The following paper was written with the assistance of the Economic Policy Institute, by Zephyr Teachout, Tiffiniy Cheng, Nancy Cleeland, Luke Puente.
What does our economy look like?
What should we do about Too Big To Fail?
There is growing consensus that the giant financial institutions at the heart of last year's financial meltdown must be better regulated to pose no further risk to the economic system as whole. The U.S. financial sector has become highly concentrated, with a handful of giant financial institutions looming over a still-large but shrinking number of small and mid-sized banks. Grown massive from years of mergers and acquisitions set off by 1990s-era deregulation, extremely over-leveraged the mega-banks were at the heart of last year's financial meltdown. , were deemed Too Big To Fail and kept afloat with trillions of dollars in government cash, loan subsidies and guarantees. Even as they used emergency measures to pump hundreds of billions of dollars into the financial system to support these private firms, regarded as Too Big To Fail (TBTF), Treasury and Federal Reserve officials vowed to never be put in the situation of having to do so again. The Obama administration, in its June? proposal for financial reform, called for singling out dangerously large and inter-connected banks as "Tier 1 Financial Holding Companies". In testimony to Congress July 31, Federal Reserve Chairman Ben Bernanke said about 25 firms would be so-designated, and that "virtually all of those firms" are organized as bank holding companies. (Several, such as the titan Goldman Sachs, only recently became bank holding companies to qualify for special government loans and guarantees.) Gary Stern, president of the Minneapolis Federal Reserve Bank, which has extensively studied the 'TBTF issue, said he was disappointed in the approach taken by Treasury, calling it "status quo plus...The Treasury proposal fails to come to grips with too-big-to-fail and therefore leaves the financial system considerably more vulnerable than it needs to be to future bouts of instability," Stern said in a speech in early August. "There is little reason to think that these steps will, individually or collectively, succeed in reining in too-big-to-fail effectively over time because they do not change the incentives which create the problem. In fact, there is nothing in the Treasury proposal designed to put creditors of large, systemically important financial institutions at risk of loss," he said. On July 27, Ben Bernanke went to a Kansas City town hall to reassure average Americans, and was confronted repeatedly with questions about the big banks: why were they bailed out and what will be done about them going forward? "The problem we have is that in a financial crisis if you let the big firms collapse in a disorderly way, they'll bring down the whole system," Bernanke told the participants. "When the elephant falls down, all the grass gets crushed as well." Bernanke said he had to "hold his nose" to rescue such institutions during this crisis. As a result, he said it was his "top priority" to fix the issue of too-big-to-fail. At the very least, there is growing agreement among economists that any firms designated as Tier 1 under the administration plan should be taxed in some way to compensate for the advantages of an implicit government guarantee. Among other things, this would help level the playing field for smaller banks and would limit the incentives for taking large risks in order to grow. In mid-August, Treasury officials appeared to move in this direction, saying they planned to set up a two-tier payment structure to fund heightened regulation and consumer protection, with the Tier 1 banks paying a greater share. This was the first time the administration broached the idea of charging a tax on the biggest financial insitutitions, which it justified by noting that big institutions tend to have more complex holdings and are thus more costly to regulate. Depending on the differential, the higher fees for big banks could also discourage institutions from getting so large in the first place. The authors of this paper believe that even more aggressive action is called for, and that proactive steps should be taken to limit the size and/or interconnectedness of financial firms. "It's human instinct to draw back from dramatic action," said Simon Johnson, a former IMF economist now at Peterson Institute, at a hearing of the Joint Economic Committee on the topic of big banks. Nevertheless, he added, failure to take action to limit bank size and interconnectedness now could lead to more severe crises down the road. In an effort to provoke discussion on the topic, we present arguments for size limits, and chart the recent growth of financial firms, which continues through the current crisis. We then explore various options for limiting their size, including the use of antitrust laws.
Big banks mean greater risk without greater efficiency
The TBTF problem most often cited by economists is 'moral hazard' -- the idea that a government guarantee against failure, even implied, will cause the mega-banks and their investors to take more risks than they would if the prospect of failure was real. The fact is that banks, especially large systemically important ones, are currently able to obtain cash at a near zero interest rate and engage in risky arbitrage activities, knowing that the invisible wallet of the taxpayer stands behind them" (from Kenneth Rogoff). As Thomas Hoenig, the president of the Federal Reserve of Kansas City, explained: “To the extent these institutions become ‘too big to fail,’ and where uninsured depositors and other creditors are protected by implicit government guarantees, the consequences can be quite serious. Indeed, the result may be a less stable and a less efficient financial system.”[4] Alice Rivlin, a vice chair of the Fed Board of Governors in the 90s and now a senior fellow at the Brookings Institution, warned that the administration's proposal to label big firms as Tier 1 could exacerbate the problem by making the government guarantee explicit. "Identifying systemically important institutions and giving them their own consolidated regulator tends to institutionalize ‘Too Big to Fail’," she said in prepared testimony to the House Financial Services Committee a July hearing. The problem works both ways, she said. "There is a risk that the consolidated regulator will see its job as not allowing any of its charges to go down the tubes and is prepared to put taxpayer money atrisk to prevent such failures. " Beyond the moral hazard problem, very large banking firms still present a serious dilemma for policy-makers simply by virtue of being so large, argue John H. Boyd and Ravi Jacannathan, in the July 2009 edition of The Economists' Voice. "Even the best of managers sometimes make fatal errors. When that occurs in a TBTF bank it is costly not just to them but costly to society." In contrast, the failure of a smaller bank can be bad for shareholders, but not the economy as a whole, as demonstrated by the processing of more than 80 bank failures by the FDIC in 2009 alone. There appears to be a positive correlation between bank size and probability of failure. Innovation can bring more risk. Big banks hold majority of risky derivatives. At the end of the third quarter of 2008, when the financial crisis peaked, the big four bank holding companies- Bank of America, JPMorgan Chase, Citigroup, and Wells Fargo- controlled 95% of all derivatives held by depository institutions. Likewise, the OCC has noted that the trading of derivatives is essentially limited to the biggest 25 commercial banks.[xii] Furthermore, five institutions- JPMorgan Chase, Bank of America, Goldman Sachs, Morgan Stanley, and Citigroup- account for a whopping 96% of outstanding credit derivatives, the most controversial sector of the market.[xii They also aren't as good at making loans as smaller banks. Boyd and Gertler (1994) found that the largest U.S. banks had loss rates on commercial loans five times those of small banks and loss rates on construction loans nearly ten times those of small banks (as of1992). They argued that regional factors did not explain those differences and concluded that part, if not all, of the As banks grew, many seemed oblivious to the growing risks they were taking on. the largest banks neglected to maintain traditionally appropriate levels of capital. While many depository institutions were guilty of this, perhaps none better demonstrate it than Citigroup. Its capital levels remained constant over the past nine years, while total assets more than doubled, from around 773 billion to 1.94 trillion.[xiv] Brad Setser, who was recently named to President Obama's National Economic Council, pointed out the paradox while serving as a fellow at the Council of Foreign Relations: “Capital isn’t rising as their balance sheet size goes up, which implies a rise, in some way?, of risk.”[xv]
Bad for consumers
According to an influential paper (.pdf) published in the Journal of Finance, diminished competition in the banking industry leads banks to “charg[e] higher loan rates.” (From the Calomiris 2000 book) One argument in favor of larger banks is that they are more efficient, and thus can benefit consumers through lower fees. However, a 2001 study by the U.S. Public Interest Research Group found that the biggest banks charged significantly higher non-interest fees than their smaller competitors, a trend that they dubbed the “big bank fee gap.”[x] This trend has continued, with the ten largest banks having 54% of their revenue attributed to fees in 2006, while the corresponding figure for the ten smallest banks is only 28%.[xi] The assumption of infinite efficiencies that still underlies much thinking on banking is simply not true. Alan Berger and David Humphrey at Wharton’s Financial Institutions Center present a neat summary of the academic consensus: “the average cost curve in banking has a relatively flat U-shape.”Alan Greenspan recently said that the Fed “had been unable to find economies of scale in banking beyond a modest-sized institution."
Bad for political system
Concentration of political power, like third world oligarchies - Simon Johnson, also a tendency to view the dominant figures as experts in their field. Consolidation in banking has led to a proliferation in political advocacy and monetary contributions by the biggest institutions. The industry as a whole has been quite active, with commercial banks having “invested” $154 million in campaign contributions and $383 million in official lobbying activities from 1998 to 2008. The biggest financial institutions were the most generous by far. Goldman Sachs spent $46 million on its government relations and campaign contributions, while Merrill Lynch went further with a budget of $68 million.[xvi] Industry giant Citigroup took home the lobbying prize by spending $108 million on such activities, while JPMorgan Chase and Bank of America added $65 million and $39 million, respectively.[xvii] Lobbying is such a facet of Wall-Street, in fact, that the entire financial sector employed 2,996 separate lobbyists, or over five per Member of Congress.[xviii]-
Bad for public good
Regulatory capture. The largest banks have the most stake in their own regulation and monetary policy in general, while the public, individually have a minor stake in the outcome. This has led the largest banks to put disproportionately more effort into influencing monetary policy in their favor. The Federal Reserve is led by members of the largest banks, therefore members of the largest banks direct monetary policy. Each of the 12 branches of the Federal Reserve have a president and 9 board of directors. The first three directors are chosen by member banks and these three directors then choose the next 3 directors from the greater community. The last three directors are chosen by the Board of Governors of the Federal Reserve, also from the greater community. The governors are appointed by the president and decide monetary policy. The directors decide among other things who regulates them.
Banks have grown much larger in recent years
As Depression-era financial regulations were loosened in recent decades, bankers across the country rushed to build empires by acquiring or merging with other banks[i] -- part of a broader wave of corporate mergers and acquisitions that swept through the economy. As a result, the number of commercial banks shrank drastically, from 13,400 in 1988 to 6,977 in 2009.[ii] From that smaller universe emerged a few giant bank holding companies that wielded substantial economic and political influence. The top five bank holding companies held about ten percent of deposits in 1995; today they control more than forty percent. In 1994, no single bank controlled more than 2.75% of deposits; currently four banks control at least three times that amount.[v] This trend in share of deposits is even more exaggerated in local markets: in the top five U.S. metropolitan cities, at least 40% of deposits are held by just three banks.[vi] Deposits do not fully reflect the relative wealth of banks, because, as noted above, the biggest banks also hold a disproportionate share of non-depository assets such as derivatives. Thomas Hoenig, President of the Federal Reserve Bank of Kansas City, noted that “the four largest bank holding companies each have more than $1 trillion of assets, which accounts for about half of the banking industry’s assets.”[vii] At of the end of the first quarter of 2009, the nineteen largest U.S. bank holding companies accounted for $8.2 trillion in assets, or approximately 60% of all assets held by depository institutions. [viii] Predictably, this period also saw sharp declines in the number of smaller banks, known as community banks. For example, the number of banks with assets under $100 million shrank by over 5,400 from 1992 to 2008.[ix] On a global scale, the U.S. banking system has become more like those of developed countries in Europe and elsewhere, which have long been dominated by a few large banks. Traditionally, the U.S. financial system was much more diversified, with many thousands of small banks -- a result of history, the federalist system and state regulations that restricted interstate banking. One argument for deregulation, which eliminated many of those restrictions, was that the U.S. system would not be able to compete on a global stage because of mismatched sizes. Since then, U.S. banks have grown to sizes comparable to those in Europe -- and all of the large banks have grown more dominant. According to the 2009 Financial Services Roundtable report, American firms account for two of the top ten global commercial and savings banks, in terms of revenue produced. Citigroup is third, while Bank of America is ninth. Furthermore, the top four revenue-producing global securities firms are incorporated in the United States, and the top five diversified financial companies by revenues are American institutions. Two of the top five financial services firms are American, with GE Capital in second place and Citigroup fifth.[xix] A report by Scorpio Partnership found that six of the top ten wealth managers in the world were American, with Bank of America taking the top spot.[xx] Finally, a review by the authors of the biggest global financial institutions by total assets found that three of the top ten firms are American: JPMorgan Chase is fifth, Citigroup is seventh, and Bank of America is tenth.[xxi] IMF researchers found that consolidation in banking markets “proceeded at a fast pace” throughout the developed world.[xxiii] Several European countries are now rethinking the wisdom of allowing such extreme concentration of financial power and are investigating policy actions to assuage the dangers of “too big to fail” in their banking systems. Several officials in Great Britain have been outspoken in their concerns since the beginning of the financial crisis.[xxiv] Among them is Mervyn King, the Governor of the Bank of England, who said, “If some banks are thought to be too big to fail, then, in the words of a distinguished American economist, they are too big.”[xxv] The UK’s Conservative Party has also been vocal on this issue, with its Shadow Chancellor of the Exchequer, George Osborne, saying, “It is clear that size itself is a risk factor” and calling for a thorough review of competition in Britain’s banking industry.[xxvi] Although taking a more moderate approach, Adair Turner, chairman of the Financial Services Authority, joined the debate, proposing a “tax on size.”[xxvii] Moreover, public sentiment is firmly behind these policy makers: an online poll conducted by The Guardian, a prominent British daily, showed that 84.8% of its readers supported the idea that too big to fail is too big to exist.[xxviii] Elsewhere, Switzerland’s National Bank is becoming increasingly attracted to the idea of both winding down the nation's financial behemoths and subsequently restricting bank size. Such a move would be unsurprising, given that Switzerland’s bank assets, totaling roughly SFr4.4 trillion, were recently worth eight times the country’s GDP.[xxix] In Australia, following a string of mega-mergers in the financial sector, Graeme Samuel, chairman of the country’s Competition and Consumer Commission. said he was “increasingly concerned that the banking system is becoming less and less competitive”.[xxx]
Options for addressing bank size
There are several strategies lawmakers could use to limit bank size. Congress could take a direct approach, passing new antitrust legislation, or expanding deposit-cap legislation. It could also take an indirect approach, passing laws that are extremely likely to cause banks to gravitate towards smaller sizes. Finally, it could take more of a carrot than stick approach, and focus on creating supports and incentives for small and medium sized banks, again making smaller scale more lucrative and attractive. 1. Direct Approaches: Antitrust and Deposit Caps What is often called “antitrust law” is more accurately described as “competition law” (embodied in the Clayton and Sherman acts, among others). In its inception, the Clayton and Sherman acts were motivated by fears of overly large businesses—and arguably because of concerns of the growing political power of big business—but in the modern court interpretation of these acts, scale, on its own, is not a reason to break up businesses or oppose mergers. Instead, modern competition law limits certain kinds of “anti-competitive behaviors,” such as price fixing and agreements in restraint of trade. However, modern competition law does provide a statutory and enforcement framework that could be used if Congress wanted to limit bank size. The Department of Justice Antitrust division is authorized to investigate potentially anticompetitive behavior, and then challenge mergers and in extreme cases demand divestitures, where a company is broken up. These same set of tools could be applied to a new law that created a “per se” size limit for financial institutions. A per se size rule could limit the absolute revenue that any financial institution could have. Alternatively, it could limit the profits of a financial institution, or its market share, or some other proxy, like the number of people employed by the company. Any company that went over this size would be penalized and broken up into smaller companies by the Department of Justice, if it was not willing to break itself up voluntarily. The idea of a per se rule for some measurement of scale is not new to the competition policy debate. Switzerland is currently contemplating limiting absolute bank size. In the 1970s, Senator Phil Hart, the “conscience of the Senate,” favored legislation that would create a per se market share cap on companies. A per se size rule has several advantages: it is the most obvious and direct policy tool that can limit whether banks become so big that their failure threatens the entire economy. Any bank that cannot fail without threatening the economy is operating in a post-free market economy, and will not—if it acts rationally—be as risk averse as a similar, smaller bank, being aware that the government (itself acting rationally) will have overwhelming incentives to limit the cost of the banks’ crash, if not outright prevent it. Intelligent, rational strategists inside a large bank will have strong incentives to grow a bank big enough that it becomes so big that its failure threatens systemic meltdown, because then some of their risks will be capped. With a per se size rule, designed to forbid banks from approaching the “too big to fail” status, intelligent strategists inside a bank will instead have to take risks and make bets assuming that failure will be absolute and costly, and that the costs will be borne internally. A more modest form of the per se size rule would only apply to mergers: no mergers that would lead to banks of certain size would be allowed. An effective scale-based rule would probably also allow for companies in the same marketplace to bring direct civil challenges to companies that exceeded the scale limit, so that the effectiveness of the law would not depend entirely upon rigorous prosecution by the department of Justice. A variation on the pre se size rule in competition law is expanding the existing per se size rule in the laws that govern the banking industry directly, enforced by the Fed. A federal law currently restricts any bank from coming, through mergers, to hold more than 10 percent of the nation’s bank deposits. The difficulty with the 10 percent cap is that it is not small enough to directly address the problem of a bank that becomes so large that it must be bailed out. Any bank with 8% of the nation’s deposits is probably “too big to be allowed to fail.” However, the effective working of the 10% cap shows that this is another area where a slight medication could have substantial impact, without changing the enforcement mechanism or having to create a new enforcement mechanism. The 10 percent cap could be changed to 1 or 2 percent, or a number that most economists believe constitutes a number where failure is, if not desirable, at least acceptable in terms of its systemic impacts. The new law could also apply to growth after mergers or simply act as a rigid limit. Furthermore, what makes this law a sound principle for banks makes it a sound principle for related industries. Congress could apply similar market-share caps to investment banks and the insurance industry. Indirect approaches: Greater Capital Requirements, Higher Taxes Lawmakers can also use several different strategies to ensure that extremely large banks must carry their own risk along with them as they grow, and create certain requirements for capitalization, risk, and tax benefits that are directly related to size, over a certain size. One strategy is to impose greater capital requirements larger financial institutions. A progressive capitalization system would both require larger institutions to maintain higher capitalization ratios (thus protecting against system-wide shock) and discourage massive growth. While this doesn’t protect against absolute failure, it addresses the problem caused last year and this year where banks whose failure might threaten economic collapse “had to” ask the government for bailouts. Highly leveraged banks are constitutionally unstable, as they do not have the capital to cover any major shock in the system. One advantage of scale-based capital requirements, like absolute size caps, is that they operate automatically, and take the pressure off of regulators who might otherwise be in the position to make discretionary choices. Give the amount of lobbying, direct and indirect, on regulators, clear rules avoid some of the problems of deliberate institutional capture. As Gary Becker has written: Capital requirements also provide a way to respond to the "too big to fail" principle when, rightly or wrongly, large firms are often kept from going bankrupt. When large financial firms get into trouble, they impose costs on everyone else both due to the repercussions on financial and other markets, and to the taxpayer monies used to bail them out to prevent their complete collapse. For example, during this crisis the sharp declines in the values of the diversified commercial bank Citigroup, and of AIG, a giant insurance company and in recent years hedge fund, imposed major costs on the system. Their collapse led to massive and continuing federal government injection of monies into these companies. A progressive system of capital requirements would also reduce the incentives to become large since this system would impose a "tax" on becoming big. In an environment when large firms are protected by the government from failing, and when their failure helps bring down other interconnected financial and other firms, decreased incentives to become a large financial institution are desirable because of the cost these institutions impose on everyone else. The administration has proposed a variation on this, a two-tiered system, where “Tier 1” banks have higher capital requirements, whereas “Tier 2” banks would not. While the idea of some progressive capitalization is good, the two-tiered system, where regulators determine which category banks fall in, is dangerous—it will put enormous political pressure on regulators in their classification decisions, lead to perverse classification incentives, and may signal that Tier 1 banks will not be allowed to fail, effectively institutionalizing a class of “Too Big to Fail” banks. The administration’s proposal could lead to a class of large, too big to fail banks, deeply intertwined with the Fed; we do not support this proposal. William Buitner has proposed requiring larger banks to produce a detailed annual bankruptcy contingency plan. A publicly available plan would effectively create a “transparency tax” on size, so that large banks that threaten systemic risk if they fail would have to be more public about their capacities, and explicit about how they would deal with bankruptcy. Buitner has also proposed limiting the “limited liability” subsidy for anything but tightly regulated narrow banks: Incentives for excessive risk taking take many forms. An obvious one is limited liability. With limited liability, an investor (shareholder) can at most lose the value of his investment. The non-linearity in the pay-off function for the shareholder this creates, encourages placing more risky bets: losses beyond a certain magnitude are not born by the shareholder. Gains of any size are appropriated by the shareholders. The combination of limited liability and leverage means that bets of almost any size can be placed by investors with this distorted, asymmetric payoff function. This can be done through conventional leverage (borrowing) or through leverage embedded in derivative contracts. A simple way to mitigate this problem is not to permit highly leveraged financial institutions (other than tightly regulated narrow banks, insurance companies and pension funds) to be limited liability companies. Instead, partnerships and other forms of unlimited, joint and several liability should be required. Partnerships and similar arrangements were the norm for investment banks until the 1990s. It is worth considering the removal of limited liability protection from highly leveraged financial entities with considerable asset-liability mismatch. This would no doubt also help keep down their size, by any metric of size. Finally, corporate taxes, which already distinguish between companies based on profits but might also be sensitive to revenue, could be used to further subsidize small companies or penalize large ones. For example, we could enact a radical increase of the corporate income tax for banks above a certain size, or provide subsidies for banks smaller than a certain size. The difficulty with using tax law is that there are often problems with enforcement, and there are fears that tax laws will drive companies out of the US. As a matter of political economy, large firms have been very successful in repealing tax burdens piecemeal and eviscerating the underlying force of tax laws. However, corporate taxation can be a flexible way to respond to the social costs and risks created by companies of different sizes. Indirect approaches: Supports for Smaller Banks, Corporate Governance Reforms New congressional laws could support community banks and credit unions, actively encouraging the growth of small and medium-sized institutions. Laws might also pay attention to the ownership structure of banks and other financial institutions, favoring those that, like credit unions, are owned by their customers. Finally, Congress and state legislatures should consider more corporate-governance reforms. Last year, the OECD released a report concluding that problems in internal corporate governance played a large role in causing the economic crisis. The problems with corporate governance are complex, but the basic idea is easy to state: corporate managers are willing to take risks with other people’s money that people wouldn’t usually take with their own money. Because managers benefit from corporate growth more than other parties involved in corporations, including shareholders, greater governance-based review of corporate decisions to grow companies may be warranted. For example, laws might change the standard of review for managerial actions that sharply and rapidly grow enterprises, making it easier for shareholders to challenge these actions when they are not in a corporation’s interests. "This can be accomplished by employing regulatory surcharges (e.g., requiring higher capital or liquidity for large, complex institutions), and by giving a financial regulator the authority to intervene and resolve the problems of large, complex, distressed financial institutions (banks and nonbanks), rather than simply bail them out." wrote Charles W. Calomiris of the American Enterprise Institute in the Wall Street Journal on April 29, 2009, 'Financial Reforms We can All Agree On.' He also recommended that significantly large institutions be required to create their own detailed plans for self-rescue should they become insolvent. NOTES - Eliminate loopholes, bring all financial institutions into the Bank Holding Company Act. - Eliminate OTC derivatives to remove a major source of revenue for big banks. - Use tax laws to tax too-big-to-fail institutions at a higher rate (Zephyr) - In addition to the above, regulatory capture must be addressed in order to actually enforce TBTF regulation. The regulatory agency must be made up of democratically-appointed officers. -Another approach is to have banks themselves draw up their own failure plan: -Raghuram Rajan, Professor of Finance at University of Chicago, speaking at St. Louis Fed: http://faculty.chicagobooth.edu/raghuram.rajan/research/papers/Homer%20J.... -“Consider next regulations aimed at “too-big-to-fail” institutions. Regulations to limit their size and activities will become very onerous when growth is high, thus increasing the incentive to dilute them. -Perhaps, instead, a more cyclically sustainable regulation would be to make these institutions easier to close. What if systemically important financial institutions were required to develop a plan that would enable them to be resolved over a weekend? -Such a “shelf bankruptcy” plan would require banks to track, and document, their exposures much more carefully and in a timely manner, probably through much better use of technology. The plan will need to be stress tested by regulators periodically and supported by enabling legislation – such as one facilitating an orderly transfer of the institution’s swap books to precommitted partners. -Not only will the need to develop a plan give these institutions the incentive to reduce unnecessary complexity and improve management, it will not be much more onerous in the boom, and may indeed force management to think the unthinkable at such times.” -- Summary of proposals by Willem Buiter: * Legally and institutionally, unbundle narrow banking and investment banking (Glass Steagall-on-steroids). * Legally and institutionally prevent all banks (narrow banks and investment banks) from engaging in activities that present manifest potential conflicts of interest. This means no more universal banks and similar financial supermarkets. * Limit the size of all banks by making regulatory capital ratios an increasing function of bank size. * Enforce competition policy aggressively in the banking sector, by breaking up banks if necessary. * Require any remaining systemically important banks to produce a detailed annual bankruptcy contingency plan. * Only permit limited liability for narrow banks/public utility banks. * Create a highly efficient special resolution regime for all systemically important financial institutions. This SRR will permit an omnipotent Conservator/Administrator to financially restructure the failing institutions (by writing down the claims of the unsecured creditors or mandatorily converting them into equity), without interfering materially with new lending, investment and funding operations. Incentives for excessive risk taking take many forms. An obvious one is limited liability. With limited liability, an investor (shareholder) can at most lose the value of his investment. The non-linearity in the pay-off function for the shareholder this creates, encourages placing more risky bets: losses beyond a certain magnitude are not born by the shareholder. Gains of any size are appropriated by the shareholders. The combination of limited liability and leverage means that bets of almost any size can be placed by investors with this distorted, asymmetric payoff function. This can be done through conventional leverage (borrowing) or through leverage embedded in derivative contracts. A simple way to mitigate this problem is not to permit highly leveraged financial institutions (other than tightly regulated narrow banks, insurance companies and pension funds) to be limited liability companies. Instead, partnerships and other forms of unlimited, joint and several liability should be required. Partnerships and similar arrangements were the norm for investment banks until the 1990s. It is worth considering the removal of limited liability protection from highly leveraged financial entities with considerable asset-liability mismatch. This would no doubt also help keep down their size, by any metric of size. [i] Loretta J. Mester, Senior Vice President and Director of Research at the Federal Reserve Bank of Philadelphia, “Some Thoughts on the Evolution of the Banking System and the Process of Financial Intermediation,” Economic Review, First & Second Quarters, 2007, available at:
Debt has turned into the struggle of our time. Debt has turned us into faithful servants to the evil bankers. Not financing the mess that is Wall St and the political process is the only way individuals can cut through the political gridlock -- we can build a grassroots, public platform for reform without tentacles in DC. It's time to break up with your bank, credit card, and debt. There are four too-big-to-fail banks that hold 40% of all of our bank deposits, and the industry's share of profit is 40% of all profits in this country - we can build a movement that creates jobs for Americans, not just profit for a few. 4 big banks, 4 ways to break up, 400 events - Join us in breaking up with them and at events all around the country pushing for the same. Heather Booth of Americans for Financial Reform recounts, "The unemployment numbers are out, and the Labor Department reports that 9.7% of our fellow Americans remain unemployed. Before we get too excited about the drop, we should note 20,000 jobs were lost, leaving 6.3 million out of work for six months or more. Worse, estimates at underemployment are approaching 20%. In a rare moment of Washington synergy, just yesterday two of the people who caused these catastrophic numbers appeared on Capitol Hill before the Banking Committee. If these bankers hadn't gambled with our savings, bought up toxic mortgages, and lobbied like hell for deregulation, 4.7 million people would still be at work. Their greedy and reckless behavior caused this financial crisis that has cost Americans millions of lost jobs, billions in tax-payer funded bailouts and trillions of lost retirement savings." The largest banks have been the debt makers and debt investors - average interest rates for big banks are well above 25% (compared to small banks whose interest rates are around 14%), which goes to endless cycles of debt that people most often can not escape, rather than the economic opportunity they promise. And government has agreed to de-regulations that have supported the growth of large banks to even larger proportions through hidden fees, casino gambling and loan tricks run rampant. The Supreme Court in 1978 and then Congress have allowed banks to skirt the state laws where they were once located for the least consumer-friendly laws in Delaware and South Dakota. This is a case of political leaders with substantial power to create a market friendly to consumers choosing to go with allowing large companies to use their market dominance to increase rates without contest. The PBS special on the "Secret History of Credit Cards" report, "In 1990, the top 10 general-purpose credit card issuers had a 56.5 percent share of the market. In 2004, the top 10 have an estimated 89.5 percent share of the market."
Gary Kalman, U.S. PIRG said, “The [unemployment] numbers... should also serve as a reminder of the practice of big banks to profit from fees from the unemployment benefits that many Americans collect through debit cards. In short, the big banks, like Citi, Wells Fargo, JPMorgan Chase and Bank of America, are raking in tens of millions of dollars on the suffering of millions of unemployed Americans. And many of the unemployed people the banks are profiting from are unemployed because of the economic ruin that followed the financial crisis caused by the banks.” We each have the personal responsibility to re-evaluate what has come to pass. We each have the personal responsibility to see where our debt has come from. We also have a personal responsibility to understand how debt has ruined the country. As people bought more to keep up with rising prices, credit cards and loans financed our lives. But, big banks' credit card rates and tricky loans took more and more from our paycheck and created a culture of ever bigger, ever more credit that no one could keep up with. Instead of fighting for reasonable rates, we borrowed more. Instead of expecting our wages to go up, we borrowed more. And prices continue to go up as more and more use their credit cards.
As MIT economics professor and former IMF chief economist Simon Johnson points out today, the official White House position is that:
(1) The government created the mega-giants, and they are not the product of free market competition
(2) The White House needs to "regulate and oversee them", even though it is clear that the government has no real plans to regulate or oversee the banking behemoths
(3) Giant banks are good for the economy
In response to the latest claims by the government, let me recap the real reason the government doesn't want to break up the too big to fails.
"The following top economists and financial experts believe that the economy cannot recover unless the big, insolvent banks are broken up in an orderly fashion:"
"In the 1980s, during the height of the Latin American debt crisis, the total risk to the nine money-center banks in New York was estimated at more than three times the capital of those banks. The regulators, analysts say, did not force the banks to value those loans at the fire-sale prices of the moment, helping to avert a disaster in the banking system."
In other words, the nine biggest banks were all insolvent in the 1980s.
Indeed, Richard C. Koo - former economist at the Federal Reserve Bank of New York and doctoral fellow with the Fed's Board of Governors, and now chief economist for Nomura - confirmed this fact last year in a speech to the Center for Strategic & International Studies. Specifically, Koo said that -after the Latin American crisis hit in 1982 - the New York Fed concluded that 7 out of 8 money center banks were actually "underwater" and "bankrupt", but that the Fed hid that fact from the American people.
So the government's failure to break up the insolvent giants - even though virtually all independent experts say that is the only way to save the economy, and even though there is no good reasonnot to break them up - is nothing new.
William K. Black's statement that the government's entire strategynow - as in the S&L crisis - is to cover up how bad things are ("the entire strategy is to keep people from getting the facts") makes a lot more sense."
* The greedy and reckless abuses of Wall Street cost jobs and created the worst economic crisis since the Great Depression. According to budget submitted by President Obama to Congress, “household net worth fell from the third quarter of 2007 to the first quarter 2009 by $17.5 trillion or 26.5 percent, which is the equivalent to more than one year's GDP." U.S. workers will lose a total of over $1 trillion in wages and salaries as a result of the present recession and the economy will continue to shed hundreds of thousands of jobs over the next three years under current policy.1 Financial reform will stop the status quo that allowed rampant Wall Street abuses, protect jobs and lead to a stronger, more stable economy that creates new jobs. - AFR * The more confidence consumers have that they are not preyed upon for unscrupulous loans, abusive credit card practices, unconscionable bank fees, and unsound investment practices, the more comfortable they will be spending money and investing in America’s economy. That spending and investment will lead to job growth. - AFR
The Obama administration, in its June? proposal for financial reform, called for singling out dangerously large and inter-connected banks as "Tier 1 Financial Holding Companies". In testimony to Congress July 31, Federal Reserve Chairman Ben Bernanke said about 25 firms would be so-designated, and that "virtually all of those firms" are organized as bank holding companies. (Several, such as the titan Goldman Sachs, only recently became bank holding companies to qualify for special government loans and guarantees.) Gary Stern, president of the Minneapolis Federal Reserve Bank, which has extensively studied the 'TBTF issue, said he was disappointed in the approach taken by Treasury, calling it "status quo plus...The Treasury proposal fails to come to grips with too-big-to-fail and therefore leaves the financial system considerably more vulnerable than it needs to be to future bouts of instability," Stern said in a speech in early August. "There is little reason to think that these steps will, individually or collectively, succeed in reining in too-big-to-fail effectively over time because they do not change the incentives which create the problem. In fact, there is nothing in the Treasury proposal designed to put creditors of large, systemically important financial institutions at risk of loss," he said. On July 27, 
