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 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.
Today’s Economist
Perspectives from expert contributors.
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
Speak Your Mind
You must be logged in to post a comment.