One of the more interesting papers I have read in the past few weeks was the January 16thspeech given by Richard Fisher, President of the Dallas Federal Reserve, in Washington.His remarks complemented his usual clear-headed approach toward the financial crisis of 2008 and banking matters in general. He laid out the risks to the financial sector, and he included a commonsensical proposal for addressing the problem of too-big-to-fail banks (TBTF), which have grown even bigger over the past four and a half years.
Not unlike children with lenient parents, the largest banks have an implicit understanding that government will not allow them to fail. For banks, absent the risk of bankruptcy, the consequences can be dangerously reckless behavior. Dodd-Frank has added complexity to the problem, benefitting lawyers and bureaucrats, but doing little for the safety of our and the world’s financial systems. Dodd-Frank, Mr. Fisher notes, runs to 16 titles and 848 pages. More than 8800 pages of regulations have been proposed, and “the process is not yet done.” He quoted Andrew Haldane, a member of the Financial Policy Committee for the Bank of England, who suggested last summer at Jackson Hole that complying with these rules would require 2,260,631 labor hours each year – or a minimum of $2.250 billion.
Mr. Fisher’s definition of banks too big to fail includes those “…firms whose owners, managers and customers believe themselves to be exempt from the process of bankruptcy and creative destruction.” As he notes, there are 5600 U.S. banks. Of those, twelve with assets between $250 billion and $2.3 trillion control 69% of industry assets. More than half the assets at TBTF banks, according to Mr. Fisher, are supported by uninsured/unsecured liabilities. And the borrowing costs to the TBTF banks are less than their smaller competitors, because lenders are willing to accept lower rates because the knowledge of a taxpayer backstop eliminates the risk of failure. It becomes self-perpetuating.
The problem, according to Mr. Fisher, extends beyond the risk of another government bailout; the nature of the large banks’ multiple business lines – securities trading, real estate, insurance, etc. – has limited their commercial lending operations. (A table Mr. Fisher provided indicates, for example, that J.P. Morgan Chase has 5,183 subsidiaries in 72 countries!) While a lack of business confidence and individual de-leveraging have perhaps played the principal roles in our nation’s feeble economic recovery, the failure of the banking industry to provide loans to small businesses cannot be ignored. Writing in the January 20 issue of the New York Times, Gretchen Morgenson commented on the continuing failure of big banks to lend. Community banks – those with less than $10 billion in assets – control just 12% of the industry’s assets, but hold more than half of all small-business loans. Large banks, without market discipline, have tended to seek riskier, and potentially more profitable, assets in which to invest – where profits would accrue to the bank’s employees and shareholders, while losses would be assumed by the American taxpayer.
Mr. Fisher illustrates his point by noting that when Lehman declared bankruptcy – a bankruptcy that is still not completely resolved – its assets were one quarter those of J.P. Morgan Chase today. He rhetorically asks: “If Lehman Brothers was too big for a private-sector solution while still a going concern, what can we infer about the big five [J.P Morgan Chase, Bank of America, Goldman Sachs, Citigroup and Morgan Stanley]?”
Mr. Fisher’s recommendation is that the big banks ultimately be separated into multiple entities along varying business lines – that they get divided into a more sophisticated version of Glass-Steagall. The first step would be to rollback the federal safety net, so that it applies only to basic, traditional commercial banking. It would “never ever” apply to the customers or lenders of any other affiliated subsidiary of the holding company. He added, “The shadow banking activities of financial institutions must not receive taxpayer support.” But, Mr. Fisher acknowledged that undoing customer inertia and management habits may take years. Regardless, in his opinion, by statute (and enforcement) only the commercial banking operations should have access to deposit insurance and the Federal Reserve’s discount window. To reinforce the statute and its credibility, Mr. Fisher proposes that every customer, creditor and counterparty of every shadow banking affiliate and of the senior holding company be required to agree to and sign a new covenant – “a simple disclosure statement that acknowledges their unprotected status.”
Mr. Fisher stated that “…government intervention may be necessary to accelerate the imposition of effective market discipline.” Entrenched forces, inertia on the part of customers and investors, and lobbyists will likely require some government intervention. But, once accomplished, “…market forces should be relied on as much as practicable.” He concluded his remarks by noting that the Administration and Congress had recently agreed on legislation that affected one percent of the population. “Surely,” he added, “it can process a solution that affects 0.2% of the nation’s banks and is less complex and more effective than Dodd-Frank.”
It is encouraging to hear the president of the Dallas Fed make such a recommendation; most problems require simple, understandable solutions. However, I am not particularly optimistic that simplicity will ever replace complexity in Washington. It is worth recalling that Cyril Northcate Parkinson who created the eponymous law – work expands so as to fill the time for its completion – worked in the British Civil Service. Mr. Parkinson had noted that even as Britain’s empire shrunk, the number of people working in the Colonial Office expanded. Bureaucrats and lawyers in Washington who thrive on complexity would starve under simplicity. Keep in mind, last September the Washington Post reported that seven of the nation’s ten wealthiest counties are in the Washington D.C. metropolitan area. It is cronyism, not common sense that determines much of the legislative and executive processes in the nation’s capital. Reform is possible at the local level, where the correlation of taxing and spending are better understood. It is far more difficult at the national level.
Nevertheless, there may be something to the old adage: “when the going gets tough, the tough get going;” so it is possible that if conditions become dire enough common sense will prevail. As Mr. Fisher noted, if we do nothing and when we next face another financial crisis, (which we will) we will be left with two solutions: bailout or end-of-the-world-as-we-know-it. While neither choice is acceptable, the answer would probably be the lesser of the two evils, bailout – an action that would likely send markets plummeting, taxes soaring and the economy cratering. Richard Fisher is indeed a voice of reason in a cacophony of Washington discordance. Let us hope that Congress and the White House are listening.
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