THE BEAR'S LAIR Too big to take risks
By Martin Hutchinson
British Chancellor of the Exchequer Alistair Darling has proposed a new banking
regulation regime under which very large "too big to fail" institutions should
be compelled to carry more capital than smaller banks. At first sight, this
looks sensible, but on further examination the change may go in the wrong
direction, having the perverse effect of making the "too big to fail" problem
worse.
The idea that a very large bank is "too big to fail" is a relatively modern one
in the United States, created by the mass bank amalgamation movement of the
1980s and 1990s. The first time I remember hearing it was at the time of the
Continental Illinois collapse in 1984, when the Federal Deposit Insurance
Corporation (FDIC) infused US$4.5 billion to rescue the bank. However, the
precedent was actually set four years earlier, in the 1980 collapse
of First Pennsylvania Bank, which had lost money through an incredibly doozy
policy of buying fixed-rate Treasury bonds and funding the purchase with
short-term deposits - the sharp rise in interest rates in 1979-80 made it
effectively insolvent, even though the accounting of that period did not
require it to admit this.
First Pennsylvania was not allowed to fail, as had previously been the
practice, nor sold to another bank (in those days prior to interstate banking,
only Mellon Bank of Pittsburgh would have been large enough to buy it), but was
granted a $300 million loan from the FDIC and $1.2 billion in other loans
because it was "essential." Since its "essential" quality consisted only in its
size, the "too big to fail" doctrine was born.
Looking back in history, the "too big to fail" doctrine could have had
application earlier. In the United States, the Second Bank of the United States
should probably have been considered "too big to fail" in 1841 - it had after
all been the country's central bank. On the other hand, Jay Cooke & Co
(1873), Knickerbocker Trust (1907) and the Bank of United States (1930) could
not reasonably have been considered "too big to fail" in terms of size,
although Cooke was certainly central to the US financial system.
In Britain, Pole Thornton, which crashed in December 1825, was relatively
small, although its network of correspondent banks was extensive and its
failure brought down many other banks. Gurney, which fell in 1866, was
certainly large enough to apply a "too big to fail" doctrine, but had been
known to be in trouble for five years, so the smart money had got out. Barings
was not considered "too big to fail" either when it was rescued (1890) or when
it wasn't (1995), although on the former occasion it was deemed too good a name
to be allowed to collapse. Finally Northern Rock, which was rescued at enormous
taxpayer expense in 2007-08, was a gimcrack empire that should never have been
allowed to grow so large and whose collapse should have been welcomed.
In Continental Europe, the most important precedent was that of 1931, when
Austria's Creditanstalt, which had more than 50% of Austrian deposits, was
rescued by the Rothschilds and the Austrian National Bank. Fears of the
inflationary effect of the rescue caused a run on the Austrian currency that
spread the panic first to Germany then to Europe as a whole, turning a moderate
recession into the Great Depression. In that case, the policy decision to
consider Creditanstalt too big to fail brought down the entire European
economy, suggesting that "too big to fail" designations are not without risk.
Darling's proposal to make it more difficult for "too big to fail" banks to
require bailing out thus addresses a real problem. However, it seems unlikely
to provide a solution. Increasing the capital base required of large banks will
make them uncompetitive with their smaller brethren on simple, low-risk
businesses, because their capital costs of, for example, additional lending
business will be greater. It will therefore force them into higher-risk
businesses, where smaller banks are less able to compete because of their lack
of specialist staff.
In particular, such a requirement is likely to drive the largest banks towards
businesses whose capital requirements are modest (often because regulations
have not caught up with reality) and whose risks are large. That would include
securitization, through which they will be able to take assets off their
balance sheets altogether, and credit default swaps (CDS), where they will be
able to assume gigantic credit risks while reporting only the modest
"mark-to-market" value of all CDS save those relating to companies near
default.
Public and private equity business will also become relatively more attractive
for such banks because their capital requirements on equity holdings will not
be increased further and their cost of leverage will be extremely competitive.
The Darling proposals would thus turn the largest banks into hedge funds, their
losses guaranteed by the taxpayer. Not a move in the right direction. A tax on
liabilities above a certain absolute level would work better, since it would
encourage the largest banks to divest assets so as to remain below the
threshold, but would also tend to force their operations towards riskier and
more profitable businesses. The regulation of "too big to fail" banks should
restrict them to the less risky portions of the financial services business,
leaving the highest-risk businesses to be carried out by smaller entities whose
failure would not endanger the banking system.
This is not something that can be left to fester. On Friday, it was announced
that Goldman Sachs' profitability and potential bonuses are running ahead of
2007 levels. This cannot be through carrying out low-risk business, nor through
sophisticated advisory work, the market for which has been distinctly
depressed. It can only be through "principal trading" and the like - the
activity that since 1990 has turned Goldman Sachs into the world's largest
insider-trading hedge fund, profiting from its access to corporate
decision-making, its deep knowledge through its trading desk of financial flows
on a day-to-day basis and its superb "crony capitalism" network of contacts to
carve out superior returns at the expense of the market as a whole.
Goldman Sachs, which currently operates under a banking license, is the most
egregious example of the moral hazard that the "too big to fail" doctrine can
cause. Its activities distort markets because it is able to profit as principal
from transactions in which its prestige and standing are deemed essential.
Doubtless a substantial portion of its returns have come from the field of
credit default swaps, in which it was bailed out by taxpayers after the AIG
failure to the tune of $13 billion. In this area in particular, its operations
are almost entirely to the detriment of the US economy as a whole, since it is
able to profit by manipulating markets into creating bankruptcies - the ability
to profit from CDS on AIG while at the same time receiving a taxpayer bailout
of losses on CDS written by AIG was truly egregious.
Hence any effective "too big to fail" regulation needs to cut Goldman Sachs
down to size before taxpayers' pocketbooks are hit with yet another gigantic
loss. The advisory role of traditional investment banking is essential; it is
extremely inefficient to outsource high-level market and securities design
expertise to every borrower and investor that needs it. It is also necessary to
have an underwriting mechanism for new issues, although the London merchant
banks demonstrated that this function could equally well be assumed by
investment institutions, with the bank acting as mere arranger and broker. The
hedge-fund function of a proprietary trading desk is also valuable in
moderation, but should be separated from the advisory and underwriting
functions because of the gigantic conflicts of interest involved. None of these
operations should be guaranteed by taxpayers.
The solution is thus clear. Institutions that benefit from a "too big to fail"
guarantee should be sharply restricted in their operations, becoming modeled on
the pre-1986 UK clearing banks. They would be able to advise, underwrite in
moderation, lend and take deposits, but their activities beyond the
commoditized sectors of financial services would be sharply restricted by
regulations specific to their "too big to fail" position. In turn, they would
have lower funding costs than their competitors because of their low risks and
effective government guarantee, thus being highly competitive in low-risk
product areas.
Principal trading, credit default swap (if legal) securitization and other
high-risk operations would be assumed by institutions whose size was limited by
statute, both in terms of assets and capital. Essentially, most of the
high-risk business would be done by hedge funds, whose size and leverage would
be restricted. That way, the high-risk businesses that had true profit
potential would be done by low-regulation institutions, which would in their
turn have relatively high funding costs (lending of "too big to fail" banks to
such entities would be tightly restricted). By separating the guaranteed
institutions by business line rather than by capital requirements or tax, the
principal functions of a free market would be preserved.
It's government regulation, yes. But propping up "too big to fail" institutions
with taxpayer money is also government intervention, and without wholesale
reform we have lost the possibility of allowing the free market to reign
supreme through providing deposit insurance, over-expanding the money supply,
regulating and guaranteeing home mortgages and bailing out the banking system.
A root and branch reform of the financial system, including a "Volckerization"
of the Fed to prevent it over-expanding credit, would be ideal but is
presumably politically impossible. As a second-best solution, if we must have
"too big to fail" banks, they must be made safe and boring. Taxpayers deserve
no less.
Martin Hutchinson is the author of Great Conservatives (Academica
Press, 2005) - details can be found at www.greatconservatives.com.
(Republished with permission from PrudentBear.com.
Copyright 2005-09 David W Tice & Associates.)
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