Truth from the Top

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by Simon Johnson

WASHINGTON, DC – It is unusual for a senior government official to produce a short, clear analytical paper. It is even rarer when the official’s argument both cuts to the core of the issue and amounts to a devastating critique of the existing order.

Hoenig, former President of the Federal Reserve Bank of Kansas City, has spent his career working on issues related to financial regulation. He communicates effectively to a broad audience – and understanding the technicalities of finance is not needed to grasp his main points.

One of those points is that the world’s largest financial firms have equity that is worth only about 4% of their total assets. As shareholders’ equity is the only real buffer against losses in these corporations, this means that a 4% decline in their assets’ value would completely wipe out their shareholders – taking the companies to the brink of insolvency.

In other words, this is a fragile system. Worse, the current regulatory treatment of derivatives and of funding for large complex financial institutions – the global megabanks – exacerbates this fragility. Perhaps we are moving in the right direction – that is, toward greater stability – but Hoenig is skeptical about the pace of progress.

As he points out, the relevant studies show that the megabanks receive large implicit government subsidies, and this encourages them to stay big – and to take on a lot of risk. In principle, such subsidies are supposed to be phased out through measures being taken as a result of the 2010 Dodd-Frank financial-reform legislation. In practice, these subsidies – and the politics that makes them possible – are firmly entrenched.

The facts may startle you. In 1984, the US had a relatively stable financial system in which small, medium, and – in that day – what were considered large banks had roughly equal shares in US financial assets. (See Hoenig’s chart for precise definitions.) Since the mid-1980’s, big banks’ share in credit allocation has increased dramatically – and what it means to be “big” has changed, so that the largest banks are much bigger relative to the size of the economy (measured, for example, by annual GDP). As Hoenig says, “If even one of the largest five banks were to fail, it would devastate markets and the economy.”

The Dodd-Frank legislation specifies that all banks – of any size – should be able to go bankrupt without causing massive disruption. If the authorities – specifically the Federal Reserve and the FDIC – determine that this is not possible, they have the legal power to force the banks to change how they operate, including by reducing their scale and scope.

But the current reality is that no megabank could go bankrupt without causing another “Lehman moment” – that is, the kind of global panic that resulted in the days after Lehman Brothers failed in September 2008.

In particular, experts like Hoenig who have thought about the cross-border dimensions of bankruptcy emphasize that it simply would not work for a corporation the size of JPMorgan Chase ($3.7 trillion in assets), Bank of America ($3 trillion), or Citigroup ($2.7 trillion).

“Panic is about panic,” Hoenig says, “and people and nations generally protect themselves and their wealth ahead of others. Moreover, there are no international bankruptcy laws to govern such matters and prevent the grabbing of assets.” I would add that the chance of bankruptcy courts cooperating across borders in this context is nil.

As a result, the Federal Reserve and the FDIC should move immediately to force the megabanks to become much simpler legal entities. Current corporate structures are opaque, with the risks hidden around the world – and various shell games allowing companies to claim the same equity in more than one country.

Breaking down the components of banks into manageable pieces makes sense. The Federal Reserve has recently taken a step in that direction by requiring that global banks with a significant presence in the US operate there through a holding company that is well-capitalized by US standards.

This is not about preventing the flow of capital around the world. It is about making the financial system safer. Anyone who disputes the need to do this – and much more – should read and respond to Hoenig.

Source: Project Syndicate