The six very large U.S. bank holding companies — JPMorgan Chase & Co. (JPM), Bank of America Corp. (BAC), Citigroup (C) Inc., Wells Fargo & Co. (WFC), Goldman Sachs (GS) Group Inc. and Morgan Stanley (MS) — share a pressing intellectual problem: They need to explain why they should be allowed to continue with their dangerous business model.
So far their justifications have been weak, and the latest analysis on this topic from Goldman Sachs may even help make the case for breaking up the financial institutions and making them safer.
egislative proposals from two senators, Democrat Sherrod Brown of Ohio and Republican David Vitter of Louisiana, have grabbed attention and could move the consensus against the modern megabanks. Under intense pressure from Democratic Senator Elizabeth Warren of Massachusetts, Federal Reserve Chairman Ben S. Bernanke conceded recently that the U.S. still has a problem with financial institutions that are seen as too big to fail. Pressed by Republican Senator Chuck Grassley of Iowa, among others, Attorney General Eric Holder is sticking to his story that these companies are too big to prosecute. Cyprus offers another vivid reminder of what happens when banks (S5FINL) become too big to save.
In this context, it is no surprise to see the financial sector wheel out its own intellectual big guns. A frisson no doubt rippled through the financial-lobbying community last week with the release of a report from Goldman Sachs’s equity research team, “Brown-Vitter bill: The impact of potential new capital rules.” This is the A-team at bat, presumably with clearance from the highest levels of management.
Yet instead of providing any kind of rebuttal to the proposals in Brown-Vitter, the report may strengthen the case for breaking up the six megabanks, while also requiring that they and any successors protect themselves with more equity relative to levels of debt. Read the report with five main points in mind.
First, notice the lack of sophistication about bank capital itself. The authors write of banks being required to “hold” capital, as if it were on the asset side of the balance sheet. They go on to construct a mechanistic link that implies that “holding” capital prevents lending.
Banks don’t hold capital. The proposals are concerned with the liability side of the balance sheet — specifically, the extent to which banks fund themselves with debt relative to equity (a synonym for capital in this context). Higher capital requirements push companies to increase their relative reliance on equity funding, thus increasing their ability to absorb losses without becoming distressed or failing. If the transition is properly handled, there is no reason that more equity funding would translate into lower lending.
Second, the Goldman Sachs analysts seem completely unaware of the recent book by Anat Admati and Martin Hellwig, “The Bankers’ New Clothes,” in which those authors — who are top finance professors — debunk the way many bank representatives (including the authors of the Goldman Sachs note) look at issues around capital.
More equity relative to debt on a bank’s balance sheet means that equity and debt become safer: The bigger buffer against losses helps both.
Goldman Sachs makes much of the implications for return on equity, without mentioning any adjustment for risk. Bankers are generally paid based on return on equity without proper risk adjustment. Naturally, they like a great deal of leverage, but the reasoning they use to justify this is fallacious (see Chapter 8 in Admati and Hellwig).
Admati and Hellwig make the broader case that we can run our system much more safely. Goldman Sachs made a big mistake by refusing to take them on directly.
The bank is correct in its assessment that bank equity is higher than it was before the 2007-08 crisis, but this is the natural reaction to a near-death experience. Over the cycle, big banks will again become more leveraged (meaning they will have less equity relative to debt). As a result, Goldman is far too optimistic in its projection of the capital levels that will be needed when the next crisis hits. Current — and likely future – – levels of equity capital are insufficient for our intensely interconnected financial system.
Contrast Goldman Sachs’s note with this excellent speech last week by Tom Hoenig, vice chairman at the Federal Deposit Insurance Corp., on the illusion of the Basel III rules in particular and the right way to think about capital more generally.
Third, while the Goldman Sachs analysts get some points for stating the obvious about Brown-Vitter — “In our view such a bill would incent the largest banks to break up” — they fail to explain why this would be a bad thing.
They do, however, have a line about how banks could only be broken up along existing divisional lines, though they fail to make clear why they believe this is the case or how it would be the best deal for shareholders. Also, once the too-big-to-fail subsidies fade, these new companies would probably be smaller than projected by Goldman Sachs. Less complex, easier to govern and more transparent to supervisors sounds pretty attractive, to officials and investors. (Any client can request a copy of Goldman’s May 2010 report, “U.S. Banks: Regulation.” See Page 32, where it explains how JPMorgan and Bank of America would be worth more if broken up. Richard Ramsden is the lead author of both this report and the one cited above.)
Fourth, the analysts express concern that these smaller companies will be less diversified and therefore more fragile than the megabanks. Delusions of diversification are precisely what brought us to the brink of catastrophe in September 2008. Have the smartest people on Wall Street really learned so little?
From a social perspective, we want a system in which some companies can fail while others prosper, more like the conditions under which hedge funds operate. For macroeconomic purposes, we want diversity within the financial sector, not diversification within Citigroup (which has come close to failing three times since 1982 precisely because of this misperception).
Fifth, on supposed progress to eliminate too big to fail, Goldman’s arguments fall under the heading of what Winston Churchill called terminological inexactitude. The Orderly Liquidation Authority under the Dodd-Frank financial reform law won’t work for complex cross-border banks, such as Goldman, because there is no cross-border resolution authority. Living wills have so far proved to be a joke, and annual stress tests show every sign of becoming a meaningless ritual that undermines serious supervision.
What will move forward the debate? Will it be another money-laundering scandal, another disaster in the European financial system, or further revelations about the London Whale and Libor?
Or will it be thoughtful people sitting down to evaluate the best in-depth arguments for both sides? If it’s Admati and Hellwig v. Goldman Sachs in the court of informed public opinion, reformers win in a landslide.
(Simon Johnson, a professor at the MIT Sloan School of Management as well as a senior fellow at the Peterson Institute for International Economics, is co-author of “White House Burning: The Founding Fathers, Our National Debt, and Why It Matters to You.” The opinions expressed are his own.)
To contact the writer of this article: Simon Johnson at firstname.lastname@example.org.
To contact the editor responsible for this article: Max Berley at email@example.com.
A bill to roll back a bill that has not yet been fully implemented- Talk about being ahead of the times.
Rep. Jim Himes (D-Conn.), a former Wall Street executive, is joining Rep. Randy Hultgren (R-Ill.) to introduce legislation that would undercut one of the most meaningful elements of the 2010 Dodd-Frank Wall Street Reform Act.
The bill would “allow banks to keep commodity and equity derivatives in federally insured units,” Politico reported on Wednesday, meaning that banks would no longer be forced to spin off their trading desks. It would weaken Dodd-Frank’s “push out” provision, otherwise known as the Prohibition Against Federal Government Bailouts of Swaps Entities, which bars federal assistance from being provided to any swaps entity.
Derivatives — which Warren Buffett has referred to as “financial weapons of mass destruction” — are viewed as a key trigger of the 2008 economic crisis.
“We need financial regulation that allows businesses and the banks they use to have access to the tools that help keep prices of consumer goods—like groceries and home heating oil—steady, while ensuring that the taxpayers are never again on the hook for the types of wild bets helped crash the economy in 2008,” Himes said in a press release. “This bill maintains Dodd-Frank’s prohibition on that risky behavior at banks that are insured by the taxpayers while allowing businesses that produce products Americans use every day to continue to use swaps to maintain predictability in their operations and in the prices of their products.”
Himes, who was recently named the national finance chairman of the Democratic Congressional Campaign Committee, is a former executive at Goldman Sachs, where he was a vice president.
In 2010, Himes took heat from consumer advocates for opposing the Senate’s version of the financial reform bill, at which point he characterized derivatives as a “political football.”
“The discussion of derivatives in the political world has become a zero sum game,” Himes told the Connecticut Mirror. “But there’s a lot more common ground here than the people who are yelling about this would have you believe.
This article was edited after publication to clarify the effect of the bill and updated to include a comment from Himes.
Occupy the SEC, Frustrated With Regulatory Defiance of Volcker Rule Implementation Requirements, Sues Fed, SEC, CFTC, FDIC and Treasury « naked capitalism
If you read the claim below, you’ll see that the various regulators were given specific dates as to when to complete the rulekmaking. Not only are the out of compliance, they appear to have no intent of finalizing the Volcker Rule.
Occupy the SEC Volcker Rule Lawsuit 2/26/13 by
It is easy to dismiss this sort of undertaking as quixotic or agitprop, but that misses the point. If you look at effective opposition movements in other countries, such as Otpor in Serbia, they used stunts and humor to, as the BBC put it,
…dispel fear among those who want to show their opposition to the government.
And for long periods of time, while the rest of the opposition was in a state of slumber, Otpor demonstrated that there was a group of people who were prepared to overcome an all-pervasive apathy and demonstrate against the regime. Whatever the methods used, Otpor has always given proof of a seriousness of purpose.
In the US, the challenge is somewhat different. While the issue of widespread apathy is the same, one critical difference is that much of the public still fails to understand the degree to which the ruling classes no longer represent their interests. Oh, they may resent the banks, and they may also hate Congress, but most people deeply need to believe they live in a system that is fair and where business and political leaders (some if not all) still deserve respect and admiration. So efforts like this suit, which in a few short pages sets forth regulators have simply refused to do their job, whether out of intellectual laziness or due to their indulgence of bank stymieing tactics, puts another chink in the official defenses of cronyism.
Rather than delaying reform of derivatives for banks that are backed by federal deposit insurance (thus making the taxpayer liable for paying for investment banking risks), why not take away the commercial part of these investment banks? Investment banks make the risky bets and investment banks should pay for their own risks without any help from taxpayer insurance.
Better yet, outlaw altogether all derivatives that are based on speculation! The financial crisis of 2008 was directly a result of the use of toxic derivatives instruments called CDOs.
JPMorgan to BofA Get Delay on Rule Isolating Derivatives
JPMorgan Chase & Co. (JPM), Goldman Sachs Group Inc. (GS) and Bank of America Corp. won a delay of Dodd-Frank Act requirements that they wall off some derivatives trades from bank units backed by federal deposit insurance.
Commercial banks including the Wall Street firms may get as long as an additional two years — until July 2015 — to comply with the rules, the Office of the Comptroller of the Currency said in a notice yesterday. The so-called pushout provision was included in the 2010 financial-regulation law as a way to limit taxpayer support for risky derivatives trades.
JPMorgan & Chase Co.’s headquarters in New York. Photographer: Peter Foley/Bloomberg
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The Commodity Futures Trading Commission and other regulators need to complete swap rules to allow “federal depository institutions to make well-informed determinations concerning business restructurings that may be necessary,” the OCC said in the notice. Dodd-Frank requires that equity, some commodity and non-cleared credit derivatives be moved into separate affiliates without federal assistance.
Regulators including Federal Reserve Chairman Ben S. Bernanke had opposed the provision, saying it would drive derivatives to less-regulated entities. In February, the House Financial Services Committee approved with bipartisan support legislation that would let banks keep commodity and equity derivatives in insured units by removing part of the rule.
The OCC is prepared to “consider favorably” requests for transition, the regulator said in the six-page notice. The agency said delays could be extended for a third year based on consultations with other regulators.
JPMorgan had 99 percent of its $72 trillion in notional swaps trades in its commercial bank in the third quarter of 2012, according to the OCC’s quarterly derivatives report. Bank of America had 68 percent of its $64 trillion in its commercial bank, according to the report.
Banks including Citigroup Inc. (C) will be given as long as two years beyond the July 16 deadline to move their swaps businesses, the OCC said. They must submit written requests describing how a transition period would reduce harmful effects on mortgage lending, job creation and capital formation. The requests, which must be submitted by Jan. 31, also must weigh how the transition period would affect insured depositors.
The Federal Deposit Insurance Corp. expects to release rules or guidance in coordination with other regulators that apply to different types of banks, Andrew Gray, the agency’s spokesman, said today in an e-mail. None of the 65 firms that registered as swap dealers with the CFTC by the end of last year are directly overseen by the FDIC, Gray said.
The Federal Reserve has primary oversight of swap dealers that have registered with CFTC including Bank of New York Mellon Corp. and Goldman Sachs Bank USA. The pushout provision’s impact on uninsured U.S. branches and agencies of foreign banks is also unresolved by the OCC’s guidance and lack of guidance from the FDIC and the Fed.
The uninsured branches of foreign banks should be given the same treatment as U.S. insured depository banks, Sally Miller, CEO of the Institute of International Bankers, said in an e-mail today. “It is imperative that this disparity of treatment be addressed quickly,” said Miller, whose organization represents banks including Credit Suisse AG (CSGN) and Deutsche Bank AG.
Eric Kollig, a Fed spokesman, declined to comment on the Fed’s approach to the issue.
“The procrastination of both regulators and the banks on this portion of Dodd-Frank has been pretty amazing,” Marcus Stanley, policy director for Americans for Financial Reform, a coalition including the AFL-CIO labor federation, said yesterday in a telephone interview. “The swaps-pushout provision is a really important part and something that absolutely should be a central part of the regulatory framework.”
Blanche Lincoln, an Arkansas Democrat who led the Senate Agriculture Committee during talks leading to Dodd-Frank, sponsored the original provision in 2010. It applied to more more types of derivatives before it was scaled back amid objections from Bernanke and former FDIC Chairman Sheila Bair.
“I never myself thought it made a great deal of sense,” Barney Frank, the Massachusetts Democrat who helped draft the Dodd-Frank law and whose last day in Congress was yesterday, said on Feb. 16 when he backed changes to the pushout provision.
Ken Bentsen, executive vice president of public policy and advocacy at the Securities Industry and Financial Markets Association, said Congress should still seek changes.
“We continue to believe that the underlying swaps push out provision is bad policy,” Bentsen said yesterday in an e-mail, noting that regulators haven’t proposed how the provision would work. “Given this uncertainty, it is impractical to require compliance by July 2013,” he said.
To contact the reporter on this story: Silla Brush in Washington at firstname.lastname@example.org