Too Big To Fail: How to End It?

Harvey Rosenblum has written \”Choosing the Road to Prosperity: Why We Must End Too Big to Fail—Now,\” in the 2011 Annual Report of the Federal Reserve Bank of Dallas. He does a good job of explaining the \”why,\” but–perhaps constrained by his position at the Fed–pretty much whiffs on the question of \”how.\”

Rosenblum points out that \”too big to fail\” is now de facto national policy (footnotes and references to exhibits omitted):  \”In short, the situation in 2008 removed any doubt that several of the largest U.S. banks were too big to fail. At that time, no agency compiled, let alone published, a list of TBTF institutions. Nor did any bank advertise itself to be TBTF. In fact, TBTF did not exist explicitly, in law or policy—and the term itself disguised the fact that commercial banks holding roughly one-third of the assets in the banking system did essentially fail, surviving only with extraordinary government
assistance. Most of the largest financial institutions did not fail in the strictest sense. However, bankruptcies, buyouts and bailouts facilitated by the government nonetheless constitute failure. The U.S. financial institutions that failed outright between 2008 and 2011 numbered more than 400—the most since the 1980s.\”

Moreover, enabling banks with an overdose of toxic assets to stagger forward makes it hard for monetary policy to then use those banks as part of a mechanism for stimulating lending and the macroeconomy: \” Bank capital is an issue of regulatory policy, not monetary policy. But monetary policy cannot be effective when a major portion of the banking system is undercapitalized. The machinery of monetary policy hasn’t worked well in the current recovery. The primary reason: TBTF financial institutions. Many of the biggest banks have sputtered, their balance sheets still clogged with
toxic assets accumulated in the boom years.\”

So far, the policy response to \”too big to fail\” has taken two forms: promising not to do it again, and higher capital requirements. Neither is likely to put an end to \”too big to fail.\” 

The Dodd-Frank legislation promises no more bank bailouts–but why would anyone believe such a vow? 

\”Dodd–Frank says explicitly that American taxpayers won’t again ride to the rescue of troubled financial institutions. … Going into the financial crisis, markets assumed there was government backing for Fannie Mae and Freddie Mac bonds despite a lack of explicit guarantees. When push came to shove, Washington rode to the rescue. Similarly, no specific mandate existed for the extraordinary governmental assistance provided to Bear Stearns, AIG, Citigroup and Bank of America in the midst of the financial crisis. Lehman Brothers didn’t get government help, but many of the big institutions exposed to Lehman did. Words on paper only go so far. …

\”While decrying TBTF, Dodd–Frank lays out conditions for sidestepping the law’s proscriptions on aiding financial institutions. In the future, the ultimate decision won’t rest with the Fed but with the Treasury secretary and, therefore, the president. The shift puts an increasingly political cast on whether to rescue a systemically important financial institution …The credibility of Dodd–Frank’s disavowal of TBTF will remain in question until a big financial institution actually fails and the wreckage is quickly removed so the economy doesn’t slow to a halt. Nothing would do more to change the risky behavior of the industry and its creditors. For all its bluster, Dodd–Frank leaves TBTF entrenched.\”

Higher capital requirements will reduce some of the advantage of giant banks: \”Policymakers can make their most immediate impact by requiring banks to hold additional capital, providing added protection against bad loans and investments. … TBTF banks’ sheer size and their presumed guarantee of government help in time of crisis have provided a significant edge—perhaps a percentage point or more—in the cost of raising funds. Making these institutions hold added capital will level the playing field for all banks, large and small.\”

But higher capital requirements are mainly aimed at reducing the need for bank bailouts, one bank at a time. In a systemic financial crisis, they may well not suffice: \”A nightmare scenario of several big banks requiring attention might still overwhelm even the most far-reaching regulatory scheme. In all likelihood, TBTF could again become TMTF—too many to fail, as happened in 2008.\”

It seems to me that if one is deeply serious about stopping too big to fail, two other policies need to be considered. One possibility would be a policy of \”narrow banking,\” where banks are perhaps limited to commercial banking, investment banking, and wealth management, but are barred from running hedge funds, or being dealers or market makers in financial securities.  I posted about one such proposal along these lines a couple of weeks ago, in \”What Should Banks Be Allowed To Do?\”  Such \”narrow\” banks would take on less risk, and would also be limited to operating in a smaller part of the overall market for financial services

The other possibility is to put a limit on how big banks can grow. Rosenblum writes in a footnote: \”Evidence of economies of scale (that is, reduced average costs associated with increased size) in banking suggests that there are, at best, limited cost reductions beyond the $100 billion asset size threshold. Cost reductions beyond this size cutoff may be more attributable to TBTF subsidies enjoyed by the largest banks, especially after the government interventions and bailouts of 2008 and 2009.\”

Rather than letting TBTF provide an implicit subsidy for greater size, the government could require that when a bank grows to, say, $200 billion in assets, it needs to develop a plan for splitting itself in two, and when a bank approaches $300 billion in assets, it needs to put that plan into effect. For banks, an advantage of such a proposal is that their activities would not need to be restricted, because the failure of even a few such banks wouldn\’t be catastrophic. For perspective, JPMorgan Chase and BankAmerica both had more than $2 trillion in assets in 2011, while Citigroup and Wells Fargo both had well over $1 trillion in assets. Too big to fail, indeed.

What Should Banks Be Allowed To Do?

Charles Morris offers a nice overview of the course of bank regulation in the last century or so in \”What Should Banks Be Allowed To Do?\” It appears in the Fourth Quarter 2011 issue of the Economic Review published by the Federal Reserve Bank of Kansas City.

For me, the article serves two useful purposes. First,  it\’s a reminder of why bank deregulation in the 1980s and 1990s wasn\’t some clever ploy by the financial-sector lobbyists, but was absolutely necessary given the evolution of the industry at that time. To be sure, the deregulation could have been carried out in different ways, posing different risks, but some kind of deregulation was unavoidable. Second, it makes the case for limiting what banks are allowed to so. I\’m completely persuaded that the proposed reform would make the banking sector safer and with less risk of needing a bailout, but I\’m less sure that the reform would make the financial sector as a whole safer. Let me say a bit more about each of these, drawing heavily on Morris\’s exposition.

The banking sector as it emerged from the 1930s had five characteristics salient for the discussion here: 1) it was overseen by bank regulators for safety; 2) it had access to a public safety net of emergency loans from the Fed and deposit insurance; 3) it was forbidden to go into other financial areas like investment banking, securities dealing, or insurance; 4) it faced legal limits on the insurance it could pay on deposits; and 5) it faced geographic restrictions on branching across state lines and within states. In short, it was an industry that was shielded from competition, limited in what it could do, and heavily regulated.

In the 1970s, the wheels began to come off this wagon. Those who wished to save money began to seek out investment options like mutual funds, including money market mutual funds, and insurance companies. Banks were limited in the interest rate they could pay, and inflation was high. Banks began to hemorrage deposits. Those who wished to borrow money found other options, too. They borrowed through commercial paper, through high-yield bonds, and through securitized markets including mortgage-backed securities and asset-backed securities. Separate finance companies made car loans and loans for retail purchases. Other companies financed trade receivables.

In short, both the savers and the borrowers were migrating outside the banking industry. Instead, the process of financial intermediation between savers and borrowers was happening outside the banking industry, in what came to be called the \”shadow banking\” sector.  If the banks had not been deregulated and allowed to compete in this new financial sector–at least in some ways–the banks themselves would have shrunk dramatically and a very large part of the U.S. saving and borrowing would have passed completely outside the purview of the bank regulators.

As banks were allowed to compete across the financial sector more broadly, starting in the 1980s, the industry began to consolidate. This made some sense: when banks were allowed to open branches across states and across state lines, for example, not as many small banks were needed. But the top banks not only became very large, but an ever-growing share of their assets were outside the traditional business of banking. Here\’s how Morris summarizes how the industry evolved (footnote omitted):

\”Technological improvements, interstate banking, and the GLB [Graham-Leach-Bliley] Act resulted in fewer banks and a much more concentrated banking industry, with the largest BHCs [bank holding companies] ultimately engaging in more varied and nontraditional activities. For example, the number of banks fell from about 12,500 in 1990 to about 6,400 in 2011. The share of industry assets held by the 10 largest BHCs rose from about 25 percent in 1990 to about 45 percent in 1997 (just before the GLB Act) and to almost 70 percent in 2011. The share of loans and deposits of the top 10 BHCs
also rose sharply (Table 1). In addition, only four of the 10 largest BHCs that existed before the passage of the GLB Act remain today (Citigroup, JPMorgan Chase, Bank of America, and Wells Fargo), with those four BHCs having acquired five of the other top 10 BHCs.

\”Table 1 also shows how the activities of the 10 largest BHCs have changed in the past 14 years. In 1997, the share of banking assets relative to total assets at these companies was 87 percent, with only one company having a share less than 80 percent. Today, the share of banking assets is 58 percent, with only two BHCs having a share greater than 80 percent.\”

Morris\’s diagnosis and proposed solution are straightforward. Bank holding companies have gotten into too many risky financial activities, and so should be restrained. But Morris is also clearly and sensibly aware that just trying to turn back the clock to 1930s-style regulated banking isn\’t possible. That toothpaste is out of the tube. He suggests that banks be allowed to pursue three areas of business:

  • Commercial banking—deposit taking and lending to individuals and businesses.
  • Investment banking—underwriting securities (stocks and bonds) and providing advisory services.
  • Asset and wealth management—managing assets for individuals and institutions.

 Conversely, Morris argues that banks be barred from three other areas:

  • Dealing and market making—intermediating securities, money market instruments, and over-the-counter derivatives transactions for customers.
  • Brokerage services—brokering for retail and institutional investors, including hedge funds (prime brokerage).
  • Proprietary trading—trading for an organization’s own account and owning hedge and private equity funds.

The key distinction here for Morris is that underwriting securities and providing advice are largely fee-based services. They don\’t involve putting much of a bank\’s capital at risk. Dealing, market-making, hedge funds, and private equity all involve taking risks with capital that are harder both for the institution to understand and for regulators to monitor.

Morris\’s proposal is certainly sensible enough, but it does leave me with a couple of questions. First, if banks were holding lots of mortgage loans, as they clearly could be under Morris\’s proposal, then they would have been vulnerable to a meltdown of housing prices like the one that has occurred. Thus, it\’s not clear to me that anything in this proposal would have limited the very aggressive home lending that occurred or the price meltdown afterward. Indeed, the sort of limited banks Morris advocates might in some ways have been relatively even more exposed to losses in the housing market.

Second, Morris\’s proposal, like all \”narrow bank\” proposals, would clearly make the banking sector safer. But one of the disturbing facts about the financial troubles of 2008 was that it wasn\’t just commercial banks that were deemed to be systemically important to the U.S. economy: it was also investment banks like Bear Stearns, money market funds, insurance companies like AIG, brokers that sell Treasury bonds, and others. Focusing on banking is all very well, but the shadow banking sector and the potential risks that it poses aren\’t going away.

The Rise of Global Banks in Emerging Market: Future of Banking #3

Thorstein Beck has edited an e-book for Vox on \”The Future of Banking.\” It consists of 12 short and highly readable essays by expert economists, based on their academic research. The book is packed full of interesting and relevant analysis. This is the first of three posts on a few of the ideas that jumped out at me. The topics of the three posts are:

1) The dangers of persistently low interest rates
2) The misguidedness of a financial transactions tax
3) The rise of global banks in emerging markets 

My twentieth-century mind is used to thinking of global banking as an industry dominated by banks from high-income countries. That believe is already outdated, and becoming more so. Neeltje van Horen provides some background in \”The changing role of emerging-market banks.\”

Although many in the West are not familiar with emerging-market banks, they are by no means small. In fact, the world’s biggest bank in market value is China’s ICBC. The global top 25 includes eight emerging-market banks. Among these, three other Chinese banks (China Construction Bank, Agricultural Bank of China, and Bank of China), three Brazilian banks (Itaú Unibanco, Banco do Brasil, and Banco Bradesco) and one Russian bank (Sberbank). While excess optimism might have inflated these market values, these banks are large with respect to other measures as well. In terms of assets all these banks are in the top 75 worldwide, with all four Chinese banks in the top 20. Furthermore, in 2010 emerging-market banks as a group accounted for roughly 30% of global profits, a third of global revenues, and half of tier 1 capital.\”

Van Horen gives a number of reasons why growth of emerging market banks will outpace that of banks from advanced economies:

  • \”[L]oan-to-deposit ratios in general are very low due to the net saving position of these countries. This sheltered emerging-market banking systems to a large extent from the collapse of the interbank market and reduced the need for substantial deleveraging. This allows them now to continue lending using a stable and often growing source of deposit funding.\”
  • \”[M]ost emerging-market banks already have high capital ratios, limiting pressures for balance sheet adjustments. In addition, the new capital rules under Basel III are likely to be much less painful for these banks as they typically have less risky assets and their investment-banking business tends to be small.\”
  • \”[A] large part of the population in the emerging world is still unbanked. This provides for ample growth opportunities in these markets. In contrast, due to overall economic weakness and ongoing deleveraging among firms and households expected credit growth in advanced economies is low.\”
  • \”[T]he macroeconomic outlook in these countries is much better than that of advanced countries. Not faced with major sovereign debt problems nor large current-account deficits, most emerging markets are on pretty solid footing. Even though they will not be isolated from the problems in Europe and the United States, the dependency of these markets on the West has diminished in recent years.\”

I believe that if the U.S. economy is to grow at a robust pace over the next decade or two, it needs to figure out how to hook itself to the rapid growth that is occurring in emerging markets around the world. One of my standard examples is that this can happen as emerging markets where the legal and financial institutions can be rather shaky make use of the more developed financial, legal, and managerial structures of the U.S. economy. For example, while emerging market economies invest in safe U.S. assets, like  Treasury bonds, funds flow from the U.S. back these emerging markets looking for private sector investment opportunities. (For example, see my July 13, 2011, post on \”Producing Safe Assets, Searching for Risky Opportunities.\”) But van Horen\’s essay makes me wonder whether emerging markets will actually need the institutional infrastructure of U.S. and European banking and finance for very long, or whether they are moving into position to provide these lucrative industries within their own countries.

Dangers of Low Interest Rates: The Future of Banking #1

Thorstein Beck has edited an e-book for Vox on \”The Future of Banking.\” It consists of 12 short and highly readable essays by expert economists, based on their academic research. The book is packed full of interesting and relevant analysis. This is the first of three posts on a few of the ideas that jumped out at me. The topics of the three posts are:

1) The dangers of persistently low interest rates
2) The misguidedness of a financial transactions tax
3) The rise of global banks in emerging markets 

The Federal Reserve and central banks all around the world dropped interest rates to rock-bottom levels. This step made good sense in the depths of the financial crisis from 2007 into 2009. But now it\’s late 2011, and the policy of super-low interest rates continues on with no end in sight. Such a policy isn\’t risk free.

One issue is raised by Steven Ongena and José-Luis Peydró in their essay: \”Loose monetary policy and excessive credit and liquidity risk-taking by banks.\” 

\”Recent theoretical work has modelled how changes in short-term interest rates may affect credit and liquidity risk-taking by financial intermediaries. Banks may take more risk in their lending when monetary policy is expansive and, especially when afflicted by agency problems, banks’ risk-taking can turn excessive. …

 Our results in Jiménez et al (2011) suggest that, fully accounting for the credit-demand, firm, and bank balance-sheet channels, monetary policy affects the composition of credit supply. A lower monetary-policy rate spurs bank risk-taking. Suggestive of excessive risk-taking are their findings that risk-taking occurs especially at banks with less capital at stake, ie, those afflicted by agency problems, and that credit risk-taking is combined with vigorous liquidity risk-taking (increase in long-term lending to high credit risk borrowers) even when controlling for a long-term interest rate.\”

A similar point is made by the IMF in its Global Financial Stability report last June

Low interest rates in advanced economies are promoting pockets of re-leveraging by lowering the “all-in” cost of debt capital for corporate borrowers. This is encouraging investors to use financial leverage to generate sufficiently attractive returns on equity. Although credit spreads are still higher than before the crisis, ultra-low short-term interest rates mean that the cost of debt is now lower, both for floating-rate and fixed-rate debt. This lower cost of borrowing renders debt servicing ratios more favorable, even at higher debt loads, thereby enabling companies to operate with more financial leverage …

As leveraged loan prices recover (after the deep discounts of 2008–2009) and yields fall, investors are increasingly turning to financial engineering to achieve double-digit returns. Both new and refinanced private equity transactions suggest that related corporate balance sheets are quickly approaching pre-crisis leverage multiples. Though the aggregate amount of financial leverage provided remains far less than before the crisis, high-yield corporate bond and leveraged loan investors have recently been borrowing at higher earnings multiples, not much below 2007 levels.

Notwithstanding recent market jitters, the “search for yield” is also spurring flows into emerging markets, notably corporate debt markets. These inflows, although volatile, are often magnifying already ample domestic liquidity. These conditions, if they continue, risk stretching valuations and raising worries that some countries could be re-leveraging too quickly. Flows into mutual funds for emerging market debt have been strong (behind only high-yield and commodities funds as a percent of total outstanding amounts). Even record amounts of EM corporate bond issuance cannot keep up with demand, and investor due diligence is waning.

Much of the discussion about the ultra-low interest rates seems to be based on an assumption that the only danger is a re-emergence of inflation, and as long as inflation is comfortably around the corner, then the low interest rate policy can persist indefinitely. But if the low-interest rate policy is promoting excessive leverage, tricky financial engineering, and a waning of due diligence in other assets, this set of risks also needs to be taken into account.

I would also add that when central banks use a combination of low interest rates and the \”quantitative easing\” policies where they purchase large quantities of government and private-sector debt, the central bank is setting up a situation where if or when interest rates rise, the central bank will face enormous losses on the low-interest rate financial assets they are now holding. 

The FDIC Changes the Base for Deposit Insurance

I confess that since the federal funds interest rate fell to near-zero in late 2008, I haven\’t paid much attention to it. But Todd Clark and John Lindner of the Cleveland Fed (pp. 5-7) offer a quick overview of some factors that have affected that rate since late 2010. In particular, they discuss a change I  probably should have known about, but had not: apparently, the Federal Deposit Insurance Corporation no longer uses bank deposits as the base for deposit insurance premiums, but now uses the difference between bank assets and bank equity as the base for deposit insurance.

Clark and Lindner write: \”Historically, the federal funds rate has been the primary instrument of monetary policy. Daily federal funds rates since November 2010 fall loosely into a series of three trends, all of which can at least be partially explained by an event that has influenced market participants. In November, the Fed announced the second round of large-scale asset purchases, which consisted of the Fed buying $600 billion in Treasury securities through the end of June 2011. From early November there was a steady decline in the federal funds rate from about 20 basis points to 17 basis points. The purchases increased the supply of reserves in the federal funds market, which pushed down the price, the federal funds rate. Put another way, the increased supply forced cash investors to compete in the market at lower interest rates.\”

\”Similarly, the decision by the Treasury in early February 2011 to wind down its Supplemental Financing
Account balance inserted more reserves into the market for cash investors to place. Combined with the asset purchases, this move accelerated the decline in the federal funds rate. This acceleration was reflected in another 4 basis point decline, from 17 basis points to 13 basis points, over the following two months.\”

\”By far the most studied of the three events, however, has been the change in the FDIC assessment base for deposit insurance. Many observers have argued that this is the move that caused the dramatic
drop in the federal funds rate at the beginning of April, and it has also been credited for holding the
eff ective rate at a fairly constant level of 10 basis points.\”

\”With the new FDIC assessment policy, insured depository institutions will be charged an insurance premium not on their amount of deposits, but on the difference between their total assets and their equity. Broadly speaking, this equates to their liabilities, but there are some subtleties that we are going to skip over. Due to the change in the assessment base, depository institutions are now forced to pay an extra fee for any financed assets, including funds that they might borrow in the federal funds market. Since many of the funds available in the federal funds market are provided by nonbank institutions, the current primary purpose of borrowing these funds is to earn the interest on reserves (IOR) available at the Fed. So, banks are making the diff erence in the two rates (fed funds and IOR) as a profit. The new assessment implicitly increases the cost of the federal funds by adding that assessment rate onto the fed funds rate. As a result, some banks have exited the market, reducing overall demand for the funds dramatically. The fall in demand has reduced the funds rate.\”