The whole history of civilization is strewn with creeds and institutions which were invaluable at first, and deadly afterwards. Journalist Walter Bagehot
Banking reform measures are moving rapidly through the U.S. House and Senate, so much so that bills may be voted on as early as next week. This is one reform effort where even President Obama is engaged from the start with ideas and recommendations. As with health care, the two chambers have different proposals they are looking at, so now is the time for interested citizens to put forth their own views.
The big U.S. banks were the source of the global financial crisis, in part because their bigness and their practices were copied by major banks around the world. What happens in this reform effort is being watched avidly in many countries, because it will say much about how global finance is to be conducted.
What is often missing in these discussions are the assumptions people make about banking and its role in a modern economy. We should begin therefore with some first principles.
Basic Principles of Modern Banking Which Should Guide Bank Reform
Banks are an almost irresistible attraction for that element of our society which seeks unearned money. FBI Director J. Edgar Hoover
1. The fundamental role of banks is to lend money, so that those who are credit worthy and with sound investment proposals may have access to capital not otherwise available through their own resources or through the securities markets. This role is fundamental to the economy because it helps the nation invest its resources wisely, leading to economic growth and job creation.
2. The matching of those who have capital with those who need capital is not banking and it is not lending. It is trading, otherwise known as broking. Those who engage in trading primarily undertake market risk, which is the risk that there will be a price mismatch between the time they have initiated and then completed a match. Brokers are therefore best suited to raising money for clients through securitizations, taking on a temporary pricing risk when they raise money through a bond or equity issuance.
3. Bankers, on the other hand, undertake credit risk, which is the possibility that those to whom they lend will default, failing to repay in part or full the principal and interest they owe on their loans. Managing market risk is an entirely different discipline from managing credit risk; the former requires a sense of market pricing and the potential direction of such prices, while the latter requires a sense of the balance sheet, income, and cash flow strength of a borrower.
4. The management of a trading or broking business, otherwise known as investment banking, requires a modest amount of capital as long as management controls its mismatched positions carefully (positions which are not fully hedged), and controls its own levels of debt (an excessive amount of leverage can destroy an investment bank). Trading and broking require government oversight, but do not require the government to provide lines of credit or other financial support should the firm fail. The government’s role is not only to monitor the safety and soundness of the broking firms, but to protect the public and the markets from unscrupulous brokers.
5. Bankers, on the other hand, cannot possibly post enough capital to match the loans they make, so they need direct access to government capital. This is done through the miracle of fractional reserve banking, in which the bank can make a loan by obtaining the amount directly from the central bank and setting aside a small reserve or none at all at the central bank. Banks also have the privilege of taking in deposits from the general public, and borrowing in the name of the bank from the public, both of which provide liquidity necessary for lending.
6. The privileges accorded to the banking sector, especially the right to borrow money directly from the government and the right to take the public’s money in the form of deposits, are unique, and banking has always been thought of as a special sector of the economy that requires special government oversight to protect the interest of the taxpayers and the public as depositors.
7. It is difficult to do banking properly, to gauge the credit-worthiness of potential borrowers, and to manage the bank’s liquidity so that it can meet cash demands under almost all circumstances. Because of this, banks do fail, and in such an event, the goal of the regulator is to minimize the losses to the government by liquidating bank assets at the best price possible, and to minimize losses to the public by guaranteeing most of the bank’s depositors. The goal of the regulators is not to prevent the bank from failing. If bank management senses it will be rescued under all circumstances, the due care and discipline necessary to manage bank risks properly disappears quickly.
How Banking Went Astray
I hate banks. They do nothing positive for anybody except take care of themselves. They’re first in with their fees and first out when there’s trouble. Chief Justice Earl Warren
These seven principles of modern banking are pertinent to the period from 1913 on, when the U.S. established the Federal Reserve as its central bank. At that time, banks were allowed to engage in both banking and broking, which seemed workable in the 1920s when times were booming, but the mingling of the two disciplines was found to be a serious problem when investigations in the 1930s revealed the banking industry to be rife with double-dealing and fraud. The primary characteristic of the Depression was the lack of money ”“ ”œno one has any money” was a common complaint ”“ which was not surprising considering over half the banks in the country failed, wiping out the savings of millions of Americans. To remedy this Congress established deposit insurance, paid for out of a fund levied on bank profits. Congress also set a very strict dividing line between commercial banks, with access to Federal Reserve loans, and investment banks without such access and which were restricted to the trading and broking business.
Unarguably, this system worked well for nearly half a century until it began to break down in the 1970s. Investment banks began encroaching on commercial bank territory by taking on consumer deposits without any FDIC insurance. Large commercial banks began underwriting bond and stock issues for their customers. Both industries devised ways to move much of this activity off the balance sheet and out of the eyes of their regulators, their shareholders, or the general public. A new class of instruments arose called derivatives, which proved relatively useful and safe when confined to easily priced and liquid instruments like foreign exchange and short term loans, but which turned cancerous when applied to the securitization of long term mortgage loans. By 2000, among the big commercial and investment banks the concept of credit risk, as understood by the precept ”œknow thy customer” had become old-fashioned. These institutions did not know their customer. They felt they didn’t need to in large transactions because the risk was immediately being securitized away to someone else (even though it was very clear these investors had far less of a chance of understanding the credit risk they were being sold). When it came to the millions of home equity, credit card, and auto loan customers, credit risk was done in the aggregate through models and credit scores. The only place traditional credit risk was being done in the U.S. was at the smaller community banks.
We cannot talk about this period, and we cannot intelligently talk about reform of the banking industry, without discussing two critical financial sectors which arose in the 1970s and were dominant players by 1990: the hedge fund industry, and the private equity, or leveraged buyout industry. Hedge funds are private pools of capital that to this day are completely unregulated, and that promise investors better returns than might be available from traditional mutual funds. Supposedly, they do this by both buying the market and sometimes being short the market (mutual funds are only long the market), but the truth is they can only generate large returns by taking on large risk through leverage. They may borrow two to three times the amount of assets they have in order to juice up their returns, and they are therefore intricately involved with the banking industry and its push for larger and larger amounts of credit being devoted to this industry. This in turn led to the banks placing this additional credit off balance sheet.
The theory behind the leveraged buyout industry is that by taking poorly managed companies private, the industry can clean up these companies, install new management if necessary, reduce expenses, and bring them back to the public markets in a healthier form. The truth behind this industry is that it long ago ran out of truly badly run companies in need of their services, so the industry seeks out any company with assets that can liquidated, connives with management to buy the company from its shareholders, loads the company up with debt, takes out hundreds of millions of dollars of ”œfees” for itself, fires 25% or more of the staff, transfers production to China or other cheap manufacturing sites, and then makes millions of dollars more by bringing the company back to the public markets and selling shares to naÃ¯ve investors. Few of these companies ever perform well in the long term once they go through this process, and many have not survived this recession. The private equity business is a predatory business that destroys manufacturing capital and enriches only the pockets of private equity companies. This too is an unregulated and secretive industry with heavy reliance on the banks for the loans to undertake their buyouts.
By the time Ben Bernanke was facing the financial crisis of 2007 ”“ 2008, the major banks in the U.S. were incapable of being described as commercial or investment banks ”“ they were both, with little emphasis anymore on standard credit risk analysis. Their predominant corporate customers were hedge funds and private equity funds; companies like Apple or Microsoft didn’t need to borrow from the banks and used them only for some services. The four largest banks held nearly half of all residential mortgages, and two-thirds of all home equity lines of credit, auto loans, and credit card loans. These banks were the largest campaign contributors to Congress and to presidential candidates. They employed an army of lobbyists to influence any legislation affecting them, often doing so out of the public eye. The five largest investment banks were almost entirely devoted to the hedge fund and private equity industries, with Goldman Sachs indistinguishable in its practices from a hedge fund itself.
What Ben Bernanke did with his rescue efforts, in collaboration with Henry Paulson at the Treasury and later Timothy Geithner, was to make this situation worse. Other than Lehman Bros, no firms in the crisis were allowed to fail, meaning that concentration of assets among the survivors grew even more severe. Some of these banks, like JP Morgan Chase and Goldman Sachs, now have near monopolies on certain products, and all of them treat retail customers like nuisances. Credit to all sectors of the economy has been cut severely by these surviving institutions. The investment banking industry proper has disappeared, now that the two remaining firms of Goldman Sachs and Morgan Stanley have been given banking franchises, but neither of these firms is acting like a bank or shows any intention to do so. Over a trillion dollars of bad mortgage assets have been transferred from these banks to the Federal Reserve, which now says it will take twenty years for the Fed to dispose of these securities. The Fed has been loath to reveal the details of these holdings and no one in Congress is pressuring the central bank to force the banks, now rife with profits, to takes these securities back on their own balance sheets and off the backs of the taxpayers.
Every proposal before the House or the Senate, or emanating from the White House, is a repudiation of Ben Bernanke and the work of his collaborators at Treasury. The proposals include dismantling the big banks, forcing credit default swaps and similar derivatives on to exchanges, capping the percentage of national financial assets any bank may own, and shutting down leverage. These are good ideas for a start, but we need much more.
The Culture of Greed and Easy Money
Bank failures are caused by depositors who don’t deposit enough money to cover losses due to mismanagement. Vice President Dan Quayle
Apropos of the Mr. Quayle’s comment, the policy solution of the Fed and the administration to this crisis has been simple: throw money at the banks in a frantic attempt to recapitalize them for their losses. Theoretically, this will prevent horribly painful consequences for the economy if any of them should fail, and whether or not that is true, no one disagrees that merely being in this situation of fearing a bank failure is disgraceful. No one bank or group of banks should ever be able to hold the nation hostage like this, though it is not clear that Ben Bernanke appreciates this point. He still is keeping interest rates at zero percentage, which is nothing more than a forced transfer of wealth from savers to mismanaged banks, because only the banks can borrow at zero percentage, and they certainly aren’t lending for less than 5% if they are lending at all.
The very first lesson we should learn from this crisis, which we thought this nation learned in the 1930s, is never again. Never again should any bank be too big to fail. There is a workable process in place for handling bankrupt banks, and it is conducted by the FDIC. We need to find a way to make this process work for the very largest banks.
The second lesson we should learn from this crisis is that we should not as a nation have to learn these lessons over and over again every 80 years. Something has to be done to make the legislative changes this time stick.
The third major lesson relates to the use of debt. We need to move away from debt as a product, to debt as a discipline. The big banks took on Madison Avenue marketing techniques to push debt on to anyone who breathed, and right in front of them were our legislators who took on obscene amounts of national debt without a qualm. This debt orgy has now come to a halt and a vicious cycle of debt repudiation and repayment has set in. While this cycle plays out, it would help if our banking industry and political leadership started talking about debt as a discipline. Right now we are moving into a period where the sentiment is growing that defaulting on one’s debt is no more or less than the creditors deserve. This is an understandable sentiment, especially for consumers who were tricked into debt, but it is not a sentiment that leads to long term economic growth. Until this nation gets serious about debt as a discipline, an economic recovery will elude us.
Fourth, our political and economic elites failed this country grievously. Our elites were consumed by greed and easy money, and while they encouraged the middle class consumer to live beyond their means through debt, the elite 2% of the population took home the lion’s share of the nation’s income. So pervasive has greed been, that we accept as natural the $500 million bonus of a private equity king, the perversion of Christianity that is taught as the ”œprosperity gospel” by evangelical ministers, the easy use of free jet travel from corporations that is lavished on Congressmen, the journalists who get rich becoming celebrities while abandoning their journalistic independence and responsibilities, the $50 million payouts given to CEOs who have failed at their jobs, the mega-million pay packages given to hucksters like Glenn Beck and Rush Limbaugh or mediocre baseball athletes, the fluidity with which the sons and daughters of the wealthy move into coveted slots at universities and cushy jobs in their father’s industry despite their manifest disqualifications for the work, the revolving door open to Congressmen and their staffers and various admirals and generals into consulting and board gigs that pay hundreds of thousands of dollars on top of the generous pensions these ”œpublic servants” receive, the speaking fees and book contracts that turn celebrity politicians like Bill Clinton and Sarah Palin into multi-millionaires, and so on and so on. Those who should be leading this country, and contributing to its development, have spent the past 25 years joining the parade of looters and predators who have found ways to extract wealth from the middle class and the poor in this country.
Lubricating all of this has been easy money, and more recently for the banks, free money. The easy money policies of Alan Greenspan and now Ben Bernanke, both of whom believe the only way to a sound economy is to load up the consumer with ever-increasing amounts of debt, have marched hand-in-hand with a philosophy of greed and self-interest that would have made Ayn Rand proud. Indeed, what better characterizes the economy of the past quarter century than the musings of Rand’s fictional hero John Galt, who felt government was in almost all circumstances evil and a hindrance to economic growth, who disdained the ”œweakness” of altruism, and who considered it proper and natural that men of his talent be able to take whatever they want from society.
For nearly all this period we have had a personal acolyte of Ayn Rand as the head of the Federal Reserve. Alan Greenspan during his tenure never met a mega-merger among banks that he didn’t approve. He responded to every bank crisis with a bail out. He ignored the predatory lending practices of the banks and ignored the warnings of Board governors closest to him who were concerned about fraud in the housing market. Bubbles in the dot.com boom and the housing boom were blandly dismissed. He saw no problems with the mountains of debt that were being piled on to consumers and corporations because asset values were rising as well. Instead of demanding that banks enhance their credit standards, he allowed banks to rely on the compromised ratings of Moody’s and Standard & Poor’s. The growing disparity of wealth between the powerful 2% of this country and everybody else was not his problem.
This is the last important lesson of the banking crisis. You cannot prevent future problems if you do nothing to reform the Federal Reserve, and if you do not dismantle the culture of greed that is the modus operandi of the powerful and the connected. The sense of exceptionalism and entitlement is so strong among the elite that eliminating this culture will be very difficult. We see even now that the chairman of Goldman Sachs insists with all sincerity that he is doing the Lord’s work and America will be hurt if anyone dares to meddle with his business’s right to print money.
Let’s Start with the Banks
The country is governed for the richest, for the corporations, the bankers, the land speculators, and for the exploiters of labor. Author Helen Keller
The task of reforming the banks is simple to describe, though it may be monumental to put in place.
A bank license should be extended only to those financial institutions that are in the business of lending, not the business of broking or securities underwriting. Goldman Sachs and Morgan Stanley should be obliged to return their banking licenses and access to the Federal Reserve, and revert to investment banking status.
A bank should not be allowed to engage in broking or securities underwriting This constitutes a reinstatement of the Glass-Steagall provisions from the 1930s. Practically, it means that JP Morgan Chase, Citigroup, Bank of America, and Wells Fargo will need to divest themselves of their private equity, hedge fund, mutual fund, asset management, and related businesses. They will have to shut down their SIVs and similar off-balance-sheet asset backed securitization businesses.
A bank may conduct trading only in the service of its clients, not as a stand-alone speculative venture or for the purpose of structuring complex deals. Goldman Sachs and others would have us believe that it is impossible to distinguish one trading desk from another, and that we therefore cannot put limits on trading. This is nonsense. Everybody in the business knows what a trader does. A trader spends the day actively making two-way, bid/offer prices to other professionals in the market. As a market maker, a trader provides important liquidity, and is allowed to maintain inventory that needs to be managed for market risk purposes. This will naturally lead to trading profits and losses, but not of the magnitude we are now seeing, because other forms of trading, like structured finance, private equity investing, etc., none of which involves active bid/offer price making, will be disallowed.
No bank should be too big to fail. What this means in practice is that if a bank gets into trouble, the normal process by which the FDIC liquidates the institution and protects depositors should be allowed to proceed unimpeded. Rescue packages by the Treasury or the Federal Reserve must be disallowed. Congress is going through various definitions of what constitutes too big to fail, such as a certain percentage of the nation’s loans or deposits. I suggest this definition be set annually by the FDIC, and be defined as that point where the simultaneous failure of the three largest banks in the U.S. would deplete the FDIC reserves. It is necessary to capture at least the three largest failures in this exercise in order to incorporate the systemic risk that now pervades the system (if Citigroup fails Bank of America is likely to fail, e.g.). The FDIC by the way is garnering useful information in its current bank closure program that will allow it to properly model the costs of closing a large bank. For example, we know now that the FDIC is selling assets of closed banks for about 50% of their carrying value at the time the bank failed. This would be a useful assumption when closing down a large bank.
We also know that the FDIC is almost out of reserves already and cannot cope with the failure of a large bank. Therefore the practical effect of this measure is to force JP Morgan Chase, Citigroup, Bank of America, Wells Fargo, and perhaps some large regional banks to shed some of their consumer loans and deposits. These banks may argue that some businesses, like credit card issuance, need economies of scale that only a big bank can afford. This may require that the bank sell its proprietary technology to the buyer of its credit card portfolios in order to comply with the law.
All derivatives need to be traded on registered exchanges, with daily publication of marks and transparency of open interest. This rule will apply to futures, swaps, options, and related products like collateralized debt obligations, whether traded by a bank, investment bank, hedge fund, or any other organization. The registered exchange need not be governed in the U.S. by the CFTC (the banks have some experience in managing and owning exchanges safely and soundly), but it must have the transparency and safeguards such as daily collateralization of open positions that constitute best practices among exchanges.
To be truly independent, the risk management function in financial institutions must report to the board of directors. Ideally, the CEO and chairman of the board function in a bank will be split in the future, so that risk management can report to the chairman as an outside party not involved in the day-to-day management of the company.
Hedge funds and private equity businesses must be regulated by the government. The regulator must have the authority to impose capital constraints on these businesses, require much more public reporting of their activities, cap the amount of leverage that may be used, and outlaw predatory practices such as have occurred recently when company pension plans are raided to pay private equity a ”œdividend.”
The Federal Reserve regulatory function should be abolished. The Federal Reserve should concentrate on monetary policy and economic research. It has shown itself far too susceptible to regulatory capture and it has seriously encroached on the Constitutional prerogative of Congress to raise revenues and issue debt. Shorn of its regulatory duties, the Fed will find itself able to concentrate on the economy as a whole, and not on protecting the banks at all costs.
In its place, a regulator like the Comptroller of the Currency should be given responsibility for bank oversight, and the Securities and Exchange Commission responsibility for oversight of brokers, investment banks, exchanges, mutual funds, hedge funds, and private equity funds. There may be room in this construct to keep the Commodities Futures Trading Commission, but its role could well be done by the SEC. The problem with this proposal is that both the OCC and the SEC have been suborned by the firms they are supposed to regulate, so there will have to be a thorough house cleaning and restaffing of these organizations for this idea to work.
Unfortunately we cannot get rid of Ben Bernanke now that he has been reconfirmed in his job, though sufficient public pressure might compel him to resign. Still, President Obama has the chance to appoint several replacement board members at the Fed and should use that opportunity to position people who will help the Fed find a completely new direction.
The revolving door between government and financial companies must be constrained. I propose that no employee of a financial company may work for a financial regulator unless they have been out of the industry for at least 7 years. Similarly, no government employee may work for a financial company unless they have been out of the government for at least 7 years. The argument that such individuals may lose their expertise over such a long period of time has merit, but the goal of the proposal is to force the government to build up its own expertise through career hires, rather than seeding the regulatory agencies with people whose interest may be more with the industry they just left.
No financial company may lobby the Congress. Yes, this violates the recent trend set by the Supreme Court to invest corporations with personhood and allow them unfettered ability to bribe Congress or influence public opinion. And yes, it would be desirable to forbid lobbying by any corporation. But we have to start somewhere, and there is no doubt that a Congress that is beholden to the financial industry for the bulk of its campaign contributions is a Congress that is not simply useless, but detrimental to the public interest. If we do not reform campaign laws in a major way, we will once again repeat this experience after a generation or two has forgotten the lessons. Indeed, it won’t take 80 years to go through this again; it is clear Congress, the regulators, and the banking industry had already forgotten the lessons from the Enron and Worldcom collapses.
It is also clear that the proposals before the Congress now are nowhere as comprehensive as these here, nor do they represent an overarching understanding as to what banking should look like in the future. We are at risk of enacting half-hearted measures that will be easily circumvented by high-paid lawyers and avaricious bank executives. While the mood among Congress and the public is propitious for bank reform, the wrong sort of reform risks setting us all up for another even worse version of the financial crisis we just went through.