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Economix Blog: How the World Bank Makes Doing Business Easier

June 13, 2013 by NewsMaker Leave a Comment

Simon Johnson, former chief economist of the International Monetary Fund, is the Ronald A. Kurtz Professor of Entrepreneurship at the M.I.T. Sloan School of Management and co-author of “White House Burning: The Founding Fathers, Our National Debt, and Why It Matters to You.”

The World Bank is not known as a very pro-market place. It’s a big organization with a great deal of expertise at putting together top-down development projects. If the government of a relatively poor country wants a dam, a set of roads or a port, the World Bank is the place to apply for assistance. The bank also does important work helping some of the world’s poorest people, and this is a focus of the new president, Dr. Jim Yong Kim (I endorsed his appointment during the contentious discussion that followed).

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At the same time, the World Bank has some pockets of activity that are very helpful to private-sector activity and entrepreneurs, particularly in many of the more troubled economies. One of the most important efforts, the Doing Business indicators, has been under severe pressure of late. The latest indications are that the World Bank will keep these indicators in operation, but there is still a chance that World Bank management will cave in on important details to pressure from influential quarters, including China.

The Doing Business indicators measure what is involved in setting up and running a relatively small business in 185 economies around the world. There are also subnational reports available for some places, for example Italy in 2012-13.

“Starting a Business,” one of the indicators, by its own description:

measures the procedures, time and cost for a small to medium-size limited liability company to start up and operate formally. To make the data comparable across 185 economies, Doing Business uses a standardized business that is 100 percent domestically owned, has start-up capital equivalent to 10 times income per capita, engages in general industrial or commercial activities and employs between 10 and 50 people within the first month of operations.

This may sound rather dry or overly specialized, but in fact this approach is highly revealing. The indicators draw on expert opinion; the methodology is based on a suite of top-notch research papers.

These data are highly informative, indicating where there are barriers to business creation and development. The cross-country comparisons are not sufficient for making big policy moves; more country-specific context is always needed to assess exactly what changes are needed and how to make them effective. But the World Bank’s Doing Business database is a very useful dashboard that indicates issues that need more attention from any policy maker who would like to make it easier to do business in his or her country.

Such details are extremely annoying or even threatening to three distinct categories of people: some high-level administrators in the World Bank, people who run cozy business cartels and officials who do not like transparency of any kind.

Some top World Bank administrators oppose the Doing Business indicators because these measures shine too much light onto exactly what is happening in particular countries. It is much easier to concoct country-by-country measures, preferably with a methodology that is not straightforward for others to replicate.

Local business oligarchs are, as you might suppose, rather unenthusiastic about the entry of new companies. They are happy when local officials, with whom they typically have a good relationship, help erect barriers to entry through creating needless red tape. Using the government to keep down the competition is a viable strategy in many parts of the world.

And officials in many countries really do not like transparency. Why draw attention to your regulations when these are not best practices? The Doing Business indicators are particularly helpful when used to compare cities or other localities within a country. Why should the red tape in one city be so much higher than in the city just up the highway? You can see why this sort of well-informed metric would not make officials happy.

A number of countries have expressed forcefully dissatisfaction with the indicators in their current form. China is the most notable critic, but some other governments are also not happy with this type of transparency.

As a result of this pressure, Dr. Kim set up an independent review panel for the indicators. Initial indications were that this review would recommend against continuing with Doing Business – and that Dr. Kim would go along with this view.

Along with some colleagues, I wrote to World Bank management urging them not to undermine the Doing Business indicators. Support for our position from across the political spectrum has been strong, at least within the United States. Michael Klein, a former vice president at the World Bank, deserves special mention for his efforts at organizing informed opinion in the United States and in many other places.

Indications last week from Dr. Kim are that the Doing Business indicators will continue, at least formally without big changes. It remains to be seen whether the quality of the indicators is compromised – for example, some countries would like to take out the detailed tax information.

International organizations sometimes think they can play games of this nature because no one is watching or no one understands the details – or what is really at stake. In this case World Bank management should be aware that outside experts are watching carefully and waiting patiently for the next moves.

The best way forward is to develop further measures that capture additional important features of regulatory reality. Better design of economic policy is easier when stronger benchmarking tools are available. The World Bank should continue to produce the Doing Business data as currently constituted and encourage ideas for useful new indicators.

Article source: http://economix.blogs.nytimes.com/2013/06/13/world-bank-on-verge-of-making-a-good-decision/?partner=rss&emc=rss

Filed Under: Economy News Tagged With: co author, jim yong kim, kurtz

Economix Blog: Simon Johnson: The Myth of a Perfect Orderly Liquidation Authority for Big Banks

May 16, 2013 by NewsMaker Leave a Comment

On Tuesday, with some fanfare, the Bipartisan Policy Center in Washington rolled out a report, “Too Big to Fail: The Path to a Solution.” Focused on how to “resolve” big financial companies — a technical term for the details of handling the failure of such institutions — the report is elegantly written and nicely laid out. You can either read the very short version, the short version or the long version of the same material. Unfortunately, in all three the authors fail to persuade that the problem of too-big-to-fail is fixed or can be brought under control if only we follow their recommendations.

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Their argument has three elements. First, big financial companies can be resolved either in bankruptcy or, more likely, through using the orderly liquidation authority, or O.L.A., created by the Dodd-Frank Act of 2010. Second, the key to making O.L.A. workable is sufficient “loss-absorbing” long-term debt and equity at the holding-company level. Third, the implication is that most or all of the big banks already have sufficient “loss-absorbing” debt and equity at the holding company level to make this work.

As a result, the authors contend, we (or perhaps financial-sector executives) are in luck — no significant structural changes, like simplification or reductions in scale, are needed at megabanks.

All three parts of this argument are unconvincing — and the bottom-line policy implication, “do little, be happy,” is downright dangerous.

The first point about the workings of bankruptcy and O.L.A. may sound good on paper but is simply not plausible in the real world. We are talking about huge, complex and opaque companies — typically including hundreds of thousands of employees across more than 100 different countries, with 2,000-plus legal entities. Even well-informed investors cannot figure out where the risks really lie — and the recent London Whale experience at JPMorgan Chase raises questions about whether officials or even company managements have much more of a clue.

The exercise of having large bank holding companies draw up “living wills” to show how their failures could be handled under normal bankruptcy procedures (part of the Title I requirements under Dodd-Frank) is widely regarded as having yielded little or nothing of value. There will be a do-over later this year, but I have yet to find a well-informed person — in either the private sector or government — who is optimistic about the outcome.

In addition, the United States authorities have so far failed to designate a single nonbank as systemically important — and thus subject to additional prudential requirements (a technical term, meaning closer scrutiny and supervision), including preparation of a living will. The authors show no awareness of the painful lessons from A.I.G., Lehman Brothers and the run on money funds in September 2008. None of those entities were banks (a specific legal and regulatory term), but this report seems oblivious to the implications.

If the market questions, and it does, whether the Federal Deposit Insurance Corporation could handle the failure of a single big bank holding company (already subject to close supervision, in principle), what are the chances of persuading anyone that a significant nonbank financial institution could be resolved in an orderly fashion?

To be fair, the authors of the Bipartisan Policy Center report would like to modify the bankruptcy code — adding a new Chapter 14 (an idea that originated with the Hoover Institution). But why should the financial sector, or anyone else, get special treatment? If we are going to use bankruptcy when companies fail — and this would be my strong preference, if I thought it could be done without destroying the world economy — surely there should be one set of rules for everyone.

Once you establish special treatment and break with precedents, the entire legal process becomes murky, unpredictable and likely to spread more fear than confidence in the outcomes.

Of course, megabanks and other systemically important financial companies cannot go through bankruptcy today without generating the risk of a broader economic collapse — again, one lesson from the fall of 2008. An obvious response would be to induce these companies to change the structure, scale and nature of their activities in order that their failure could be handled by bankruptcy. This is precisely the intent of Title I in Dodd-Frank.

The authors of this report, however, prefer instead to rely on the orderly liquidation authority, including the proposed “single point of entry” for bank-holding companies. In the current version of this plan, the F.D.I.C. would take over a failing institution and force recapitalization at the holding-company level through wiping out equity holders and converting long-term subordinated debt owed by the holding company into equity, while allowing operating subsidiaries to continue in business and to pay their liabilities in full.

I fully support the F.D.I.C. in its attempt to build a workable O.L.A., and there are presumably situations in which this set of tools could help. (I’m a member of the F.D.I.C.’s Systemic Resolution Advisory Committee, but the views here are mine alone.)

But I have not heard any of the relevant responsible officials express the kind of frothy optimism for O.L.A. that bubbles through in this report.

The authors do cite a recent speech by Mary Miller, under secretary for domestic finance at the Treasury Department, in which she says that too-big-to-fail is substantially fixed by the O.L.A. and other measures. But, as John Parsons and I pointed out at the time, her speech is deeply flawed at many levels and absolutely does not represent the public views of the F.D.I.C. or the Federal Reserve.

Regarding whether she provides a realistic assessment of O.L.A., Ms. Miller’s language actually confuses liquidation — the closing of a company and the winding down of its activities — with resolution (see Page 6 of her speech). I pointed out this problem two weeks ago to the Treasury Department; unfortunately, it has made no discernible attempt to tighten the wording or issue any kind of clarification.

The second point in the Bipartisan Policy Center report’s argument completely misses the key systemic issues, including the basic mechanics of how global crises spread.

The authors do mention the issues of global resolution — handling a financial failure across borders — but only to dismiss the thorny realities as trivial. As for the report’s recommendations, regarding global resolution these amount to exhorting the F.D.I.C. to get foreign countries to cooperate (good luck) and to threatening to bring Congress back in to legislate cross-border cooperation (a legislative and diplomatic impossibility).

The authors are top experts (legal and financial), so surely they have been following the news from Europe, including a series of botched bank rescues, the debacle in Cyprus and now a row at the highest political levels about whether to protect uninsured depositors more or less than bondholders. Not surprisingly, the split is between countries where such depositors have more sway (e.g., France and Spain) and those where bondholders have a stronger voice (e.g., Britain and Denmark). Who will get what kind of support — or be forced to swallow a bail-in (i.e., take losses) in a potential crisis?

It is impossible to say with any accuracy.

Writing in The Financial Times on Monday, Wolfgang Schäuble, Germany’s finance minister, made it clear that we are a long way from having an integrated bank resolution regime in Europe. In a crisis, it’s every finance minister and central banker for himself.

This matters a great deal because, as the Federal Reserve governor Jeremy Stein pointed out in a recent speech, the costs of financial stress are felt not just when there is an outright failure but also when financial institutions suffer losses and come under pressure. In terms of macroeconomic impact, “near collapse” can be almost as damaging as actual failure, particularly amid great uncertainty about who will bear what kind of loss.

And this leads to perhaps the greatest deficiency in this report: a complete failure to discuss the importance of who holds the quasi-mythical “loss-absorbing debt” at the holding company level. If such debt is held by highly leveraged institutions, with or without obvious systemic importance themselves, then a sharp fall in the value of this debt (leading up to the forced conversion into equity) can help spread a crisis far and wide.

The same problem exists for money-market funds, which remain highly susceptible to runs. Would it be stabilizing or destabilizing if a large amount of this debt were held across borders?

And who will be allowed to insure this debt, through credit default swaps or in some other complicated way using derivatives? If Goldman Sachs insures any kind of bail-in liabilities of JPMorgan Chase (or another megabank), that should make us very worried.

Third, all roads lead to equity capital, in a way that the authors of this report fail to appreciate fully.

If the big banks really had sufficient equity to absorb likely losses, we would be discussing equity levels close to those proposed in legislation by Senators Sherrod Brown, Democrat of Ohio, and David Vitter, Republican of Louisiana. (I wrote in more detail last month on Bloomberg View about Brown-Vitter and its impact so far.)

But the Bipartisan Policy Center report takes the view that such levels of equity funding (relative to total assets) are a bad idea. The wording here seems close to that in a recent document issued by Davis Polk Wardwell, a law firm (not surprising, as one of the authors of the center’s report is a senior person at that firm). Both Davis Polk and this report are completely wrong on equity — a point that I made in this blog recently (including the misinterpretation of the pivotal new book by Anat Admati and Martin Hellwig).

At least implicitly, the report is putting great weight on long-term subordinated debt at the holding company level. How much is there?

Moody’s, the rating agency, issued a report on this question in March (“Reassessing Systemic Support in U.S. Bank Ratings – an Update and F.A.Q.”). There is more than one way to do the relevant calculations, but Moody’s entirely plausible methodology suggests that total capital subject to a bail-in (equity plus the right kind of debt at the holding company level) is 4 or 5 percent of total assets for some of our biggest banking conglomerates (see Exhibit 3 in that report).

I’m comparing bail-in capital with total assets, not risk-weighted assets – as the risk weights are wrong in every crisis. However, I would caution that Moody’s does not adjust these debt numbers according to whether they are held by bail-in creditors – i.e., entities on which the F.D.I.C. would actually be willing to impose losses.

Next, we should expect megabanks and their representatives to whine that reasonable levels of bail-in capital (e.g., 20 to 30 percent of total assets; see Pages 7 and 8 of this letter to the Fed by Sheila Bair, Professor Admati, Richard Herring and me) — and a conservative definition of bail-in creditors — will crater the real economy. We hear this assertion every time financial reforms are discussed. For example, the financial consulting firm Oliver Wyman (which is also involved in the Bipartisan Policy Center report) made this point on the Volcker Rule; see my assessment).

The Bipartisan Policy Center report depicts a pair of mythical beasts — the perfect orderly liquidation authority and its partner, the bail-in creditor. More broadly, this appears to be part of a concerted effort by megabanks and their allies to convince you, and the Board of Governors of the Federal Reserve, that the existence of these beasts will hold all other evils at bay.

Such mythical beasts do not exist in the real world.

Article source: http://economix.blogs.nytimes.com/2013/05/16/the-myth-of-a-perfect-orderly-liquidation-authority-for-big-banks/?partner=rss&emc=rss

Filed Under: Economy News Tagged With: expert contributors, kurtz, simplification

Today’s Economist: Simon Johnson: The Problem With Corporate Governance at JPMorgan Chase

May 9, 2013 by NewsMaker Leave a Comment

Some proponents of the current American version of corporate capitalism contend that if there is a problem with the way our largest companies are run, shareholders will take care of it – by putting pressure on directors, sometimes voting them out. Shareholders are not supposed to replace chief executives directly but apply pressure to the board to improve oversight and produce management change when appropriate.

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In contrast, critics like to point out that owners – including small shareholders, pension funds and large mutual funds – seem unable to exercise even a modicum of control over many of today’s larger corporations, particularly the largest financial institutions.

The situation at JPMorgan Chase, in the run-up to its annual meeting on May 21, is an interesting test case with regard to two specific decisions: whether Jamie Dimon should continue to serve as both chief executive and chairman, and whether three members (David Cote, Ellen Futter and James Crown) of the risk committee of the board should be voted out.

Two proxy advisory firms – Glass, Lewis Company and Institutional Shareholder Services Inc. – have called for JPMorgan Chase shareholders to vote against the recommendations of management on both issues. Leading shareholders have apparently not yet made up their minds – and are being lobbied hard by supporters of Mr. Dimon to resist change. Mr. Dimon likes being chief executive and chairman and very much wants to keep things that way.

The interests of shareholders would be better served by following the advice of Glass Lewis and Institutional Shareholder Services. (Glass Lewis is also recommending that the three members of the board’s audit committee be replaced; I support that suggestion.)

Changing board governance is not a panacea at any company. An independent chairman can be an effective constraint on a chief executive, but many chairmen lack the stature or experience to play that role. And the risk committee of a big bank will always be constrained by the knowledge and ability of board members, very few of whom understand the risks in large financial institutions today. (There is a process of certifying that board members have relevant expertise; it is meaningless.)

Still, JPMorgan Chase undoubtedly has a serious problem from a shareholder perspective that needs to be addressed through strengthening board oversight.

Exhibit A in this discussion is the recent report by the Senate Permanent Subcommittee on Investigations, headed by Carl Levin, Democrat of Michigan, the chairman, and John McCain, Republican of Arizona, its ranking minority member, into the so-called London Whale trades that lost more than $6 billion. This report finds repeated failures in risk management at the highest levels within the company.

As Senator McCain put it (see the second statement):

JPMorgan executives ignored a series of alarms that went off as the bank’s Chief Investment Office breached one risk limit after another. Rather than ratchet back the risk, JPMorgan personnel challenged and re-engineered the risk controls to silence the alarms.

The report itself is more than 300 pages and the exhibits run around 500 pages (links to both documents are on the upper left on this page). For a concise statement of the core issues, I recommend this analysis by Bart Naylor of Public Citizen focusing on Exhibit 46 and explaining how JPMorgan Chase executives were gaming regulatory constraints to drive up their stock price (and presumably bonuses).

Specifically, the bank’s senior management changed how they calculated the risk of their positions so that they could reduce the amount of equity funding they needed. This allowed them to increase their leverage (borrowing relative to assets) as well as their risk – without this risk actually showing up in a report.

Mr. Dimon says he did not know this was going on, but even his denial is a concession that his management system completely broke down.

JPMorgan Chase’s policy, as stated to shareholders in its annual report, required risk limits to be taken seriously, with senior management responsible for signing off on high-level model changes. It is not unreasonable for shareholders to expect Mr. Dimon himself would take these risk limits seriously. And where was board oversight in this entire process?

For further detail, you can read the summary opening statement by Senator Levin (the first statement on the subcommittee’s Web page). Or try this somewhat more colorful and even emotional assessment by Matt Levine, a commentator who does not usually agree with people like Senator Levin, Mr. Naylor, and me that very large banks can pose serious danger to society (caution: Mr. Levine’s language is not suitable for family members too young to have a brokerage account).

Or, if you are a JPMorgan Chase shareholder, read the full report – or at least the executive summary. And wonder about whether a handful of traders and one inexperienced risk officer (with questionable authority) can effectively oversee a complex derivatives portfolio that grew tenfold over a period of months (with a notional value eventually in the trillions of dollars). How can a member of the board’s risk committee without financial services expertise possibly spot the risks and ensure management is keeping the bank out of trouble?

Senator McCain makes the link to the important broader policy issue on Page 3 in his opening statement:

This bank appears to have entertained – indeed, embraced – the idea that it was quote “too big to fail.” In fact, with regard to how it managed the derivatives that are the subject of today’s hearing, it seems to have developed a business model based on that notion.

Whether shareholders should be bothered by a firm’s being too big to fail is an interesting question. If this status purely confers a subsidy – in the form of taxpayer support when things go badly – then we should expect shareholders to be quite excited by the prospect.

Unfortunately for shareholders, the JPMorgan Chase case demonstrates that the distortion of incentives also means it is much harder to control what goes on at a large complex financial company. From 2000 through the end of 2012, the stock was down 15 percent; midsize banks have done much better over this time period. You can call this “too big to manage,” but it is more likely that executives and traders on the inside are doing well, so it is really outsiders (e.g., shareholders, as well as taxpayers) who are doing badly.

The London Whale losses did not bring down the company, but shareholders still have cause to want change. When planes almost collide at an airport, we do not say, “there was no actual accident, so that means the system works well.” Instead, our reaction is along the lines of, “What went wrong?” and “How can we prevent this from happening again?”

But at JPMorgan Chase, it is business as usual, despite reports of further regulatory investigations into other areas of the bank, including whether it helped manipulate interest rates and commodities prices and whether it was honest with shareholders and regulators about the London Whale big bets on derivatives.

What is likely to happen on or before May 21? Large shareholders will not want to rock the boat, and the prospect of continuing too-big-to-fail subsidies is too alluring. Mr. Dimon and his board will get another chance.

That will be good news for Mr. Dimon and his directors, but bad news for the rest of us, again. And JPMorgan Chase’s shareholders will likely not do so well, once more.

Article source: http://economix.blogs.nytimes.com/2013/05/09/the-problem-with-corporate-governance-at-jpmorgan-chase/?partner=rss&emc=rss

Filed Under: Economy News Tagged With: international monetary fund, kurtz, management change

Today’s Economist: The Case for Megabanks Fails

May 2, 2013 by NewsMaker Leave a Comment

The megabank lobby has finally put its best arguments on the table. After years of silly Twitter posts, weak research papers and other forms of unimpressive public relations, those opposed to further financial reform now have serious representation in the debate about what to do regarding too-big-to-fail banks.

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On April 30, the law firm Davis Polk Wardwell issued “Brown-Vitter Bill: Commentary and Analysis,” confronting head-on the proposal from Senators Sherrod Brown, Democrat of Ohio, and David Vitter, Republican of Louisiana, that would require bigger banks to fund themselves with more equity (and less debt, relative to their total balance sheet).

The Davis Polk document, well written and with clear footnotes to its sources, provides transparency and style, a great improvement over most pro-megabank writing that I have reviewed here over the years. On substance, however, Davis Polk is completely wrong.

We can break down the problems with its analysis into five dimensions of banking: law, economics, markets, politics and history.

On key points of law, the Davis Polk analysis is less than complete. This might seem surprising, given that Davis Polk is one of the country’s best-known law firms, but if it accurately described the full legal situation, all is lost for its case. The heart of the problem is cross-border resolution, in other words, the ability of the Federal Deposit Insurance Corporation to manage the government-supervised approach to handling the failure of a global megabank.

Davis Polk makes a big deal out of Title II of the 2010 Dodd-Frank legislation, which granted new powers to the F.D.I.C. And it is right that under some circumstances it could be helpful to use the proposed “single point of entry” approach by the F.D.I.C. — meaning that this agency would recapitalize a failing financial company solely through liquidating the holding company, wiping out equity and converting debt into equity.

Davis Polk, however, is wrong to imply (see the top of Page 7) that bankruptcy courts could not already handle the precedence of claims; it’s the extension of F.D.I.C. power to bank holding companies and nonbank financial companies that is new here.

But this resolution authority does not apply across borders. It needs to be supplemented by a network of agreements with other countries, which would agree in advance exactly how to handle various assets and liabilities (as the F.D.I.C. is committed to do in the United States). Citigroup, for example, does business in more than 100 countries. So far, the F.D.I.C. has an agreement with the Bank of England, which could be helpful, although it remains to be seen how it holds up in a crisis (and the requisite legislation in Britain is not in place yet). But where is the agreement with the euro zone or Asia or any other market where Citi (or our other largest five banks) have their global presence? There is none, and there is no prospect for such an agreement.

Davis Polk refers to a resolution simulation run by the Clearing House (see the top of Page 8). But this simulation assumed a very simple cross-border structure and also that the British cooperated fully with the American authorities. If you are willing to assume that the world will be such an easy place to work, then why worry about anything? This is not a smart public policy approach.

On economics, Davis Polk cites Anat Admati and Martin Hellwig’s new book, “The Bankers’ New Clothes” (the first time I have seen the megabank side acknowledge that the book exists). Unfortunately, its staff members show no sign of having read it. Professors Admati and Hellwig have already refuted all the points about economics that Davis Polk tries to make.

Davis Polk is very taken with the idea that Professors Admati and Hellwig’s argument rests entirely on theory developed by Franco Modigliani and Merton Miller (and they also mention me as following this approach). Davis Polk then makes a big deal about how this theory does not entirely match the real world.

But nobody asserts that it does match for banks or for any other company. It only provides a starting point for thinking about issues that do matter in the real world.

Professors Modigliani and Miller made an important point — an increase in leverage, by itself (i.e., more debt relative to equity in the funding of a firm) does not create value. Banks, however, love leverage more than other companies because it allows them to exploit guarantees and subsidies from taxpayers.The heart of today’s economic argument is much more about the nature of the subsidies provided to very large financial institutions and how these distort incentives. The people running these companies are encouraged to take on more debt because this allows them to get more of the upside when things go well, while the downside is someone else’s problem.

In effect, global megabanks are creating a very high level of systemic risk, a form of pollution. They should at least pay a fee. That we subsidize and therefore encourage this financial pollution makes no sense. This is all well explained by Professors Admati and Hellwig in Chapter 9 of their book.

Davis Polk is also impressed with some recent working papers that assert that banks play an important role in the economy, including by issuing debt. That may be the case, although you might question how much weight you want to put on working papers and speeches dated April 11 and April 12, 2013 (see Footnotes 17 and 18).

But these arguments are largely irrelevant to the issues at hand — again, see Professors Admati and Hellwig (Chapter 10). The downside risks associated with highly leveraged large banks are many; look around as we stumble out of the deepest and longest recession since the 1930s. By all means, allow big banks to issue debt. The point is to require that it be backed by a lot more equity than is currently the case (i.e., the precise proposal of Brown-Vitter). If these activities are truly valuable, they will continue when the subsidies are curtailed.

On markets, Davis Polk takes the current megabank line that there is no proven too-big-to-fail subsidy. This is a weak and inadvisable position. There is a debate about the precise size of this subsidy, but there are similar debates for any interesting economic variable, including gross domestic product, inflation or unemployment. Davis Polk cites Mary Miller, the Treasury under secretary (Page 10), on the idea that there is no subsidy. John Parsons and I took her positions apart here last week, and unfortunately Davis Polk does not engage with any of the main points we made.

And on the topic of recent working papers (from Sept. 1, 2012), I recommend that Davis Polk read “The Value of Implicit Guarantees” by Zoe Tsesmelidakis and Robert C. Merton, which makes the strong case that too-big-to-fail companies receive cheaper funding during crises.

The general question is simple. Does a global megabank borrow more cheaply because creditors expect, with some positive probability, that they will receive downside insurance from the government or the associated central bank under some circumstances?

Talk to people in the credit markets who do not work for big banks. Talk off the record and behind closed doors (so there are no potential repercussions from the too-bit-to-fail crowd) about how they (the actual and potential creditors) perceive the credit of Citigroup or JPMorgan Chase or Deutsche Bank. Creditors understand clearly the value of implicit protection that still exists.

On politics, Davis Polk insists that the government and the Federal Reserve cannot provide further bailouts or any form of subsidies during a crisis. This is naïve.

Henry Paulson, the former head of Goldman Sachs, is not a man you would have picked as likely to want more government intervention. Yet he appeared, as Treasury secretary, with cap in hand before Congress in September 2008, pleading that some form of enormous bailout for the financial system was needed to avert Armageddon.

You might agree or disagree with that assessment by Mr. Paulson and Ben Bernanke, the chairman of the Federal Reserve, but there is no question that this will long remain a country in which Congress trusts our senior officials to tell it to them straight in a crisis. If the secretary of the Treasury and the chairman of the Federal Reserve say they need new legislation to authorize various forms of government subsidy, then this is substantially what they will get —along with a lot of discretion on how to implement it.

The “no future bailout” promises (and legal commitments) in which Davis Polk sets such store are not credible. Congress cannot prevent any future Congress from acting. This is a fundamental principle of our democracy and, in many instances, it has served us well.

The real issue remains: what are the threats and the real policy alternatives in the next crisis? If Citi is on the brink of failure again (and it has been close to failure three times in recent decades), what would the consequences be for the real economy — both in the United States and around the world?

On history (see Pages 11-13), Davis Polk is weak. There are fewer footnotes and more assertions, including points that are plainly wrong (for instance the bizarre idea that “too much common equity and cash reserves” caused persistent deflation at the end of the 19th century (see the last paragraph on Page 12). The firm’s entire discussion of the 19th century neglects to mention that the United States was on a version of the gold standard (without a central bank) that had very particular implications for the dynamics of banking over the business cycle. The analysis also confuses the academic work of Milton Friedman (who focused on the money supply) with that of Mr. Bernanke (who emphasized the role of credit and bank failures in the Great Depression).

It also appears (see Pages 12-13) to confuse the provision of “lender of last resort” liquidity with equity capital requirements. If you want to make our central bank stronger politically and therefore better able to deal with unexpected liquidity crises, you should be on the side of higher equity capital.

And Davis Polk consistently misses the most important point about small banks, in history and today. These companies ought to compete, to succeed and to fail, based on their own actions, when we have a relatively even playing field in our financial sector. We had this for a long time and it worked well. Small banks are willing and able to step up again, once we remove the excessive subsidies from their too-big-to-fail competitors.

Davis Polk ultimately put its cards on the table on Page 13, suggesting that the Fed’s lender-of-last-resort lending — the ultimate backstop — should be available to “all financial institutions engaged in the socially beneficial function of maturity transformation,” meaning the entire financial system.

The term “moral hazard” does not appear in the Davis Polk document, but that is what this is all about. Davis Polk is advocating a continuation of the present distorted incentives or an expansion of these incentives. The firm declined to comment on my critique of its report.

Powerful people on Wall Street will get the upside when things go well; you and I get stuck with the downside. Why is this a good arrangement for anyone other than a few well-placed executives and their lawyers?

Article source: http://economix.blogs.nytimes.com/2013/05/02/the-case-for-megabanks-fails/?partner=rss&emc=rss

Filed Under: Economy News Tagged With: kurtz, politics and history, sloan school of management

Today’s Economist: Simon Johnson: The Importance of Elizabeth Warren

November 8, 2012 by NewsMaker Leave a Comment

Gretchen Ertl/Reuters Elizabeth Warren greeting supporters in Boston after her Senate victory on Tuesday.

Simon Johnson is the Ronald A. Kurtz Professor of Entrepreneurship at the M.I.T. Sloan School of Management and co-author of “White House Burning: The Founding Fathers, Our National Debt, and Why It Matters to You.”

One of the most important results on Tuesday was the election of Elizabeth Warren as United States senator from Massachusetts. Her victory matters not only because it helps the Democrats keep control of the Senate but also because Ms. Warren has a track record of speaking truth to authority on financial issues – both to officials in Washington and to powerful people on Wall Street.

Today’s Economist

Perspectives from expert contributors.

During the campaign, Ms. Warren’s opponent and his allies made repeated attempts to portray her as antibusiness. In the most bizarre episode, Karl Rove’s Crossroads GPS ran an ad that contended that she favored bailing out large Wall Street banks. All of this was misdirection and disinformation.

Ms. Warren has long stood for transparency and accountability. She has insisted that consumers need protection relative to financial products – when the customer cannot understand what is really on offer, this encourages bad behavior by some companies. If this behavior spreads sufficiently, the entire market can become contaminated – damaging the entire macroeconomy, exactly as we have seen in the last decade.

Honest bankers should welcome transparency in all its forms. And the Consumer Financial Protection Bureau, which Ms. Warren helped to establish, has made major steps in this direction.

Ms. Warren has strong support from the progressive wing of the Democratic Party, and her resistance to sharp practices by big banks resonates across the political spectrum. (Disclosure: James Kwak and I wrote positively about Ms. Warren and her approach in “13 Bankers.”)

She has also established an impressive track record for effective oversight in Washington. As the chairwoman of the Congressional Oversight Panel for the Troubled Asset Relief Program, she drew bipartisan praise (until, of course, she decided to run for public office).

How much can a new senator accomplish? Within hours of her victory, some commentators from the financial sector suggested that no freshman senator could achieve much.

This is wishful thinking on their part. A newly elected senator can have a great deal of impact if she is well informed on relevant details, plugged into the policy community and focused on a few key issues. It also helps if such a senator can bring effective outside pressure to bear – and Ms. Warren is a most effective communicator, including on television. She has an unusual ability to cut through technical details and to explain the issues in a way that everyone can relate to.

Ms. Warren is a natural ally for Senators Sherrod Brown of Ohio, Jeff Merkley of Oregon, Carl Levin of Michigan, Jack Reed of Rhode Island and other sensible voices on financial sector issues (including some on the Republican side who have begun to speak out). My expectation is that Ms. Warren will work effectively across the aisle on financial sector issues without compromising her principles – and this could really be productive in the Senate context.

Hopefully, Ms. Warren will get a seat on the Senate Banking Committee, where at least one Democratic slot is open.

President Obama should now listen to her advice. Senator Warren should have been appointed head of the Consumer Financial Protection Bureau in 2010 – but was opposed by Treasury Secretary Timothy Geithner. Unfortunately, the president was unwilling to override Treasury.

If President Obama wants to have impact with his second term, he needs to stand up to the too-big-to-fail banks on Wall Street.

The consensus among policy makers has shifted since 2010, becoming much more concerned about the dangers posed by global megabanks. That has been clear in recent speeches by the Federal Reserve governor Daniel Tarullo; Richard Fisher, president of the Federal Reserve Bank of Dallas; and Andrew Haldane of the Bank of England (all of whom I have covered in this space – including last week).

At the same time, we should expect a renewed effort against all recent attempts at financial sector reform – a point made by American Banker, a trade publication, immediately after the re-election of President Obama.

Scandals of various kinds will be thrown into this mix. The full extent of money laundering at HSBC is only now becoming apparent. Complicity of various institutions in rigging Libor should also become clearer in coming months. No doubt there will be big unexpected trading losses somewhere in the global banking community. The European macroeconomic and financial situation continues to spiral out of control.

Senator Warren is well placed, not just to play a role in strengthening Congressional oversight but also in terms of helping her colleagues think through what we really need to make our financial system more stable.

We need a new approach to regulation more generally – and not just for banking. We should aim to simplify and to make matters more transparent, exactly along Senator Warren’s general lines.

We should confront excessive market power, irrespective of the form that it takes.

We need a new trust-busting moment. And this requires elected officials willing and able to stand up to concentrated and powerful corporate interests. Empower the consumer – and figure out how this can get you elected.

Agree with the people of Massachusetts, and give Elizabeth Warren every opportunity.

Article source: http://economix.blogs.nytimes.com/2012/11/08/the-importance-of-elizabeth-warren/?partner=rss&emc=rss

Filed Under: Economy News Tagged With: kurtz, misdirection, simon johnson

Economix Blog: Simon Johnson: Why Are the Big Banks Suddenly Afraid?

August 30, 2012 by NewsMaker Leave a Comment

Top executives from global megabanks are usually very careful about how they defend both the continued existence, at current scale, of their organizations and the implicit subsidies they receive. They are willing to appear on television shows – and did so earlier this summer, pushing back against Sanford I. Weill, the former chief executive of Citigroup, after he said big banks should be broken up.

Today’s Economist

Perspectives from expert contributors.

Typically, however, since the financial crisis of 2008 the heavyweights of the banking industry have stayed relatively silent on the key issue of whether there should be a hard cap on bank size.

This pattern has shifted in recent weeks, with moves on at least three fronts.

William B. Harrison Jr., the former chairman of JPMorgan Chase, was the first to stick out his neck, with an Op-Ed published in The New York Times. The Financial Services Roundtable has circulated two related e-mails “Myth: Some U.S. banks are too big” and “Myth: Breaking up banks is the only way to deal with ‘Too Big To Fail’” (these links are to versions on the Web site of Partnership for a Secure Financial Future, a group that also includes the Consumer Bankers Association, the Mortgage Bankers Association and the Financial Services Institute).

Now Wayne Abernathy, executive vice president of the American Bankers Association, is weighing in – with a commentary on the American Banker Web site.

These views notwithstanding, mainstream Republican opinion is starting to shift against the megabanks, as former Treasury secretary Nicholas Brady makes clear in a strong opinion piece published in The Financial Times.

Mr. Brady was Treasury secretary under Presidents Ronald Reagan and George H.W. Bush, and to the best of my knowledge, no one has ever accused him of being any kind of leftist.

Yet Mr. Brady’s thinking in his Financial Times commentary is strikingly similar to the reasoning that motivated the Brown-Kaufman amendment (supported by 30 Democrats and three Republicans) in 2010, which would have put a hard cap on the size and leverage of our largest banks, i.e., how much an individual institution could borrow relative to the size of the economy. (See this analysis by Jeff Connaughton, who was chief of staff to Senator Ted Kaufman; Senator Sherrod Brown, Democrat of Ohio, is still pushing hard on this same approach.)

Mr. Brady also stresses that we should make our regulations simpler, not more complex. Senator Kaufman made the same point repeatedly – and capping leverage per bank (Mr. Brady’s preferred approach) would be one way to do this.

Mr. Brady is not alone on the Republican side of the political spectrum. A growing number of serious-minded politicians are starting to support the point made by Jon Huntsman, the former governor of Utah and a Republican presidential candidate in the recent primaries: global megabanks have become government-sponsored enterprises; their scale does not result from any kind of market process, but is rather the result of a vast state subsidy scheme.

As Paul Singer, a hedge fund manager and influential Republican donor, says of the big banks, “Private reward and public risk is not what conservatives should want.”

A second problem for the bankers is that their arguments defending big banks are very weak.

As I made clear in a point-by-point rebuttal of Mr. Harrison’s Op-Ed commentary, his defense of the big banks is not based on any evidence. He primarily makes assertions about economies of scale in banking, but no one can find such efficiency enhancements for banks with more than $100 billion in total assets – and our largest banks have balance sheets, properly measured, that approach $4 trillion.

Similarly, the Financial Services Roundtable e-mail on “Some U.S. banks are too big” is based on a non sequitur. It points out that United States trade has grown significantly since 1992, and it infers that, as a result, the size of our largest banks should also grow.

But the dynamism of the American economy and its international trade after World War II was not accompanied by striking increases in the size of individual banks, and our largest banks did not then increase relative to the size of the economy, in sharp contrast to what happened since the early 1990s.

In 1995, the largest six banks in the United States had combined assets of around 15 percent of gross domestic product; they are now over 60 percent of G.D.P., bigger than they were before the crisis of 2008.

The Financial Services Roundtable is right to point out that banks in some other Group of 7 countries are larger relative to those economies. But which of these countries would you really like to emulate today: France, Italy or Britain?

The Financial Services Roundtable also asserts, in its other e-mail, that the Dodd-Frank financial reform legislation and the Basel III new capital requirements have made the banking system safer. That may be true, although the evidence it presents is just about cyclical adjustment; after any big financial crisis, banks are careful about funding themselves with more equity (a synonym for capital in this context) and holding more liquid assets.

The structure of incentives in the industry hardly seems to have changed, as witnessed, for example, by the excessive risk-taking and consequent large trading losses at JPMorgan Chase recently.

We need a system with multiple fail-safes, and making the largest banks smaller and less leveraged would achieve precisely that goal.

Mr. Abernathy’s article takes a much more extreme position. He contends that banks are already unduly constrained – by Dodd-Frank and Basel III – and this is holding back economic growth.

Mr. Abernathy goes so far as to say that if the banks were to raise $60 billion in additional equity capital, this “holds back $600 billion of economic activity.” In other words, strengthening the equity funding of banking would cause an economic contraction on the order of 4 percent of G.D.P.

Such assertions are far-fetched, not based on any facts and have been completely discredited (see the work of Anat Admati and her colleagues on exactly this point). Mr. Abernathy was assistant secretary for financial institutions under George W. Bush. If he has any evidence to support his positions – a study, a working paper, a book? – he should put it on the table now.

To make such assertions without substantiation is irresponsible. (A document from a lobbying organization would not count for much, in my view, but let’s see if he has even that.)

The big banks and their friends should be afraid. Serious people on the right and on the left are reassessing if we really need our largest banks to be so large and so highly leveraged (i.e., with so much debt relative to their equity). The arguments in favor of keeping the global megabanks and allowing them to grow are very weak or nonexistent. The arguments in favor of further strengthening the equity funding for banks grow stronger – see the recent letter by Senators Sherrod Brown and David Vitter, which I wrote about recently.

The views of sensible people like Secretary Brady, Senator Kaufman, Governor Huntsman and Senator Brown are spreading across the political spectrum.

Article source: http://economix.blogs.nytimes.com/2012/08/30/why-are-the-big-banks-suddenly-afraid/?partner=rss&emc=rss

Filed Under: Economy News Tagged With: banking industry, kurtz, sloan school of management

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