Your humble blogger has been saying that the new bank rescue scheme, which is a covert backstop of nearly all uninsured deposits, is a disastrous extension of government support to institutions that are welfare queens save for executive and manager pay levels. And the Fed may make banks’ “Heads I win, tails you lose” bet even bigger by announcing that all deposits will be guaranteed.
We’ve argued since the crisis that banking is the most heavily government subsidized industry, far outstripping the military-surveillance complex in the support it gets from the great unwashed public. Yet every time banks predictably drive themselves off the cliff, they get even more goodies, with virtually nada in the way of new restrictions or punishment of miscreants. The US is keen to perp walk Donald Trump, but not bank executives.1
Aside from the long-overdue need to prosecute more bankers and also swiftly remove bank top managers who demonstrate that they are bad at banking, the US needs to regulate banks like utilities. They need to be kept stupid and allowed to make safe and boring profits. So no one talented will want to work for them? Outside of IT, where big banks’ systems are held together with duct tape and baling wire, banking does not require “talent” (which today usually amounts to rule-breaking or at least soft corruption), but people who perform reliably and competently. Our financial system is dangerously outsized. One way to put that in reverse is to set out to reduce pay levels across the industry.2
Georgetown Law professor and former Special Counsel to the Congressional committee which supervised the TARP Adam Levitin weighs in on where this even greater permissiveness towards banks is set to take us. Levitin starts by pointing out that the authorities simply will not shut down or otherwise hog-tie sick banks:3
The response to the current crisis only confirms that regulators will not shut down troubled banks: the Fed’s new Bank Term Funding Program is a zombie-bank life-support program. The new Fed facility allows banks to borrow against their Treasuries and agencies at par, not at market value. That’s a way of extending support to banks that have failed at Banking 101 and mismanaged their interest rate risk. What that should tell everyone is that the game plan for dealing with this crisis is basically the same as in 2008: extend and pretend. Specifically, banks will be given all sort of support to enable them to avoid immediate loss recognition (as many would be in prompt corrective action territory if their securities portfolios were marked to market) and to claw their way back to solvency through retained earnings. In 2008, the extend and pretend was about bank’s loan portfolios. Now we’re just repeated the song in the key of securities.
The idea that regulators simply will not order abandon ship until the bow is below water is reinforced by the history of regulatory (inaction) on all sorts of other legal violations by banks, be it for AML or consumer protection. Exhibit A here is Wells Fargo, a repeat recidivist, still having a charter. If regulators will not take away the charter of a bank that engages in repeated and egregious violations of law, when will they ever do so?
Levitin contends that the problem is that regulators are afraid of intervening early because doing so makes them look bad. Sadly, I think the root problem is even worse.
Bank regulators think it’s good for banks to be profitable because retained earnings are the big source of additional capital for banks. That means they are too willing allow financial firms to engage in “innovation,” particularly the sort that looks like it generates earnings now and the greater risks are hidden or can be ‘splained away. As Taleb warns, tails are fat so in lots of cases those risk bombs blow up. More generally, this pro-“innovation’ stance fits with the pervasive US regulatory stance that everything not specifically prohibited is permitted, while for banking, the regime needs to be that anything not specifically permitted is prohibited. But that’s another change we are unlikely to see.
A second problem is the US does not seem to have the capability to resolve any really large bank, particularly one with capital market operations. And there is a pragmatic problem: those banks have large trading books. It’s not clear how they could be wound down (the last time I can recall anything like that happening was with LTCM ad they were big enough to be dangerous but not part of the central plumbing).
Consider the last really big bank resolution: Continental Illinois, then the fourth largest bank, in 1984. Continental Illinois was in receivership till 1991.4 I suspect that result has led the FDIC to be extremely resolution averse (despite Shiela Bair, to her credit, wanting to pull the plug on Citigroup during the crisis, but she was checked by Geithner and Bernanke, who withheld information about huge areas of Citi’s operations, making it impossible for her to make an informed decision).
Mind you, that does not mean there are no answers to this problem, but they entail regulators doing what they don’t like to do, at least in the US: acting like they are in charge. For instance, punishments of banks that defy or ignore regulator warnings about serious problems could be subjected to removal of key executives and board members. That means regulators would need to be able to find replacements quickly. In theory that is not hard: the world is awash in senior bankers who lost out in political fights and would love to be personally vindicated by being called into a rescue operation. The tricky part is having a vetting process that is fast, robust, and can be defended as not cronyistic.
Another approach is to limit top bankers salaries and bennies to a comfortable but not egregious level (you would need rough bank size and regional cost of living adjustment) and have bonuses put in a rolling five year deferred account. If a bank fails, is put in resolution, or liquidates voluntarily, the bonuses are wiped out first, before any haircutting of shareholder equity. That structure would not only reduce bank risk-taking but would also give executives incentives to try to sell or break up a sick bank before it got to be a goner.
Levitin then explains how, as we’ve already warned, that we’re in store for even more subsidized risk-taking and incompetence with no brakes on the process:
What we’ve seen in 2008 and now in the Panic of 2023 is that regulators will disregard deposit insurance caps whenever they get twitchy about the possibility of contagion in the banking system…
Uncapping deposit insurance is basically a way of saying that banks will not be allowed to fail. Because if deposits are all guarantied, banks should not face runs and liquidity problems and any solvency issues can be massaged through extend and pretend. That’s a really troubling outcome. If we continue to have private ownership of banks (and no one is suggesting otherwise), then we’re in a situation in which there’s privatization of gains and socialization of losses: heads-I-win, tails-you-lose.
I can tell you how that movie ends: S&L Hell. Banks will be incentivized to engage in every riskier behavior. And given that regulators will be unwilling to toe the line, we’re going to be right back in the S&L situation of the 1980s: zombie banks being allowed to invest in race horses, shopping mall developments, etc. because of higher yields to offset their past losses. To be sure, the FDIC will start charging more in premiums, but that won’t fix the situation—they’ll always be below market pricing (and will be a regressive cross-subsidy). At some point this system becomes untenable, and then there’s going to be a MUCH worse crisis…
But don’t count on Congress addressing the problem: doing so would curtail credit. Congress is always incentivized to prefer easy money policy, and lax bank regulation is one way to implement easy money. The reason Congress is incentivized to prefer easy money policy is that there’s a concentrated interest that cares about it—would-be borrowers (like home mortgage borrowers and small businesses)—while those who pay for it—non-borrowers who do not want to be subsidizing this system—are a diffuse interest group who aren’t likely to see the connection between weak bank regulation and the costs they bear with higher deposit insurance premiums that get passed through to them in the form of lower APYs and higher bank fees. The former group donates and votes on this issue. The latter group does not.
All this leaves me somewhat despairing. Insuring all deposits would be workable … if regulators would actually rein in banks. (Desirability is another matter…) But the combination of cravenly prudential regulation and functionally uncapped deposit insurance is really toxic. Perhaps I should just go and buy some bank stock (especially now that it’s discounted) because after a couple of years of retained earnings to get back to solvency, the real winners will be bank equity holders, who will get all the upside and bear none of the downside.
We actually foresaw this all in ECONNED (Chapter 10) but I will spare you the lengthy quotes. The US is going to keep going on an inertial bad path. The result will be more and more misallocation of capital, more funds going to leveraged speculation and shiny investment objects like SPACs, unicorns, and apps, as opposed to real economy activities that will improve infrastructure, productivity, and quality of life.
Continued misrule by finance will also assure the US falls behind China even faster than we would otherwise. But of course we’ll blame China for competing unfairly rather than doing the hard work of getting our house in order.
1 Wells Fargo’s Carrie Tolstedt, its enthusiastic massive customer fraud implementer in chief, just entered a deal where she pleaded guilty to one count of obstructing a bank examination and could be sentenced for up to sixteen month. Sentencing is scheduled for April. Critics pointed out that Tolstedt did not act alone, and had plenty of co-conspirators, particularly in former chairman and CEO John Stumpf as well as other C-suite members. I did not find any evidence that she has been handcuffed.
2 In his seminal article, The Quiet Coup, Simon Johnson described how pay levels for bankers in 1980 were on a par with the average across sectors. Both compensation levels and total industry employment rose after then as financialization took hold.
3 Levitin is a long-standing ally and wants his posts read and hence is fine with my extensive hoisting of his very fine copy.
3 However, sometimes there are unexpected benefits to having a big bank on public life support. From a 2018 post:
A story we think can’t be told often enough: In the 1987 crash, the Chicago MERC almost failed; it was saved only with a three minute margin by Continental Illinois CEO Tom Theobald being in the office early and overriding an internal (and procedurally correct) order to not fund a $400 million loan against a failed customer order. John Phelan, head of the NYSE, said if the MERC hadn’t opened, the NYSE would not have opened, and if it has closed, he was not sure it would have been able to reopen.
And would Theobald have made that call if he had been running a privately owned bank? Continental Illinois was still under FDIC resolution. It took over seven years for the Feds to get out of the Continental Illinois business.