Yves here. Simon Johnson, former IMF Chief Economist and now a professor at MIT’s Sloan School, provides an update on the state of Too Big to Fail. The short version is that despite the de facto bailouts of Silicon Valley Bank and Signature Bank (by extending deposit guarantees to the rich who had no legal basis for expecting that support), bank lobbyists are pushing for even more largesse.
Below (and I strongly urge you to read his piece in full), Johnson calls for more equity as the remedy to the Too Big to Fail problem. It’s disappointing to see Johnson offer what he has to know is only a “better than nothing” solution. Johnson wrote one of the most important articles about the crisis early on, The Quiet Coup, was an active commentator as the crisis developed and in its aftermath, and was one of the louder pro-reform voices.
Recall that it was none other than Timothy Geithner who advocated more bank equity as the way to make banks safer. But as Johnson surely knows, that idea had been debunked by the Bank of England Director of Financial Stability Andrew Haldane, in a seminal paper, The $100 billion question. It explains how the total amount of bank equity is inadequate to even begin to pay for the cost of periodic financial crises.
Haldane starts with Martin Weitzman’s classic analysis of how to deal with so-called externalities, which are costs imposed on people who have nothing to do with a transaction (think of a dive bar opening next door and your household suddenly facing blaring music and party to loud arguments). If the private costs are higher than the public costs, you tax. If the public costs are higher than the private costs, you prohibit. From our post:
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. Holdane was criticized at the time, the bone of contention being that his estimate of the long-term global GDP cost of the 2007-2008 crisis was way too high. In fact, the protracted period of so-called “secular stagnation” proved Haldane to be correct.
Our 2010 post continued with key findings from Haldane:
Yet after applying a wrecking ball to the global economy, the banks got big handouts, and like Fannie and Freddie pre crisis, the banks get to borrow at cheaper rates than would otherwise apply because investors understand full well that governments stand behind big financial firms. Haldane again:
It is possible to go one step further and translate these average ratings differences into a monetary measure of the implied fiscal subsidy to banks…The resulting money amount is an estimate of the reduction in banks’ funding costs which arises from the perceived government subsidy..
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…
On these metrics, the too-big-to-fail problem results in a real and on-going cost to the taxpayer and a real and on-going windfall for the banks.
Even though Haldane established that the amount of equity needed to impose a high enough tax to stop banks from doing destructing things would put them all out of business, other efforts to look at the bank equity problem came up with ballpark figures that are so high as to be depicted by banker as tantamount to forcing their closure (Note this is an exaggeration, but they’d have to change the way they operate so radically that it would amount to the death of their current mode of operating….an outcome sorely to be desired save by bankers and pols in their pay).
First, let’s turn to another critically important observation, by Steve Waldman, Capital can’t be measured. It is very carefully argued, so forgive the necessarily long-ish extract. Ironically, Waldman starts by taking issue with Simon Johnson, back in 2010, recommending more bank equity. It’s one thing for Johnson to depict the idea of “more bank equity” as better than nothing, as opposed to sufficient. From Waldman:
Simon Johnson and James Kwak are absolutely right. Sure, “hard” capital and solvency constraints for big banks are better than mealy-mouthed technocratic flexibility. But absent much deeper reforms, totemic leverage restrictions will not meaningfully constrain bank behavior. Bank capital cannot be measured. Think about that until you really get it. “Large complex financial institutions” report leverage ratios and “tier one” capital and all kinds of aromatic stuff. But those numbers are meaningless. For any large complex financial institution levered at the House-proposed limit of 15×, a reasonable confidence interval surrounding its estimate of bank capital would be greater than 100% of the reported value. In English, we cannot distinguish “well capitalized” from insolvent banks, even in good times, and regardless of their formal statements…
The bottom line is simple. The capital positions reported by “large complex financial institutions” are so difficult to compute that the confidence interval surrounding those estimates is greater than 100% even for a bank “conservatively” levered at 11× tier one capital.
Errors in reported capital are almost guaranteed to be overstatements. Complex, highly leveraged financial firms are different from other kinds of firm in that optimistically shading asset values enhances long-term firm value. Yes, managers of all sorts of firms manage earnings and valuations to flatter themselves and maximize performance-based compensation. And short-term shareholders of any firm enjoy optimistic misstatements coincident with their planned sales. But long-term shareholders of nonfinancial firms prefer conservative accounts, because in the event of a liquidity crunch, firms must rely upon external funders who will independently examine the books. The cost to shareholders of failing to raise liquidity when bills come due is very high. There is, in the lingo, an “asymmetric loss function”. Long-term shareholders are better off with accounts that understate strength, because conservative accounting reduces the likelihood that shareholder wealth will be expropriated by usurious liquidity providers or a bankruptcy, and conservative accounts do not impair the real earnings stream that will be generated by nonfinancial operations.
This logic inverts for complex financials. Financial firms raise and generate liquidity routinely. Many of their assets are suitable as collateral in repo markets. Large commercial banks borrow freely in the Federal Funds market and satisfy liquidity demands in part simply by issuing deposits that are not immediately withdrawn. For large financial firms, access to liquidity is rarely contingent upon a detailed audit by a potential liquidity provider. Instead, access to liquidity, and the ability to continue as an operating firm, is contingent upon the “confidence” of peer firms and of regulators. Further, the earnings of a financial firm derive from the spread between its funding cost and asset yields. Funding costs are a function of market confidence, so the value of a financial firm’s real future earnings increases with optimistic valuation. For a long-term shareholder of a large financial, optimistically shading the firm’s position increases both the earnings of the firm and the “option value” of the firm in difficult times. It would be a massive failure of corporate governance if Jamie Dimon or Lloyd Blankfein did not fib a little to make their firms’ books seem a bit better than perhaps they are, within legal and regulatory tolerances.
So as a result, if you were to try to impose a high enough equity level, banks would squeal that it was impossibly high. From a 2010 post:
Treasury Secretary Geithner, who tacitly admits that the so-called Dodd Frank bill fell short of the level of intervention needed to prevent another financial crisis, has taken to touting the idea that getting enough capital into the banking system will do the trick, which means he is effectively fobbing the problem off on Basel III.
Now narrowly speaking, the idea that enough bank capital would do a lot to prevent future crises isn’t wrong, but it begs the question of what “enough” is. Absent a lot of other coordinated measures (constraints on off balance sheet entities, much tougher accounting, limits on rehypothecation, securitization reform), “enough” would need to be a very big number. Steve Waldman, who wrote a definitive post on why bank equity figures are at best a conjecture, put the needed level of bank equity ex other measures at 30% of assets, a level that Wolf [Richter] independently deems to be within the required range.
But fear not! There is a possible remedy, proposed by of all people William Dudley, a former Goldman Sachs partner and then head of the New York Fed. It was such a good idea that the financial press pointedly ignored it after he presented it in a speech.
Dudley’d deadly and elegant solution is to make bank executives and producers bear the first loss in any bank rescue, by withholding most of their bonuses as subordinated equity.
To make this work, you’d need an adequately long period of bonus retention (say five years, which is what Warren Buffett uses in his reinsurance business) so as to greatly reduce the “IBG/YBG” problem (“I’ll be gone, you’ll be gone”).
You would also need a pretty stringent definition of who should be included, such as anyone with P&L responsibility, anyone with client responsibility (beyond a certain small retail account size) and anyone senior in operations and control functions. You would also need to bar the firms increasing salaries to reduce the proportion paid in bonuses by attributing any increase in salary (beyond levels in line with inflation) after the new rule was first publicized to be attributed to bonuses for the purpose of the subordinated equity rule.
Now to Johnson’s new post.
By Simon Johnson is the co-author of Power and Progress: Our Thousand Year Struggle Over Technology and Prosperity. He was previously chief economist at the International Monetary Fund, and he is currently the Kurtz Professor of Entrepreneurship at MIT’s Sloan School of Management. Originally published at the Institute for New Economic Thinking website
What should we learn from events earlier this year at Silicon Valley Bank, Signature Bank, First Republic, and Credit Suisse? Do the “bailout” actions taken by the US and Swiss authorities indicate that Too Big to Fail is still with us? Have we made no progress at all since the collapse of Lehman Brothers? Are we primed for another big financial crisis?
TBTF is still with us, for the simple reason that it never went anywhere. In 2008, Lehman had total liabilities of around $650bn; Bear Stearns was a bit smaller. In 2023, Credit Suisse’s balance sheet was about $800bn and shrinking fast. SVB was around $250bn. Oh, and Long-Term Capital Management owed about $120bn in 1997.
Currently, JP Morgan is close to $4trn and UBS is around $2trn. Could either of them fail, in the sense that creditors would face losses? Don’t be ridiculous.
TBTF is not at its heart about law and regulation. It’s about game theory. Specifically, imagine this scenario. You are in the Oval Office. The Treasury Secretary says: this bank is about to fail. The Chairman of the Federal Reserve adds: if we let them fail, the result will be massive damage to our economy, with millions losing their jobs, and the knock-on negative effects on the rest of the world will be enormous. The president turns to you and asks: well, should we let them go bankrupt?
Unless and until you can answer affirmatively, with complete confidence and better data than have top officials, there are TBTF banks. The threshold for receiving some form of government support for otherwise uninsured depositors might depend on the day or how the world economy is doing, but on present evidence it appears to be around $100 billion.
This does not, however, mean we have made no progress since 2008. Sure, the biggest banks got bigger, “living wills” are purely performative for megabanks, and resolution planning was thrown out of the window in the US and Europe when the mini-crises of 2023 hit. But the big banks have lost their aura of cleverness.
Consequently, shareholders and management cannot expect the support that they received in the fall of 2008. Creditors, however, can generally expect a lot of protection. (The Swiss elected to wipe out convertible bond holders but not equity. But that seems to have been some quirk of Swiss foreign relations, vis-a-vis who owned the stock.)
Before 2008, to propose regulation was to be regarded by the establishment as a Luddite who did not understand the deep smarts of modern finance. Today the Bank Policy Institute is embarked on a major campaign to lower capital requirements – and this involves a full-frontal attack on the Federal Reserve. The BPI is antagonizing senior Fed officials, making it very unlikely for the bank lobby to win while damaging the reputations of all sensible bank executives. Remember the excessive lobbying of the tobacco industry and where that ended up for all involved?
Will there be another big crisis? The answer depends on capital, a concept that is much misunderstood or mis-explained, even in the specialist press. It would be better to use the word equity, because the key concept is how much equity banks are allowed to fund themselves with, relative to debt.
Higher debt to equity means, when things go well, a higher return on equity unadjusted for risk – and more compensation for executives. But when markets or the economy turn down, low levels of equity are quickly wiped out by losses and insolvency looms.
Equity levels were very low in 2008 – a few percentage points for some big banks. Now equity requirements are higher, although they should be raised further for the TBTF crowd.
We have made progress. Sure, not enough to forestall crises. But the political power of the big banks has been broken and their confrontational tactics are unlikely to prevail any time soon. This particular form of state capture is over.