Quite a few readers excitedly sent a link to a Bloomberg editorial, “Why Should Taxpayers Give Big Banks $83 Billion a Year?” which summarizes a study by Kenichi Ueda of the International Monetary Fund and Beatrice Weder di Mauro of the University of Mainz that the editors used to extrapolate that the five biggest US banks are “barely profitable” if they weren’t able to borrow at artificially cheap rates thanks to the market perception that they are too big too fail.
The Bloomberg article, while analytically flawed, still winds up being too charitable. It looked at only one subsidy, how the implicit guarantee too big to fail guarantee lowers the borrowing costs of the biggest banks. Now on the one hand, Matt Levine is correct to point out that Bloomberg sloppily applied a funding cost advantage based on bond yields to deposits and short-term funding as well. However, he also cheerily acts as if deposit insurance is fairly priced (as in banks are “paying” for deposit insurance, hence no subsidy there). That’s bollocks, and Levine ought to know better. Even Greenspan conceded that FDIC insurance was too cheap.
The highly respected Andy Haldane of the Bank of England, in a 2010 paper, “The $100 billion Question” reached a conclusion not quite as dire as Bloomberg’s, but still in the ballpark:
Table 4 shows the estimated value of that subsidy for the same sample of UK and global banks, again between 2007 and 2009. 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.
So the biggest banks are borderline profitable to unprofitable over the cycle. And remember, the first acute phase of the crisis didn’t start until August 2007, and there were intervening periods through September 2008 where risk spreads fell back.
And remember, we really aren’t looking at the right question. Funding subsidies are only one piece of the puzzle.
Ed Kane of Boston University estimated that in 2009, the cost of systemic risk insurance to the largest banks would have been roughly $300 billion. If we look at the five biggest banks in the Bloomberg list (JP Morgan, Bank of America, Citigroup, Wells Fargo, and Goldman) and look at the proportion of funds they took in the $205 billion TARP Capital Purchase Program plus the additional $20 billion each in equity purchases for Citi and BofA through the Targeted Investment Program, you get that those banks received 57% of the total.* Let be generous and round it down to 50%. You still get an estimated $150 billion in subsides for the five biggest banks. So contra Levine and big bank defenders, doing a more precise tally actually makes matters worse, not better, for the big banks.
Moreover, none of these analyses factor in the ongoing subsidies of ZIRP and quantitative easing. Lest anyone forget, interest rates were dropped to the floor to keep the banks from keeling over and the Fed dares not increase them until it deems the economy to be looking perkier. I’ve seen estimates that the cost of ZIRP to savers is $350 billion. That is yet another subsidy to the banks, particularly the biggest ones. Recall that this is the second time in a decade that the Fed has chosen to impose negative interest rates to help banks. Greenspan also dropped Fed funds rates in the dot bomb era, not for the usual one quarter, which had been the Fed’s previous behavior in a recession, but for a full nine quarters. Greenspan was apparently unduly concerned that a stock market downturn lead to deflation.
QE is a harder-to-measure subsidy. QE has been focused on lowering the cost of mortgage credit, which gooses the value of mortgage-related assets. Even though the Fed focuses on how it helps homeowners, it isn’t hard to imagine that the central bank is at least as concerned with how it flatters bank balance sheets.
And we have other important forms of government support. The US has been pushing, hard, for foreign countries to open their financial markets so they can be conquered by US financial firms. They strong-armed the Japanese to deregulate banking, with the result that they went head over heels for zaitech (
speculation financial engineering), which no doubt served to make their joint real estate/stock market bubbles worse. The Asian crisis served as another opportunity to wedge the door open in formerly protected markets. How much is it worth to have Bob Rubin, Larry Summers, and Timothy Geithner lobbying on your behalf?
And make no mistake that the decision to treat banks as favored children is long-standing. Consider this:
Our current approach to regulating commercial banks is bankrupt….After years of benign neglect, we are now engaged in debate over the future of our banking system at a time when our banking system is, along with our economy, fundamentally weaker than at any time since the Depression….
In fact, a credit crunch is underway…As the economy weakens, the cash flows of supporting the debt payments of all sectors of the economy erode. As defaults mount, bankers curtail credit further. Borrowers curtail their expenditures further. Economic activity falls. Cash flow falls. Credit flows are curtailed further. Given the heavy debt burden of many sectors of the economy, and the weakness of the banking system, a downward spiral, once started, could continue for quite a while…
Even if we are lucky and are able to arrest this spiral, the recovery is likely to be anemic…
Today, the banking system is like a long-neglected bridge. The nation has not been paying attention to it; its functions are taken for granted. It is now beginning to show signs of rapid deterioration. Unless a major effort is taken to shore it up, it is likely to collapse.
Fortunately, President Bush, the Treasury department, the Federal Reserve, the Federal Deposit Insurance Corporation, and many members of Congress are well aware that the problems in the banking industry need to be addressed now, and a new answer is needed. Indeed, in early 1991, there appeared to be a concerted effort by government to improve the profitability of the banking system….This is the central issue we face.
The book was Bankrupt, and author was Lowell Bryan, one of the three leaders of McKinsey’s banking practice at the time. It is typical McKinsey leading edge conventional wisdom: banks desperately needed to rebuild their capital bases, ergo, they needed regulation oriented towards making them more profitable. Since the deregulation of the 1980s had led directly to the savings & loan industry blowing itself up impressively (aided in many of the most dramatic cases by Mike Milken), one might conclude that haphazard deregulation is not such a bright idea. And the weakened equity bases of banks also might mean they needed breaks until they got back on their feet, not permanently.
It turned out that Greenspan’s engineering of an extremely steep yield curve in fact did enable banks to earn their way back out of the hole they were in much faster than the pundits expected. But banks had been pushing to get into higher-return investment banking businesses since the 1960s, and used the change in regulatory assumptions to their full advantage. All restrictions on interstate banking were eliminated in 1994. By 1996, Glass Steagall was a dead letter.**
The point is that the banking industry has been profitable (at times, seemingly very profitable) only at the result of long standing government intervention to assure its profitability. It is no exaggeration to say that the banking industry enjoys so much public support that it can in no way be considered to be a private enterprise. But we’ve put in place the worst of all possible worlds: we’ve allowed an industry that couldn’t figure out how to operate profitably on its own to extract undeservedly large subsidies, with the result that financial services industry has become extractive. Its pay is wildly out of line with the social benefits it provides (indeed, many of its most predatory activities are also its best remunerated) and it has also grown disproportionately large, sucking resources away from better uses (we’d clearly be better off if math and physics grads were tackling real world problems rather than devising better HFT algorithms. And when you have bank branches displacing liquor stores, you know something is out of whack).
The better solution in 1991 would have been to engineer a modestly and reliably profitable and boring banking industry. But that would have taken a lot more thought than letting bankers do what they wanted, which was enter the Wild West of investment banking. The result has been more frequent and severe financial crises, culminating with one that nearly destroyed the global economy. Unfortunately, no one in the officialdom seems able to recognize that the only time we had a long period of stability in the banking system in the US was when banks were strictly regulated and made only modest profits. Until policymakers are willing to act on that understanding, financiers will keep up their extortionate practices until they bleed their host dry.
*Trying to factor in AIG would not improve the picture, since the reason for saving AIG was that banks were its credit default swaps counterparties, so the salvage operation for AIG was a backdoor bailout of the big US and international banks. You would show the spillover to foreign banks, but Kane’s number was for domestic banks only.
** The Fed issued a ruling that permitted bank holding companies to obtain as much as 25% of their revenues from investment banking activities.