees fit to throw into the mix the work of Oliver Williamson who won the Nobel Prize last week. Williamson works on the theory of the firm and is particularly interested in the question of where the firm’s limits should be. In other words what determines a firm’s size? Calomiris argues that Williamson explains why firms get larger – it is cheaper than having smaller firms all contract with each other in the open market. But this is a superficial reading of Williamson. The deeper and more accurate reading is that it is cheaper for firms to grow only when the cost of information is excessive. Thus large organizations economize on information. Calomiris needs to explain why, in the modern electronic financial market place, where transactions costs are negligible, economizing on information costs automatically implies large banks. I don’t see in any of Williamson’s work an argument saying that such growth is automatic. On the contrary, Williamson seems to support the efficacious nature of markets and is simply seeking to explain the existence of business firms by highlighting the fact that ongoing uncertainty inhibits free markets from performing the way textbooks argue they should. In my mind Williamson hews more closely to New Classical orthodoxy than either his inspiration – Ronald Coase back in the 1930’s – or Calomiris’s interpretation would indicate.
Either way putting Williamson’s name into an op-ed about mega banks seems to be a tawdry effort to beef up his argument’s intellectual heft, rather than giving it actual substantive support.
Anyway: the break up the banks effort flows as much from the social and political argument about their disproportionate power as it does from pure economics. For far too long we have bowed down to the purist economics crowd: they are the ones who brought us the derivatives business in the first place, as well as the wonderful risk models that blew up last year. Their credibility is shot.
In the end this discussion comes back to our attitude towards the bank’s power.
I just cannot reconcile the existence of the concentration of such power in so few hands with the continued health and vibrancy of the American system of values and institutiuons.
That’s why this is important and discussion should not be restricted limited arguments such as either to Tarullo’s bureaucratic view, or Calomiris’ economics based view.
But at least there’s discussion. That’s a good start.
