Too Big to Fail and Reform

Simon Johnson of Baseline Scenario points to a tough amendment to the not-so-tough Dodd financial-reform bill (so not-so-tough, in fact, that Larry Kudlow calls it “terrific free market reform!”) to ask whether the Volcker Rules live.

Those are the ones the administration (or the president part of it, anyway) pitched to rein in the size of too-big-to-fail banks and to limit the ability of commercial banks to gamble with deposits.

Sen. Sherrod Brown’s amendment would force the breakup of ginormo banks like JPMorgan Chase, Bank of America, Citigroup, and Wells Fargo. Anyone with liabilities (including off-balance-sheet ones) totaling more than 3 percent of GDP would have to break itself up in three years and everyone would have to remain under that limit.

U.S. gross domestic product was $14.2 trillion in 2008 (less in 2009 but no numbers yet). That would put the cap on liabilities at $426 billion. To put that in perspective, between them, Bank of America, JPMorgan Chase, and Citigroup would each have to split themselves into at least five companies. BoA has $2 trillion in liabilities, JPMorgan has $1.9 trillion, while Citigroup has a measly $1.7 trillion.

On its face, this is a dangerous concentration of power. The top six banks have assets totaling 63 percent of GDP, up from 17 percent in fifteen years, as Johnson reported in The New Republic last month. Further (emphasis mine):

The banks have the power to preserve this arrangement. While the U.S. financial system has a long tradition of functioning well with a relatively large number of banks and other intermediaries, in recent years, it has been transformed into a highly concentrated system for key products. The big four have half of the market for mortgages and two-thirds of the market for credit cards. Five banks have over 95 percent of the market for over-the-counter derivatives. Three U.S. banks have over 40 percent of the global market for stock underwriting. This degree of market power brings with it not just antitrust concerns, which this administration has declined to act on, and a huge amount of economic risk—but great political influence as well.

It’s worth noting that antitrust actions, which is not quite what Sherrod’s amendment is—let’s call it an “antibust” action—have benefited markets before (think Ma Bell). But what about the economies of scale, you say. “There are no economies of scale for banks above $100 billion in total assets,” Johnson notes.

Of course, such a tough amendment as Brown’s has about as much chance of passing as I have of getting a $9 million bonus from CJR. For why (on the former!), see Johnson’s incredible Atlantic piece last year on the oligarchy’s “Quiet Coup.” Hey, this is turning into a Simon Johnson Reader.

But there’s a deeper and more disturbing similarity: elite business interests—financiers, in the case of the U.S.—played a central role in creating the crisis, making ever-larger gambles, with the implicit backing of the government, until the inevitable collapse. More alarming, they are now using their influence to prevent precisely the sorts of reforms that are needed, and fast, to pull the economy out of its nosedive. The government seems helpless, or unwilling, to act against them.

In today’s post, Johnson hits on a critical point worth exploring further:

… there’s a big problem with relying on subtle regulators. Over the past thirty years, almost all our regulators and supervisors have become either sleepy or captured – in a cognitive sense – by the very people they are supposed to be watching over.

There’s no doubt about that. And that’s why Johnson recommends firm legislative requirements that force the situation, rather than relying on the wacky idea that some future systemic-risk regulator will really dismantle a Lehman Brothers or AIG because it becomes too big and dangerous.

There are lonely voices in the power structure that seem to understand these things. The Huffington Post reports on Kansas City Fed President Thomas M. Hoenig’s speech today in which he lambasts the too-big-to-fail, too-powerful-to-break-up problem:

When the markets are no longer competitive, firms become a monopoly or an oligopoly and it matters more who you know than what you know. Then, the economy loses its ability to innovate and succeed. When the market perceives an unfair advantage of some over others, the very foundation of the economic system is compromised.

“The protected will act as if they are protected, they will retain their status independent of performance, and the public will suffer.

One of the basic rules of saving and investing is “don’t put all your eggs in one basket.” Here’s what happens when you have most of your eggs in the TBTF basket:

“This framework has failed to serve us well,” he said. “During the recent financial crisis, losses quickly depleted the capital of these large, over-leveraged companies. As expected, these firms were rescued using government funds from the Troubled Asset Relief Program (TARP). The result was an immediate reduction in lending to Main Street, as the financial institutions tried to rebuild their capital. Although these institutions have raised substantial amounts of new capital, much of it has been used to repay the TARP funds instead of supporting new lending.”

Small banks, on the other hand, continued to lend. “In 2009, 45 percent of banks with assets under $1 billion increased their business lending,” Hoenig noted.

Problem is, so many of the small and regional banks have been consolidated and so much of the industry is concentrated at the top that the small fry hardly make a ripple.

Hoenig reiterates Johnson’s point on the oligarchical aspects of the financial industry, though he puts it much nicer.

These large institutions wield considerable influence,” Hoenig said. “Looking back, one sees that the crisis was inevitable, if for no other reason than that these TBTF firms would push the boundaries until there was a crisis.”

Also interesting is that allowing this consolidation has distorted the playing field against the remaining smaller banks. Hoenig (emphasis mine):

“TBTF status provides a direct cost advantage to these firms. Without the fear of loss to creditors, these large firms can use higher leverage, which allows them to fund more assets with lower cost debt instead of more expensive equity. As of year-end, the top 20 banking firms held Tier 1 common equity equal to only 5.1 percent of their assets. In contrast, other banking institutions held 6.7 percent equity.

“If the top 20 firms held the same equity capital levels as other smaller banking institutions, they would require $210 billion in new equity or reduced assets of over $3 trillion, or some combination of both.

This is a basic fairness issue. There are many untold stories here. Find a small bank, compare it to the BofA across the street, and tell us a story. TBTF banks need to justify their existence.

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Ryan Chittum is a former Wall Street Journal reporter, and deputy editor of The Audit, CJR's business section. If you see notable business journalism, give him a heads-up at Follow him on Twitter at @ryanchittum.