Richard Fisher, president of the Dallas Fed, has long been a proponent of serious financial sector reform. As a former commercial banker, he sees quite clearly that the legislation now headed into "reconciliation" between House and Senate versions amounts to very little. He also knows that pounding away repeatedly on this theme is the best way to influence his colleagues within the Fed and across the policy community more broadly.
He is now taking his game to a new, higher level. Couched in the diplomatic language of senior officials, his speech on June 3 to the SW Graduate School of Banking was both a carefully calibrated assault on the administration's general "softly, softly" approach to the big banks and a direct refutation of arguments put forward by Larry Summers in particular.
As the title of Mr. Fisher's speech implies, if the legislation is not real financial reform (and it is not, according to him), then our current policy trajectory amounts to facilitating further rounds of financial dementia.
As a statement of our true problems—dismissing the red herrings and focusing on the core issues—Mr. Fisher's speech is a succinct classic. Cutting to the chase:
"Regulators have, for the most part, tiptoed around these larger institutions [big banks]. Despite the damage they did, failing big banks were allowed to lumber on, with government support. It should come as no surprise that the industry is unfortunately evolving toward larger and larger bank size with financial resources concentrated in fewer and fewer hands."
This is most definitely not a market outcome.
"Based on these considerations, coupled with studies suggesting severe limits to economies of scale in banking, it seems that mostly as a result of public policy—and not the competitive marketplace—ever larger banks have come to dominate the financial landscape. And, absent fundamental reform, they will continue to do so. As a result of public policy, big banks have become indestructible. And as a result of public policy, the industrial organization of banking is slanted toward bigness."
This is an unfair, nontransparent, and dangerous taxpayer subsidy at work.
"Big banks that took on high risks and generated unsustainable losses received a public benefit: TBTF [too big to fail] support. As a result, more conservative banks were denied the market share that would have been theirs if mismanaged big banks had been allowed to go out of business. In essence, conservative banks faced publicly backed competition."
Mr. Fisher is agreeing with arguments sometimes heard from the left of the political spectrum, but he is most definitely coming at this more from what is traditionally—and accurately—regarded as the right (like Gene Fama of Chicago or Tom Hoenig of the Kansas City Fed).
"It is my view that, by propping up deeply troubled big banks, authorities have eroded market discipline in the financial system."
In this context, attempts to regulate big banks more effectively will fail because the underlying political economy dynamic (i.e., how the creditors understand government policy toward big banks) encourages excessive risk taking and greater leverage one way or another.
"The system has become slanted not only toward bigness but also high risk. Consider regulators' efforts to impose capital requirements on big banks. Clearly, if the central bank and regulators view any losses to big bank creditors as systemically disruptive, big bank debt will effectively reign on high in the capital structure. Big banks would love leverage even more, making regulatory attempts to mandate lower leverage in boom times all the more difficult. In this manner, high risk taking by big banks has been rewarded, and conservatism at smaller institutions has been penalized. Indeed, large banks have been so bold as to claim that the complex constructs used to avoid capital requirements are just an example of the free market's invisible hand at work. Left unmentioned is the fact that the banking market is not at all free when big banks are not free to fail."
Add to this the deference of the US Treasury to the international negotiations on capital requirements, and the manifest problems of the G-20 in this regard—held to the lowest common denominator again over the weekend (i.e., no mention of capital requirements or other substantive reregulation in the communiqué). Fisher's assessment is right on target: relying on regulation alone is unwise and most definitely the triumph of hope over experience.
"Regulatory reform discussions portray the need to control systemic risk as a new game in town—as if it were a new responsibility that need only be assigned. This is not the case: Bank regulators have long viewed the containment of systemic risk as a primary rationale for capital requirements. The problem is that capital regulation has rarely been truly successful."
"… While we do not have many examples of effective regulation of large, complex banks operating in competitive markets, we have numerous examples of regulatory failure with large, complex banks."
And just saying, "let ‘em fail" is also quite unrealistic as policy for megabanks—because this has been proven, time and again, not to be "time consistent," i.e., you can promise to do this all you want, but:
"We know from intuition and experience that any financial institution deemed TBTF will not be allowed to fail in the traditional sense. When such an institution becomes troubled, its creditors are protected in the name of market stability. The TBTF problem is exacerbated if the central bank and regulators view wiping out big bank shareholders as too disruptive, extending this measure of protection to ordinary equity holders."
"… Even a combination of enhanced regulation and resolution would likely be inadequate. The temptation to use regulatory discretion to avoid disruptions is just too great."
But Mr. Fisher is most devastating when he takes on the arguments developed by Larry Summers (and used by many senators) against imposing binding size caps on the largest banks.
Larry Summers, you may recall, argued that "most observers" agree that breaking up big banks would actually make the financial system more risky. It turns out that "most observers" are actually just a few commentators with what Fisher assesses as "hollow" arguments. For example, on the idea that smaller banks would all copy each other and follow identical high-risk strategies,
"…going by what we see today, there is considerable diversity in strategy and performance among banks that are not TBTF. Looking at commercial banks with assets under $10 billion, over 200 failed in the past few years, and as we have seen, failures in the hundreds make the news. Less appreciated, though, is the fact that while 200 banks failed, some 7,000 community banks did not. Banks that are not TBTF appear to have succumbed less to the herd-like mentality that brought their larger peers to their knees."
And reference to the banking problems of the 1930s is simply not relevant.
"Such a liquidity crisis among small banks would be unlikely today, as we now have federal deposit insurance, which protects deposits for funding. And, I might add, the Federal Reserve has demonstrated quite effectively over the past two years that we not only have the capacity to deal with liquidity disruptions but also the ability to unwind emergency liquidity facilities when they are no longer needed."
Overall, Fisher is blunt.
"…sufficient or not, ending the existence of TBTF institutions is certainly a necessary part of any regulatory reform effort that could succeed in creating a stable financial system. It is the most sound response of all. The dangers posed by institutions deemed TBTF far exceed any purported benefits. Their existence creates incentives that will eventually undermine financial stability. If we are to neutralize the problem, we must force these institutions to reduce their size."
This is most definitely not a retreat to some financial stone age.
"A globalized, interconnected marketplace needs large financial institutions. What it does not need, in my view, are a few gargantuan institutions capable of bringing down the very system they claim to serve."
And, he points out, if his fellow regulators could only think clearly about this issue, there is hope.
"…the financial regulatory reform bill has left regulators (specifically, the Board of Governors and the Federal Deposit Insurance Corp.) with the authority to impose greater restrictions on firms whose living wills are not credible. That authority, as I mentioned previously, could include ‘[divesting] certain assets or operations…to facilitate an orderly resolution.' I would argue that regulators should freely use this broad authority to commit credibly to resolution with creditor losses by reducing big banks' size and interconnectedness."
Sadly, the indications are that too few officials are likely to agree with Mr. Fisher any time soon.
French Connection: The Eurozone Crisis Worsens Sharply
with Peter Boone, June 4
The big news is France. With sentiment worsening across Europe, France has lost its relative safe haven status—credit default swap spreads on French government debt were up sharply today.
The trigger—oddly enough—was Hungary's announcement that its budget is worse than expected (blaming the previous government—this is starting to become the European pattern) and in the current fragile environment discussed yesterday, this relatively small piece of news spooked investors. But these developments only reinforced a trend that was already in place.
It did not help that the Irish minister of finance announced Ireland has 74.2 billion euros of guaranteed bank loans, bonds, and systemic support falling due between now and October 1. This is around 55 percent of GNP. It sounds like everyone backed by the Irish government had the "clever" idea to roll over their debts to just before the guarantees expire.
The big losers are Portugal, Ireland, Italy, Greece, and Spain as always, but Belgium is now in the line of fire and France is clearly under pressure. The spread between French and German credit default swaps (measuring the relative probability of default) is up—yesterday this was 40 basis points, today it stands at 44 (up from just 5 basis points at the end of 2009; most of the increase is since mid-March, with a sharp acceleration recently). French bonds have become illiquid, with wide bid-ask spreads; not what is supposed to happen in a safe haven. This is going to make the French angry—watch for more market slanders from top French politicians over the weekend; you know they would just love to ban trading in something.
Earlier today the French Prime Minister came out with a quote for the ages:
"I only see good news in parity between euro and dollar."
Be careful what you wish for—such statements will drive the Germans crazy as they see further evidence that inflation lovers are clearly winning influence and might just gain control at the European Central Bank (ECB).
This has the potential to become a run on most non-German bonds in the eurozone. Next we will see pension funds and reserve managers stepping back and waiting to see what happens—there is no profit in buying French bonds for a 40 basis point spread over Germany given the risks and illiquidity that we have seen in other markets.
The eurozone leadership may be tempted to address the short-term issues by providing much greater quantitative easing (i.e., putting a lot more money into circulation through buying government bonds) than the ECB has already promised. However, the ECB does not have the fiscal backing necessary to take that sort of sovereign risk, as this is ultimately a mix of a bank run and serious private and public sector solvency problems.
These solvency problems will worsen as they are allowed to fester. And if the ECB announces it will buy French bonds, investors will probably step further back and just let them buy. We are beyond the point where mere expressions of intent-to-support will lead to a private sector rally.
Investors increasingly fear that it is simply unsustainable—economically and politically—for the ECB to support the rollover of public and private debts. If investors—acting on this belief—refuse to rollover bonds, the entire policy disintegrates into the uncontrolled money issue. Quantitative easing on this basis will fail.
The ECB is going to be forced to show a deeper hand, potentially along three dimensions.
First—the euro authorities have to let the euro truly collapse, e.g., below parity with the US dollar. This reduces solvency issues across the eurozone. Ironically, by doing nothing, and bickering within Europe as Rome (and Madrid and even Paris) burns, this is one measure that Europe seems set on delivering.
Second—if the euro devaluation does not come fast enough (or does not promise enough immediate future growth), the ECB and others will push for a "Plan B" within which at least some of the weaker eurozone countries implement "voluntary" debt restructurings (of the kind more common and not necessarily so traumatic in emerging markets: see Kazakhstan)—in which they make offers to bondholders to restructure and threaten to default if they are not accepted.
This will end rollover risk among these sovereigns—particularly as the banks will be forced to follow suit. European bank regulators need to work with each major European bank to ensure it is adequately capitalized postrestructuring. This is a good time to change management/directors and look at imposing losses on at least some unsecured creditors, although the fear at such moments is always that systemic panic will set in; vulnerable financial structures induce bailouts (and future moral hazard, as President Obama can attest). The ECB will need to provide liquidity to prevent bank runs.
Third—the eurozone nations that remain without a restructuring will need G-20 support to roll over their public debts while rolling over or—failing that—restructuring some private financial sector debts. This includes France.
Progress on steps 2 and 3 require consensus within Europe and determined actions with international support. This remains nearly impossible until nations face the obvious risk of national financial collapse.
We are not there yet but this is the dangerous glide path. As the bond market moves toward a buyers' strike and with Europe's leaders doing nothing—simply hoping all their problems will melt away by themselves—the path of least resistance is to spiral downward.
Pressure from other governments will quickly mount and offers of international help will appear without any difficulty. The G-20 will soon be desperate, again, to get Europe to seriously sort itself out.
And think of the diplomatic coups that await China when it figures out how to throw its more than $2 trillion of reserves into the fray.
Surely the White House finally understands what is going on—they must lift their heads from the compelling tragedy of the Gulf coast and determine whether American global economic leadership rises or falls.
Eugene Fama: "Too Big To Fail" Perverts Activities and Incentives
June 2, 2010
In our continuing financial debate, one of the central myths—put about by big banks and also not seriously disputed by the administration—is that reigning in "too big to fail" banks is in some sense an "antimarket" approach.
Speaking on CNBC at the end last week, Gene Fama—probably one of the most pro-market economists left standing—pointed out that this view is nonsense.
Having banks that are too big to fail, according to Fama, is "perverting activities and incentives" in financial markets—giving big financial firms a license to increase risk; where the taxpayers will bear the downside and firms will bear the upside."
Fama is not backing down from any of his previous strong pro-market views—as explained by David Cassidy in the New Yorker recently (the full article on the Chicago school is also good, but requires a subscription)—and we can argue about his views on the functioning of financial markets or capitalism more broadly. When everyone is opportunistic and the "rules of the game" themselves are up for grabs—for example through lobbying based on existing and expected future super-profits (e.g., from being allowed to exercise any form of monopoly)—then bizarre and bad things can happen.
But, in any case, Fama is completely correct that:
"[Too big to fail] is not capitalism. Capitalism says—you perform poorly, you fail."
He is also correct that "complicated regulation may be a nice idea in principle but in practice it never works." Regulators get captured by the people they are supposed to be regulating (as now illustrated in the oil and gas industry); this is "not unusual; it happens all the time."
Fama has obviously considered just letting big banks fail ("I would have been for that all along"), but he recognizes that this cannot work in our political realities—governments will step in and make bail for banks when there is serious trouble. And, as Senator Ted Kaufman pointed out in his exchange with Senator Mitch McConnell, allowing the collapse of huge banks is a recipe for turning crisis into catastrophe.
Fama argues "the only solution is to raise capital requirements of these firms dramatically," maybe up to 40 to 50 percent, which is an idea we have also advanced. It's an interesting question whether this by itself would take the failure of megabanks completely off the table—that would probably depend on the extent to which they were allowed to game the system, for example with risk taken through derivative positions against which they hold too little capital.
Still, Fama is thinking along exactly the right lines—and this is further confirmation that the consensus on big banks is shifting.
If implemented properly, capital requirements of the kind he proposes would essentially force the largest six or so banks today to become much smaller. Given that capital requirements are set by regulators, who claim to be pro-market, they should take careful note of Fama's views—and look for ways to implement a tough version of this approach.
The Consensus on Big Banks Shifts, but Not at Treasury
May 30, 2010
Attitudes toward big banks are changing around the world and across the political spectrum. In the United Kingdom, the new center-right government is looking for ways to break them up:
"We will take steps to reduce systemic risk in the banking system and will establish an independent commission to investigate the complex issue of separating retail and investment banking in a sustainable way; while recognizing that this will take time to get right, the commission will be given an initial time frame of one year to report."
The European Commission, among others, signals that a bank tax is coming; presumably, as suggested by the IMF, this will have higher rates for bigger banks and for banks with less capital. And other European officials are increasingly worried by the lack of capital in German banks, by the recent reckless lending sprees in Ireland and Spain, and by the dangers posed by banks that are much bigger than their home countries (e.g., Switzerland).
Yet top Obama administration officials refuse to change their opinions in the slightest; they have dug in behind the idea that they represent the moderate center on banking policy. This is a weak position; it is simply a myth with no factual basis—the people who pushed effectively for more reform over the past few months were the center, not the left, of the Democratic Party.
In the best profile to date of Tim Geithner, by John Heilemann in New York Magazine, even the Treasury secretary himself expresses frustration with the biggest banks—calling them "the warlords."
"The irony here was rich, of course, since Geithner's stabilization scheme would turn out be strikingly favorable to Wall Street. From the outset, his aim was never to punish the banks. Quite the contrary, it was to save them—by pouring money into them, restoring confidence in them, treating them with kid gloves. Nor was his goal to restructure the financial system. It was to prevent the existing system from collapsing and then strengthen the rules governing its operation. In all this, Geithner was betraying the extent to which he shared Wall Street's mindset, even if he wasn't a creature of it. "His office was there and he was deeply enmeshed in that culture and he had those relationships," says one of his best friends. "That part of the critique is fair."
David Brooks argued in the New York Times on Friday—writing about a different industry—that this is unavoidable, and perhaps normal:
"Finally, people in the same field begin to think alike, whether they are in oversight roles or not. The oil industry's capture of the Minerals Management Service is actually misleading because the agency was so appalling and corrupt. Cognitive capture is more common and harder to detect."
More specifically, however, it's not that ‘people in the same field begin to think alike,' but rather that ‘people who are supposed to regulate' begin to see the world through the eyes of the biggest private sector players. Note, for example—and this is important—most hedge fund managers agree big banks are dangerous and will again mismanage risk in a reckless manner.
And cognitive (or cultural) capture, as we argued last year in The Quiet Coup, runs deep in the financial system. Last year David Brooks rejected our argument; it seems the graphic failures of big oil have further shifted the consensus.
Geithner insists that, above all, he represents the reasonable center of responsible opinion, "I care about us passing [reform legislation] good and strong," he tells me. "And my feeling is that you have to do this from the center."
But this is simply not a left-right issue (look at the blurbs and reviews for 13 Bankers). This is regulatory capture, as laid out by George Stigler from the University of Chicago (a man of the right)—supersized by the increasing gap since 1980 in incomes between the regulated and the regulators (see figure 2 in this paper , on pg. 29, by Thomas Ferguson and Robert Johnson).
Mr. Geithner is no closer to a moderate, centrist view on the financial sector than Robert Rubin and Larry Summers were vis-à-vis derivatives (and financial deregulation more broadly) in the 1990s—as documented at length in 13 Bankers.
The constraints on size, leverage, and activity of our largest banks could have been much stronger in the Senate bill (and presumably in the final legislation). Matt Taibbi has a good account of what was (and what could have been) and this is not denied by the administration (speaking to John Heilemann):
"If enacted, Brown-Kaufman would have broken up the six biggest banks in America," says the senior Treasury official. "If we'd been for it, it probably would have happened. But we weren't, so it didn't."
(In case you missed it, Brown-Kaufman was an amendment to the main financial reform bill in the Senate; more detail here.)
The people in charge of our strategy toward big banks are not fools and they are not corrupt; they are also not doing things just because someone on Wall Street calls them up. Our top policymakers are simply convinced that what is good for the biggest and most dangerous element on Wall Street is good for the American economy.
This is cultural capture in its purest and most extreme form. It increasingly stands out as a problem both in the US context and around the world. Unfortunately, the White House and Treasury may be the last to realize this.
