Yes, the Tech Giants Are a Big Problem—But the Untamed Finance Industry Could Still Blow Up the Economy

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Yves here. To add to Marshall’s tally of ticking time bombs in finance-land: another source of systemic risk is central counterparties for derivatives. They were supposed to reduce risk by shifting clearing and settlement of many types of derivatives out of banks and over to entities that would be well capitalized and at arm’s length to the banks. We’ve written how the central counterparties are new TBTF entities, since charging high enough margin and other loss reserves to provide for enough liquidity to handle a serious shock would make many derivatives uneconomical.

We summarized some of the failings in a 2018 post, which included key points from a recent Bloomberg op-ed by derivative maven Satyajit Das:

First, oversight is fragmented….

Second, the system assumes traders can meet margin calls at short notice…In practice, volatile market conditions require higher margins, which exacerbate systemic cash needs, force mass liquidation of positions and increase the central counterparty’s risk.

Third, initial margin-setting relies on risk models — based on assumed price behaviors and historical volatility and correlation data — that have repeatedly failed in the real world….the ability of non-defaulting members to bear losses may be lower than expected. Even single counterparty limits, designed to avoid concentrated exposure, are imperfect, as Norway’s case highlights.

Fourth, central counterparties have adverse incentives. To gain market share, they might undercut each other on margins or default fund contributions, thus undermining the stability of the system itself. The default waterfall also entails moral hazard: Strong firms, forced to bear the liabilities of the weak, have little motivation to become clearing members.

By Marshall Auerback, a market analyst and commentator. Produced by Economy for All, a project of the Independent Media Institute

Judging from the public conversation we’re having as we head into the early stages of the 2020 presidential election, bankers no longer appear to be public enemy number one. Big tech appears to have that title.

Still, let’s not forget that the actions of several large financial institutions in the run-up to 2008 were largely responsible for catastrophic job losses of millions of households, the repossession of their houses, the destruction of their retirement savings, the collapse of a multitude of businesses, an ongoing stranglehold into myriad forms of debt, and a relentless lobbying machine that exonerates it from any kind of oversight with real teeth.

The legislative response to this fiasco, the Dodd-Frank Act, is being undermined every which way, and wasn’t all that strong to start with. It was passed in order “to ‘promote financial stability,’ ‘lift our economy,’ and ‘end too big to fail,’” argued financial observer Tyler O’Neil, “and the bill has achieved none of those goals.” In fact, it created a host of perverse incentives that have likely made our problems a whole lot worse. Financial reform might be yesterday’s news, but we are inching closer to another economic crisis, in which the “old news” might very well become new and relevant again.

Why is that? For one thing, Dodd-Frank did not structurally alter the banking system (in contrast to the aftermath of the Great Depression via Glass-Steagall). The big “too big to fail” (TBTF) banks got bigger. And by bigger, we’re talking about a sizable ownership stake over 60 percent of GDP.

One prominent example is the newly established Consumer Financial Protection Bureau (CFPB—an Elizabeth Warren proposal that actually initially proved to be one of the few effective reforms introduced by the new banking legislation). The CFPB has been largely gutted by “acting” head, Mick Mulvaney. Likewise, the oversight provisions for big banks have been watered down by the appropriately named Crapo Bill, and Dodd-Frank’s detailed rule-making injunctions have largely been left to the discretion of bank-friendly executive agencies, such as the Federal Reserve, Office of the Comptroller of the Currency (OCC), and Securities and Exchange Commission (SEC), all of which have historically shown themselves to be prone to regulatory capture.

Even one of Dodd’s contributing architects, Lawrence Summers, in a piece co-authored with Harvard Ph.D. candidate Natasha Sarin, found no evidence “that markets… regard banks as substantially safer today than they were in the pre-crisis period.” Many of the same practices that led to the collapse of the financial system in 2008 are as prevalent today as they were in 2007. These include the revival of some of the most toxic products that contributed to the last crash, such as the synthetic collateralized debt obligation (CDO) and the related collateralized loan obligation (CLO), along with an ongoing regulatory culture that still expresses itself in policy preferences that favor industry interests over those of ordinary citizens.

Given the Democrats’ renewed enthusiasm for antitrust (at least as it applies to big tech), the question is whether “break ’em up” to foster greater competition is the way to go with banks, or whether a more “function-centric” approach to regulation makes more sense going forward. On big tech, I’ve written beforethat size per se may not be the best benchmark to establish optimal regulation. The same might be true for banks.

Simply mandating a breakup in the sector, married to “free market” competition and other market-based reforms, is unlikely to do the trick (that criticism applies as much to GOPers as it does to Democrats). As professors Marc Lavoie and Mario Seccareccia have observed, “greater competition could be a good thing in industries producing, say, ‘widgets,’ since the lower the price that could potentially ensue as a result of lower profits and greater productivity that would be impacted by the competition would have positive welfare benefits for the community at large.” But Lavoie and Seccareccia also recognize that banking is not only about profit for profit’s sake or competitive free markets; therefore, “applying these principles of competition to the banking sector, where there exists tremendous externalities, could be disastrous.”

One of those “externalities” arises from the fact that the banking sector has a unique social dimension that in many respects does not readily lend itself to all of the dictates of a competitive free market system. There is a reason why our government made a conscious policy decision after the Great Depression to guarantee the liabilities of the banking system via the Federal Deposit Insurance Corporation (FDIC). It was to protect the integrity of the payments system, the lifeblood of an economy, as well as the businesses and consumers who relied on the provision of credit provided by the banks.

A controlled oligopoly that disincentivizes banks from embracing risky speculation is one way to go (it works reasonably well in Canada, for example) because it focuses the regulatory thrust on function and outcome, rather than size alone. However, the U.S. banks are much bigger in asset size. “Too big to fail” (TBTF) is relevant here because Dodd-Frank has done nothing to stop the banks from getting bigger, even though they pursue many of the same reckless policies that caused their banks to blow up in the last cycle. In fact, the implicit TBTF safety net has virtually guaranteed that bankers would continue to take on excessive “tail risk” (i.e., too high a risk of ruin), argues Professor Edward Kane.

It is in that sense that size matters: much as the costs of a massive environmental cleanup increase in proportion to size, so too are the social and economic externalities much higher when associated with a big bank. But at the core, it is function married to TBTF that creates the root problem; simply using antitrust to foster competition is unhelpful if all such competition does is to drive banks, regardless of size, to embrace increasingly reckless activities that augment their respective bottom lines, and do so in a way that ultimately compromises the integrity of the payments system. There are some things banks should not be allowed to do, period.

So what’s the right approach: do high levels of concentration in the banking sector promote greater financial instability, or is it a question of function? In truth, they are interrelated, but function matters more.

Ask any neutral observer today whether Goldman Sachs or the Japan Post Bank (the world’s biggest deposit holder) poses a greater threat to financial stability and virtually all will agree that it is the former. That is because systemic risk is largely engendered via function, and “interconnectedness,” rather than asset size. In contrast to Goldman Sachs (or virtually any large American commercial or investment bank), the range of activities of the Japan Post Bank is limited to a fairly mundane roster of traditional banking functions—it is primarily a savings institution. As its Wikipedia page notes, “its only loan products are overdraft  lines secured by time deposits and Japanese government bonds on deposit with the bank.” This makes it highly stable, despite its massive size.

Nobody is realistically suggesting that we restrict our banks’ functionality to the degree of the Japan Post Bank. We can’t turn back the clock that far. But the Japan Post Bank example is an important illustration that a simplistic focus on size isn’t enough.

The corollary also applies: a group of relatively small institutions that act in a correlated fashion can be just as dangerous to the payments system as one large entity if the underlying activity in which they engage collectively is unsafe. Lehman Brothers’ activities were being replicated elsewhere (the “interconnectedness” problem), by others. Had it just been one small bank, the problem could have been better contained. Again, function supersedes size in terms of regulatory priority.

By the same token, it’s too pat a conclusion to argue that the collapse of a small institution such as Lehman Brothers somehow absolves the big banks. The root cause of Lehman’s failure was that it was a relatively small institution struggling to compete with the TBTF banks, whose massive balance sheets gave them a built-in advantage over the smaller competitor. Working to match the returns of the bigger banks, Lehman’s smaller balance sheet forced management to undertake further riskier activities (as well deploying dangerous levels of leverage). The resultant toxicity of their balance sheet made Lehman unsalvageable, leading the government to let it go bust.

“Let it go bust” is harder to do with a bigger bank. The externalities can be catastrophic. At the same time, the public instinctively understands the benefits of the implicit TBTF backstop accorded to big banks and hence continues to “vote” with its deposits. Which is to say that banking customers have increasingly migrated to these very same behemoth institutions precisely because the government has repeatedly shown that it will not let them go under (in contrast to smaller institutions like Lehman). America’s three largest banks by assets—JPMorgan Chase, Bank of America, and Wells Fargo—“have added more than $2.4 trillion in domestic deposits over the past 10 years, a 180% increase,” according to an analysis of the regulatory data conducted by the Wall Street Journal in 2018. (In the case of Wells Fargo, this ongoing deposit growth is truly incredible, given that the bank has seen its already low reputation decline further, in light of the scandalsthat have recently been uncovered.)

The same WSJ report goes on to note that this deposit growth represents “an increase from 20% of the country’s total deposit base in 2007 to 32%, an amount [that] exceeds what the top eight banks had in such deposits combined in 2007.” Add Citi to this group, and you have four banks holding almost half of America’s total deposit base.

The WSJ article also points out that “45% of new checking accounts were opened at the three national banks, even though those lenders had only 24% of U.S. branches… [whereas] regional and community banks… had 76% of branches but got only 48% of new accounts.” That matters because “new checking customers, who tend to be younger, are valuable to banks because they often provide more business later on by, for instance, taking out a mortgage or opening a brokerage account.” Rapid, unchecked business expansion, combined with regulatory laxity and TBTF bailouts, has therefore given banks an enormous incentive to get as big as possible. Dodd-Frank hasn’t changed that. In fact, a working paper commissioned by the Federal Reserve Bank of Philadelphia by authors Elijah Brewer III and Julapa Jagtiani has furnished multiple examples of banks paying significant premiums to ensure that they would be over the asset sizes commonly viewed as the requisite thresholds to become too big to fail.

But TBTF is even worse than that, because in many cases, it can actually sustain the lifespan of an otherwise insolvent bank, what Professor Ed Kane calls “zombie” banks: “Insolvent Living-Dead firms whose creditors would force them into bankruptcy were it not for various governments’ implicit TBTF guarantees” (Deutsche Bank is one example that immediately springs to mind). That matters because if you’re a bank CEO and you know that in reality your bank is already insolvent, what’s the disincentive from continuing to speculate with the bank’s balance sheet? TBTF enhances reckless moral hazard.

Although banks consistently lobby the government when an attack is made on their “profit-making activities,” the focus of those lobbying efforts obviously shifts to bailouts, the minute they are about to blow up. All of a sudden “government-led socialism” doesn’t seem so pernicious. It is not unreasonable to restrict the banks’ activities, especially when deposit-taking institutions are in a position unique to virtually any other business. The government underwrites their main liabilities—i.e., their deposit base—via the FDIC. No other business is afforded this level of protection.

Likewise, regulation has become increasingly complex and cumbersome in direct proportion to the complexity of the activities undertaken by the banks themselves. That’s often used as an excuse to minimize regulation, when in fact it should provoke a different response: namely, restricting the range of systemically dangerous activities/financial innovations, so that the regulation accordingly can be simplified, and easier to enforce. (Parenthetically, a function-centric approach is better here than simply focusing on boosting capital buffers, which many bank reformers have advocated. To be sure, capital buffers do constitute an important insurance policy for a bank in the event of a financial calamity, but regulation optimally should tackle the activities that give rise to the need for the “insurance policy” in the first place.)

If banks persist in undertaking a proscribed activity via regulatory arbitrage, or some other form of legerdemain, the challenge for policy makers/regulators is to contain the resultant fallout so that it does not endanger the financial system as a whole (as well as jailing the offending bankers so that “too big to fail” doesn’t morph into “too big to jail,” as clearly occurred in the 2008 crisis aftermath). At a bare minimum, the goal should be, as Keynes argued in Chapter 12 of the General Theory, for finance to act as a handmaiden of industry (or productive “enterprise”) rather than the other way around, since the latter condition results in an overly financialized system that is dominated by largely unfettered rentier speculative activity.

Unfortunately, Keynes’ aspirations remain unfulfilled. Banks dominate industry and work in ways that derogate from broader public purpose. The tolerance of TBTF doctrine illustrates that we don’t yet have the political will to curb the speculative activities of the large deposit-taking institutions (again, another byproduct of their size, as it gives the banks more lobbying muscle to resist such changes). But if we don’t come to grips with this problem, there will inevitably be another crisis. In fact, it’s almost certainly too late to avoid that eventuality. But at a minimum, let’s hope we do better when the next banking crisis hits, as it surely will, much as night follows day.

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    1. Yves Smith Post author

      Thanks so much for asking! He is still dying but more slowly than initially projected. He managed to get out of two scheduled euthanasia appts (vet comes to your house) by hiding shortly before the vet was due to arrive. He generally acts the same, he’s in his usual good mood but he’s only eating about 1/4 of what he usually does. So if the cancer doesn’t plug up his urinary system entirely (which means I’d have to put him down pronto, it would painfully kill him in 2-3 days), he’ll starve. He’s gone in a month from being 9.5 lbs to 8 lbs.

  1. human

    “Judging from the public conversation we’re having as we head into the early stages of the 2020 presidential election, bankers no longer appear to be public enemy number one. Big tech appears to have that title.”

    This is a feature, not a bug.

    1. RBHoughton

      They are all feeding at the immorality trough.

      We can’t regulate people who refuse to be regulated. They simply put their own people in control and neutralise any authority that might inconvenience them. We have to await the tbtf firms going down and then prevent POTUS and the legislature from again protecting them. A nationwide petition to our political masters of our intent. Wall Street should practice what it preaches which is Hayek’s non-intervention in markets. Let them solve their own problems if they can. The house of cards will then go down the tubes taking the stock and commodity markets with them and we’ll change the means of exchange to something reliable that is unavailable for gambling.

  2. Sound of the Suburbs

    To regulate the system you need to understand the system, but hardly anyone does.

    The UK eliminated corset controls on banking in 1979 and the banks invaded the mortgage market and this is where the problem starts.

    Whoever put those corset controls in place knew what they were doing; no one since 1979 has had a clue and the economy has been running on debt.

    We have been pulling future prosperity into today to inflate the value of the nation’s housing stock and the present has looked good at the expense of the future, when that debt gets paid back.

    What did Glass-Steagall actually do?

    Glass-Steagall separated the money creation side of banking from the investment side of banking. It also stopped the money creation side of banking from trading in securities.

    Without Glass-Steagall the bankers could create money to buy securities they produced themselves in a ponzi scheme.

    This is what they did in 1929 and 2008.

    1929 and 2008 look so similar because they are.

    Richard Werner points out, the Basel rules are based on the assumption that banks are financial intermediaries, but they are not.

    This is RT, but this is the most concise explanation available on YouTube.

    Professor Werner, DPhil (Oxon) has been Professor of International Banking at the University of Southampton for a decade.

    Financial stability is quite easy when you understand the system as Richard Werner explains. It’s just a matter of ensuring bank credit is directed into activities that grow GDP with the debt.

    If you see the private debt-to-GDP ratio rising bank credit is going into the wrong places that don’t grow GDP, e.g. inflating asset prices like real estate.

    Richard Werner was in Japan when it all went horribly wrong in the 1980s. Japan had an extremely stable economy that went massively wrong and this gave him all the clues necessary to work out what went wrong.

    The Chinese have now worked this out, but only just in time to see their Minsky Moment dead ahead.

    1. Milton

      This is RT, but so this is the most concise explanation available on YouTube.
      Fixed it for you.

      Excellent segment. Professor Werner distills the information so that even I can grasp the significance. Thanks.

    2. notabanktoadie

      It’s just a matter of ensuring bank credit is directed into activities that grow GDP with the debt. Sound of the Suburbs

      Like automation to dis-employ the public with what is, in essence, the public’s credit but for private gain?

      Now that the “job creators” are now net job destroyers, that approach is obsolete at best?

  3. rrenel

    I receive a small pension from Deutsche Bank and wonder if one of the financial engineers out there is working on a way for me and others to cash-out, perhaps via a CPO?

  4. The Rev Kev

    I use to think that an effective solution would be for Congress to pass a law. What it would say is that any bank or financial institute that blew themselves up and needed to be bailed out would have to meet the requirements of this law whose terms would be harsh. They would need to be nationalized for a starter. The management team would have to be replaced and all the books gone over with an outside accountancy team that would have to give a true picture of that firm under penalty of imprisonment for trying to guild any lilies. I can think of a few other conditions but realized that it would be pointless as Wall Street would use their political muscle to have any conditions waived due to political expediency. A shame that.
    The reason that I said that last sentence is that if the banks go south in an even bigger way than 2008 (likely as no lessons have either been learned or applied since then), then those bankers may find that the US government may not be always your friend. I do not think that the US populace would be willing to let even a bigger bail-out happen without their pound of flesh. The time for an Obama to protect the bankers has well and truely passed. Next time people will be out for blood. MBS in Saudi Arabia showed the way when he gathered up that country’s billionaires and shook them down for billions. A desperate government might resort to a few public arrests in Wall Street itself of some high placed bankers. The bankers may find that they will be getting the Butina/Manning treatment because when you come down to it, a politician will always throw somebody else under a bus before themselves. And the bankers will have only themselves to blame.

    1. shinola

      “The bankers may find that they will be getting the Butina/Manning treatment…”

      If only…

      I wish I could be that optimistic.
      Money can’t buy you love, but it can buy favorable representation in CONgress.

  5. Susan the other`

    Finance should act as the handmaiden of industry to avoid a financialization spiral. This is such a logical diagnosis that you almost have to conclude that our competition zeitgeist has caused maximum incentives for the finance industry to promote exponential complexity with counterparty risk. It works for their own survival. We should write laws that address non-productive competition/investments directly. Financial instruments that have nothing to do with reality should not be allowed to make a gain with money that is designed for the real world economy. That’s just like the business model for crypto coins. It’s pure nonsense. Another, more basic, contradiction that goes hand in hand with this is the use of sovereign money as both a medium of exchange and an unregulated store of value. It would be a gargantuan task to fix all the things about finance that are goofy – so we should certainly start with institutions that are strictly regulated against exponentiation of money or asset value because the end game can only go in one of two ways – it can either explode or implode, and the result is the same enormous (and totally unnecessary) tragedy.

  6. Chauncey Gardiner

    To immunize the payments system from the types of speculation Auerback described, reinstate the Glass-Steagall Act; enforce regulations pertaining to capital adequacy, liquidity and asset quality; enforce securities laws; and prosecute control fraud.

  7. ewmayer

    At the risk of seeming tautological –

    “There are some things banks should not be allowed to do, period. So what’s the right approach?”

    Um, those things the author notes which banks should not be allowed to do, period … how about not allowing banks to do said things, period?

    “Nobody is realistically suggesting that we restrict our banks’ functionality to the degree of the Japan Post Bank. We can’t turn back the clock that far.”

    Actually, for a large % of the citizenry, a non-rent-extracting postal bank would represent a radical advance, not a regression. We need banks to act *more* as basic utilities in support of the “lifeblood of the economy” payments system, not less. The unlearnt-by-the-policy-elite lesson of the GFC is that we need a functioning banking *system*, and to the extent that allowing the speculative/parasitical portions of the sector to fail while government-backstopping the payments-system-supporting organs supports that, it should be done. Yes, interconnectedness and TBTF-ness make that a nontrivial task – one more reason they should be regulated away, insofar as is possible.

  8. Marshall Auerback

    I did link the piece to Warren Mosler’s proposals, which would represent a good starting point as to where we should go with financial reform. The key, as Warren notes, is regulating the asset side of the banks’ balance sheets, rather than the liabilities side. Which is why his proposals are better than, say, simply advocating higher capital buffers. The latter is a useful insurance policy, but ideally, we want to get banking to a point where the insurance policy doesn’t need to be exercised.

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