Let's accept as a premise that as an outcome of the financial crisis, we now have too many giant banks and other financial institutions that are "too big to fail." And that this means the next global financial crisis will be worse than the one we've just endured in the absence of government reforms that are both comprehensive and vigorously, continually enforced.
Some casualties of the global financial crisis of 2008-09. (GMAC, the former General Motors Acceptance Corp. has rebranded its GMAC Bank as Ally Bank.)
I hestitate to say all you need know of what's required is in two brilliant, consise articles. But these two articles offer a layman's explanation of what went wrong, how to fix it for now and future generations, and the horrific consequences if governments don't act. The articles are David Ross's succinct proposals for subtantive financial-regulatory reform in the current Harvard Magazine. And ace New York Times business columnist Joe Nocera's Saturday piece on the need for tough, uniform global standards.
It would be nice, free-marketer that I am, to indulge in the luxury of simply hoping that the system will not again lead the global economy to the edge of the abyss. But as David Moss notes in his superb blueprint for future financial regulation,
"Private financial markets and institutions have always had trouble managing risk - and especially systemic risk - on their own. The long series of financial crises that punctuated American history up through 1933 testifies to this fact, as does the current crisis, which exploded not coincidentally during a period of aggressive financial innovation and deregulation."
The deregulation, of course, was the unwinding of the Glass-Steagall act and the Banking Act of the mid-1930s, which for about 50 years protected the U.S. system from crisis - a routine experience prior to the recession, beginning with the first panic, in 1792 and followed every 15 to 20 years or so by another catastrophic failure of the system. It wasn't long before the initial undoing of those safeguards - with bank deregulation in the early 1980s- that America endured its first systemwide failure since the Depression, the savings and loan crisis. And the current crisis has its origins in the revocation of Glass-Steagall, by Bill Clinton and a G.O.P. Congress, in 1999; the 2004 decision by the U.S. Securities and Exchange Commission, then headed by former G.O.P congressman and Bush appointee, to permit major investment firms to regulate themselves; and the failure of America's four financial services regulators to conceive and enforce rules for the burgeoning market in credit default swaps - an insurance product that enable banks and other institutions to legally hold on their books billions of dollars in risky investments which, because they were "insured" by CDSs, did not require an accompanying addition of capital reserves to cushion the blow if those investments went sour.
There was, unfortunately, yet another crucial factor, the so-called Basel II rules that came into effect a few years ago, by which the global banks set their own guidelines on what constituted undue risk, and made matters still more dangerous by assuming unimpeachable credibility on the part of credit-rating agencies. (Which we now know rubber-staped their Triple-A imprimatur, for fat upfront fees from securities issuers, in their own go-go-era quest for spiralling profits.)
As Ross also notes, that 50-year period of comprehensive government regulation spanning the mid-20th century was a period of tremendous financial-product innovation, from credit and debit cards to adjustable-rate mortgages and ATMs - even as the system's stability remained rock-solid. Regulation, in other words, was no brake on entrpreneurship and lucrative, but judicious, risk-taking. We need a return to that framework, with modifications to account for relatively recent "innovations" like subprime mortgages, collateralized debt obligations (CDOs) and off-balance sheet hideaways for dodgy assets.
As matters now stand, the U.S., Britain and other leading nations have created, with their prompt and costly bailouts of failing financial institutions, the greatest degree of "moral hazard" the world financial system has ever seen. Moral hazard is the economists' (and sociologists') term for the undue risk we take when we feel invincible, because we believe we have become better protected against calamity.
The classic example is the Volvo driver who compensates for the extra safety afforded by that vehicle by driving more recklessly than he used to, knowing he stands a better chance of survival in a rollover than in his previous, non-Volvo vehicle. But Volvo drivers do die in accidents, and, just as bad, the careless driving of a Volvo operator endangers others on the road. This is precisely the phenomenon underway earlier this decades as banks, hedge funds, derivatives traders, default-swap peddlers, securities firms, mortgage brokers and other financial players took a holiday from prudence in the belief that the government would save them if their reckless pursuit of lavish short-term gains ultimately blew up in their faces, destroying great companies like Merrill Lynch Inc., the world's largest brokerage; Wachovia Corp., America's fifth-largest bank; American International Group Inc. (A.I.G.), world's largest insurer; and Royal Bank of Scotland Group PLC, second-largest European bank and now a ward of the British state. (There were too many other casualties of self-inflicted wounds to mention, Lehman Brothers, Bear Stearns and Britain's Northern Rock among them.)
The nacent crisis now confronting us is that the forced merger of the most careless of the insolvent giants into larger institutions, and the bulking up of surviving institutions by acquiring the sound assets of failed ones, has further consolidated an industry that already was dominated by far too few actors, all caught in the same groupthink. As Charles Prince, the deposed CEO of a crippled Citigroup Inc. said not long before he was fired, If everyone else is dancing, you can't be a wallflower. Right. And now Citigroup, too, is a ward of the state.
A new age of superbanks that are "too big to fail": Between 2000 and June 2009, the four largest U.S. banks' share of total national deposits has almost doubled, from 21.9% to 39.6%. Chart by Reuters blogger Rolfe Winkler.
The next crisis, already visible, is that governments having rescued any bank or other financial institution whose failure was deemed to be a threat to the system (a "systemic risk"), banks and others have every incentive to become even bigger to qualify for "too big to fail" status, and every incentive to pursue fat executive bonuses that come with glowing short-term financial results with no regard to future risk because they know the government will bail them out. Or rather, the taxpayer will. By the end of last year, the U.S. alone had spent or allotted a staggering $11 trillion to stabilizing the financial system. And that's a fraction of what American taxpayers will ultimately shell out.
An argument certainly can be made that the biggest banks should be broken up, as Theodore Roosevelt busted trusts early in the 20th century, and the AT&T monopoly was split up by court order in 1984. (And has since re-amalgmated into just three players from the original seven "Baby Bells.")
Ross allows that, of course, there were many factors in the recent crisis, unprecedented since the Great Depression, in which, but for swift, powerful government intervention, we'd now be experiencing a second Dirty Thirties. Among these would be selling $540,000 mortgages to homebuyers with paltry income, no collateral, and no downpayment.
But, Ross argues:
"At root, this was a crisis of big institutions. As asset prices rose, many of the huge financial conglomerates played a pivotal role in inflating the [unprecedented U.S. housing] bubble. They used their pristine credit ratings (and their illusion of permanence) to access cheap funds on a tremendous scale, and they employed those funds in support of countless high-risk transactions and investments. Once the bubble began to deflate, it was many of these same huge (and hugely leveraged) firms that helped precipitate a vicious downward spiral as they all began desperately trying to sell troubled assets simultaneously. [What came to be dubbed "toxic assets" or "toxic waste."] And when the bubble finally burst, federal officials concluded that they had to save these very same institutions from collapse, because the failure of any one of them could have triggered an avalanche of losses, potentially threatening the financial system as a whole."
The recent bailout of the global financial system obviously was necessary, or world commerce would have ground to a halt and resulting unemployment would have been much higher than the 7.1 million U.S. and 480,000 Canadian jobs lost since the crisis hit its zenith last year. But the massive bailout leaves us with a huge problem, one even greater than the legacy of government deficits necessitated by the rescue.
Governments in America, Europe and Asia have established a precedent whereby poorly run financial institutions will be rewarded for their greed and incompetence by being rescued with taxpayer funds. The new danger is that banks, taking the wrong message from catastrophe they created, will become even more reckless in future knowing they will be rescued. Except the next time around, the institutions will be larger and costlier to bail out.
"The extension of implicit guarantees to all systemically significant financial institutions takes moral hazard in the financial system to an entirely new level. Creditors of these institutions will monitor less aggressively, knowing that the federal government stands as a backstop, and they are likely to pay less attention to the riskiness of these institutions in chasing the highest yields. If we are not careful, the inevitable result will be more (and more excesssive) risk-taking, greater losses, and further crises. If we are going to provide guarantees - and that decision has already been made - it is essential that we create effective mechanisms for monitoring and controlling the inevitable moral hazard."
How do we prevent another crisis worst than the last?
* Identify in advance financial institutions so large they pose a systemic risk should they fail. Create a System Risk Review Board to flag these firms, which would include any operator of sufficient size, including currently unregulated hedge funds, derivatives speculators, private equity shops and the like. Then regulate them accordingly, subjecting them to greater scrutiny than community and regional banks and smaller-scale brokerages and other financial players. Regulation already has failed if a government finds itself without warning having to rescue a financial Leviathan.
* Systemically key institutions would have to set aside larger reserves than their smaller peers. They would subject to minimum liquidity requirements, to guard against sudden losses - a means of discouraging excessive lending in boom times and fire sales of assets in bad times, depressing entire markets. They endure also a maximum leverage ratio, risking only, say $15 or $20 for every $1 they have in capital, rather than the $30 and $40 that was the norm in the U.S. and Europe leading up to the current crisis. And the largest insitutions would be restricted in off-balance sheet activity, so that regulators and investors would have a more true picture of their risk exposure.
As Ross sees it, the pride bankers and other financial actors once took in size would be turned on its head, as financier sought to avoid becoming too big to fail, with all of the restrictions that come with that status:
"However implemented, an important advantage of the proposed system is that it would provide financial institutions with a strong incentive to avoid becoming systemically significant. This is exactly the poosite of the existing situation, where financial institutions have a strong incentive to become 'too big to fail', precisely in ordeer to exploit a free implicit guarantee from the federal government. This unhealthy state of affairs can be corrected by being clear about the system nature of financial institutions and regulating them appropriately, rather than waiting until they are already in trouble to act."
Nocera, in an imagined conversation among Obama and a handful of fellow heads of state of European nations, has the U.S. president proposing to Gordon Brown, Angela Merkel and Nicolas Sarkozy their embrace of the strict reforms set out earlier this month by Obama's treasury secretary, Timothy Geithner.
In America, Obama wants two basic, common-sense changes:
* A doubling of a major financial player's capital to about 8% of total assets, from the current meagre 4%. He wants to see banks increase capital in good times, to cushion themselves against for bad times without having to come to the government for help.
* The same stricter leverage ratios that Ross recommends, and which have served Canada's Big Five banks so well in the current and previous crises.
Speaking as Obama, Nocera writes:
"What I really like about Tim's ideas about capital it that even without other reforms, they have the potential to change bank behaviour. If a bank wants to be so large that it is too big to fail, it can do so - but it will have to put up much more capital than a smaller competitor. if a bank wants to dabble in derivatives, it will have to pay a price in higher capital requirements. If a bank wants to invest in risky assets - ditto
"Banks hate higher capital requirements because they depress profits. So they'll have to make a choice: risky assets or lower capital requirements. They won't be able to do both."
Global uniformity on as many of these standards as possible would be ideal. The conventional wisdom is that the epicentre of the latest crisis was America. While that's largely true, the European banks have far less capital reserves than the large American banks and it's of poorer quality. The European financiers have no leverage ratios. This is where Gresham's Law comes in - that bad money drives out good. If a London bank, operating with slender reserves, can thereby out-compete a Chicago bank that has prudently set aside rainy day funds equal to 8% of assets, the Chicago bank is at an obvious competititve disadvantage. So if the law allows, as it currently does, the Chicago bank will cut its reserves - and margin for error - by redeploying its reserves into investments of varying risk. And so among the world's "superbanks," none will be adquately prepared for a shock, and the entirely system will be vulnerable to cascading failures. Which is, again, what we just now narrowly avoided only because governments worldwide went deeply into deficit to bail out a plethora of bad actors and ease the global recession they caused.
In the fall of 2008, seemingly isolated problems at selected financial institutions abruptly became a full-blown, global banking crisis. The September collapse of U.S. brokerage Lehman Brothers prompted bankers worldwide to stop lending to each other, much less to clients, fearing they might not get their funds back. With global lending at a standstill, corporate employers bent on preserving capital quickly laid off workers to protect their own cash reserves. Paulson, caught unawares, was forced with little preparation to plead with Congress for an emergency $700-billion (U.S.) bank-rescue package, which an equally unprepared Congress gave him with the greatest reluctance. (Paulson, centre, is shown here with House Speaker Nancy Pelosi and Senate Majority Leader Harry Reid.)Finally, there is in Europe an undisguised sense of indignation that the Americans got the globe into this mess. But, as noted, the European and Asian institutions were even more averse to prudential management than their American cousins. More to the point, Nocera has Obama saying,
"We have spent somehwere around $150 billion (U.S.) saving one company, A.I.G. One of the reasons we did so was to prevent many of your banks from collapsing. By having the American government back those A.I.G. credit-default swaps - the very ones you banks used to game Basel II - we upheld the illusion that those swaps represented genuine capital. If those swaps had disappeared during the crisis last year, many of your banks could well have failed."
As it happened, A.I.G.'s hyper-active credit-default operation, peddling insurance against losses on loans and other investments to banks on five continents, was run by a rogue manager whose bosses back in New York had no idea how much risk A.I.G. was amassing. In A.I.G.'s name, It was backstopping mortgages on strip malls in Budapest and trailer homes in Gulfport, Miss. for huge upfront fees that delighted New York until the mortgagees were foreclosed upon suddenly and in the thousands, and the giant A.I.G. found itself swiftly descending into insolvency save for Uncle Sam stepping in to buy 80% of the firm with a giant cash infusion.
The beauty of these reforms, and variations of them, is that they don't require inventing the wheel - unlike the case with the New Dealers, for whom there were no precedents for such comprehensive government oversight. They require only a return to the exacting scrutiny of regulators that applied during those 50 years of relative serenity, and a few tweaks here and there to account for, say, trading in derivatives, which, like fire, are useful and indeed essential but need careful handling.
Will we see anything like what I'm describing come to pass? My guess is that it will happen, but grudgingly and with a few vital pieces missing. Much depends on the new generation of bankers coming up the ranks. If it's another generation of Gordon Gekkos, there will be a requirement for tremendous political will to impose measures that protect financiers from each other and the rest of us. If it's a generation anything like the Scots who dominated the first several generations of Canadian banking, the financier will welcome a return to the serenity of 1935 to 1980, and a new global "level playing field" in which no one is rewarded for mischief or unchecked greed.
Laurence Copeland (Reuters): It's all over. The banks have won.
Rolfe Winkler (Reuters): Break up the big banks.
Neil Barofsky (HuffPost): Banking system may now be a more dangerous place.
Felix Salmon (Reuters): The beginning of the end of meaningful reform.