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Big Banks, Big Banking Industry
Simon Johnson writes that he's seen a lot of bank crises during his years at the IMF, and eventually problems with the banking sector always roll downhill onto the rest of the economy. Unsurprisingly, the same thing has happened here:
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.
Top investment bankers and government officials like to lay the blame for the current crisis on the lowering of U.S. interest rates after the dotcom bust or, even better — in a “buck stops somewhere else” sort of way — on the flow of savings out of China. Some on the right like to complain about Fannie Mae or Freddie Mac, or even about longer-standing efforts to promote broader homeownership. And, of course, it is axiomatic to everyone that the regulators responsible for “safety and soundness” were fast asleep at the wheel.
But these various policies — lightweight regulation, cheap money, the unwritten Chinese-American economic alliance, the promotion of homeownership — had something in common. Even though some are traditionally associated with Democrats and some with Republicans, they all benefited the financial sector. Policy changes that might have forestalled the crisis but would have limited the financial sector’s profits — such as Brooksley Born’s now-famous attempts to regulate credit-default swaps at the Commodity Futures Trading Commission, in 1998 — were ignored or swept aside.
Johnson's solution is twofold: nationalize the bad banks and then carve them up into a bunch of small banks so they can never harm us again. I have my doubts. Not about nationalization, which I suspect is inevitable, but about the size of individual banks being at the root of our problem. As Johnson himself suggests, banks would have to get pretty damn small — smaller than Lehman Brothers and Bear Stearns were — before their failure could be tolerated, and I'm just not sure we live in a world where that's practical.
After World War II we eventually rejected the Morgenthau plan to deindustrialize Germany, deciding (wisely, I think) that industrialization per se wasn't the cause of the conflict. Likewise, I think crude bank size is a red herring for our current financial collapse. Small banks can become overleveraged just as easily as big ones, hedge funds pay higher salaries than Wall Street behemoths, the interconnectedness of the global financial sector is a bigger cause of systemic worries than size alone, and credit expansions spiral out of control largely due to lack of political will, not because Citigroup is large and clumsy. Those are the things we should be focused on.
Now, Johnson makes the fair point that the kind of systemic regulation I prefer is impossible to put in place because big banks have so much lobbying power that they can prevent it. But again, I don't think it's big banks that produce this kind of power, it's a big banking industry. If we can somehow shrink the overall size and profitability of the industry, their lobbying power will shrink too. And if we limit their leverage, limit systemic credit expansion, and force more sunlight into Wall Street's trading activity, there's a pretty good chance we can do that.
It won't be easy, of course. As Johnson says, the finance industry still has enormous sway in Washington and will fight tooth and nail to keep their toys from being taken away. But hell — if we can't do it now, of all times, then what chance do we have of permanently slashing the size of big banks either? Not much. So since it's going to be a fight either way, why not attack the roots instead of the branches?
POSTSCRIPT: Just in case it's not clear, Johnson's article is terrific reading, well worth a few minutes of your time. I happen to disagree with his technical approach to reducing the size and power of the finance sector, but his description of the problem is top notch.
Plus, of course, he might be right and I might be wrong. So go read it.
Banking and Finance
Is it too much to ask that we stop calling Banking and Finance "Industries"?
Agreed, this is an awesome
Agreed, this is an awesome and sobering article.
Bank Nationalization
Unless things really go downhill from here, at most you could see the "nationalization" and dismemberment of one or two big banks-Citicorp and BofA. For Johnson's remedy to be effective, you would need systemic nationalization in which all of the top 10 or 20 institutions are seized and down-sized. That is not going to happen.
Presumably with a strong regulatory regime reinstated, the banks will conclude on their own that there is just not enough business to go around, and downsize on their own.
If we follow this road we
If we follow this road we risk losing international dominance in the finance industry and the ability to create future massive bubbles in the world economy. If we aren't willing to do the work there are plenty of folks in rural China who will gladly walk the distance to Beijing to try their hand at derivative trading.
BTW, concerning Fargo. I'm afraid to go over there but I expect powerline to start writing about how Obama doesn't care about white people.
For once I agree with you
Leaving aside the bizarro racialist comment about some trivial little city supra...
On your substance:
Small banks can become overleveraged just as easily as big ones, hedge funds pay higher salaries than Wall Street behemoths, the interconnectedness of the global financial sector is a bigger cause of systemic worries than size alone, and credit expansions spiral out of control largely due to lack of political will, not because Citigroup is large and clumsy. :
Yes, and large numbers of small banks with heavy interconnection - over-leverage by whatever standards is not even particularly necessary in this instance, can bring down a system. The 1930s European crisis was touched off by counter-party failures that began with a not particularly huge bank, but interconnectedness of the right kind... even in the 1930s.
My only problem is your continued obsession with Hedge Funds. Hedge Funds are not as important in this as you seem to think and you don't seem to actually understand what they are. To be fair of course lots of entities that were not really Hedge Funds in the classic sense - really just disguised mutual investment schemes - started calling themselves Hedge Funds in the past ten yrs. Your obsession with the Hedge Funds - which have not really been at the root of the banks problems - is obsessing about probably the one problem the market is going to take care of. The Hedge Funds (or pseudo hedge funds) are being crushed, and capital is fleeing them. Insofar as these boys are all Qualified Investors (rich people), the capital losses no doubt should give your readership a little tinge of joy, as they love liquidating the Kulaks.
Fargo
@cannonball
Fargo has been declared a federal disaster area. In some hours of coverage on CNN yesterday I saw not just 12-year-olds (and few of those) but grown men in military fatigues who I assume are in the National Guard. I believe that before the federal government can intervene, the governor and/or mayor has to make a request and I haven't heard of any thing happening in that department. There seems to be an evacuation plan in effect and since Fargo, unlike NO, is well connected to the hinterland there will probably not be the kind of monster traffic tie-ups that occurred in NO.
It wasn't just liberal blogs that focussed on Katrina: maybe the most outrage at the screwup was expressed by Anderson Cooper of CNN; of course you may consider him a liberal (whatever that means --- critical of Bush, I guess) and no liberal blog invented the "heckuva job" quote. Not only that, it was the MSM who pointed out the staged photo-op where GWB promised complete support for recovery and if only "liberals" reported in ensuing years that that was a crock too, well, reality does show a liberal bias.
Personally, I was never more ashamed of my country then in those horrific days; make of that what you will.
But if you want to go off-topic, you should work on you snarkiness --- this one registers about a 4 on a scale of 10.
What about limited liability and leverage.
tagged as:- solution
I know its very alliterative - the three Ls - but I think that is where the real problem lies. Limited liability should mean limited leverage. As I'm sure someone else has pointed out, Merchant Banks were very conservative in their investments when they were partnerships.
Bucks stopped there
"“buck stops somewhere else” sort of way — on the flow of savings out of China." Well can't deny that a whole lot of bucks have stopped (for now) in the People's Bank of China. Certainly more than a Trillion and closer to 2 Trillion (most of their 1.9 T or so in reserves are in dollars but I can't find the share with 2 minutes of googling).
http://en.wikipedia.org/wiki/List_of_countries_by_foreign_exchange_reserves
However, there is no guarantee that the bucks will stop there. If Zhou Xiaochuan isn't bluffing, we will face a second crisis on top of the first (but he's obviously bluffing).
http://tinyurl.com/dn54va
So long as the bucks stay there for a couple more years, I'm happy. Actually, I love the idea that the Chicoms are shoring up world capitalism. It's a dirty rotten job but someone's got to do it.
Close the lemon store
I don't think that learning the right lessons from the current crisis by default means limiting the size of financial players, though that is certainly a possible building block for the regulatory framework that needs to be put in place.
As long as the financial sector is supposed to operate according to market rules, the overriding principles have to be that there can be no institution 'too large to fail' and whoever gladly pockets the profits of a finanacial institution has to be prepared to take its losses, all of them.
No more lemon socialism!
Johnson frames the problem too narrowly
During the boom, it wasn't just the Lords of Finace who were benefiting. The gravy train extended far, far down, to include real estate agents, small-time house flippers, small-time mortgage bankers and mortgage brokers, builders, construction workers, and tradesmen. The bubble meant easy money for tens of millions of people. That's why standing in front of the gravy train yelling "Stop!" would have been a futile exercise. In a long career studying financial crises, I have never seen a case of meaningful pre-emptive regulation. Not one.
The only really large banks
The only really large banks should be Government entities or international entities (that is UN owned/operated).
Yes, I am calling for a reduction of the private banking system! Make the world bank and ACTUAL bank.
What Simon Johnson first
tagged as:- solution
What Simon Johnson first suggests is that basically a bank is a bank, big or small, and sometimes they will fail (to err is human), and that happens more often when the economy goes bad. Surprise? No. Another point is hardly arguable as well. Big banks often develop close ties to governments, just like most big important industries. Finally, he asserts that this might create problems for reforming and reorganizing big banks when they fail, because they will leverage (pun alert!) their influence with government. That is called lobbying and access, and we know that exists, I hope. Why is this influence a particular problem? Because, the lobbying often results in governments failing to act on bank reorganizations and go instead with a government subsidized poorly functioning big bank (a Zombie bank). This is a known process that he carefully documents with examples from other countries. Why is this a problem? For him, a big bank is defined as one that is large enough to have a systemic effect on the economy and a poorly functioning banking system will create a significant drag on the economy. Many economists seem to agree this too. He recognizes that solving this issue might be difficult, but proposes a solution that he knows will probably not win him friends among bankers and the finance elite.
I cannot see any problems with his arguments, and nobody else seems to have any good arguments against it, even if they disagree in passing, such as here. I am not sure that his is the only solution. What if we forced big banks to pay FDIC insurance in proportion to their systemic risk on the economy? It might keep banks from getting too big, but not artificially cap them at some size limit. But again, there are problems for executing on this idea, such as defining that systemic risk, and maintaining the regulatory oversight. Unfortunately, it seems the bigger obstacle is coming to terms with the idea that we do need substantive banking reform.
Leverage & responsibility
Over-leverage through over-securitization has been one of the biggest culprits here and I don't know if Johnson discusses that at all. But it's one big reason why all that paper that got shuffled around existed in the first place.
Securitization meant that loan originators have been able to insulate themselves from bad or dodgy loans, so that all those systemic incentives to originate loans just took over completely and there was no countervailing risk.
I would favor a rule that whoever originates a loan has to keep something like 10% or 20% of it. That would take away some of the incentive to make crap loans that then get traded around. It wouldn't be hard to do since the whole basis of this last episode was the ability to slice these loans apart.
Banks do need regulation for their own damn good, not to mention everybody's collective good. In the 19th century we had a panic every 20 years and they happened mostly because banks were issuing their own paper currency without backing. They regularly got over-extended, there was mass liquidation, and recovery took anywhere from three to eight years.
Bank-like institutions have just done the same damn thing, and our bright boys (bright old men?) in the Treasury and at the Fed and in Congress all sped it along. Now they're busy trying to prevent the liquidations.
Truly, as Cicero said, to be ignorant of what happened before you were born is to be forever a child.
Funny, I was thinking about
Funny, I was thinking about small banks this morning. Showing my age, I actually remember small banks, which were envisioned as sleepy, regulated public utilities: you know, borrow at 3 (%), lend at 4 (%) and on the golf course by 5 (o'clock) or however it went. Well, we blew up the S&Ls in the 70s because their long term portfolios couldn't handle the brave new world of high interest rates; and for the last 20 years we tossed aside Glass-Steagall and the single-state banking model because we were told that the U.S. financial industry couldn't compete with the international banking centers in London, Tokyo, etc. unless we had de facto national banks of our own. Going global might have been the easy way to churn huge amounts of government debt into the financial markets, but today it turns out that the financial services megasupermarket model had a pretty hidden high cost that arguably outweighed the benefits. The revelation that virtually every American financial institution is now either big or too interrelated to fail does provide the political will for comprehensive regulation, in particular to cut down on the insane leverage levels and creating large exposures to derivatives. But regulation is a matter of political will, and who knows what kind of policies will be applied at the SEC after memories of the current crisis fade? It might be good if the ability of a reckless bank to hoover up deposits, FDIC-insured or otherwise, in order to pursue unwise financial schemes was limited to one state where it had brick-and-mortar presence. Smaller banks would lack the clout and enabling ideology to push for relaxation of regulatory standards. Sometimes, small is beautiful and a little inefficiency is a good thing.
It looks to me like Johnson
It looks to me like Johnson means we ought to have no bank that is too big and complex to be nationalized (like the opponents of nationalization keep arguing). So the empirical size limit is no bigger than Indymac (which FDIC was successfully able to manage through the process). This way nationalization remains a viable option as well as a credible threat to management and sharehodlers. I am assuming that also means limits on the complexity of an institution's business model. No City-style consumer bank-investment house-insurance company-gambling casino combos!
Albrecht
Insolvent S & L's were
Insolvent S & L's were seized, their foreclosure portfolio turned over to HUD or RTC, their depositors paid off and then shut down. The auction of foreclosed homes to buyers, who were mostly going to live in them, quickly readjusted home values and the economy recovered in a short time.
Insolvent banks are not being seized, their foreclosure portfolios are not being sold quickly and they remain in operation, mucking up the revaluation of homes through some very odd real estate transactions. Realtors are not being used to move the market to its new equilibrium, but are being squeezed out of the business by the banks and their property managing subcontractors. There is no transparency and many 'auctions' are never listed so that sweetheart deals are being given to insiders. Zombie banks are keeping the economy voodoo for much longer than is necessary.
Wow
What a great article.
Thanks for the link.
Good size and bad size
AIG is a pretty big company but my understanding is that most of it is just fine, doing all the basic stuff insurance companies do. What killed it and is killing us is a relatively small part of the company that went completely off the rails.
How small would AIG have to have been not to have had a Financial Products group?
Small banks
We did quite well in the 50's and 60's with small banks.
While it may be true that small banks can become over leveraged just as easily as large banks, the impact of Bumfuck State Bank going insolvent is way less of an issue than Citibank going belly up.
It is unlikely that every small bank would over leverage at the same time. But when there are only 2 or 3 critical banks, the probability of being stupid is much higher.
Size begets size, Collective Action and Bank Size.
It may well be that a swarm of bees can do as much harm as a behemoth. But on the lobbying point I disagree. Reading of the Wall Street Watch Report on the scale of lobbying www.wallstreetwatch.org suggests there are minimum scale effects to play in that game where you can buy insurance from politicians to use the taxpayer's revenue power to truncate their losses. Shrinking the sector may help, but the Logic of Collective Action (Mancur Olson) suggests that many small banks would have a much harder time coordinating a collective response, than a goliath Financial Services Holding Company. So I disagree with Mr. Drum. Big Banks are a concern over and above the big banking industry.
Also once a firm reaches Too Big to Fail Status the funding costs start to come down reflecting the diminished loss risk associated with the predicted need for state intervention. No single small institution would receive that funding subsidy and catalyst to even greater size. There are differences.
Yeah man, I'm right there
Yeah man, I'm right there with you:
"Top investment bankers and government officials like to lay the blame for the current crisis on the lowering of U.S. interest rates after the dotcom bust or, even better — in a “buck stops somewhere else” sort of way — on the flow of savings out of China. Some on the right like to complain about Fannie Mae or Freddie Mac, or even about longer-standing efforts to promote broader homeownership."
It really should be pinned on them, and not on the dotcom bust, or something similar.
- Julie, Free Credit Report Consultant
Big banks, big trouble
tagged as:- solution
Without retyping the encyclopedia Americana . . .
Big banks were not always this big. Because it was not always this profitable to be that big. After Bush-W took office, all hell broke loose. Bush appointed John Hawk to the administrator of the "O.C.C." Office of Comptroller of Currency (the official Federal regulatory agency). He was on their payroll and shirked his obligation to protect consumers. This was organized on purpose.
The oversight for the O.C.C. was also transferred from the generally pro-consumer House Committee on Energy and Commerce, led by Rep. John Dingles, to the already bought-and-stacked House Financial Services Committee. This event was also NO ACCIDENT and required complicity from the central Republican House leadership.
These big banks managed to become totally immune from state banking laws. Essentially, if one had a federal license, felonies were permitted—and have occurred fairly regularly.
The Federal Courts have also been rendered impudent from decades of Republican appointments. Thus, if you happen to live in a "D" state (with strong consumer protections), the rulings by your state supreme court will likely look nothing in common with court rulings rendered by the Federal Circuit Courts, covering the same topics. Since large banks have their HQs in states where they make the rules anyway, the consumer or small business is forced to either litigate in the bank’s home state (good luck) or in your own state’s Federal Courts. (caught between a rock and another rock).
The banks throw money around with retained law firms and control the playing field. From there, its like taking candy from babies.
I agree that the rules should be modified and instead of the current 10% limit on total branch locations, all banks should be limited to 5% (nationally) and also 5% per state. Moreover, they must be made to comply with both state and federal banking regulations VERY IMPORTANT.
But we the consumers can do this ourselves, without help from Washington.
Here is the best solution I know:
1. Move your account(s) to either a state chartered local bank or credit union.
2. Each of us reading should become a miniature activist network and compose and circulate a group email urging friends, family and associates to do the same—and also to forward the e-mail around.
In Nov. 2008, we all voted at the ballot-boxes and this appears not to have achieved the desired results. Why? Because the giant commercial enterprises vote with their checkbooks. We can collectively trump them with our checkbooks. This can be done. The money you save will certainly be your own. Please explain to your friends that this is not merely an attempt to punish the giant financial institutions. It is a measure designed to protect their own money as well. End it. End it now. Move your money somewhere sane. Bank-it-local. Thank you.
Respectfully submitted~
Absolute leader of the Troll Kingdom
Big Banks, Big Banking Industry
tagged as:- solution
Simon Johnson's article is excellent. I can't agree more with the causes and solutions but I would like to add one thought.
If the banks were required to maintain a high level of capital to back up their products, Credit Default Swaps, dirivatives, securities, insurance, loans or whatever, then would we have this crisis regardless of the bank's size. It appears that the banks leveraged themselves far beyond comprehension.
Citigroup is a great big cluster f***
As a former computer programmer at Citigroup in Dallas, I can't help but believe that their financial and upper management gurus (such as they are) are as incompetent, narrow-minded and self-absorbed as the folks who were running the show in their information technology department.
Merchant Banking
Well I guess there is really no easy answer to all of this
IMF and some banking
IMF and some banking industry is the responsible for the economical downturn, because their whimsical step makes this kind of crises. Well, Johnson's solution is really good enough to avoid the crises.