Too Big To Fail

Of all the issues facing the economy one stands out as having potential to throw the economy back into crisis. Yes, the lack of consumption may make us fall into a second recession, but that is not a crisis – we know how to deal with it. No, the lack of long term safety and soundness in our banking system remains as that potential trigger. Specifically the damage that could be done by banks that are deemed ‘too big to fail’ [TBTF]

I have sounded off on this plenty of times so I will not repeat myself: I think we need a mixture of breaking up the big banks and much more rigorous regulation on their activities, especially on their trading accounts.

The debate on how to manage these behemoths is no getting up a head of steam. Today Barney Frank weighed in with his proposal to institute a tougher regulatory regime. I don’t agree with his proposal since it leaves the big banks whole, but at least we now have something to shoot at or argue over.

The central component of the Frank idea is to establish a central authority comprised of representatives of various regulatory agencies with the power to wind up the mega banks in a relatively painless way.

One of the bug stumbling blocks we have at present is that, while shareholders stand to lose everything in bankruptcy, bondholders and, crucially, counter-party creditors are protected by the taxpayer safety net. This extension of safety to sophisticated creditors, rather than just to ordinary depositors, has vastly complicated the winding up process of banks and made the cost to taxpayers extremely high. This ongoing, and implicit rather than explicit, guarantee by the taxpayer sits behind the willingness of creditors to continue to lend to big banks even when the bank’s leverage has reached dangerous levels. As I have said before: this implicit guarantee needs to be made explicit. The banks should either pay for it or give it up. Since they cannot operate any longer without the taxpayer safety net they’d have to pay. That would hammer their profits and strip away their delusions of grandeur.

But Frank doesn’t go there. Instead he simply seems to advocate a more efficient bankruptcy process that would foist losses on the bondholders as well as the equity holders. This means that in an extreme event the guarantee would disappear for the bondholders at least. But for an ongoing bank taxpayers would still be on the hook and creditors would be willing to lend at lower rates than would be otherwise prudent.

Lest this sounds arcane I want to point out that the implicit guarantee does not extend to smaller banks: those we have let fail. The implication of this is that smaller banks are at a constant competitive disadvantage: their cost of borrowing will be higher, this means their margins and profits will be lower. The big banks will be able to gobble up even more of the business. they will get even more TBTF.

I have no problem with having aggressive bankruptcy plans available to the regulators – the whole Lehman and AIG mess suggests such plans are long overdue. But tightening control must go beyond that.

As George Shulz has said: too big to fail means too big to exist.

Break up the banks.

Addendum:

I have a good friend who works at one of the regulators. His view from the inside is much more nuanced than mine and, in some ways, more pessimistic. The point being that there seems to be a total lack of political will to attack the issues presented by mega banks. Amongst these issues are:

• International conformity of regulation – right now the big banks simply move business around the globe to countries with less strict regulations. When they go bust this leaves a trail of legal recrimination, confusion, and indecision. This ‘regulatory arbitrage’ needs to be stopped.
• The entire mess of derivatives needs to be curtailed. The big banks have conjured up ways to package and sell things that boggle the mind. Just the names of some of the corners of Wall Street tell it all: ‘dark pools’ where trades take place away from public scrutiny; synthetic derivatives, which are derivatives based upon other derivatives; and, of course my favorite, sovereign credit default swaps – which only have value if the US defaults on its debt, at which point I would wager the banks trying to collect will have deeper problems than US treasury default.
• Capital rules that need to be adjusted to rein in off balance sheet assets and take away the lower capital requirement for securities.
• Risk management techniques that are self evidently fatally flawed: the collapse of the banks last year was less a capital adequacy problem than a liquidity problem. The entire fabric of risk management failed: from the fancy math right through to the inability to sell assets to raise cash. We all need to understand that markets fail. Without accepting that central premise everything else doesn’t matter. When markets fail no one can sell assets – there are no active buyers, that sends asset values crashing well below any reasonable floor, panic ensues, and banks suddenly lurch from being safe and sound to bankrupt because what they thought was a source of cash is no longer available.
• Compensation reform. This is less easy than it sounds since it requires re-wiring the way we all think about finance. A few years ago no one paid anywhere near the attention to daily stock market gyrations as we do now. The emphasis on quarterly earnings reports needs to go away. This relentless short term focus forces managers to take risks beyond that acceptable long term. Since bonuses tend to be tied to the short term the entire focus of business needs to shift to the long term view. Only then will pay structures be easy to reform.
• Lastly the rating agencies, whose complete lack of objectivity drove them to insanely poor analysis, need to be forced into a totally reconstructed and neutralized way of business. Those who rated what became toxic assets as triple A need to be removed from the industry permanently: they obviously were both clueless and probably corrupt.

One last thing on liquidity.

Another good friend of mine with military background used to tell the tale, suitably sanitized of course, of US military planners constantly failing to recognize the logistical bottlenecks represented by limited troop availability. Each sector commander assumed that the ‘cavalry’ was available to him to deal with a crisis is his designated area. What they all missed is the effects of a systemic crisis: clearly the same cavalry cannot be in two places at once fighting two separate crises. This is analogous to bank liquidity: banks who make liquidity plans built upon the assumption that they alone will be looking for cash miss the point. A systemic crisis means everyone will be trying to raise cash. That will flood the markets and destroy asset values. Risk management has to be systemic. How we do that and preserve bank independence is another matter.

Big bank war games perhaps?