Ordinarily, it might not seem worth the bother to debunk yet another piece of bank propaganda. However Thursday’s op ed by former JP Morgan Chase chairman William Harrison, “Don’t Break Up the Big Banks,” recites a classic set of time-worn canards. As regulatory compliance expert Michael Crimmins said via e-mail, “It’s sounding desperate that they’re dragging Harrison out of retirement to spout this drivel.”Thus shredding this piece makes for one-stop shopping on this topic.
In classic Ministry of Truth style, Harrison depicts the critics of big banks as logically challenged:
The first fallacy is that the emergence of large, universal banks — combining commercial banking with investment banking — was an artificial or unnatural development. In 1990, there were 15,000 banks in the United States; this fragmented market meant that banks could not achieve economies of scale or easily serve clients on a national or global level.
Guess what, sport fans? Bigger banks exhibit DISECONOMIES of scale. Every study of banking ever done show that banks have a slightly positive cost curve once a certain size threshold is passed. That means that costs rise as banks get bigger. One study found the break point to be $100 million in assets, most find it to be between $1 and $5 billion in assets; I’ve seen ones that put it at $10 billion. The sort of bank Harrison is defending is vastly above that size level; JP Morgan at year end 2011 had $2.3 trillion in assets.
But what about those cost cuts you see when banks merge? Refer back to the diseconomies of scale: the acquirer and target each could have achieved those savings and even a smidge more without a merger. The transaction served as a excuse for expense reduction that each bank could have done separately.
As for “serving clients on a global scale,” big companies have long had numerous banking relationships, and take a “horses for courses” approach. The idea, say, that size would give JP Morgan an advantage in doing a merger in France is nuts. Major corporations typically make sure to have relationships with local banks in major countries in which they do business. While the major UK and US banks might snag some top local graduates, the native institutions are going to have a much bigger network of local contacts and expertise.
The real issue, which Harrison does not deal with honestly, is that the US banks used the European “universal banking” model as an excuse to push for regulatory waivers in the US. But universal banking has not served Europeans well. Any bank analyst will tell you that the large European banks went into the crisis more levered than their American counterparts, and they’ve made less progress in rebuilding their balance sheets. In addition, their big banks are even larger relative to their domestic GDP than the behemoth Americans. And some central banks have decided that level of risk is unacceptable. Contra Harrison, the Swiss National Bank now requires its banks to have 20% equity to force them to do a combination of shrinking and raising more equity. And after screaming bloody murder, UBS and Credit Suisse have decided that’s actually an advantage for them.
Back to Harrison:
Even now, the American financial services industry is far less consolidated than its peers across most of the developed world.
This is a virtue, not a defect.
Andrew Haldane, the Bank of England’s director of financial stability, has written that more diversity among financial players, which is the opposite of the model Harrison advocates, is pro-stability. Similarly, Australia has a very concentrated banking sector, and the IMF has issued warnings about its stability. And Canada, which is widely seen as having a financial system that weathered the crisis particularly well, is recognized for having done so precisely because its regulators were cautious about the universal banking model and curbed the major Canadian banks’ activities. Back to Harrison:
None of the first institutions to fail during the crisis — Countrywide, Bear Stearns, IndyMac, Fannie Mae and Freddie Mac, Merrill Lynch, Lehman Brothers, the American International Group — were universal banks.
Let me turn the mike over to Crimmins:
Indeed. Yet the failure of these non universal banks and non-banks threatened to bring down the US banks and the European universal banks in one fell swoop. As counterparties to the TBTF banks these counterparties were de-facto universal banks. Their failures, especially AIG, were also those of big banks in substance, if not in form. Shame on any fool who insults our intelligence by making this argument with a straight face.
As as Crimmins implies, the big banks needed to be rescued as well, and the scope of the assistance, as most NC readers know full well, go well beyond the TARP. Savers and retirees are still being taxed to help the monster banks in the form of super low interest rates.
Harrison tries to blow off how these companies have become too complex to manage:
A company of any size needs robust management and controls to manage complexity. Remember that smaller financial institutions — look at MF Global, Bear Stearns, Knight Capital — have had their share of risk-management failures too.
In fact, large global institutions have often proved more resilient than others because their diversified business model ensures that losses in one part of the enterprise can be cushioned by revenues in other parts. In some cases, complexity can be an antidote to risk, rather than a cause of it.
This is pure and simple dishonest argumentation. The fact that small firms “had their share of risk management failures” in no way exonerates the colossal risk management screw ups at the biggest players that led to a global financial crisis (or did you somehow forget that part?). And JP Morgan wasn’t a paragon, it was simply less visibly bad. Post-crisis, it was revealed to have taken what Lehman called “goat poo” as collateral for months; the realization that it was holding some empty bags appears to have been the proximate cause for the seizing of cash and collateral that was the fatal blow.
And let us not forget that JP Morgan, praised as the most well managed and best risk controlled, has been exposed as a rogue institution, as far as its risk controls are concerned (confirmed by their external auditors). As Crimmins wrote in July:
The first stunner, that JP Morgan was restating the first quarter financials, should have caused a deafening ringing of alarm bells. For a company of JP Morgan’s stature to be compelled to restate prior period financials is a very clear signal of bigger problems with their overall financial reporting.
As for the “resilience” that has nothing to do with complexity. Complexity is a function of inter-relatedness. Harrison is talking about diversification. If JP Morgan bought a big pharmaceutical company, it would be even more resilient. The party line is that even if banks are in a lot of businesses, they won’t necessarily all go down together. But that didn’t happen in the crisis. Indeed, as banks become more and more trading driven and markets become even more interconnected, the traders’ saying applies: In a crisis, all correlations move to one.
Harrison resorts to the Big Lie:
Commentators point to the inordinate influence large banks have on the political process. They fear that regulators are cowed by a large bank’s position and power. These critics seem to believe that regulators are incapable of making independent judgments. In the real world, this is just false.
Go read Neil Barofsky’s book Bailout or Frank Partnoy’s extremely well documented Infectious Greed for counterevidence. And you see proof every day. Just look at the brouhaha over Benjamin Lawsky’s order against Standard Chartered. The federal banking regulators still haven’t gotten over being shown up, and are continuing a campaign in the press against Lawsky, arguing that banks won’t cooperate with investigations. Huh? That’s an admission that regulators are so captured that they don’t know how to investigate any more.
This part is another flat out lie:
Another criticism I often hear is that large banks receive huge, implicit subsidies from the government and can borrow more cheaply because they are seen as “too big to fail.” But the facts don’t bear this out. An AA-rated bank deemed too big to fail by pundits cannot borrow any more cheaply than an AA-rated industrial company. One can see it every day in their bond spreads.
The industrial company/financial ratings comparison is deliberately misleading. Financial firms are vastly more levered that industrial companies of similar ratings and have thus always faced higher borrowing costs.
The rating agencies actually make a ratings distinction based on the TBTF status. As Andrew Haldane wrote (emphasis mine):
One such measure is provided by the (often implicit) fiscal subsidy provided to banks by the state to safeguard stability. Those implicit subsidies are easier to describe than measure. But one particularly simple proxy is provided by the rating agencies, a number of whom provide both “support” and “standalone” credit ratings for the banks. The difference in these ratings encompasses the agencies’ judgement of the expected government support to banks.
Table 2 looks at this average ratings difference for a sample of banks and building societies in the UK, and among a sample of global banks, between 2007 and 2009. Two features are striking. First, standalone ratings are materially below support ratings, by between 1.5 and 4 notches over the sample for UK and global banks. In other words, rating agencies explicitly factor in material government support to banks.
Second, this ratings difference has increased over the sample, averaging over one notch in 2007 but over three notches by 2009. In other words, actions by government during the crisis have increased the value of government support to the banks. This should come as no surprise, given the scale of intervention. Indeed, there is evidence of an up-only escalator of state support to banks dating back over the past century.5
Table 3 takes the same data and divides the sample of UK banks and building societies into “large” and “small” institutions. Unsurprisingly, the average rating difference is consistently higher for large than for small banks. The average ratings difference for large banks is up to 5 notches, for small banks up to 3 notches. This is pretty tangible evidence of a second recurring phenomenon in the financial system – the “too big to fail” problem.
It is possible to go one step further and translate these average ratings differences into a monetary measure of the implied fiscal subsidy to banks. This is done by mapping from ratings to the yields paid on banks’ bonds;6 and by then scaling the yield difference by the value of each banks’ ratings-sensitive liabilities.7 The resulting money amount is an estimate of the reduction in banks’ funding costs which arises from the perceived government subsidy.
Table 4 shows the estimated value of that subsidy for the same sample of UK and global banks, again between 2007 and 2009. <strong>For UK banks, the average annual subsidy for the top five banks over these years was over £50 billion – roughly equal to UK banks’ annual profits prior to the crisis. At the height of the crisis, the subsidy was larger still. For the sample of global banks, the average annual subsidy for the top five banks was just less than $60 billion per year. These are not small sums.
Table 4 also splits UK banks and building societies into “Big 5”, “medium” and “small” buckets. As might be expected, the large banks account for over 90% of the total implied subsidy.
Remember, Harrison just tried to con you into believing this enormous subsidy didn’t exist.
The last bit is disingenuous:
Finally, some critics have called for a revival of the Glass-Steagall Act (which separated commercial and investment banking) and a tougher version of the Volcker Rule (which would bar banks from using their money to make bets in their own trading account), without, it seems, having read either. The Glass-Steagall Act (repealed in 1999) prohibited commercial banks from underwriting debt and equity issues, a very safe activity; it did not prohibit banks from trading, engaging in derivatives, leveraging themselves or making bad loans.
If you took what he said literally, he’s just argued for ALSO restricting bank activity in trading, derivatives, leverage, and lending generally, which is something I’d favor. Glass Steagall might be a place to start, but it is insufficient. We’ve argued that banks are so heavily subsidized that they can’t properly be considered private enterprises and should be regulated like utilities.
But let’s go back to Glass Steagall. The restriction on underwriting had the effect of being in the secondary market business (trading and sales, for bonds, brokerage, for listed stocks) much less attractive. And those business, as integrated businesses (which they became in the 1970s and 1980s) were risky. For instance, bulge bracket firm First Boston nearly failed in the late 1970s, and did fail in the 1980s (it was rescued by Credit Suisse).
As for derivatives, had Greenspan not been the Fed chairman, it’s very likely banks would not have been allowed to build up businesses of the scale that they did. Volcker has made it clear that he disapproves of a lot of the risks banks take with deposits. And Greenspan’s hands off attitude to derivatives was stunning. I had some experience in the field by virtue of having worked with one of the leading players in that space. I recall gasping out loud when I read in Institutional Investor that Greenspan was going to take a “let a thousand flowers bloom” posture towards over the counter derivatives and merely look over the banks’ shoulders as far as their risk models were concerned, as opposed to implementing regulatory standards. I knew it would end in tears; it took longer and was a bigger blowup than I could possibly have imagined.
On to the next bit of banking PR:
Scale allows them to deliver, like big-box stores, more innovation, greater convenience and consistent, reliable service.
As Crimmins said via e-mail:
Big box stores rely on a labor arbitrage business model to deliver lower prices to US consumers to their own customer’s employment detriment. (Wal-Mart , Apple, etc keep prices low due to low labor costs at their non US suppliers). Banks rely on regulatory arbitrage to deliver superior returns to their investors and employees. These benefits are fully funded by their most vulnerable retail customers.
The big banks scale pits their retail customers against their larger institutional customers. On a net basis their retail customers pay for the benefits their institutional customers enjoy.
Harrison closes by waving the flag:
One of America’s great strengths is that we are home to the broadest, deepest and most efficient capital markets in the world. It’s a competitive advantage that we can’t afford to lose.
And the reason we obtained and still have that position? It was by virtue of having good regulations that protected investors. Investors prefer dealing in markets where front running is prohibited, disclosures are clear and complete, and insiders can’t take unfair advantage of their privileged information. Harrison clearly thinks he is addressing an audience that never ventures into the business pages. After the raping of customers in Lehman’s UK brokerage, the Libor scandal, and now Standard Chartered, London’s light touch regulation is coming to be recognized as a hazard to investors’ health. As indicated above, Credit Suisse and UBS have found their safe haven status enhanced by taking their regulatory medicine. But Harrison would never admit that the sort of remedies that other regulators have imposed on universal banks might actually be good for the American behemoths as well.