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.
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?