Glass Half Empty

The debate on regulatory reform to prevent another banking crisis in the US is far from over

By Echelon.

Published on October 10, 2013 with No Comments

mark hager nov

April is the cruelest month in T.S. Eliot’s The Waste Land, but for twenty-first century America it’s got to be September. Twelve years ago came assault on the twin towers and seven years later came the Wall Street panic. The first touched off two catastrophic wars while the second triggered an economic collapse from which we’re still reeling. The struggle goes on to avoid repeat versions of both September disasters. In the Middle East that struggle has led us by questionable steps to the brink of a Syrian intervention that would aid jihadist allies of the 9/11 terrorists. At home, despite substantial effort, a spectre of systemic bank failures and taxpayer bailouts continues to haunt our nightmares.

Among many imponderables, a wiser U.S. foreign policy has at least one pretty clear requirement: more hesitant use of military force. In financial reform, by contrast, even minimal clarity may be hard to find.Reform discussions have revolved among five main approaches:
1) procedures for ‘orderly liquidation’ of failing banks;
2) the ‘Volcker Rule’ ban on proprietary trading;
3) limits on maximum bank size;
4) requirements that banks rely less on borrowed funds, more on equity financing; and
5) revival of the ‘Glass-Steagall’ separation between commercial and investment banking. Under the post-meltdown Dodd-Frank reform law of 2010, banks whose collapse might cause system-wide financial collapse must develop ‘living wills’ with comprehensive risk modeling and plans for ‘orderly liquidation’ in the event of impending failure.

There are several reasons to doubt this solution. It understates the difficulty of predicting risks, a difficulty that helps cause bank failures in the first place. Meanwhile, advance planning for orderly liquidation ignores the fact that actual liquidations involve complex negotiations among multiple stakeholders. Moreover, liquidation plans for single banks may prove worthless against shocks hitting the entire sector at once, like Wall Street’s overexposure to mortgage defaults in 2008. A plan to keep one domino from toppling others is no use when the whole table shakes.

The ‘Volcker Rule’ under Dodd-Frank bans banks from ‘proprietary trading’: buying and selling securities for their own profit rather than on behalf of clients. Like all gambling, proprietary trading yields no aggregate economic benefit: every gain equals someone else’s equivalent loss. By destabilizing both players and markets, it arguably harms the financial system. Proponents contend that the Rule will ensure a more secure credit system.
The difficulty lies in telling the difference between proprietary and client-driven trading. Some forms of client-driven trading—market making and hedging to name two—may look like proprietary trading in that they involve securities trading by banks and sometimes yield profits for them as a by-product. How can banks find safe harbour and how can prosecutors press the right cases? Regulators struggling to draft guidelines distinguishing proprietary from client-driven trading have produced a 300-page draft. Will the Volcker Rule be workable and worthwhile at the end of the day?
Some reform proposals focus directly on the ‘too big to fail’ (TBTF) problem, spotlighted harshly by the massive taxpayer bailouts of 2008, and propose limits to bank size. Consolidation in the financial sector has never been greater. As of 2009, the big four—Bank of America, Citicorp, JP Morgan Chase and Wells Fargo—held some 40% of total deposits. Market share of the ten largest stood at 60%, up from 25% in 1990. By 2012, the big four held 54% of total assets.

But size limit proposals confront questions of specification, compliance and utility. First, how should size limits be specified? Second, what sanctions apply for non-compliance and what steps does a non-compliant bank take to get into compliance? Third, would size limits really prevent meltdowns caused by reckless investment and financial interconnectivity and might they undermine performance incentives for banks near the line?

An important proposal now before Congress, the ‘Brown-Vitter’ bill named for its Democratic and Republican co-sponsors, would force the biggest banks to rely more heavily on equity as opposed to loan financing. In the first half of the twentieth century banks operated with equity capital equaling twenty to thirty percent of assets. Today, equity/asset (E/A) ratios hover around two or three percent. This shift indicates a massive trend away from equity toward loan financing. This puts banks at higher risks of insolvency and magnifies transmission of risk through the interlocking financial sector.
Both prior to the 2008 meltdown and afterward, lenders have financed the Wall Street casino because the big banks are deemed—you guessed it—TBTF. Your money is safe there, no matter how risky the business model, as long as taxpayer purses can be pinched for a bailout, keeping the Street above water and able to pay creditors. In fact, Wall Street can borrow at premium low rates, keeping capital costs below what smaller rivals face, precisely because of the implied taxpayer guarantee.

Brown-Vitter would force big banks to reduce their use of borrowed funds. This would remove some of the borrowing-cost advantage enjoyed by TBTF banks, while cutting their insolvency risks and reducing the danger of credit meltdowns and taxpayer bailouts.
Low bank equity and heavy borrowing encourage risky investment by shifting loss exposure from shareholders to outside creditors. It also heightens dangers and market fears of insolvency when bank asset values decline. A bank with only two percent equity stands on the brink of insolvency if its asset portfolio declines just one percent.

Moreover, low equity makes it harder for stressed banks to raise emergency loans. And by forcing asset sales when liquidity tightens or loans come due, it creates cascades of declining asset prices, eroding the portfolios of all banks holding such assets. Danger and fear gush through the system. Lending to firms and households dries up as banks struggle to hold cash.

By contrast, a high ‘equity cushion’ allays fears of loan defaults and depositor ruin by pushing losses onto shareholders with only ‘soft’ claims on bank wealth. There is no rush to asset sales because declining equity value absorbs the impact of portfolio declines without instant insolvency.
The most serious objection to Brown-Vitter is that mandating high E/A ratios would curtail availability of loan funds and thereby saddle firms and households with higher borrowing costs. Bank assets consist largely of rights to collect on loans made. Imagine a bank with $10 billion equity and an E/A ratio of two percent. If its assets consist entirely of outstanding loans, that comes to $500 billion. (10/500=.02) If legally required to hike its E/A ratio to 20%, its equity can support only $50 billion in loans outstanding. To conform with the law, it must shrink its loan portfolio tenfold. The resulting credit contraction is disastrous, say Brown-Vitter’s critics.

oct mhBut shrinking A is not the only way to increase E/A. One could also increase E while holding A constant. Our bank can continue with $500 billion in loans outstanding at an E/A ratio of 20% by raising its aggregate equity to $100 billion. It can do so by selling more shares, by retaining more earnings rather than issuing dividends, or both. So mandating higher E/A need not yield credit contraction. During a specified grace period, for example, laws could ban dividends and require new equity issues for banks falling below the mandated E/A ratio. Though there is reason to worry, transition without credit contraction may be feasible.
The latest recent Congressional reform proposal involves restoration of the 1933 Glass-Steagall Act requiring strict separation between ‘commercial’ banks—those that accept deposits and use them to issue loans to firms and households—and ‘investment’ banks, which trade in financial instruments and earn fees for structuring the issuance of bonds and equities. Under Glass-Steagall, investment banks could not accept deposits and commercial banks could not deal in financial instruments. A coterie of both Republican and Democratic lawmakers has recently submitted a ‘Twenty-First Century Glass-Steagall Act’ designed to restore the commercial/investment bifurcation repealed by Congress in 1999.

Between its passage in 1933 and its repeal in 1999, according to its advocates, Glass-Steagall safeguarded depositors against risky financial dealings, while also protecting the U.S. Treasury, which guarantees deposits against bank failures. Critics castigated Glass-Steagall, however, for stifling innovation and wealth creation in the finance sector. Its repeal had support from both parties. Restoration of Glass-Steagall might be wise and, post-2008, draw a lot of support, but it might not be the critical priority and it would certainly not solve all problems. It might protect depositors but leave leeway aplenty for risky mischief by TBTF investment banks.

A graduate of Harvard Law School, Mark Hager lives in Pelawatte and consults on complex legal and writing challenges. He also provides training on negotiation skills with Sea-Change Partners.


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