Fed’s Hoenig: big banks are a threat to capitalism

The Fed’s Thomas Hoenig delivered a striking speech this week on the systemic risk posed by the “Too Big to Fail” status of US banks.  In one of the bluntest speeches from a US central banker I have seen in some time, Hoenig suggests that so-called “systemically important financial institutions” have become a threat to capitalism itself.

How can one firm of relatively small global significance merit a government bailout? How can a single investment bank on Wall Street bring the world to the brink of financial collapse? How can a single insurance company require billions of dollars of public funds to stay solvent and yet continue to operate as a private institution? How can a relatively small country such as Greece hold Europe financially hostage? These are the questions for which I have found no satisfactory answers. That’s because there are none.

Because there are no satisfactory answers to these questions, I suggest that the problem with SIFIs is they are fundamentally inconsistent with capitalism. They are inherently destabilizing to global markets and detrimental to world growth. So long as the concept of a SIFI exists, and there are institutions so powerful and considered so important that they require special support and different rules, the future of capitalism is at risk and our market economy is in peril.

Strong words indeed. Hoenig then goes on to outline how a once stable, competitive banking system has come to be dominated by just a handful of huge players, all of which are now so big that their failure would bring down the entire system.

The U.S. economy is the most successful in the history of the world. It achieved this success because it is based on the rules of capitalism, in which private ownership dominates markets and individuals reap the rewards of their success. However, for capitalism to work, businesses, including financial firms, must be allowed, or compelled, to compete freely and openly and must be held accountable for their failures. Only under these conditions do markets objectively allocate credit to those businesses that provide the highest value.

For most of our history, the United States held fast to these rules of capitalism. It maintained a relatively open banking and financial system with thousands of banks from small community banks to large global players that allocated credit under this system. As late as 1980, the U.S. banking industry was relatively unconcentrated, with 14,000 commercial banks and the assets of the five largest amounting to 29 percent of total banking organization assets and 14 percent of GDP.

Today, we have a far more concentrated and less competitive banking system. There are fewer banks operating across the country, and the five largest institutions control more than half of the industry’s assets, which is equal to almost 60 percent of GDP. The largest 20 institutions control 80 percent of the industry’s assets, which amounts to about 86 percent of GDP.

The chart below shows the dramatic extent of this change over the past two decades.

Source: FT.com

Slick bankers like JPMorgan’s Jamie Dimon have railed against any talk of curbing the big banks’ size or leverage, arguing that this would put US banks at a competitive disadvantage. Hoenig has no time for this argument.

Now, with their bailout costs amounting to billions of taxpayer dollars, SIFIs are larger than ever. Strikingly, they are arguing that they should not be held to stronger capital standards if the United States hopes to remain globally competitive. That assertion is nonsense.

And Hoenig is right. It is abundantly clear that the big banks do not hold enough capital, and that much more stringent capital requirements would produce a great social benefit with little measurable cost. As Stanford University’s Anat Admati says:

The Basel III bank-regulation proposals … fail to eliminate key structural flaws in the current system. Banks’ high leverage, and the resulting fragility and systemic risk, contributed to the near collapse of the financial system. Basel III is far from sufficient to protect the system from recurring crises. If a much larger fraction, at least 15%, of banks’ total, non-risk-weighted, assets were funded by equity, the social benefits would be substantial. And the social costs would be minimal, if any.

Back to Hoenig, who appears frustrated that the recent Dodd-Frank regulations do nothing to address the elephant in the room. If Hoenig had his way, banks would be treated like regulated utilities.

Dodd-Frank adds new layers… but it fails to employ one remedy used in the past to assure a more stable financial system—simplification of our financial structure through Glass-Steagall-type boundaries. To this end, there are two principles that should guide our efforts to restore such boundaries. First, institutions that have access to the safety net should be restricted to certain core activities that the safety net was intended to protect—making loans and taking deposits—and related activities consistent with the presence of the safety net… banking organizations should be expressly prohibited from activities that include dealing and market-making, brokerage, and proprietary trading, which expose the safety net but have little in common with core banking services.

But such reforms could have unintended consequences if they are not accompanied with measures to rein in the behaviour of  non-bank financial institutions:

A legitimate concern of limiting the safety net is that this could worsen the risk of financial instability by pushing activities to the unregulated shadow banking system. Clearly, focusing solely on the regulated banking industry and ignoring the unregulated shadow banking system would not solve the problem and, in fact, might expand the shadow banking sector that was an integral part of the financial crisis.

Much of the instability in the shadow banking system stems from its use of short-term funding for longer-term investment. The solution to this instability problem is not to provide a safety net for the shadow banks and regulate them more but, instead, to remove exceptions in which money market instruments are treated essentially as deposits. The current exceptions encourage significant short-term funding of longer-term assets.

One gets the feeling that Hoenig knows the battle has already been lost. The big banks are bigger and more powerful than ever. There is zero chance of a return of Glass Steagall. Memories of the recent crisis are already fading. There’s a Presidential election coming in 2012. And guess who calls the shots in US presidential compaigns?

Source: OpenSecrets.org

Depressing, innit?

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  1. Rather than the battle having been already lost he may be preparing the way for round 2 of the battle.

    Little has been resolved and fragility remains.

    As the global stimulation phase runs out of puff many of the items stowed away in the too hard basket a couple of years ago will re-emerge.

    We are a dim lot and it may take a few more whacks before we start to accept there are dangers in letting the credit cowboys roam free.

    • These credit cowboys are indeed running free and will not be harnessed. We should probably change Too Big To Fail to Too Powerful To Regulate Taxpayer Guaranteed Not To Fail.

  2. That is an interesting statement by Hoeing, and I would expect career limiting. How the major US banks which own stock in the FED will react will be predictable.

    Also, given the large presidential funding that the big banks currently give to both parties nothing will be done.

    Congress can’t control the FED and Alan Greenspan made a statement to that effect, and nor can they really control the banks given that they rely on them for political funding.

    • From memory, Hoenig is retiring from the Fed – In the FOMC he has often (but not always) held a dissenting view and my guess is now, given impending retirement, he is in a position to be more forthright.

      Nonetheless, we are indeed all captive to the machinations (and needs and desires) of global finance which by extension is really the derivatives market – out of control, virtually unregulated and built on a 700trillion to quadrillion dollar deck of cards.

      So in a way, yes, too big to fail!

      • I have a NY banker mate, and he said today it’s scary. Many banks are in bad shape so that’s why a Greek bailout needs to happen now. It’s not new news, but no one know what the fallout would be. How dangerous is that!

        • Was recently mooted that via CDSs (I think?) one of the major banks had bet against Greek default and that as these trades have a life of their own (hedging, hedging picked up by others and hedging, hedging picked up by others…) and it was the domino effect of outright default and subsequent region contagion (not actually for the countries involved per se, but for the derivatives market financiers) that was of most pressing concern. This is off the top of my head (as I heard it) – so I stand prepared to be corrected.


      • That’s correct — Hoenig is retiring in October, which perhaps gives him a little more freedom to speak his mind. He as always been a bit of a dissenter though. It would be unthinkable to get these types of comments from Bernanke….

        • That’s only too true. Bernanke is captured and can do no other.

          There is some distant hope that via direct fiscal stimulus (infrastructure spend) the situation can be salvaged but the timing is problematic due to debt ceiling, deficit and political issues. There does seem to be some movement in that direction, only possible it seems, upon some strengthening of balance sheet position. The goal all along???? Who knows.

          The truth is, any regulation post Glass Steagall, has been ineffective. The power and influence of the financial sector simply overwhelming…secured and cemented via the revolving door.

          Unfortunately, any moves to correct the situation now, are impossible. It would take some sort of catastrophic event and even then, because of residual power, I would remain doubtful.

          In my most pessimistic moments, it seems to me we have knowingly, but unquestioningly, bought into this game, and we play until the end.

          Of course, all may end well. That is what I hope.

  3. Alex Heyworth

    Gee, the Fed wouldn’t have had anything to do with the banks getting so big and powerful, would it? It’s a complete coincidence that so many of the Fed’s top honchos have come from Goldman Sachs, and vice versa? Come on!

    Time to reread The Creature from Jekyll Island.

  4. Capitalism was abandoned long ago in the US, since at least 1913 when the Fed was established. They have a long history of bailing out banks, financial institutions and other industries. If those bailouts hadnt happened over the decades the current TBTF banks would not have achieved their current size.

    In fact i would go as far to say that it would be normal for a bank looking for high growth through high risk activities to necessarily fail well before achieving TBTF size without govt/CB intervention.

    Hoenig’s comments are too little too late.

  5. Hi guys, it is pleasure to read this blog. I just would like to remind you what Marx had written about capitalism. One of the main features of the capital is its tendency of concentration and centralization through financial markets. This process is more than obvious during the last 20-30 years. Hoenig is much right when argue that without competition capitalism is dead. But Marx argued too that competition give birth to monopoly. Everyone wants to be monopolist, but we all we are for genuine competition. This is a very important contradiction of the free market itself. For unlimited growth, financial capital needs total freedom, which globalization has already provided to it. The rest is a lost battle, because money can buy everything and everyone.