Taming the megabanks

Reuters

A street sign for Wall Street hangs in front of the New York Stock Exchange May 8, 2013.

Article Highlights

  • Three years after the passage of the financial-reform legislation, America's megabanks are even bigger.

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  • The gravest of many problems with Dodd-Frank is that the law is based in a misunderstanding of how/why the Megabanks grew so large.

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  • We need a much better approach to eliminating the inventives that have so badly distorted America's financial sector.

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  • Wall Street's basic job -- the allocation of capital -- is fundamental to our free market economy.

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  • Only by addressing the practices that gave rise to "to big to fail" can we move closer to finding a solution.

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Editor's note: This article originally appeared in issue number 16 of National Affairs from summer 2013.

In 2010, the Dodd-Frank Wall Street Reform and Consumer Protection Act was hailed by its champions as the solution to the problem of "too big to fail." The text of the legislation itself claimed the act would "protect the American taxpayer by ending bailouts" of big banks, and the law created a host of new federal programs designed to improve accountability and transparency in the financial system - including an oversight body explicitly designed to eliminate investors' expectations of government bailouts. Pointing to these innovations, Dodd-Frank's proponents claimed to have ushered in a new era of financial regulation in which no bank's recklessness would ever again be subsidized with a government guarantee.

Yet four years after the end of the Great Recession, and three years after the passage of the financial-reform legislation, America's megabanks are even bigger. Wall Street is more concentrated and the financial sector is more politically powerful than ever before, and there is little evidence that the most important lessons from the 2008 financial crisis have been taken to heart. What happened?

The gravest of the many problems with Dodd-Frank is that the law is based in a fundamental misunderstanding of how and why the megabanks it seeks to tame grew so large and complex in the first place. That growth was caused not by an unregulated market spun out of control, but by a set of disastrous federal policies. By repeatedly bailing out banks deemed too essential or too interconnected to fail, the federal government has incentivized - and even facilitated - the consolidation and astronomical expansion of the big banks. The certainty of a government backstop has provided the largest banks with a significant competitive advantage in the marketplace, which has created an artificial incentive for massive growth and risk-taking that is detrimental to the financial system.

If this cycle is to be stopped, legislators will need to approach the regulation of our biggest banks from a market-based perspective rather than through more layers of regulation and bureaucracy. They must seek to eliminate the distorting effects of taxpayer bailouts and to end the government-created incentives for banks to grow unmanageably large and to take on unsustainable risk. Doing so should point policymakers to a crucial, if counterintuitive, conclusion: To defend free markets and avoid another disastrous crisis, we need policies that would shrink and break up America's biggest banks.

GOVERNMENT GUARANTEES

Federal banking regulations were originally established more for the benefit of consumers than of financial institutions. The first major federal financial regulatory law, the Banking Act of 1933 (also known as the Glass-Steagall Act), created the Federal Deposit Insurance Corporation for the exclusive purpose of guaranteeing the safety of depositor accounts in member banks. Prior to the creation of the FDIC, depositors, debt holders, and stockholders had been completely exposed to the risk of losing their savings if their banks collapsed. Depositors would typically recover perhaps 50% to 60% of their money if their banks went bust, and the only protection they had against such a disaster was their own due diligence. Under the new law, however, if a bank became insolvent, the FDIC would step in to ensure that depositors didn't lose a dime of their savings. Designed to prevent the sort of bank runs common in the early years of the Great Depression, the FDIC assured depositors that they would be protected even if their banks failed.

Any time a bank became insolvent, the FDIC would establish a new, temporary institution called the "deposit insurance national bank." The DINB would handle the bank's failure either by liquidating its assets in an orderly fashion and paying off depositors or by arranging a merger with a healthy institution, whichever was least expensive to the government. But in 1950, Congress created an additional option: The federal government could save the failing bank. The Federal Deposit Insurance Act of that year endowed the FDIC with the power to prevent a bank's failure through direct loans or asset purchases if that bank's survival was deemed "essential" to ensuring the continued availability of banking services in its community. With the law's enactment, the FDIC entered the bailout business.

Two decades passed, however, before a financial institution would be deemed so essential to its community that it had to be saved. In 1971, a history of too many dubious loans, an inadequate capital buffer, and poor management had driven Boston's Unity Bank and Trust to the brink of collapse. Interestingly, it was not fear of financial turmoil that compelled the FDIC to act to save the bank; rather, the agency was concerned about social upheaval. Unity was a run-of-the-mill community lender in Boston's mostly black Roxbury neighborhood, but it was also the largest black-owned business in New England. Amid the racial unrest of the late 1960s and early '70s, officials in Washington were worried about social contagion if such a prominent minority-owned business were to fail in an already volatile inner-city neighborhood. The Los Angeles Watts Riots of 1965 were still fresh in the minds of officials, and similar unrest was not out of the question in Roxbury. Just a few years earlier, riots had contributed to driving Jewish businesses and residents out of the neighborhood.

A board member of the FDIC at the time, Irvine Sprague, recalls the Unity episode in his book Bailout: An Insider's Account of Bank Failures and Rescues. Sprague writes that, faced with Unity's impending collapse, neither he nor then-FDIC chairman Frank Wille

had any trouble viewing the problem in its broader social context. We were willing to look for a creative solution....[My] vote to make the "essentiality" finding and thus save the little bank was probably foreordained, an inevitable legacy of Watts....[The] Watts riots ultimately triggered the essentiality doctrine.

Pursuant to that doctrine, the FDIC made a $1.5 million, five-year loan to Unity. The loan was later extended for another five-and-a-half years in 1976, despite reports of continued mismanagement. Only when it became clear there was little likelihood that Unity would ever be able to repay the loans did state banking officials finally shutter the firm in 1982.

Despite the ultimate futility of Unity's bailout, the precedent had been set. In the years that followed the bank's original rescue, federal bailouts quickly became much larger and increasingly common. And with the increasing activity came expanding justifications for intervention. The FDIC's essentiality doctrine became, as befitted Vietnam-era Washington, a de facto "domino theory" of bank bailouts.

In 1972, the agency made a $35.5 million loan to Detroit Commonwealth Bank, which, with a $1.5 billion asset portfolio, was the 47th-largest bank in the country. In this case, Washington no longer feared riots; instead, the worry was that Detroit Commonwealth was, to use a current term, "too interconnected to fail." According to Sprague's book, Federal Reserve chairman Arthur Burns believed the bank's failure could produce a "domino effect" and thus posed a systemic risk to the financial system. Just two years later, the Federal Reserve itself got into the bailout business directly, extending a $1.7 billion loan to Franklin National Bank in 1974. That bank eventually failed, and several executives went to prison.

By 1984, the domino theory had evolved into "too big to fail." Continental Illinois - a bank saddled with bad energy-industry loans purchased from the failed Penn Square Bank of Oklahoma - was the seventh-largest bank in the country, with some $40 billion in assets. Fed chairman Paul Volcker, like Arthur Burns before him, was concerned that financial failure and losses to creditors would cause contagion resulting in a nationwide bank panic. Bank regulators thus agreed to purchase $4.5 billion in troubled loans.

Later that year, in a congressional hearing investigating the bailout, the comptroller of the currency identified 11 bank holding companies, including Continental, as too essential to the financial health of the economy to be allowed to fold. Connecticut congressman Stewart McKinney summed up the testimony by coining a now-famous term: "Let us not bandy words. We have a new kind of bank. It is called too big to fail. TBTF, and it is a wonderful bank."

In effect, large financial institutions had grown beyond the government's ability to regulate. The various measures the government had put in place to protect consumers were no longer adequate for contending with the failure of a big bank. As a result, big banks simply could not be allowed to collapse.

It did not take long for banks to adjust their behavior accordingly. They realized that the bigger and more interconnected they became, the more essential they would seem in the eyes of regulators, and thus the more insulated from failure they would become. This increased security, in turn, afforded the big banks a huge market advantage over their smaller competitors, allowing them to bloat even more - thereby perpetuating a dangerous cycle of uncontrolled growth.

HOW BIG ARE THE BIG BANKS?

Just how serious has this problem become? Consider that, during the past three decades, assets at the six largest American banks have surged 1,900% - from $482 billion to $9.6 trillion. Citibank, which was the largest American bank in the 1980s, had total assets of $126 billion in 1983. Today, its assets have reached $1.9 trillion - an expansion of roughly 1,400%. And even Citi's holdings are dwarfed by those of the largest bank, JPMorgan Chase, with assets totaling $2.4 trillion. For perspective, this amount is roughly equivalent to the entirety of the federal government's receipts for 2011.

Hamilton Place Strategies, a powerful Washington-based strategic-communications firm working for the big banks, cautions against reading these impressive numbers as a sign of "an out of control, large banking sector that must be reined in." Pointing to data from the Clearing House bank trade association, HPS argues that, over the past 20 years, the market capitalization of the S&P 500, the value of U.S. exports, and the value of all U.S. commercial-bank assets (not just those of the biggest banks) have risen more or less in tandem, by roughly 380%.

But exports and the S&P 500 are not the normal measures we use in talking about the larger economy. The far more relevant comparison is to measure the growth of the banking sector against the growth of gross domestic product - that is, the growth of the whole economy. At the end of 1992, the assets of all American commercial banks amounted to 56% of GDP. By the end of 2012, they were 80% of GDP. Financial profits as a share of total corporate profits, meanwhile, doubled between the early 1970s and 2008. After dipping during the Great Recession, they have quickly bounced back to surpass their previous levels. Banks' profits in the first quarter of this year were $40.3 billion, the highest on record and an increase of nearly 16% from the first quarter of 2012, according to the FDIC.

That banks control an increasingly large share of the economy is not a new phenomenon - nor is it a phenomenon unique to the United States. According to an analysis by the Bank of England, the average ratio of bank assets to GDP in advanced economies rose from 16% to 70% between 1870 and 1970, a steady increase of about six percentage points per decade. But starting in the 1970s, that trend accelerated dramatically, thanks to the widespread liberalization of financial regulations (which included policies like the elimination of credit controls and the deregulation of interest rates). According to the Bank of England, the ratio of bank assets to GDP in advanced economies has risen by about 30 percentage points per decade since 1970, standing at more than 200% on average today. When bank size is examined through this lens, the growth of the financial sector in the United States doesn't seem quite so out of control; after all, total bank assets in our country - including those of commercial banks and other lenders - are around 120% of GDP.

But there is a major problem with this comparison: American banks do not follow the same accounting rules as their European counterparts. The international accounting rules used in Europe require the inclusion of a much larger share of the risk exposure from derivatives - a particularly risky and complicated financial tool - when measuring a bank's assets and liabilities than American accounting rules do. When these European accounting standards are applied to American banks, total U.S. bank assets rise to 170% of GDP, according to a Bloomberg analysis. And the biggest American banks come to look very much like their international counterparts. As Bloomberg's analysts reported: "JPMorgan Chase & Co., Bank of America Corp., and Wells Fargo & Co. would double in assets, while Citigroup Inc. would jump 60 percent....JPMorgan would swell to $4.5 trillion from $2.3 trillion, leapfrogging London-based HSBC Holdings Plc. and Deutsche Bank AG, each with about $2.7 trillion," to become the biggest bank in the world.

These figures point to another worrying trend beyond the overall growth of the American financial sector: the increasing dominance of a few behemoth institutions. In 1983, the six biggest American banks had assets equal to 14% of the nation's GDP. Today, their assets equal a staggering 61% of GDP, a massive increase.

As the Bank of England has reported, the share of the American banking market held by the top three banks rose from around 10% in 1990 to 40% in 2007 (still well below the concentration found in many European countries, where the top three banks tend to account for between two-thirds and three-quarters of the market). This concentration has only increased in America since the financial crisis, the 2008 Troubled Asset Relief Program, and Dodd-Frank: The top three institutions now account for 48% of all U.S. bank assets. If international capital standards were used to judge bank concentration in the United States, undoubtedly well over half of all U.S. bank assets would be held by JPMorgan Chase, Bank of America, and Citigroup.

Megabanks often argue that their size allows them to make use of economies of scale, which is the only way they can compete with massive foreign rivals and provide essential services to American companies working abroad. But there is little evidence that banks need multi-trillion-dollar balance sheets to realize such benefits. In fact, when a bank offers a supermarket of services, it may actually find diminishing returns from the added complexity of its operations. The financial crisis proved that banks can become both too big and too complex to function efficiently.

Former Merrill Lynch CEO John Thain noted this phenomenon in 2009, specifically with reference to the company's business in complex derivatives. "To model correctly one tranche of one [collateralized debt obligation] took about three hours on one of the fastest computers in the United States," Thain explained. "There is no chance that pretty much anybody understood what they were doing with these securities. Creating things that you don't understand is really not a good idea no matter who owns it." More recently, JPMorgan Chase - widely regarded as the best-run bank on Wall Street - suffered a loss of $6 billion when the derivatives gambling of a trader known as the "London whale" went south. The bank's CEO, Jamie Dimon, lamented that this investment strategy was "flawed, complex, poorly reviewed, poorly executed, and poorly monitored."

Banks are not growing this large and unwieldy purely because of competition and the global market. Decades of experience have proved that when a firm rises to the status of "systemically important" (as Dodd-Frank labels such large, interconnected banks), it will pursue increasingly risky ventures. If those ventures succeed, bankers and shareholders make money; if they fail, American taxpayers foot the bill. The federal government has thus established, and continues to subsidize, an enormously profitable business model for certain megabanks. It's no wonder that the nation's financial institutions are actively seeking to become "too big to fail": Once they do, they can't lose.

THE DOOM LOOP

Government guarantees do not merely encourage big banks to expand; they also aid their growth along the way. In a recent review of a number of academic studies about the advantages enjoyed by big banks, Andrew Haldane, the executive director for financial stability at the Bank of England, considered what appeared to be a pattern of evidence of economies of scale for banks with assets exceeding $100 billion. Past research had suggested that these economies tend to increase with the size of the bank. But Haldane pointed to work by researchers at Oxford University and the Bank of England showing that the apparent advantages for increasingly large banks come not from economies of scale but from the increasing likelihood of their having government backing.

A 2012 study for the International Monetary Fund found that government backstops lower big banks' borrowing costs by about eight-tenths of a percentage point. (This markdown applies to all of a big bank's liabilities, including customer deposits and bonds.) Applied to the liabilities of the ten American banks with the most assets, this government-guarantee advantage translates to an annual taxpayer subsidy of $83 billion. As a Bloomberg editorial noted in February, "To put the figure in perspective, it's tantamount to the government giving the banks about 3 cents of every tax dollar collected." Another study, published earlier this year by economists at Syracuse University, Virginia Tech, and New York University, tracked the implicit subsidy provided to large institutions over a 20-year period. The researchers found that, between 1990 and 2010, the value of the subsidy averaged around $20 billion a year - topping $100 billion in 2009.

The Bank of England's Haldane calls this practice a "self-perpetuating ‘doom loop.' " Decades ago, policymakers proved they would not hesitate to resort to bailouts if they detected the slightest hint of market contagion. As the banks grow larger and more interconnected, this implicit government guarantee of their debt becomes ever stronger in the eyes of investors.

One way to look at the power of this guarantee is to see how effectively it counteracts market forces. Many financial analysts argue that if the big banks were broken up, the combined shareholder value of the smaller units would be greater than that of the original banks. This suggests that "universal banks," with their supermarket approach to financial services, are in fact less efficient because of their size, not more so. Why, then, do shareholders not demand that the banks split up to generate higher profit margins? Perhaps because these analyses overlook a crucial point: They fail to account for the implicit subsidy enjoyed by banks big enough to assume a government bailout in the event of a crisis. If these banks were broken up, the smaller units would no longer be considered too big to fail and so would lose their implicit government guarantee. The loss of the guarantee would make the smaller banks subject to higher funding costs, which would then eat into whatever additional value their more manageable size might otherwise create. This is why market forces are not already dismantling the big banks, and why Dodd-Frank almost certainly did not end "too big to fail." Until the government proves it can resist bailing out a failing megabank, big banks will continue to do business at a major discount, and this implicit subsidy will continue to incentivize preserving the status quo.

The same 2013 study by researchers at Syracuse University, Virginia Tech, and NYU found that Dodd-Frank has done little to change the investor expectations that keep this "doom loop" cycling. Because Dodd-Frank requires the government to explicitly name institutions that it believes are "systemically important," investors believe that these companies are highly likely to receive government support in the event of a financial crisis. These banks thus enjoy enormous advantages over their smaller competitors. The researchers concluded that, "[a]s a result, the credit market doubts whether Dodd-Frank will mitigate TBTF, believing instead that it will likely exacerbate the problem." Indeed, the study notes that investors' belief in a government backstop for big banks actually strengthened between 2008 and 2010.

It is not hard to see why. Rather than eliminating "too big to fail," Dodd-Frank enshrines and expands it. The law created the Financial Stability Oversight Council with the stated goal of eliminating the expectation "on the part of shareholders, creditors, and counterparties of [large financial] companies that the government will shield them from losses in the event of failure." To this end, large banks and other financial companies designated as "systemically important" are supposedly subject to stringent oversight by the Federal Reserve. The Fed and the FSOC even have the power (on paper, at least) to break up "systemically important" big banks if they pose a "grave threat" to the stability of the financial system. But given the continued funding advantage enjoyed by bigger banks, it is clear that financial markets continue to view the megabanks as holding "get out of jail free" cards supplied by Washington. And why shouldn't they? The new oversight council will do little to change the behavior of industry players, and thus nothing to stem the growth of Wall Street's big banks.

In testimony before Congress in 2009, former Fed chairman Paul Volcker, then the chairman of the President's Economic Recovery Advisory Board, predicted this outcome. For that reason, he advised against using the "systemically important" standard:

[T]he clear implication of such designation whether officially acknowledged or not will be that such institutions, in whole or in part, will be sheltered by access to a Federal safety net in time of crisis; they will be broadly understood to be "too big to fail"....What all this amounts to is an unintended and unanticipated extension of the official "safety net," an arrangement designed decades ago to protect the stability of the commercial banking system. The obvious danger is that with the passage of time, risk-taking will be encouraged and efforts at prudential restraint will be resisted. Ultimately, the possibility of further crises - even greater crises - will increase.

Despite these warnings, the "systemically important" designation remains at the center of the Dodd-Frank statute - one of many reasons why few expect Dodd-Frank to end "too big to fail."

It is possible, of course, that these doomsayers have been too hasty in issuing their bleak prognostications. Federal Reserve chairman and megabank regulator Ben Bernanke, for instance, is not yet ready to pass judgment. While he concedes that markets will likely continue to expect a Washington bailout if a megabank gets into trouble, he wants to give Dodd-Frank and the Basel III international regulatory process a chance to eliminate that expectation before we take further steps.

The problem with this "watchful waiting" approach, however, is that we don't know when the next financial crisis will happen. After all, such crises have not followed a predictable pattern. Upon surveying the number and variety of shocks to the U.S. financial system over the past three decades - the Latin American debt crisis, the 1987 U.S. stock-market crash, the savings and loan crisis and bailout, the Russian debt crisis, the failure of Long-Term Capital Management, the dot-com bubble and bust of the late 1990s and early 2000s, and finally the housing-price collapse and financial crisis - economist David Romer concluded that "the idea that large financial shocks are rare, and that we therefore should not worry greatly about them, seems fundamentally wrong. What I find striking about this list is not just its length, but its variety....In short, the range of potential financial shocks is long and varied....So I think the right conclusion to draw is that financial shocks are likely to be both frequent and hard to predict - not just in their timing but in their form."

In other words, we may not have time to wait for expectations to change. We need a much better approach to eliminating the incentives that have so badly distorted America's financial sector - and we need it now.

FINDING A SOLUTION

The key challenge, of course, is to determine what principle should guide that better approach. In one sense, decades of bad behavior by politicians, banks, and investors have taught a useful lesson: No matter how many new anti-bailout regulations are layered upon the financial sector, lawmakers simply will not allow an essential bank to fail. Even when lawmakers want to do the right thing and avoid creating moral hazard, the demands of panicked voters, financial markets, and campaign contributors can be nearly impossible to resist. Recall that, when the House voted down the TARP bailout in September 2008, the market plunged, and legislators quickly changed their minds. As the Bank of England's Haldane points out: "The history of big bank failure is a history of the state blinking before private creditors."

Knowing that lawmakers cannot be trusted to refrain from bailing out megabanks points us to an important conclusion: The only way to solve the problem of "too big to fail" may be to solve the problem of big banks, period - by taking pre-emptive action to make banks smaller, simpler, and safer.

There are several forms this kind of policy solution could take. One pre-emptive option would place a cap on a bank's non-deposit liabilities, measured as a fraction of GDP. In a speech delivered late in 2012, Fed governor Daniel Tarullo advocated this fix, noting: "For the largest U.S. financial firms, nondeposit liabilities today are highly correlated with the systemic risk measures used at the Federal Reserve Board to measure interconnectedness and complexity for purposes of evaluating the financial stability effects of mergers." In other words, a cap on non-deposit liabilities would effectively act as a cap on bank interconnectedness and systemic risk. One advantage of this idea is that it would not specifically tell banks how to run their businesses. By simply placing a cap on liabilities, lawmakers would leave the responsibility of finding the most efficient ways of meeting the requirement to the experts: the bankers themselves. Some of the more obvious options available to a bank include shedding less profitable assets or funding itself more thoroughly through deposits or through equity.

To be sure, there is a major drawback to this solution: While researchers and experts can attempt to estimate the ideal level of risk and maximum bank size, it is all academic until it is tested in the marketplace. Simon Johnson, former chief economist at the IMF, has proposed capping each bank's non-deposit liabilities at 2% of GDP, or about $300 billion. JPMorgan Chase, Bank of America, Goldman Sachs, Citigroup, and Morgan Stanley all have non-deposit liabilities around two to three times that amount and would thus be required to downsize. But markets must be the final arbiter, and unfortunately the market system continues to be distorted by government incentives and implicit guarantees. Allowing markets to determine the ideal level of risk is thus a complicated matter.

Another pre-emptive option available to legislators is to restructure the biggest banks according to business type. Under the 1933 Glass-Steagall Act (the same banking act that established the FDIC), lawmakers required the separation of commercial banking from investment banking as a populist response to the stock-market crash that many believed had triggered the Great Depression and as a way of restoring public confidence in the financial system. In 1999, however, this portion of Glass-Steagall was repealed, allowing financial institutions to fuse these two business functions. One possible approach regulators could take to limit bank size, then, is to reinstate the prohibition on affiliations between commercial and investment banks.

It should be noted that even if the 1999 repeal of Glass-Steagall had never happened, many of the financial institutions central to the 2008 crisis would have collapsed anyway: For example, investment banks Bear Stearns, Lehman Brothers, and Merrill Lynch did not have significant insured depository holdings. Still, no one knows what shape the next financial crisis will take, and separating the commercial and investment banks may well save the market from another catastrophe. As the Fed's Tarullo points out, "separating commercial from investment banking could at least mitigate the risks of extending the safety net provided depository institutions to underwriting, trading, and other activities of very large firms." In other words, deposit insurance would apply to a smaller slice of the financial sector. But it is more likely that restoring Glass-Steagall would be as futile today as the original rule was when it was first conceived during the 1930s - more public-relations exercise than helpful policy solution. Had Glass-Steagall been in place before the Great Depression, it would not have prevented that crisis; had it not been repealed, it would not have prevented the Great Recession.

A different approach to restructuring banks, devised by FDIC director and former Kansas City Fed president Thomas Hoenig, is based on the principle that the government safety net should not protect activities that "create such complexity that their management, the market, and regulators are unable to adequately assess, monitor, and control bank risk taking." The Hoenig plan would considerably broaden and strengthen Dodd-Frank's "Volcker Rule," which attempts to ban proprietary trading. It would prohibit banks from any trading whatsoever - be it proprietary or for customers or for hedging purposes - as well as from "making markets" (that is, standing ready to buy and sell securities from its own inventory), since doing so requires the ability to trade. Banks would also be barred from owning complicated securities such as the collateralized debt obligations that were at the heart of the subprime-mortgage meltdown on Wall Street.

In short, Hoenig would make banks boring, allowing them to engage only in traditional activities based on long-term customer relationships such as commercial banking, asset management, and - unlike Glass-Steagall - stock and bond underwriting. Limiting banks to these transparent, well-understood, and narrow activities would also make capital regulation more effective, because there would be less need for complicated risk-based requirements of the sort found in the Basel international regulatory frameworks.

But perhaps the most straightforward and intuitive solution to the problem of "too big to fail" banks is simply to require all banks to finance their lending with more equity from shareholders, as opposed to money borrowed from creditors. Equity acts as a safety cushion against a decline in asset values, so if a bank has a bigger cushion, it can more easily survive a large drop in the value of its assets. Borrowing, on the other hand, magnifies both the upside and the downside of an investment. For example, a 20% down payment on a house that then rises in price by 5% produces a 25% return on equity when sold. Likewise, a 5% drop in price produces a 25% loss. But what if the down payment - the equity cushion - is just 10%? In that case, a 5% home-price increase generates a 50% gain, and a 5% price decline yields a 50% loss. Big banks are no different from home owners in their appreciation of the power of leverage, except that when the biggest financial players suffer losses, they expect to land in Uncle Sam's safety net.

The question is how much of an equity cushion is enough to protect a firm from catastrophic losses. The Basel III international standards, for instance, propose a minimum equity level of 3% of a bank's total assets. But that means that if the bank's assets were to suddenly decline in value by 3%, the entire equity cushion would be gone, and any further losses would make the bank insolvent. A higher capital ratio would reduce the risks banks face during market downturns, making them less likely to encounter liquidity and solvency problems.

Under current U.S. accounting rules, JPMorgan Chase, for example, has a capital cushion equal to 6.3% of total assets, unweighted for risk. But the recent history of the banking industry suggests that a much higher capital cushion would be desirable to ensure solvency in the case of a major loss. As Anat Admati and Martin Hellwig note in The Bankers' New Clothes: What's Wrong With Banking and What to Do About It, for much of the 19th and early 20th centuries, it was common for banks to have equity totaling 20% to 40% (or more) of their assets. These deep cushions were not the result of government regulation: The markets demanded such equity levels in the days before government bailouts. In light of this history, Admati and Hellwig suggest that "[r]equiring that banks' equity be at least on the order of 20-30 percent of their total assets would make the financial system substantially safer and healthier. At such levels of equity, most banks would usually be able to cope on their own and require no more than occasional liquidity support." To reach those levels, banks could either retain more earnings (as opposed to paying them out as dividends) or sell more stock to the public.

Bankers offer several arguments against the idea of vastly increased equity requirements, but they can generally be reduced to two broad concerns. First, these bankers suggest that if their firms had to "hold" more capital, there would be less money available for lending throughout the economy. But this notion seems to confuse capital requirements with reserve requirements - the portion of customer deposits that regulators say a bank must hold in reserve instead of lending out. Equity capital isn't "held" or "set aside." An equity-capital requirement merely refers to how banks are funded.

This points to the second concern expressed by opponents of higher equity requirements: They worry that such requirements would increase banks' funding costs. And they are correct, since our tax code subsidizes debt financing at the expense of equity financing. Interest payments on debt are tax deductible; equity payments, such as those made when a company distributes dividends, are not. Indeed, Brookings Institution financial scholar and former JPMorgan Chase investment banker Douglas Elliott argues that this tax preference is a big reason why banks finance themselves with debt as opposed to equity. A simple solution would be to amend the tax code in order to scale back or remove these distorting incentives. This change should apply not only to banks, but to firms of all types. In fact, many corporate-tax reform proposals recommend creating incentives for funding companies' activities with equity rather than with debt in order to reduce the exposure of firms to risk in the financial markets.

None of these potential avenues to reducing the size of the megabanks would, on its own, solve the problem of "too big to fail" once and for all. In combination, however, they could go a long way toward reducing many of the dangers that still plague the banking industry after Dodd-Frank. Most important, they could help correct the unhealthy incentives now facing bankers, investors, and lawmakers - and could finally allow the market to determine the proper size of banks and the risks they are willing to take.

BREAKING UP BIG BANKS

Wall Street's basic job - the allocation of capital - is fundamental to our free-market economy. But a system in which select firms are protected by the government against the possibility of failure is not a free market: It is little more than a rent-seeking racket. The danger of loss is what motivates markets to impose discipline on borrowers and to take only smart investment risks. Because of the government's long legacy of interventions and bailouts, that discipline is now far weaker than it should be.

Unfortunately, the massive law meant to re-impose such discipline has only made matters worse. By requiring more oversight of banks deemed to be "systemically important," Dodd-Frank requires the government to publish a list of which banks federal policymakers view as too essential not to save. Instead of eliminating the perverse incentives behind "too big to fail," the law has strengthened and codified them.

Only by addressing the practices that gave rise to "too big to fail" can we move closer to finding a solution. If the problem is that some banks are so large and interconnected that their failures would bring down the entire economy, policymakers must keep banks from becoming so dangerously large and interconnected in the first place. By following the measures outlined here, lawmakers could allow market incentives to reshape the megabanks into firms of manageable size, reach, and complexity. In so doing, our politicians could ensure that, when the next financial crisis arises, they will be less likely to face an impossible choice between bailouts and economic collapse. This should also make them less likely to perpetuate the harmful cycle of government-assisted bank growth that has undermined our free-market system.

James Pethokoukis is the DeWitt Wallace Fellow at the American Enterprise Institute and a CNBC contributor.

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About the Author

 

James
Pethokoukis
  • James Pethokoukis is a columnist and blogger at the American Enterprise Institute. Previously, he was the Washington columnist for Reuters Breakingviews, the opinion and commentary wing of Thomson Reuters.

    Pethokoukis was the business editor and economics columnist for U.S. News & World Report from 1997 to 2008. He has written for many publications, including The New York Times, The Weekly Standard, Commentary, National Review, The Washington Examiner, USA Today and Investor's Business Daily.

    Pethokoukis is an official CNBC contributor. In addition, he has appeared numerous times on MSNBC, Fox News Channel, Fox Business Network, The McLaughlin Group, CNN and Nightly Business Report on PBS. A graduate of Northwestern University and the Medill School of Journalism, Pethokoukis is a 2002 Jeopardy! Champion.


     


    Follow James Pethokoukis on Twitter.

  • Email: James.Pethokoukis@aei.org

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Events Calendar
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Wednesday, April 16, 2014 | 10:00 a.m. – 11:00 a.m.
Calling treason by its name: A conversation with Liam Fox

Join us at AEI as the Right Honorable Liam Fox sits down with Marc Thiessen to discuss and debate whether America’s intelligence agencies have infringed on the personal privacy of US citizens.

Event Registration is Closed
Thursday, April 17, 2014 | 4:00 p.m. – 5:00 p.m.
The curmudgeon's guide to getting ahead

How can young people succeed in workplaces dominated by curmudgeons who are judging their every move? At this AEI book event, bestselling author and social scientist Charles Murray will offer indispensable advice for navigating the workplace, getting ahead, and living a fulfilling life.

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No events scheduled this day.
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No events scheduled this day.
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No events scheduled this day.