Fact and Fiction Behind Too Big to Fail
Congress may have removed Glass-Steagall barriers for all engaged in banking, but it sure didn’t create an even playing field. In fact, legislation in 1999 and 2008 suffocated two key financial sectors: investment banking and commercial banking. Comparing two giants from each sector — JPMorgan Chase and Goldman Sachs — shows how.
Humans set the bubble’s growth in motion, and humans need to undo the damage. Isolating the government guarantee from investment bank trading will promote rational regulation and restore both commercial and investment banking to their respective roles. Let the world follow our leadership.
Goldman and JPMorgan: Large Banks. Similarities Stop There
Goldman Sachs and JPMorgan Chase are leading investment banks. Both are engaged in commercial banking and own taxpayer-guaranteed banking subsidiaries. Both are among the top six bank holding companies (BHCs) on the Fed’s Top Fifty BHC list (next link).
Both banks dominate not only balance sheet assets, but also derivatives trading and credit derivatives underwriting. (Click on the next link.)
But comparing them and their histories reveals not only their differences, but also the damage done to both types of banking in the elimination of the barriers between commercial and investment banking. Goldman was once a financially strong, highly respected investment bank, known for its own innovation and execution and for quickly adopting other investment banks’ innovations. The colossal JPMorgan Chase brought with it massive federal backing as the Fed and then Congress allowed it to enter the securities trading arena. How could a privately-held Goldman compete in its own investment banking arena against that government-backed “fortress balance sheet”? Goldman went public in 1999 and set up its own commercial bank in 2004. If JPMorgan Chase could invent credit derivatives, Goldman could do them just as well. Thus began the worst bubble in human history.
JPMorgan Chase was formed by the 2000 merger of two major commercial banks — J.P. Morgan and Chase Manhattan. As Glass-Steagall barriers between commercial and investment banking were eroded beginning in 1987 then entirely removed by the passage of Gramm-Leach-Bliley in 1999, this merger joined a succession of big bank mergers to profit from this cataclysmic policy shift.
In 1987, J.P. Morgan & Co. was a bank holding company, parent of commercial bank Morgan Guaranty Trust. In 1995, First Chicago, parent of the First National Bank of Chicago, merged with NBD, parent of the National Bank of Detroit. In 1998 Ohio-based Bank One acquired First Chicago NBD. Then in 2004, JPMorgan Chase merged with Bank One. One can find hand-wringing research on bank regulators’ websites about increasing concentration of assets in the commercial banking industry, but no regulator stopped the mergers.
In its 10-K (the annual report filed with the SEC), JPMorgan states that it has two FDIC-guaranteed banking subsidiaries, JPMorgan Chase Bank, N.A., and Chase Bank USA, N.A. The former is their commercial banking subsidiary with U.S. branches in 17 states, doing business as Chase. The latter issues their credit cards.
Goldman Sachs didn’t have an FDIC-guaranteed bank until 2004, according to its 10-Ks. It initially chartered Goldman Sachs Bank USA in Utah as an industrial bank. It wasn’t the only investment bank to do so. Morgan Stanley has long had an FDIC-guaranteed bank chartered in Utah, used for its big retail broker/dealer customer base. Goldman Sachs pretty much deals with institutions and the wealthiest individuals.
In 2008, both investment banks were made bank holding companies, regulated by the Federal Reserve. Goldman Sachs Bank USA changed its charter to New York state, and Goldman moved the majority of its derivatives into its taxpayer-guaranteed banking subsidiary. (Click on the next link.) Its derivatives counterparties benefited from Goldman Sachs Bank USA’s government support and even its higher credit rating over time.
How did the derivatives activities compare in size to Goldman’s consolidated income and assets? This next link shows that the banking subsidiary with its FDIC involvement had little of the Goldman Sachs Group income or assets, but large percentages of its derivatives.
Well, why not? As we saw in an earlier post, JPMorgan Chase’s derivatives were always in its taxpayer-guaranteed bank subsidiary. In fact, J.P. Morgan & Co. was where credit derivatives were invented.
The most common type of derivative, the interest rate swap, is a useful tool for commercial bank funding management. But not all of the big banks are allowed to use the taxpayer guarantee to back their derivatives trading. Click on the next link to see the select history of where derivatives have been booked in the biggest banks.
Comparing their number of employees shows a massive difference between these two institutions. JPMorgan Chase’s retail banking branches in 17 states combined with its other business operations and bank branches around the globe employ about 240,000 people. It’s a large number of employees associated with the U.S. taxpayer guarantee. Goldman may have evolved a global footprint with a large percentage of its staff based outside the Americas over the past decade, but its number of employees is vastly smaller — about 34,000, nearly entirely in investment banking. It’s hard to think of Goldman as a David to JPMorgan Chase’s Goliath, but it is definitely smaller.
Since Goldman Sachs has been able to back its derivatives only since the bursting of the bubble in 2008 and not to the degree that JPMorgan Chase enjoys, it must really gall Goldman CEO Lloyd Blankfein every time JPMorgan CEO Jamie Dimon refers to JPMorgan’s balance sheet as a “fortress”. After all of the largest banks were required to accept billions of Federal assistance when the bubble collapsed, Mr. Dimon reminded the public of his opinion many times, implying his institution would never have collapsed. In an interview with Bloomberg LP’s Editor-in-Chief, John Micklethwait, Mr. Dimon opined on the systemic bank issue, among others, stating, “We like our hand.” That’s a hand most CEOs in the private sector would love to have — government backing of their risks. And, as illustrated using regulatory filing data in these posts, it’s really a hand that all the biggest banks enjoy — the backing of a Federal guarantee never intended to act as a floor under investment banking’s trading risks.
Goldman Sachs did a stellar job of adopting credit default swap underwriting. It responded to the entry of huge commercial banks into the investment banking arena by setting up its own FDIC-guaranteed bank. Goldman was forced by the large commercial banks and by Congress to chase the attributes enjoyed now by all. That history reveals the path to the bubble and the key aspects of breaking them up. It is certainly not just about their asset size.
It’s Not Just the Deposits and Cash That Are Affected
An earlier post (Reason #6) described how derivatives have siphoned cash out of commercial banking. In recent years regulatory responses intended to prevent another systemic event have led to liquidity stress — greater difficulty in trading government debt. It is also used as collateral.
“Basel III” is a series of new regulatory requirements agreed to by the world’s central bankers’ central bank (based in Basel, Switzerland). Focusing on liquidity, regulators now want the largest banks to hold a cushion of liquid (very marketable) securities to sell should they have difficulty rolling over their short-term debt during periods of stress. The largest banks rely on short-term debt for a substantial part of their funding.
In an interview in the University of Chicago Magazine’s Spring 2017 issue, Professor Raghuram Rajan states that this is a “fertile area for research”. (UChicagoMag_1705-2017_Spring) Having served both at the IMF and as governor of the Reserve Bank of India from 2013 to 2016, he was heavily involved in global financial policy. He said large amounts of liquidity in financial markets breed complacency. “More liquidity means more leverage. More leverage means more financial fragility. That complacency comes back to hit us in down times, and then the down times take a long time to get out of, because we’re still rebuilding the mechanisms that we shouldn’t have let go of in the good times.” The highly-respected investor Mohamed El-Erian shares that view.
Public Perception — A Roadblock for Other National Issues
The U.S. faces many major issues with big financial implications, but dealing with them has continually stalled in Washington. Income inequality, jobs, and the middle class or “little guy” were hot topics in yet another presidential campaign. And in yet another administration, paralysis is rising again. How can a nation reform healthcare, the tax structure, and entitlements without dealing first with this massive subsidy of the wealthy? Any of these initiatives would have a much better chance of success if tied to removing this huge subsidy.
Millenials will shape the future of democracy. Many work in this sector. I would suggest that breaking up the biggest banks and isolating the taxpayer guarantee from investment bank trading might even be something some within the biggest banks wish for. They are too competitive to ask for it and must rely upon Congress to legislate the change so that they all face the transition at the same time. Derivatives and financial innovation for institutional and sophisticated wealthy users could proceed without being suffocated by public mistrust with its associated Congressional regulatory excess. A contract isn’t the issue. It’s the behavior of the humans behind it.
Ultimately it’s about that government guarantee. As Michael Lewis concludes in his book, The Big Short, market structure is about incentives. Humans are humans. There is greed and various shades of morality among all human groups. The current financial market structure creates huge incentives to take reckless risk knowing that the taxpayer ultimately stands behind the TBTF banks.
We cannot rewrite this history with its lasting impact, but we can better protect the ability of future generations to productively engage in their world’s economy.
Anger isn’t the reason to break them up. It’s economics, democracy, and real capitalism.