During the Microsoft antitrust case, some institutional investors were keen for Microsoft to lose, and not because they were short its stock. They felt that Microsoft being in both the operating systems business and the applications business had become a negative. They believed that separating the two businesses would not only produce higher multiples over time for each as “purer” plays, but having each new business more narrowly focused would be better for growth in the long term.
We have a similar discussion taking place regarding the big banks, and the pro-breakup case is even stronger there than for the software giant. Last weekend, the Harvard Law blog posted a piece by Peter Wallison of the American Enterprise Institute. For those who don’t know Wallison, both he and the AEI are fond of making strained at best, completely dishonest at worst, cases for large financial services industry players. I had wanted to shred his piece regardless and a comment in the Financial Times by Andrew Haldane, executive director of financial stability at the Bank of England and widely recognized as one of the savviest economists on this beat, happens to rebut one of Wallison’s main arguments, that of the “value” of these complex financial firms. Haldane’s article was prompted by an EU proposal to break up banks along risky trading businesses versus deposit-taking related activities. This overview comes from the Wall Street Journal:
Mind you, we think this focus is somewhat misplaced. While it would clearly be desirable to reduce the size and degree of integration of the “too big to fail” banks, the first order of business is to reduce interconnectedness. Even if the officialdom finally got the willpower to split up the behemoth firms, the authorities clearly regard the capital markets as too important to allow to fail. Although bank lending is important, in the US, more credit is ultimately provided through securities markets than on balance sheet bank lending. These markets are over the counter, meaning the big dealer banks buy and sell from end investors. The dealer banks are tightly interconnected via counterparty exposures (particularly in derivatives markets). As we saw with Lehman, if one goes down, it has serious ramifications for its peers. And because the dealers tend to pursue similar strategies, when one looks wobbly, providers of short-term funding for the entire industry start looking for the exits. So reining in over-the-counter derivatives, particularly credit default swaps, needs to be a top priority.
But reducing the size and complexity of the big firms is nevertheless a worthy goal, if nothing else to reduce their political influence (smaller, more specialized firms would have different interests and instead of seeing megabanks all on the same page, you’d see the new players duking it out on some issues).
Readers might enjoy the Wallison piece, in a perverse way, it’s an almost laughable overreach. It starts with a big assumption: that banks are such valuable and important enterprises that we need to evaluate the costs and benefits. Amusingly he takes the dismissive posture that the critics have not looked at “the most elementary issues”.
Erm, Wallison cannnot NOT know of Andrew Haldane’s work, and Haldane has already decisively debunked Wallison’s claim regarding cost and benefits of intervening to reduce the risks of the biggest banks, so he’s just established that he is willing to lie to make his case (par for the general caliber of his intellectual honest, he also depicts the FDIC interventions in Wachovia and WaMu as examples of TBTF banks being prevented from failing. No, these were big ordinary banks where a sale to an incumbent was a less costly resolution than a liquidation. This has nothing to do with TBTF, this is the standard FDIC approach applied to very large banks). Whether or not the other critics are aware of Haldane’s critique is irrelevant. We’ve quoted this section of Haldane’s paper “The $100 Billion Question” repeatedly because its findings are devastating. As we wrote earlier:
More support comes from Andrew Haldane of the Bank of England, who in a March 2010 paper compared the banking industry to the auto industry, in that they both produced pollutants: for cars, exhaust fumes; for bank, systemic risk. While economists were claiming that the losses to the US government on various rescues would be $100 billion (ahem, must have left out Freddie and Fannie in that tally), it ignores the broader costs (unemployment, business failures, reduced government services, particularly at the state and municipal level). His calculation of the world wide costs:
….these losses are multiples of the static costs, lying anywhere between one and
five times annual GDP. Put in money terms, that is an output loss equivalent to between $60 trillion and $200 trillion for the world economy and between £1.8 trillion and £7.4 trillion for the UK. As Nobel-prize winning physicist Richard Feynman observed, to call these numbers “astronomical” would be to do astronomy a disservice: there are only hundreds of billions of stars in the galaxy. “Economical” might be a better description.
It is clear that banks would not have deep enough pockets to foot this bill. Assuming that a crisis occurs every 20 years, the systemic levy needed to recoup these crisis costs would be in excess of $1.5 trillion per year. The total market capitalisation of the largest global banks is currently only around $1.2 trillion. Fully internalising the output costs of financial crises would risk putting banks on the same trajectory as the dinosaurs, with the levy playing the role of the meteorite.
Yves here. So a banking industry that creates global crises is negative value added from a societal standpoint. It is purely extractive. Even though we have described its activities as looting (as in paying themselves so much that they bankrupt the business), the wider consequences are vastly worse than in textbook looting.
Back to the present post. The implication of the Haldane analysis is stark: the cost of major financial crises is so horrific that the big banks cannot even begin to pay for the damage they inflict on others. This means radical interventions to reduce systemic risk are not only warranted, they are highly desirable.
The Wallison piece is rife with rhetorical fallacies: tu quoque in complaining that the folks who want to break up banks aren’t proposing to break up non-banks like AIG (ahem, he’s airbrushed out that that actually was the original plan, and then the newly-installed CEO Robert Benmosche and his board defied Treasury, and Geithner, never one to cross a big financial firm, acquiesced. And your humble blogger was not alone in objecting to this change in plans).
Wallison disingenuously treats “Too Big to Fail” literally, as in all about size, when the regulators are clearly concerned with SIFIs, systemically important financial institutions. Geithner and others have conceded that crisis conditions might reveal unexpected players to be systemically important (no one is going to forget that after LTCM), but the fact that regulators might not have perfect foresight is no excuse for not dealing with obvious candidates. And complexity is just as important a characteristic of SIFIs as bulk. Indeed, proposals such as that of the Vickers Commission in the UK calls for ringfencing the retail and small business operations (this differs from the EU proposal, in that it is less than a full split, and the lines are as of now drawn in different places). Those both serve to make each unit smaller but at least important, less difficult to manage and supervise.
Haldane points out that global banks, which in the early 2000s traded at two or three times the book value of equity. Most now trade at a discount to book, sometimes a large one. That means investors simply don’t believe their balance sheets. Haldane contends regulators can help:
There is a strong case for regulators stepping in to lessen the uncertainties over valuations. That might mean calculating prudent valuations across banks’ balance sheets, as the Bank of England’s Financial Policy Committee recently suggested with respect to UK banks.
These prudent valuations would help in removing residual uncertainty about banks’ legacy portfolios. They could thereby spur private investors to return to banks, when they might otherwise be fearful of paying for yesterday’s mistakes. That would boost bank valuations and support bank lending.
It’s much easier to say that in the UK than here. Geithner’s “foaming the runway” strategy of using mortgage modification programs not to help borrowers but to make life easier for banks by spreading out foreclosures, was a sop to Bank of America above all.
But this suggestion is a warmup to Haldane’s main point:
Many large universal banks are a complex portfolio of franchises. It is very difficult to value any individual component of that portfolio in the current environment. And it is almost impossible to value the portfolio as a whole. For example, in the current environment are investment banking revenues a hedge or a headache?
At present, investors are pricing for a migraine. Market prices suggest the banking whole may be worth less – in some cases much less – than the sum of its parts. There are market-implied diseconomies of scale and scope. The problem for investors appears to be not so much too-big-to-fail as too-complex-to-price.
This was last the case in the depths of the Depression. Then, mirroring recent experience, US bank price-to-book ratios fell from above two to well below one between 1928 and 1933. This set the stage for the Glass-Steagall Act, a market-induced but regulatory-enforced unbundling of the banking portfolio.
Actually, what set up Glass Steagall was an alliance of the Rockefeller interests with the Jewish financial firms, which were not meaningful retail bank players, against the House of Morgan. But despite its true origins, the effects were nevertheless salutary. Stock underwriting and brokerage, which evolved into integrated investment banking over time, are operationally and culturally very different than managing a commercial banking business. The former is a flexible, adaptive organization that pushes decision-making authority down the ranks to allow for opportunity capture; Amar Bhide called it “hustle as strategy”. And the partners overseeing profit centers had typically spent their careers in that business and were more producers than managers. By contrast, traditional commercial banks have tight operational controls, and focus on routinization of mundane tasks, which in turn means front line staff and lower and mid-tier managers have comparatively little discretion. And while investment bank partners had narrow scopes of responsibility, commercial bank managers oversee large empires. It isn’t hard to see why the marriage of such different management approaches has produced such ugly outcomes as commercial banks have labored mightily to become more investment bank-like and investment banks have gone public to allow them to obtain cheap capital to support much bigger operations than they could as partnerships.
While pushing financial behemoths to narrow their product lines won’t solve the too big to fail problem, it’s an important step in the right direction. And the protests from people like Wallison are an encouraging sign. It suggests the banks are concerned that the regulators, admittedly far more slowly than most citizens would like, are not relenting in their efforts to rein in systemically dangerous players.