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Guest Post: 5 Reasons We Must Break Up the Giant Banks

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Washington’s Blog

As everyone from Paul Krugman to Simon Johnson has noted, the banks are so big and politically powerful that they have bought the politicians and captured the regulators.

But the giant banks are not only dangerous because they skew the political system. There are five economic arguments against the mega-banks as well.

Impaired Competition

Fortune pointed out last February that the only reason that smaller banks haven’t been able to expand and thrive is that the too-big-to-fails have decreased competition:

Growth for the nation’s smaller banks represents a reversal of trends from the last twenty years, when the biggest banks got much bigger and many of the smallest players were gobbled up or driven under…

As big banks struggle to find a way forward and rising loan losses threaten to punish poorly run banks of all sizes, smaller but well capitalized institutions have a long-awaited chance to expand.

So the very size of the giants squashes competition.

Less Loans, More Bonuses

Small banks have been lending much more than the big boys.

The giant banks which received taxpayer bailouts actually slashed lending more, gave higher bonuses, and reduced costs less than banks which didn’t get bailed out.

Lack of Transparency in Derivatives

JP Morgan Chase, Bank of America, Goldman Sachs, Citigroup, and Morgan Stanley together hold 80% of the country’s derivatives risk, and 96% of the exposure to credit derivatives.

Experts say that derivatives will never be reined in until the mega-banks are broken up.

Increased Debt Problems

As I pointed out in December 2008:

The Bank for International Settlements (BIS) is often called the “central banks’ central bank”, as it coordinates transactions between central banks.

BIS points out in a new report that the bank rescue packages have transferred significant risks onto government balance sheets, which is reflected in the corresponding widening of sovereign credit default swaps:

The scope and magnitude of the bank rescue packages also meant that significant risks had been transferred onto government balance sheets. This was particularly apparent in the market for CDS referencing sovereigns involved either in large individual bank rescues or in broad-based support packages for the financial sector, including the United States. While such CDS were thinly traded prior to the announced rescue packages, spreads widened suddenly on increased demand for credit protection, while corresponding financial sector spreads tightened.

In other words, by assuming huge portions of the risk from banks trading in toxic derivatives, and by spending trillions that they don’t have, central banks have put their countries at risk from default.

Now, Greece, Portugal, Spain and many other European countries – as well as the U.S. and Japan – are facing serious debt crises. See this, this and this.

By failing to break up the giant banks, the government is guaranteeing that they will take crazily risky bets again and again and again.

We are no longer wealthy enough to keep bailing out the bloated banks. We have serious debt problems. See this, this and this.

(Anyone who claims that Chris Dodd’s proposed “reform” legislation will prevent banks from getting bailed out again is wrong. If the giant banks aren’t broken up now – when they are threatening to take down the world economy – they won’t be broken up next time they become insolvent, either. And see this.)

Unfair Competition and Manipulation of Markets

Moreover, Richard Alford – former New York Fed economist, trading floor economist and strategist – recently showed that banks that get too big benefit from “information asymmetry” which disrupts the free market.

Nobel prize winning economist Joseph Stiglitz noted in September that giants like Goldman are using their size to manipulate the market:

“The main problem that Goldman raises is a question of size: ‘too big to fail.’ In some markets, they have a significant fraction of trades. Why is that important? They trade both on their proprietary desk and on behalf of customers. When you do that and you have a significant fraction of all trades, you have a lot of information.”

Further, he says, “That raises the potential of conflicts of interest, problems of front-running, using that inside information for your proprietary desk. And that’s why the Volcker report came out and said that we need to restrict the kinds of activity that these large institutions have. If you’re going to trade on behalf of others, if you’re going to be a commercial bank, you can’t engage in certain kinds of risk-taking behavior.”

The giants (especially Goldman Sachs) have also used high-frequency program trading which not only distorted the markets – making up more than 70% of stock trades – but which also let the program trading giants take a sneak peak at what the real (aka “human”) traders are buying and selling, and then trade on the insider information. See this, this, this and this. (This is frontrunning, which is illegal; but it is a lot bigger than garden variety frontrunning, because the program traders are not only trading based on inside knowledge of what their own clients are doing, they are also trading based on knowledge of what all other traders are doing).

Goldman also admitted that its proprietary trading program can “manipulate the markets in unfair ways”. The giant banks have also allegedly used their Counterparty Risk Management Policy Group (CRMPG) to exchange secret information and formulate coordinated mutually beneficial actions, all with the government’s blessings.

Again, size matters. If a bunch of small banks did this, manipulation by numerous small players would tend to cancel each other out. But with a handful of giants doing it, it can manipulate the entire economy in ways which are not good for the American citizen.

No wonder virtually every independent economist and financial expert is calling for the big banks to be broken up.

Some argue that it is logistically impossible to break up the behemoths. But if we broke up Standard Oil, we can break up the giant banks as well.

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21 comments

  1. Costard

    Impaired competition – disagree. Large banks have grown in the past twenty years because in an environment of easy money and little need or desire to perform due diligence on individual loans, the most efficient model is a large one, with scale and conveniences like atms. Smaller institutions excel when specialized knowledge is needed to lend profitably, which may be where we’re at currently. But whether your prescription makes sense – economically – depends upon future monetary policy, and therefore is an unknown.

    These megabanks developed because advantages were created in their favor through economic and legislative policy. I don’t believe you solve the problem by addressing the effect, and if size is efficiency, financial institutions will find some other, less straightforward way to maintain influence. This will not be a one-off solution. I also question whether, at this stage of the game, you can break up a large, debt-ridden, derivative- laced bank without making it more vulnerable to failure. Counterparty risks will remain on the books, and individual events of default will become more difficult to bear.

    The story behind standard oil was the railroads, which were essentially federally sponsored, monopolistic entities that the automobile – not congress – eventually curtailed. A case, IMO like this one, of politicians and pundits scapegoating the private sector offspring of a governmental monopoly.

    1. readerOfTeaLeaves

      Size does not necessarily translate to efficiency. A network of smaller banks could easily form a co-op for ATM or other services.

      And if a debt-ridden, derivative-laden bank failed, so what?
      Are we supposed to continue to let these behemoths extort taxpaying publics, while extracting compliance from electeds who are too afraid and confused to let them go down?

      The Roman Empire fell, and humanity survived it.
      The Incan Empire fell, and humanity survived it.

      Given that those derivatives are traded in secret and often deal with ‘off books accounts’, the smartest possible thing is to get rid of them. They’re like economic threats sitting out there waiting to happen; the smart thing to do is get rid of them and restrict derivatives to open exchanges.

      Letting banksters, or any other segment of an economy, call the shots is plain dumb. It’s also cowardly and feckless.

      Enough, already.

    2. Glen

      I’m not disagreeing with your assertion that size is efficiency, although the experts (Simon Johnson) seem to say that $100B seems to be the top end for efficiency associated with size.

      Given that these ARE super efficient, how do we continue to overlook the fact that these banks FAILED, and if accounting rules had not been bent beyond recognition, these banks would still be insolvent. Not forcing these banks to fail is a dramatic indicator that that Wall St is ANYTHING BUT a real “hands off” let nature take it’s course “free” market. I am not advocating the “let them fail” implosion, but as close as we can to letting nature take it’s course – these beasts need to die.

      Sadly, I think the largest lesson to be learned here is that a “fair” market IS the most efficient, but the large banks have manage to pervert the market so that it is now a rigged game. Some argue that it’s government perversion which caused this although 1) it didn’t happen until we deregulated starting with Reagan and 2) follow the money type causality suggests the insane easy money was used to buy the regulators through political contributions.

    3. NOONBALLOON

      I’m going to have to agree and disagree with you…

      Think back to the 1990’s when banks began swallowing other banks, insurance companies and other financial institutions. Remember all those mergers, and recall Alan Greenspan’s preaching about the benefits of scale. During this same time, lots of lower level banking folks were getting their pink slips… automated customer service began to take off, and I’m sure that the Chicago School of Business was made proud, but what about the loss of both quality service and knowledgeable consumers? What happens when we replace quality service with automated hoops to jump through, what happens when we replace analysis with a FICO score , and what about replacing reasonably knowledgeable borrowers and financial product consumers with record level sub-prime borrowers and those who see what appears to be a traditionally good investment grade rating and just go for it? No consideration of the aggregate markets, or credit expansion, or false perceptions…just a big dumb herd like mentality. It’s kind of like a quick drive-by curb appeal appraisal for credit as well as investment worthiness.

      These “institutions” essentially replaced their income from providing good service with that of side payments from each stage of complex structuring scheme, but without the added value. Instead of a Value Added Tax, they imposed a system of Value Added Fees, but again, without much real value being added.

      We could use cash flows from the financials of any of these companies as our comparative metaphor. What happens when we replace or outstrip our quality operating cash flows with that of some more gimmicky financing cash flows? Oh sure, cash flow is cash flow….right?

      And the law of diminishing returns?

      …well maybe it all becomes irrelevant when the rates are kept artificially low (by the Fed), over an extended period of time, and while the risk is pushed artificially high (by the likes of FANNIE & FREDDIE), but that can only be temporary at best, or until China decides the US can no longer cover its obligations.

      If the game is truly about risk and reward, then failure must be an option, and, if failure is an option, then size does matter.

  2. Patrick

    Break up the big banks? You can put that next to your “Save Tibet” bumper sticker.

    Pray tell, just who is going to break up the big banks–Congress? You have to be shitting me. Those morons don’t even know what’s in the health care bill. I’ll guarantee you that whatever they do, no matter how good it looks short term, will be a huge clusterf$$k. You know it and so does everyone else.

    But no worries interventionists like yourself and most everyone here could care less–”it’s the thought that counts”.

    A few of us, a very few, warned about any intervention starting with Bear Sterns. Had you followed that advice there would not be any big banks to breakup. The market would have liquidated all of them by now. Please save the canard about the world would have ended had the authorities not intervened. You can not know that. It is the historic hobgoblin trotted out by folks who want control backed up by their willing econ pundits.

    1. NotTimothyGeithner

      All hail the market it always works! Remember when government got out of the way from 400 to 1200 AD? Don’t they call that the “Golden Ages” or something like that?

      1. democritus

        There weren’t any banks to worry about between 400 and 1200 AD.
        But that was OK because you could still swap chickens for folk remedies.
        Good times!

        1. Glen

          It’s impossible to HAVE a functioning free market economy without a government to enforce contacts, courts, etc.

          The inverse is not true, unless you count Somalia as your idea of a function free market.

  3. Doc Holiday

    Top 3 Naked Topics:

    Credit markets (1673)
    Banking industry (1619)
    Regulations and regulators (1320)

    Keep that focus going dudes; drill down to the core of this and challenge the masters of doom!!!

  4. MyLessThanPrimeBeef

    I think a strong case always needs just one good season and in this case, it’s TBFMY – ‘TOO BIG FOR MY TASTE.’

  5. abelenkpe

    Yes we can break up the big banks. We broke up Standard Oil, we can break up the big banks.

    Many smaller banks would employ more people and would provide better customer service in their local communities.

    We should break up big media for the same reason.

    Doing so will provide more jobs, be better for the local economy, and reduce the concentrated power of big banks and big media. What confuses me is why those that argue against big government don’t seem to have a problem with big banks or big business.

  6. Francois T

    It won’t happen soon, but not for the reasons cited by the previous posters.

    The real reason is that the size of banks makes them the perfect distributing machine of campaign contributions and regulatory capture.

    Please remember this: A bank examiner at the Fed makes between 40 and 140K a year.

    Compare that with ANY low level associate at Goldamn Sachs or JP Morgan. Remember also that quite a few of these examiners are quite good at what they do. Alas, in order to secure their future, they ought to migrate to the private sector; the perfect incentive NOT to ask too many questions that may irritate a future employer.

    Furthermore, and for reasons that no one can fathom, (or at least, explain in a coherent manner) our politicians seem to believe that mega banks are a matter of national security and economic advantage. Given what mega banks do, I fail to see how the fuck they can believe such hocus-pocus, but believe they do.

  7. Francois T

    It should be clear by now that the only even that could force the pols to engineer a break up of the mega banks is a second leg of this recession.

    Said second leg would have to be much more devastating and painful than the one we’re just (so we’re told) emerging from.

    It may happen: a financial implosion of the Eurozone would hardly be a boon for the US. As a matter of fact, we could witness a contagion impossible to manage this time. It is utter folly to believe our megabanks aren’t exposed to Europe: the question is how much and how deep.

    1. Dave The Mule

      “A bank examiner at the Fed makes between 40 and 140K a year.”

      There it is. This is what Grover Norquist is really talking about: When the regulators are grossly economically inferior to the regulated, then anything goes.

  8. Jackrabbit

    Before touting Alford’s work, you should consider his prescription: limit the size of banks in relation to the *market*. Simon Johnson’s benchmark for size would be GDP.

    The difference, is that under Alford’s plan, the big banks could argue that they operate in global markets and that their size is actually rather small in comparison. Alford’s plan, then is a prescription for banks to remain big or grow bigger — or at least gives them MUCH more room to make the case to their regulators.

    It’s not surprising then, that Alford’s banker-friendly argument leaves out a crucial “inconvenient truth” about TBTF banks: the problem with banks growing to large size isn’t that they can take advantage of informational asymmetries that exist independently (where they just have more info than others), its that they CREATE and WORSEN the asymmetries. Their “market leadership” turns into a collective power than can twist markets: the manipulation of rating agencies and politicians being a case in point.

  9. A_MacLaren

    Please help give visibility to proposed legislation that will require breaking up the mega-banks and ending To Big To Fail.

    http://www.govtrack.us/congress/bill.xpd?bill=h111-5159
    H.R. 5159: Safe, Accountable, Fair, and Efficient Banking Act of 2010

    http://www.govtrack.us/congress/bill.xpd?bill=s111-3241
    S. 3241: Safe, Accountable, Fair, and Efficient Banking Act of 2010

    Any CONgress Critter that will not co-sponsor can/should/will be tarred as favoring/supporting To Big To Fail banks.

    We The People need to rally support for these bills, in the way that We told CONgress not to give Hanky-Panky Paulson his first bazooka.

    Over at The Baseline Scenario, Simon Johnson gave a thumbs up when the Senate version was first entered into the record. Now the House version has come out. Karl Denninger put out a YouTube video on it yesterday.

  10. Kent Welton

    That is a good start, but it doesn’t set to the root of the privatized debt-money process bankrupting us. Only a Public Central Bank, and Public State banks, can restore constitutional money powers and oversight and relieve us of the debt burden thrust upon us the big bank owners, who also own the “Federal” Reserve and have sole possession of the out-of-thin-air money creation privilege being used to finance speculation and undermine the real economy.

    Kent Welton,
    PublicCentralBank.com

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