Are Cries to Break Up Big Banks About Reform … Or Revenge?

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Lately, the "too big to fail" debate has intensified as if only now has an urgent need to find a scapegoat to slaughter emerged. Certainly, the numerous scandals and examples of gross mismanagement at financial institutions invite criticism and derision.

It is critical to have an intelligent and in-depth discussion about whether the top 12 U.S. banks, which make up 70% of all banking assets benefit from government subsidies and bailouts. If we really want to solve the TBTF problem, however, we need to think not just of banks, but of the entire financial sector since all participants – banks, securities firms, hedge funds, private equity firms, insurance companies and mutual and pension funds – are extremely interconnected.  All of them can cause systemic risk and negatively impact the economy.

Firstly, all politicians, every type of financial institution, rating agencies, corporations, regulators, supervisors, economists and we as individuals need to admit our role in causing, abetting or ignoring factors leading to the 2008 financial crisis.

In the early 2000s, the Federal Reserve targeted the federal funds rate lower to stimulate the economy.  The U.S., due to its large capital markets, benefitted greatly from all types of investors, including an unprecedented transfer of savings from growing emerging markets into a wide variety of U.S. financial instruments.  Additionally, the chase for yield led to securitization which lubricated lending markets and enabled all of us to get mortgages at lower rates. 

Did we collectively forget that greed is a cardinal, not a venial, sin? Did we falsify, withhold or ignore information when applying for a loan, when selling and securitizing loans or rating the mortgage-backed securities and collateralized debt obligation offspring? Did we read the prospecti to make intelligent decisions about investments or did we use the prospecti as placemats for our caviar and cocktails because we were going to use unregulated credit derivatives to transfer the credit risk to equally poorly supervised protection sellers like AIG? Did we push banks to make loans to people who were not creditworthy because all we think of is getting re-elected?  Did we lobby for low capital requirements for banks and little regulation for shadow financial institutions? Enough of the finger-pointing already! It is nostra culpa.  Recognizing our role in the crisis is critical or the same behavior will continue.

Secondly, the crisis had not even finished unfolding, and on both sides of the pond, we rushed to come up with regulatory frameworks so that the devastation would never happen again.  As time passes, we are seeing that Basel III, Dodd-Frank and European Market Infrastructure Regulation may not address all the causes of the crisis, and certainly cannot incorporate predictions about what may cause the next one.

But, even though imperfect, we must remember most of these rules have not been finalized as lobbies and legislators tie the hands of regulators. These key financial regulatory frameworks all contain provisions including more capital and higher quality capital, liquidity, leverage and transparency requirements, an unfinished Volcker Rule, ring-fencing attempts and a whole host of derivatives regulations. 

If finalized, implemented and properly supervised, it is possible that these unfolding regulatory frameworks will make enormous global banks smaller or at least keep them from getting larger. These frameworks can force banks to have better risk management if both shareholders and supervisors discipline banks.

Thirdly, we have to think of the impact of shrinking big banks.  If indeed Basel III, Dodd-Frank and EMIR prove insufficient and a more forceful way to break up big banks becomes necessary, who would do the carving and with what tools?

Big banks are not going to break themselves up just to save their image. In that case, numerous politicians would step down to save their reputation.  We must remember banks are bigger not only because of the bipartisan deregulation efforts during the Clinton era, but because of government actions during President George W. Bush's term to push the purchase of the collapsing Bear Stearns, Merrill Lynch, Wachovia and Washington Mutual.

Should legislators or regulators break up the banks?  Given the partisan gridlock in Washington, encouraging Congress to spend time on this issue is unlikely to be the best use of anyone's time.  Even if legislators were to pass a law to break up big banks, this could set a very dangerous precedent.  What sector would be next? If regulators should make banks smaller, then legislators need to pay less attention to lobbyists and more attention to empowering regulators to strengthen and implement Dodd-Frank and Basel III.

Federal Reserve Bank of Dallas President Richard Fisher and economist Harvey Rosenblum are advocating bank regulators use tools so that if any bank were to fail, it would already be too small to require that the government or regulators step in to save it. But Dodd-Frank and Basel III, if ever implemented, already provide U.S. regulators with useful tools that make it more expensive for banks to engage in excessively risky activities. However, regulators are not magicians; they need the help of legislators and the Department of Justice.

There are other issues that would need to be addressed before a breakup could take place. For example, if universal banks were broken up, steps must be taken to make sure their entities were regulated.  If securities firms were to end up out of the jurisdiction of bank supervisors, we would add more risk to the global financial sector by pushing the nonbank components to a practically unregulated shadow market. Presently, the Fed, OCC, and FDIC have the right to regulate and supervise all of a bank holding company's components.  It is important to remember that Finra, a self-regulatory organization was regulating Lehman Brothers, Bear Stearns and Merrill Lynch. Rosenblum argues that once investment houses are walled from the commercial banks and they do not receive any government support, market discipline would influence investment houses to scale back on risk.  Where was market discipline in the mid-2000s?

Forcefully breaking up big banks could also result in a high number of global layoffs. Many people might say "who cares about bankers and traders?"  But the majority of people who work at banks are not bankers or traders and do not make the big bonuses the media loves to sensationalize. They are analysts, risk managers, credit officers, IT and back office personnel, accountants, compliance officers, lawyers, graphic artists, tellers, assistants, janitors and cooks who collectively bolster the GDP.  Adding these people to the unemployment line neither helps the global economy nor punishes the true perpetrators of the crisis.

Also, the factors that lead universal banks to receive a lower cost of borrowing also benefit individuals and corporations in the form of lower interest rates for credit products.  Douglas J. Elliott of the Brookings Institution cogently argues that capital comes at a cost.  If Dodd-Frank and Basel III do make large banks smaller, these financial institutions might not be able to get a lower cost of funding and consumers will have to pay higher interest on all credit products. 

By not studying whether recent regulatory frameworks can work, we may end up with increased unemployment, higher credit costs for all and a transfer of risk from banks to shadow financial institutions. The desire for revenge may be strong, but we should not lose sight of what should be our key goal: to make the global financial sector safer. 

Mayra Rodríguez Valladares is managing principal of MRV Associates and on the faculty at The New York Institute of Finance.



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Law and regulation