The Big Bank Debate Continues
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By Patrick Sims, 202-822-1205, psims@hamiltonps.com
How do two influential figures who worked at the same bank, have drastically different views on the break-up-the-bank debate?
Yesterday, Former Treasury Secretary and Citigroup director Robert Rubin disagreed with Sandy Weill’s comments on breaking up the banks:
“I think that if you followed Sandy’s path and you broke up the banks in some fashion or other… The systemic risk, the too big to fail risk will move from one place to another place. For example, if you could curtail what the banks can do in terms of trading, it isn’t that the trading is going to go away. You have a large global economy that needs those activities but they’ll go to other platforms. I think the real question is, are there ways to deal with the risk?”
It is valuable to hear diverse arguments on the future of banking as different, and oftentimes clashing, perspectives continue to evolve. Contributing to this debate, HPS Insight released a report titled, “Banking on our Future: The Value of Big Banks in a Global Economy.” This paper was not to be a comprehensive overview, but to provide insight on a portion of this debate.
The report reinforces Rubin’s view that large U.S. banks provide significant value to the U.S. and global economies by meeting the market’s requirements, and in the event they are broken up, there are costs associated with banking activities rebalancing in favor of less regulated entities (foreign banks and the shadow banking sector) for credit intermediation needs.
The points made by Rubin, JPMorgan’s Jamie Dimon, and many others are neither radical nor new. Large banks provide significant value, and the flow of credit services to less regulated entities is a substantial concern for many economists and policymakers, and has been for some time.
It is encouraging to see that the HPS report has spurred debate. Posts by James Pethokoukis of AEI and Neil Irwin of The Washington Post’s Wonkblog reviewed the report. Simon Johnson of MIT published a critique in the New York Times’ Economix blog yesterday, taking a number of issues with the report. In addition, Mark Thoma’s Economist View blog cites Mr. Irwin’s article, among others, in compiling the arguments for and against breaking up the banks. All these responses come at the issue from different perspectives and are all worth the read.
Given the received feedback on what was included, as well as what wasn’t included in the report, it is helpful to first walk through its main points, and then, address what was left out. Like the report, this response does not comprehensively address all the issues, but we look forward to providing more insight as this debate continues.
Main Points the HPS Report Made:
U.S. banks are already smaller and safer than their global competitors –
On an absolute basis, the largest U.S. bank is the fourth largest global bank when looking at it on a U.S. GAAP basis. And on a comparative basis, U.S. bank assets are a much smaller proportion of U.S. GDP than is the case among peer banks and their respective home countries.
Small banks would not be able to meet the needs of global finance –
Global finance has expanded rapidly in recent years, and big banks play a key role in simplifying financial complexity for customers, including U.S.-based multinational corporations. The alternative that critics have proposed of small banks performing loan syndication is practically-speaking unworkable, with dozens and dozens of banks needed to be involved in large transactions.
If large U.S. banks are broken up, large foreign banks and the shadow banking sector will likely gain –
The need for global financial services will not disappear if the U.S. banks that serve that function disappear. Instead, those credit needs will migrate to other areas of the financial sector, likely foreign banks and the shadow banking sector.
Because credit and the associated risk will shift to other financial sectors that the U.S. has less regulatory influence over, the impact of breaking up large U.S. banks would actually be to reduce oversight of safety and soundness in financial services –
Ironically, it is possible that by putting regulation out of arms reach by breaking up the banks, we increase the risk of another crisis, not decrease it.
The points the HPS report did not address:
Andrew Haldane’s research on implicit subsidy as a reason for break-up –
Andrew Haldane of the BOE references research by David Wheelock of the St. Louis Fed, and Paul Wilson of Clemson University, and others, that were able to find economies of scale going up to and beyond $1 trillion in assets.
In their paper, Wheelock and Wilson comment on policy implications of capping size:
“…our results have implications for policies intended to limit the size of banks to ensure competitive markets, to reduce the number of banks deemed too-big-to-fail, or for other purposes. Although there may be [competitive] benefits to imposing limits on the size of banks [deposits], our research points out potential resource costs of such intervention.”
Haldane provides evidence that there are economies of scale at large banks, but calculates implicit subsidies that nullify these benefits, and when banks grow past the $100 billion asset threshold, he finds “there may even be diseconomies of scale”:
“…there is evidence of scale economies for banks with assets above $100 billion. Indeed, these economies tend to rise with banking scale. But this finding is based on estimates of banks’ funding costs, which take no account of the implicit subsidy associated with too-big-to-fail. Removing this subsidy raises banks’ funding costs, lowers estimates of bank value-added and thereby reduces measured economies of scale.”
Haldane applies a ratings agency approach for this calculation. Although agencies are known in the past for overrating securities, there is still an argument to be made that market expectations were initially set on these ratings and are fixed with crisis-era bailouts.
However, Haldane notes existing reforms are making progress and should be continued:
“The wrong conclusion to draw would be that existing reforms have failed or are unnecessary – quite the contrary. Rather it is that these reform initiatives, while necessary, may be insufficient to eliminate the too-big-to-fail externality.”
Haldane cites a number of reforms that can abstract potential subsidies, such as increasing capital levels, size caps, a modern day Glass-Steagall, and increased competition. This research is helpful, and no one should dismiss it.
However, as the HPS report states, over time the FDIC’s new resolution authority offers another route to eliminating the subsidy. Resolution authority gives regulators tools to wind down failing firms, while Dodd-Frank sought to alter the market incentive for investing in debt. These mechanisms, along with increased capital surcharges and liquidity requirements for the largest U.S. financial institutions will help to eliminate any potential funding advantage.
Chairman Bernanke expressed the need for these changes in 2009, and the regulatory process is continually developing on this front.
As stated in the report, reform takes time and more work needs to be done, including resolving cross-border issues, but these efforts are a better alternative than restructuring the industry through a blunt break-up.
Dudley and others on subsidies and reform –
HPS sides with the Fed’s William Dudley on the point that regulation takes time. In a speech this past November Dudley agrees on the problems with too big to fail, but realizes that regulation takes time and that we’re not at a point where we can say we need to take further action:
“Too big to fail is an unacceptable regime. The good news is there are many efforts underway to address this problem.” Dudley went on to assert that it, “…is premature to give up on the current approach: changing the incentives facing large and complex firms, forcing them to become more resilient, and making the financial system more robust to their failure.”
Douglas Elliot of the Brooking Institution moderated a discussion in December titled, “Structuring Finance to Enhance Growth and Stability,” in which the Fed’s Daniel Tarullo participated. Tarullo present three policy proposals for additional reform: reinstating Glass Steagall, capping non-deposit liabilities, and requiring large firms to hold more long-term debt for equity conversion purposes.
Tarullo concluded, “…we will never have all the analysis we might like before deciding whether to act,” giving the impression he supports these reforms sooner, rather than later.
The debate also featured many other prominent industry leaders in both the public and private sectors. There were many disagreements on calculating economies of scale, the issue of too big to fail, and future reform, but the debate helped further discussion in a positive way.
Moreover, according to IMF estimates, an implicit subsidy exists for 45 of the largest U.S. banks, not just the top few. Does that mean we should break-up the banks and cap size to that of the 46th bank? Based on a top-tier ranking of U.S. banks, the 46th largest bank is First Republic Bank out of San Francisco, CA. They have branches in seven U.S. states. This is not a large bank by global or U.S. standards.
Breaking up banks and setting an arbitrary size would cause severe disruptions across the world of finance if it were to be done so bluntly. Many agree that it’s a better alternative to see out existing regulation and use other regulatory mechanisms to balance the industry if necessary.
Issues with monetary transmission –
Richard Fisher of the Dallas Fed states that the monetary transmission effect associated with primary and secondary interest rate spread is due to “sick banks” that “don’t lend”:
“[TBTF institutions] interfere with the transmission of monetary policy and inhibit the advancement of our nation’s economic prosperity.”
First, some economists have advocated the opposite. The financial crisis may not have reduced the impact of monetary policy. Instead, overly tight monetary policy in the fall of 2008 may have caused the financial crisis. Jim Pethokoukis quotes Robert Hetzel of the Richmond Fed, who claims that the U.S. central bank tightened monetary policy in the face of a recession, making the problem worse:
“Restrictive monetary policy rather than the deleveraging in financial markets that had begun in August 2007 offers a more direct explanation of the intensification of the recession that began in the summer of 2008. Irony abounds.”
Second, many banks that specialized in mortgage lending pre-crisis are no longer in existence; some failed, some merged, and others simply diversified their lines of business into more profitable services. It’s true that bank lending is tighter than pre-crisis levels, and the transmission of monetary policy is a clear problem the Fed faces. However, this ignores the fact that real capacity restraints exist in the industry post-crisis for good reason. The crisis caused this transitory period in mortgage lending. The industry should see new entrants over time as the housing market continues to recover.
In a report on the future of housing, FBR Capital Markets provides evidence:
“Almost $1.3 trillion of capacity has been taken out of the origination infrastructure in the U.S.,” and therefore, “…the refinance boom could last multiple years rather than a few quarters.”
Why are we lacking capacity? Pre-crisis mortgage lending ran unchecked and barriers to entry in underwriting were little to nonexistent at the time. Now it’s different. For example, Bank of America bought Countrywide in early 2008 at low valuations due to the seller’s financial and legal issues. But Countrywide is responsible for a large part of this missing capacity, as post-acquisition, Bank of America thought it wise to cut its losses and exit the business in addition to closing down Countrywide’s operations.
In December, Dudley spoke on the transmission effect in the mortgage market and concluded that the spread of the primary and secondary mortgage rate, while a concern does not fully negate the impact the Fed’s easing policies. Simply put, the transmission effect is still very real. Moreover, he concluded many factors beyond just banking concentration contribute to the muting of effective monetary policy.
Fisher and others would rather take this argument down to its most basic level, that large banks are the sole cause of a transmission effect of monetary policy. This is a misleading interpretation of the evidence.
Concluding remarks:
Research and implementation of reform takes time. There are many pieces to these arguments. No one rationale is simple enough to claim as a reason to break-up such a large sector of our economy. It is important that the discussion around the role of the banking sector and its costs and benefits continue. Additionally, it is equally, if not of greater importance that oversight of systemic risks continues, not just in traditional banking, but throughout the overall financial sector.
Yale Professor Gary Gorton, cited in the HPS report, frequently discusses the financial crisis and advocates for reform:
“The ‘shadow’ or ‘parallel’ banking system – repo based on securitization – is a genuine banking system, as large as the traditional banking system,” and “…the fact that the run was not observed by regulators, politicians, the media, or ordinary Americans has made the events particularly hard to understand.” Nonetheless, he continues, “It has opened the door to spurious, superficial, and politically expedient ‘explanations’ and demagoguery.”
Similarly, Daniel Tarullo spoke in October about the need for reform outside of traditional banking:
“But Dodd-Frank does not fashion a far-reaching system of regulatory authority for the shadow banking system to parallel the one it creates for systemically important institutions, or even to address fully the significant connections – through implicit support and other channels – between the shadow banking system and systemically important institutions. This is particularly noteworthy, as there is clearly some potential for enhanced capital, liquidity, and other prudential requirements for bank holding companies to cause more activity to migrate to the shadow banking system.”
On February 1, 2013, William Dudley also spoke to reform in the shadow sector:
“The sheer size of banking functions undertaken outside commercial banking entities—even now, after the crisis—suggests that this issue must not be ignored…Pretending the problem does not exist, or dealing with it only ex post through emergency facilities cannot be consistent with our financial stability objectives.”
Research like this takes time, and the broader point of the HPS paper is that there are many pieces to these arguments.
The modern banking system, like the economy, is complex, and complex issues require a robust, fact-based public dialogue over a period of time. The current debate over the shared goal of a stronger banking sector that supports economic growth is healthy. We hope our report and the responses helps further that debate.