Prudently Managed Banks Victimized by Taxpayer-Subsidized Too-Big-To-Fail Banks; Seen and Unseen in Dodd-Frank Regulation

Dallas Fed president Richard Fisher blasted too-big-to-fail banks, CEO compensation, bank risk-taking, inadequacies in Dodd–Frank regulation, and unintended consequences of poor legislation in a speech in New York on Monday.

Please consider excerpts from Containing (or Restraining) Systemic Risk: The Need to Not Fail on 'Too Big to Fail'

I confess that in matters of monetary policy and regulation, I am often in the minority. This does not make me the least bit uncomfortable. The majority opinion is not always right; indeed, my experience as an investor has biased me to conclude that more often than not, the consensus view is the wrong view, even among the most erudite.

For example, some of you may recall the public letter written by 364 eminent economists predicting disastrous consequences that would result from Thatcher’s policy initiatives. That letter was published in the Times of London on March 30, 1981. The British economy began a recovery almost immediately afterward.

Most regulatory reform initiatives applied since the Banking Act of 1864 have missed the mark. They looked good on paper and appeared to solve the problems of the day but later proved not up to the task. This is especially true with efforts to solve the “too big to fail” problem, in which an unwillingness to follow through on prior policy commitments to actually close down large failures and impose losses on their uninsured creditors has led to what economists call “time inconsistency” in policy.

While there is much to criticize about Dodd–Frank, I cotton to those blunt statements on ending too big to fail. For, if after the myriad rules and regulations are written and implemented we have not eradicated too big to fail from our financial infrastructure, reform will have failed yet again.

In looking at regulatory reform and implementing Dodd–Frank, I think a key point worth repeating is that the distinction between “commercial banks” and “the shadow banking system” is a false one. The two became intertwined beginning with the bypassing of Glass–Steagall strictures by Sandy Weill and Citicorp and the deregulatory initiative of Gramm–Leach–Bliley. The fact is that the largest commercial banks played a major role in many of the more problematic phenomena of the recent credit boom and ensuing crisis, including the spread of what I have previously referred to as financial STDs, or securitization transmitted diseases.

In the aftermath of the Panic, these viruses linger. Last week, the New York Times printed an interesting article by Joe Nocera, who drew upon the observations of a highly regarded regional banker from Buffalo, Robert Wilmers of M&T Bank. Wilmers claimed that of the $75 billion made by the six largest bank-holding companies last year, $56 billion derived from trading revenues.

Nocera noted that "in 2007, the chief executives of the Too Big to Fail Banks made, on average, $26 million … more than double the compensation of the top nonbank Fortune 500 executives."

These recent numbers buttress Nocera’s reasonable conclusion that bank CEOs “were being compensated in no small part on their trading profits—which gave them every incentive to keep taking those excessive risks.”

I am sympathetic to these concerns. There is no logic to having the public underwrite through deposit insurance or subsidize through protective regulation the risk-taking ventures of large financial institutions and their executives. There is a substantial case to be made for separating the “public utility”―or traditional core function of banking―from the risk-taking function.

To be sure, financial problems are not limited to large institutions and their complex, opaque and conflicted operations. Regional and community institutions that have, for the most part, stuck to the public utility function have faced their own difficulties, especially in the context of construction lending. But while over 300 banks failed during the crisis, another 7,000 did not. Community and regional banks that are not too big to fail appear to have succumbed less to the herdlike mentality and promiscuous financial behavior that affected their megabank peers.

Moreover, when smaller banks got into deep trouble, regulators generally took them over and resolved them. In the treatment of big banks, regulators, for the most part, tiptoed around them. Failing big banks were allowed to lumber on, with government support, despite the extensive damage they wrought. Big banks that gambled and generated unsustainable losses received a huge public benefit: too-big-to-fail support.

Post-crisis, the large institutions are even larger: The top 10 now account for 64 percent of assets, up from 58 percent before the crisis and substantially higher than the 25 percent they accounted for in 1990. In effect, more prudent and better-managed banks have been denied the market share that would have been theirs if mismanaged big banks had been allowed to go out of business. This strikes me as counter to the very essence of competition that is the hallmark of American capitalism: Prudently managed banks are being victimized by publicly subsidized competition from less-prudent institutions.

In solving the crisis at hand during the Panic, it appears that the most imprudent of lenders and investors were protected from the consequences of their decisions; the sinners were rescued and the virtuous penalized. In crafting regulations in response to Dodd–Frank, we need to restore market discipline in banking and let the market mete out its own brand of justice for excessive risk-taking rather than prolong the injustice of too big to fail.

It is not difficult to see where this dynamic, if uncorrected, will lead—to more pronounced financial cycles and recurring crises. I would argue that the failure to reform the banking system in Japan was one of the principal reasons for that country’s “Lost Decade(s).” We must not let that pathology take hold here.

Making Matters Worse

Here, I think it wise to draw upon the insight of the classical liberal Frédéric Bastiat in his take on unintended consequences.

To the extent that a large scale becomes necessary to absorb the regulatory cost associated with reform, Dodd–Frank could intensify the tendency toward bank consolidation, resulting in a more concentrated industry, with the largest institutions predominating even more than in the past. Such an outcome would appear to me contrary to the stated spirit and goal of the act. A more consolidated industry would only magnify the challenge of dealing with systemically important institutions and offsetting their historically elevated too-big-to-fail status.

My concerns over regulation-induced economies of scale and the implications for industry consolidation apply to all the size classes of banks, given the extensive list of new or enhanced requirements created by Dodd–Frank and their associated compliance costs.

The act indicates that all banking organizations with more than $50 billion in assets should be subject to enhanced supervision. Yet, few really believe a $50 billion bank poses a systemic threat to our $17 trillion banking system. Nor is a $50 billion bank qualitatively similar along risk dimensions to the very largest ones that exceed $2 trillion in size. The top 10 banking organizations have a cutoff point of $300 billion. I posit that this group should constitute the primary target for enhanced supervision. Interestingly, despite its large share of industry assets, this group holds only about 20 percent of the small-business loans on bank books. Clearly, these institutions are engaged in substantial activities outside the traditional banking role. It is within these very largest banks, and perhaps a few slightly smaller yet highly complex or interconnected ones, that systemic risk is concentrated.

If the enhanced-supervision requirements are not highly graduated and imposed primarily on the very largest banks, it is not difficult to imagine how the costs associated with such supervision could lead mid-tier banks that exceed the $50 billion threshold—yet fall well short of megabank status—to seek merger partners in order to achieve sufficient scale by which to help cover the cost of regulation. This would compound the problem rather than alleviate it.

However, when it comes to the top 10 or so, I would apply Dodd–Frank extensively and vigorously. I would apply all the elements of heightened supervision—from enhanced standards for capital and liquidity requirements, leverage limits and risk management to the additional measures of living wills and credit-exposure reports, concentration limits, extra public disclosures and short-term debt limits—with full force.

I quoted Bastiat’s criterion for a good economist as one who accounts for “effects that must be foreseen.” Economists did not do a good job of foreseeing the financial crisis. Neither did regulators. Moreover, previous measures directed at containing too big to fail proved ineffective, with no one too surprised that when crisis came, many large-bank counterparties were protected under implicit guarantees.

Let’s hope that going forward, regulators can do better, avoiding both unintended consequences and time inconsistencies. For if they don’t, and they are unable to solve the too-big-to-fail issue in a timely manner, we will ultimately have to take more draconian measures and simply break up the largest banking organizations to eliminate the threat they pose to financial stability and economic growth.

That is my contrarian view, and I’m sticking with it.

Thank you.

Fisher Hits the Bulls-Eye.

It is exceptionally rare for me to endorse a lengthy speech by a Fed governor. However, Fisher hits the bulls-eye on many points.

• Fisher blasted Sandy Weill and Citicorp
• Fisher blasted too-big-to-fail
• Fisher blasted Dodd-Frank
• Fisher blasted CEO pay
• Fisher blasted the "herdlike mentality and promiscuous financial behavior" of large banks
• Fisher blasted the removal of Glass–Steagall
• Fisher cited trading profits and promotion of risk taking
• Fisher cited Frédéric Bastiat on unintended consequences and the seen vs. unseen

What's not to like?

I suspect this is one of the few lengthy speeches by anyone on bank regulation that would have Barry Ritholtz, Calculated Risk, Yves Smith, and myself in major agreement. It would be interesting to see them chime in.

Alas, I suspect Fisher wasted his breath. Bernanke is not behind those ideas, and getting Congress to completely revamp Dodd-Frank would be difficult at best, even with a major push by Bernanke.

Reflections on Another Lost Decade

Fisher said "I would argue that the failure to reform the banking system in Japan was one of the principal reasons for that country’s Lost Decade(s). We must not let that pathology take hold here."

Unfortunately that very pathology has already taken hold.

Greenspan and Bernanke both criticized Japan for not forcing banks to take losses and write down assets. When given the same opportunity, the Fed and ECB opted to kick the can at taxpayer expense while embarking on a misguided QE policy, just as Japan did.

Mike "Mish" Shedlock
http://globaleconomicanalysis.blogspot.com
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