Paul Volcker wants to roll the clock back and restore Glass Steagall, the 1933 rule that separated commercial banking from investment banking, but Team Obama is politely ignoring him.
Mervyn King, the Governor of the Bank of England, is giving a more strident version of the same message, calling on the biggest financial firms to be broken up, arguing that he sees no reason not to implement a Glass-Steagall type split.
But there is an interesting failure of all parties to discuss some of the real issues.
First, a quick overview of the Volcker-Administration differences per the New York Times:
The aging Mr. Volcker (he is 82) has some advice, deeply felt…He wants the nation’s banks to be prohibited from owning and trading risky securities, the very practice that got the biggest ones into deep trouble in 2008. And the administration is saying no, it will not separate commercial banking from investment operations….
The Obama team, in contrast, would let the giants survive, but would regulate them extensively, so they could not get themselves and the nation into trouble again. While the administration’s proposal languishes, giants like Goldman Sachs have re-engaged in old trading practices, once again earning big profits and planning big bonuses.
Mr. Volcker argues that regulation by itself will not work. Sooner or later, the giants, in pursuit of profits, will get into trouble. The administration should accept this and shield commercial banking from Wall Street’s wild ways.
“The banks are there to serve the public,” Mr. Volcker said, “and that is what they should concentrate on. These other activities create conflicts of interest. They create risks, and if you try to control the risks with supervision, that just creates friction and difficulties” and ultimately fails.
I think Volcker is wrong, but not for reasons one might expect. I am not opposed to separating commercial banking and investment banking (although you could achieve the same result by aggressively firewalling the depositary operations and limiting the kind of risks it could take. Having the two activities under the same roof would become pointless, indeed cumbersome, and they would over time be split up, since someone in a position to earn a deal fee would persuade management that value could be created by separating the units).
The problem with Volcker’s logic isn’t that it lacks merit, but it is not close to being the solution he imagines it to be.
The subtext of his message is that the useful social function of finance is largely served by traditional banks. He further believes that if you separate banking from investment banking, you can let investment banks fail.
Um, remind me what happened last fall?
We had a huge expenditure of effort and money to prevent investment banks from failing (at least in an disorderly fashion, Merrill was on the way to failing) because it would have taken out too much critical capital markets infrastructure. You may not like it (I sure don’t) but pretending the facts are other than what they are is not a way to get to a remedy.
The problem is that we have had a thirty year growth in securitization. A lot of activities that were once done strictly on bank balance sheets are merely originated by banks and are sold into capital markets. Think of the old model as mainframes and the new model as distributed computing.
We have now seen a lot of activity shift from banks to capital markets. And thanks to a host of factors (barriers to entry like high minimum scale, network effects, deregulation which made it easier for firms to span product and geographic markets) we now have capital markets dominated by a very small number of players. And these players are too big to fail by virtue of their ROLE, not simply their size. Lehman was considered small enough to be let go, but it was sufficiently tied to the grid so as to produce a more disruptive outcome than the authorities assumed (I am not of the view that Lehman was let go by design in a financial version of a Reichstag fire. The powers that be consistently underestimated the severity of the problems in the financial system and overestimated the efficacy of their patchwork remedies. Subprime was contained. Paulson’s bazooka would stem the need to do anything with Fannie and Freddie. The public was clearly disgusted after Bear. I said Lehman would not be rescued, it was obvious there was no will to do so. It was politically unacceptable and the Republicans were not going to go there. So everyone did a “don’t ask, don’t tell” of assuming that the system could digest the failure rather than trying to assesses the consequences in advance. Never attribute to malice that which can be explained by incompetence).
Now you could in theory go back to having much more on balance sheet intermediation (finance speak for “dial the clock back 35 years and have banks keep pretty much all their loans”). Conceptually, that is a tidy solution, but it has a massive flaw: it would take a simply enormous amount of equity to provide enough equity to all those banks with their vastly bigger balance sheets. We’re having enough trouble recapitalizing the banking system we have.
Separating commercial banks in the US out of this mix will not solve this fundamental problem. Remember, Morgan Stanley and Goldman, both pure investment banks as of last year, also nearly failed, and Merrill, Lehman, and Bear perished.
So the industry had already become so concentrated (and levered) that it had become more failure prone. So merely separating commercial banking and investment banking is not sufficient; you have to do something about the risk taking of capital market players. And sadly, the network effects in trading are powerful. Left to their own devices, the propensity is for the industry to coalesce into a format of fewer, more powerful players. And now that it is in that format, it would take a lot of intervention (Tobin taxes? barriers between products? barriers between geographies?) to not merely restructure the industry, but to keep the factors that favor concentration from reasserting themselves.
In addition, most of the key capital markets players are non-US: Barclays, RBS, HSBC, SocGen, Paribas, UBS, DeutscheBank, Credit Suisse. Eurobanks have a tradition of “universal banking,” of having combined banking and trading businesses. You might sell a variant of Glass Steagall in the UK, but you’d have a much harder time in Europe (not that this is warranted, mind you; the greater ability in Europe to use deposits to fund trading operations led to some pretty bad practices).
And the elephant in the room is derivatives. The big players have massive OTC derivatives exposures. You need a really big balance sheet to provide OTC derivatives cost effectively (recall that this is one area where the big banks were competitive players early on, and it was because derivatives “talent” would put up with nuisances of being at a commercial bank because the advantage of having a very large balance sheet was an enormous advantage). And the books are large, and most exposures are hedged dynamically.
So even if miraculously, the powers that be around the world agreed on a way to reconfigure things to make it less attractive to have a small number of integrated capital markets firm…..what are you going to do about their big derivatives books? Even if you could figure out a way to break up a business going forward, you have massive exposures, and smaller balance sheets in the new entities (and that’s before we get to possible operational and skill issues….).
Put it simply, I have yet to see anything even remotely approaching a realistic discussion of how to deal with too big too fail firms, and we have been at this for months. My knowledge of the industry is not fully current, but even so, the difficulties are far greater than I have seen acknowledged anywhere. That pretty much guarantees none of the proposals are serious, and nothing will be done on this front.
That further implies the system will have to break down catastrophically before anything effective can be done. I really hope I am wrong on this one.