Mr. Market Says Dodd-Frank Isn’t Working

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Yves here. While I am not convinced that breaking up big banks solves the “too big to fail” problem. Hedge fund LTCM nearly brought down the financial system in 1998. The comparatively small and simple by modern standards #4 bank in 1984, Continental Illinois, took seven years to resolve. Nevertheless, it would be a big step in the right direction. One of the advantages isn’t just reducing the size of firms but increasing their diversity. Andrew Haldane of the Bank of England warned that one of the big sources of instability in our modern financial system is a monoculture, in which the biggest firms are pursuing virtually identical strategies and using similar risk models (not just VaR, but FICO in their retail businesses) and trading approaches. Similarly, having more specialized players also means more contested regulatory demands as players with different customers and products jockey for regulatory advantage.

By Alexander Arapoglou, a professor of finance at the University of North Carolina’s Kenan-Flagler Business School, who been a derivatives trader and head of risk management worldwide for various global financial institutions, and Jerri-Lynn Scofield, who has worked as a securities lawyer and a derivatives trader

The objective of the 2010 Dodd-Frank legislation and other post-financial crisis regulatory reforms was to make the too big to fail banks so safe that they could not fail. Has this goal been achieved? The rating agencies answer no. If these agencies were convinced that the plethora of new rules– including increased capital requirements– had led big banks to achieve unquestioned credit standing, their bonds would be rated AAA.

Instead, bond ratings for the top 5 US financial institutions now hover around single A. These ratings scream to anyone who’s listening that the too big to fail institutions may indeed, fail. Mr. Market agrees: debt issued by too big to fail banks currently trades at prices consistent with their credit ratings.

Reforms undertaken since the demise of Bear Stearns and Lehman Brothers have failed on several fronts. The too big too fail banks are not fail-safe. They are more brittle and unable to act as shock absorbers than they were before. Holders of their shares are not deploying capital efficiently and small business is starved of financing. Where did regulatory policy take a wrong turn?

The missteps began during the financial crisis, when regulators were faced with two choices. The first would have turned back the clock on deregulation and re-erected walls between securities sales and trading, asset management, and commercial and retail banking. After such restructuring, smaller, more specialized financial firms would pose little risk to the rest of the economy if any failed.

The alternative approach– the one that was followed– was to accept that there were institutions that were too big to fail. Making these giant institutions safer became the regulatory priority. New rules were enacted and more aggressive and intrusive regulatory scrutiny mandated so, it was hoped, to prevent financial institutions from shooting themselves in the foot.

As a result, bank examiners have moved into the offices of many financial firms full time. They attend board meetings and drive business priorities by asking questions. Decisions are scrutinized lest they encourage untoward risk taking. The list of good intentioned ideas goes on and on. But to what end?
This matters because since 2008, too big to fail institutions have become much larger, posing an even greater risk to the economy than they did before. Bigger banks continue to increase their market share, the number of community banks has declined by 40%, and since June 2010, 500 of these have failed outright.

As banks have got bigger, many market participants— including at least one bank CEO– have conceded that these behemoths have become too big to manage. Goldman Sachs has reported that even JP Morgan Chase, one of the most profitable big banks, would be worth more broken into parts than kept whole– as is true with many conglomerates. The profitability of smaller, more narrowly-focused financial institutions usually exceeds that of institutions that follow a universal banking model, partly due to requirements that systemically important institutions maintain extra capital and overhead.

So how are we left? Dodd-Frank has sidestepped dealing with the central problem – a concentration of systemic risk that hangs over the real economy. Bank shareholders are worse off. Excessive capital requirements have burdened the economy without any offsetting increase in safety. The benefits to the broader economy of greater competition and better distribution have been forfeited without any offsetting gain. The corporate bond market has lost liquidity, adding costs and risk to the overall system for financing jobs, pensions, university endowments and insurance. And the decline of community banks has fallen hardest on small businesses, America’s biggest employer.

If regulators continue to to stumble down the wrong regulatory road, their next step might be to limit competition further, raising prices to guarantee bank profitability. This approach would certainly be safe, yet it would be costly, not only in terms of the cost of bank services, but it would also stymie new business formation.

There is an alternative: not to turn the clock back blindly, but to examine first what it was that made the Depression-era Glass-Steagall financial structure so robust. The regulators of that time quite rightly focused on preventing conflicts of interest and financial contagion. Their solution was to prevent the otherwise inevitable consolidation and oligopoly that follows when single firms are allowed to offer universal banking services by instead splitting up the largest financial firms and confining them to separate lines of business. More modern experts on regulation, such as Senator Elizabeth Warren, just last week again endorsed the general Glass-Steagall approach.

That framework wasn’t perfect; while it separated the domestic securities business from domestic banking, large banks continued to have securities operations in London and Tokyo. Yet while such regulations were firmly in place, the broader economy was insulated from boom-bust financial cycles generated by bank failures.

A modern version would be more far reaching. The most important banking function is the clearing function. If the financial system crashes, paychecks and payments for industrial and other supplies are “lost” and the entire economy would grind to a halt. Thus, as a first step, clearing and custody functions should be separated from everything else. They must be protected and restructured so as to best survive any future systemic shock.

But reform must go further. Trading of derivatives, securities and foreign exchange involves significantly more risk than the rest of banking. These operations should also be segregated — and more completely than in the watered-down Volcker rule that the Federal Reserve has more or less indefinitely deferred. Likewise, asset management activities should be conducted in distinct companies to avoid self-dealing. Brokerage functions should be spun off to avoid conflicts. Here, Eliot Spitzer well understood more than a dozen years ago that allowing one firm to undertake investment banking and sell securities sparked practices that inflated the firm’s bottom line at the expense of its brokerage customers. Many current regulators still have failed to absorb this lesson. Mergers and acquisitions activity should be made apart from lending decisions.

Breaking up the biggest banks would eliminate the too big to fail problem. Yet that wouldn’t be the only gain. If Goldman is right, this approach would benefit bank shareholders as well. A better plan where everyone benefits…. What’s not to like?

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  1. Bill Smith

    What does that title have to do with the article?

    The regulators could just stop giving them the exemptions in regard to deposit size….

    1. Vatch

      This paragraph shows the connection between the title and the body of the article:

      Instead, bond ratings for the top 5 US financial institutions now hover around single A. These ratings scream to anyone who’s listening that the too big to fail institutions may indeed, fail. Mr. Market agrees: debt issued by too big to fail banks currently trades at prices consistent with their credit ratings.

      That is, if banks are perceived as being sound, when they issue debt, they will pay a low rate of interest on the debt. But if the banks are perceived as being unsound, they will have to pay a higher rate of interest. Dodd Frank has apparently failed to create a perception that the largest banks are sound.

      I don’t know whether this is true, though. I don’t know whether the banks are actually paying higher rates of interest on the debt that they issue. I know that the interest they pay their depositors is insultingly low.

  2. Ed

    This actually represents the failure of one particular approach to fix the problems of capitalism, which is to allow big supposedly private monopolies, but have the government regulate them closely (the “utilities” approach). It has its attractions, though its a little too close to the corporatism favored by fascist thinkers. But other than throwing away the virtues of the opposing approaches of lots of smaller companies subjected to market discipline, or straightforward public ownership, you have the likelihood of regulators getting too friendly the big private monopolies (there is also the danger of regulators being so strict that the private companies can’t earn a profit at all, even as monopolies, but that doesn’t seem to be happening here).

    The approach may work with something like electricity and water utilities, since there bad regulation shows up immediately, in higher bills or shortages, and lots of people complain right away.

    1. James Levy

      I hate to agree with Joe Stalin about anything but his statement that “everything depends on cadres” is more and more apt. As out population grows, I see not concomitant growth in the number of capable, confident, and forward-thinking individuals who could and should be staffing our institutions. Can we even image putting up a Hoover Dam, fighting World War II, or putting a man on the moon in less than a decade of trying anymore? America has always been a nation prepared to do evil, but it was also a nation that got shit done. Now, we seem hemmed in on all fronts–we can’t adopt sustainable systems, we can’t convert to a more ecological economy, we can’t solve problems with waste and inefficiency in the distribution and storage of electrical power. Hell, we can’t even run a proper rail system. It’s easy to blame the rich, but I sense a deeper problem in the culture: a narrowing of focus, an inability to imagine, a lethargy and flabbiness of thought and will. The plutocrats are only partially responsible for this mess. The eager embrace of a suburbanized consumer culture by the educated class of Americans also must take some of the heat. Selfish and stupid penetrated well down the class ladder.

      1. sufferin'succotash

        Selfish and stupid we will always have with us, from one end of the social scale to the other.
        But when you have a political system designed to prevent popular majorities from making policies then selfish and stupid enjoy a huge advantage over unselfish and smart.

        1. Vatch

          Selfish and stupid, you say? One of today’s biggest news stories is that “American Idol” will be ending after the next season. This is huge! What will people do? For now, they are commenting on this very important event all over the internet. And I guess they’ll still be able to watch “The Voice”, the NBA championship, the World Series, the Super Bowl, and “Dancing with the Stars”. Gosh golly, why doesn’t Naked Capitalism report on this ginormous shift in the reality of our planet?

      2. hunkerdown

        It’s easy to blame the rich, but I sense a deeper problem in the culture: a narrowing of focus, an inability to imagine, a lethargy and flabbiness of thought and will.

        Let me stop you in your Whig Theory tracks right there. It isn’t a failure of imagination. It’s a failure of mimesis. Your phantasies are not inspiring. Your carrots are not credible. Your sticks are ineffective from overuse. Your value to society (ex yourselves) is increasingly tenuous. Your search for an energy sink to support the Great Chain of Being is in vain, because you don’t matter to us.

        Why are you trying so hard not to get this? What exactly is the basis of your authority, if not alignment with the elite?

      3. susan the other

        We should take proposed solutions as analysis. (Are there any that go against the establishment; I sincerely doubt it.) Permaculture is one. It is so powerful, it could change the world. If money went into permaculture, on smaller scales, individually operated by families or coops, that would be a good place for banksters to put their useless money. No “shovel ready” shit to invest in? Larry Summers’ great excuse. Actually there is no shovel ready shit to invest in that maintains the shovel ready oligarchs. Big banks, small banks – they all sell credit. And all credit is backed by the full faith and credit of the US Treasury. What the hell are we dithering about? The reason legislation to control “credit” isn’t working is because all the money is sucked off by the oligarchs. It’s just that simple. And another simple spending decision is do not ever spend money on automobiles. The car industry should be sent to the capitalist boneyard.

      4. Demeter

        Let me tell you what happens when you set out to get shit done….

        First, you are fought every step of the way by imbeciles who are threatened by any change, even that which will benefit them, if only because it will also benefit their neighbor, a person they despise for some hateful reason. Or it might cost a nickel more. Or some other trivial objection

        Second, you are blockaded by the envious, who want the glory and any power they can wring from the process, without contributing one neuron or fiber of muscle to the effort, let alone any capital.

        If you manage to overcome these immediate and personal objections, you then run the gantlet of Regulation designed to increase costs by 50 to 1000%, depending.

        If we are very unlucky, we will soon add International Barriers in the form of “trade agreements” which are nothing of the kind.

        Personally, I’m leaning towards torches and pitchforks. Low tech, effective, good for venting rage as well as getting the job done.

  3. Roger Edgington

    The Dodd-Frank bill is just a whitewash to make the people think that our so called “government ” is working for them. By the time the lobbyist got through handing out campaign contributions(bribes) it was like any other bill. If you take the name of the bill and apply the exact opposite of the name and you have what the legislation does.

  4. timbers

    Example of incredibly lame “liberal” media in action. Almost every single question Greg Sargent asks Liz Warren is a variation of “Are you saying there is no possible way even theoretically that Obama’s TPP deal can be changed for the good or to what he says it is or already is what he says it is?”

    Blatant shilling for Obama and TPP.

  5. Steve in Flyover

    You want to know why banks and private equity aren’t loaning any money?

    Because out in the blue-collar, real world economy, a return of 3-5% is doing pretty good.

    But a return of 3-5% isn’t worth the bankster’s time, when they insist (and get) 8-10%, just by playing funny money games, and the wretched refuse get to pay for any losses. Or employees, vendors, and people actually trying to run the business see their share cut, just so the banksters get theirs.

    1. Jeremy Grimm

      I agree with that assessment. But too big is a much broader problem. Banking includes myriad other complex issues. Glass-Steagall is a beginning but Yves is right — it is just a beginning. “A modern version would be more far reaching.” A lot of financial complexity has developed since Glass-Steagall and it must be controlled along with reconstructing ” … what it was that made the Depression-era Glass-Steagall financial structure so robust.”

      Just as re-enacting Glass-Steagall is not enough … we must stretch “too big to fail” to include too big for a competitive economy. The anti-trust laws must be dusted off and a lot of corporate behemoths must be sliced and diced to return such virtue as resides in “free-enterprise.”

      Furthermore, the Goverment acting on the mandates of National Defense — “True” National defense — must break down the long fragile supply chains that put our Industry and Commerce at the mercy of the whims of weather and the “unforeseen.”

      We must also change our tax laws to assure that no one person or organization can accumulate sufficient wealth (which past a certain point — is political power) to control their depravity and again guarantee government for and by the people the United States.

      Neoliberal thought must stamped out as witchcraft. We can use old shipping pallets to build the fire and bailing wire to build a structure from shipping pallets that we can bind these modern witches to with more bailing wire. In lieu of that, at least pull down their shibboleths and cast them into a cleansing fire.

      Time grows short along many lines.

  6. Argosy Jones

    Mr. Market agrees: debt issued by too big to fail banks currently trades at prices consistent with their credit ratings.

    Mr. Market is overlooking key facts, then. The debts of the “systemically dysgenic” financial institutions will be redeemed in full by the government, just like last time.

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