Fact and Fiction Behind Too Big to Fail
Commercial banking and investment banking are fundamentally different businesses. Each may stand between those who have money to spare and those who need to borrow it, but their risks, time horizons, and compensation practices differ widely.
As Glass-Steagall barriers between the two were dissolved beginning in 1987, the largest banks took higher risks, backed by the government. Financial engineering soared.
Congress’s original intention in establishing the Federal Deposit Insurance Corporation (FDIC) in 1934 was to protect lending, deposits and the payments system. These functions are essential to the economy. The FDIC instilled trust by insuring commercial bank deposits. In separating commercial from investment banking through the Glass-Steagall Act in 1933 followed by the FDIC’s government guarantee, Congress clearly did not intend to backstop investment banking’s trading risks.
Getting Congress to force separation once again may be politically challenging, even in an era of supposedly courting the middle class. But it is the only way to substantially minimize the need for future taxpayer bailouts of large banks. Separation would also promote more focused and effective regulation rather than Dodd-Frank’s snow storm.
Investment banking involves a Superbowl of risk. No team goes to the Superbowl without a strong defense. It shouldn’t be the U.S. taxpayer.
10 Reasons to Break Them Up
This post will summarize ten compelling reasons why the TBTF systemic banks need to be broken up. None argue pure size. Each reason is explained in linked posts. Click on the Reason # to link to the full argument for each.
Like most others, this “10 Reasons” list starts with Number 10. The series is bracketed by posts on history and on money in politics that creates such strong headwinds against change.
A Man-Made History: Glass-Steagall barriers between commercial and investment banking weren’t removed in one Congressional legislative act in 1999. They were dissolved by the Federal Reserve beginning in 1987.
Reason #10: Dodd-Frank defines “systemic” as $50 billion or more in balance sheet assets. The largest are in a category of their own. The biggest banks are not only much larger than the next largest banks on the Fed’s Top Fifty Bank Holding Company list, but are also heavily involved in derivatives trading.
Reason #9: Only the largest banks packaged and traded residential mortgage securitizations. In trading these new financially-engineered securities and also derivatives, they created a superhighway of risks and collected the tolls.
Reason #8: The biggest banks are the only ones underwriting credit default swaps. These “derivative” products are actually insurance contracts, but haven’t been managed like insurance. Instead they link the biggest banks together in chains. If one goes down, they all do as we saw in 2008.
Reason #7: “Ring-fencing” may be a useful regulatory tool, but it is ineffective in containing systemic risk despite Congressional promises in passing Dodd-Frank. In a systemic event, you can’t fence in trust or fence out fear.
Reason #6: Derivatives trading moves capital out of lending and therefore out of the heart of the economy. Isolating derivatives trading from the taxpayer guarantee will prevent taxpayers from subsidizing derivatives’ harmful impact on lending.
Reason #5: Derivatives’ underlying legal documents and collateral practices (their “Master Agreements”) tie the biggest banks together in new ways. Congress’s Financial Crisis Inquiry Commission heard this fact, but ignored it in passing Dodd-Frank.
Reason #4: The biggest banks use the taxpayer-backed FDIC guarantee to reduce their regulatory capital requirements. Most now book the bulk if not all of their derivatives in their FDIC-insured commercial bank subsidiary. However, some don’t or can’t, creating an uneven playing field.
Reason #3: The U.S. Bankruptcy Code was changed in 2005 to favor derivatives over loans, to the detriment of the FDIC and the taxpayer.
Reason #2: Dodd-Frank’s “Resolution Authority” was a joke on the public. No wonder the biggest bank CEOs favored it. Rather than reducing the risk of a systemic event, it just strengthens the government’s ability to take over failing banks — after they begin to collapse.
Reason #1: Allowing the biggest commercial banks to become investment banks basically blew up investment banking. The best of the U.S.’s investment banks once were highly respected and led the world in financial innovation and execution. Comparing industry leaders JPMorgan Chase and Goldman Sachs shows where JPMorgan Chase got its “fortress balance sheet” and how Goldman Sachs tried to remain competitive, forced to move into commercial banking.
Headwinds — Money in Politics: Candidates from both parties for federal office enjoy the financial sector’s largesse. Using Federal Election
Commission data, the Center for Responsive Politics/Open Secrets amply illustrates how Wall Street buys off elected officials.
How to Get There
The history of unwinding Glass-Steagall isn’t widely understood, but the resulting bubble and its collapse won’t easily be forgotten. Naming it “the Great Recession” can’t minimize its impact. We need the barriers again, within a more modern framework.
Congress must pass simpler legislation that restricts the FDIC program to institutions that engage solely in commercial banking. Commercial banks should be no larger than $500 billion in balance sheet assets, inflation-adjusted over time. They shouldn’t be allowed to associate with securities trading within any type of corporation, with some exceptions for directly-issued treasury securities.
Congress should specify a date by which boards of directors of the largest systemic banks will complete their break up in a way that meets this goal, by means that the boards choose. Commercial banks should be able to retain derivatives for hedging and funding purposes, but not trading.
Isolation allows much more efficient regulation. For Congressmen who claim that we have too much regulation and even too much capital cushion in the banking system, this is their chance. They can pursue greater regulatory efficiency and show that they really want to minimize risks of future taxpayer bailouts. It allows clarification of the role of the Fed for those who think it is too powerful. The SEC revealed how weak it had become during the building of the bubble as the Fed overpowered the SEC’s authority. The SEC can return to overseeing fair and transparent financial markets populated by firms engaging in good governance.
The sophisticated players who use financially-engineered products will be forced to evaluate the ability of investment banks to fulfill their products’ promises without the taxpayer guarantee and its associated regulatory protections.
The very controversial Volcker Rule can be revisited within the logic of transparency, trading and fair markets rather than within an argument haunted by that taxpayer guarantee and the nation’s commercial lending system.
Confidence in government can improve as elected officials show that they aren’t just bought off by the industry on one hand while on the other they complain about over-regulation, lament income inequality, or make promises of more government entitlements that they couldn’t deliver in reality.
Most importantly, the nation faces huge issues. Republican leaders in control of Congress have set ambitious goals for tax overhaul. Entitlement reform is essential, but has its own political third rail. Taking the bold, but logical step by removing the taxpayer guarantee from investment banking’s trading platforms provides a visible, substantial measure to show the electorate that big change isn’t just about rewarding the wealthy and powerful. It is also part of putting us on the path to a sustainable future for democracy, ourselves, and our children.