We Need to Break the Banks

By Simon Johnson

My problem with Monday’s expected announcement from Mr Geithner doesn’t have much to do with the details of the public-private partnership. I doubt this will work, because I don’t see the incentive for banks to sell assets at less than the value currently on their books. Right now, they have the government right where they want it - look at the body language and words of leading CEOs.

The government feels that it cannot take over large banks, there is no bankruptcy-type procedure that would work, and only deference to the CEOs of major financial institutions can get us out of this mess. This is a conscious strategy decision from the very highest levels.

I’d like to say: OK, but this is absolutely the last time we will try for a solution to our banking problems involving a private sector-led approach. Of course this would not be credible and bank CEOs know this. Instead, I propose the following.

If Secretary Geithner’s scheme works, we draw the lesson that our banks became too big and we aim to make them smaller relative to the economy moving forward. The regulatory agenda currently in progress - including for discussion at the G20 next week - would do essentially nothing to reduce the political power of big banks. We need simple caps on bank size, leverage relative to the economy and - this is harder - measures of interconnected tail risk (i.e., is everyone making the same kind of crazy loans?). Design a system with this in mind: regulators get captured and super-regulators get super-captured.

If the scheme doesn’t work, we draw the exact same lesson. And, of course, we should expect Chairman Bernanke to move forward with his Plan B (or is it Plan Z?): inflation.

In any case, our top political leadership needs to really sell some version of the following message. We let the banks get out of control and the cost will be enormous; our debt/GDP ratio will in all likelihood rise from around 40% to over 80%. We cannot afford to have the same problem again. We must break the power of banks before they break us all. And if you don’t think banks can do that much damage to economies, just look around outside the United States - the world is full of countries where growth is slowed or distorted by a financial system that becomes too powerful. This is not about tweaking the existing U.S. regulatory system; it is about complete change and - in many senses - turning back the clock to a financial system that was simpler, smaller, and much less dangerous.

Comments

[Amouna:]

We need to get rid of zombie institutions and let the free market forces purge the system of failures. We need to re-allocate capital efficiently and let the undeserving institutions fail. THis is the only way we can restore confidence in the markets and build a sounder foundation.

Right now, the markets want a radical solution, and they want this solution. All stabilization plans devised by the government have proved worthless.

Mar 23 08:58 AM

[d4winds:]

Amen. But will common sense such as yours ever prevail in Washington?

Mar 23 09:54 AM

[TaurusTrader:]

No ... No ... No ... not at this time. This is not the time to mess with banks. The economy is extremely sensitive and it can't take any more hits like LEH orBSC debacle. Moreover, we as tax payers have invested a lot to go back and make big banks go belly up. Get real people!

TaurusTrader
www.taurustrader.wordp...

Mar 23 11:10 AM

[MattZN:]

I think you are missing the point to some degree. If rampant negativity and shorting on the market prices these securities at $0.33 on the dollar (for examples), and banks want to list them at $0.66 on their balance sheets, which nobody believes, then having the government come in and price these assets at, say, $0.50 on the dollar accomplishes its goal whether or not the banks are willing to sell them at that price.

Simply put, it creates a floor which allows the banks to value the assets more reasonably without necessarily selling them, and prevents market sentiment from under-valuing the securities to the point of insanity. Suddenly the bank balance sheet becomes a lot more believable.

A lot of authors are still operating under the misguided perception that the banks have to get rid of these assets. It's almost become part of the language and everyone parrots the line as if it were true. It isn't true. All the banks have to be able to do is price the assets reasonably.

-Matt

Mar 23 11:22 AM

[lyonhead:]

I think Pandit the CEO of Citigroup was a genuis in getting the government into common shares of Citigroup. The asset value is sure to rise in the future and unrealistic preferrred share rate could be avoided. The government now has vested interest in keeping the company going and eventually selling of components to get the company down to size and out of internal conflicts of interest.

Mar 23 11:39 AM

[mahoney:]

Good article. The financial crisis would have been much attenuated if the investment banks weren't 'too big to fail.' No bank should be allowed to achieve that status again.

Mar 23 12:38 PM

[dcb:]

Unfortunately I have learned from this crisis there is a huge difference between what should happen and what will happen. I will also say that as far as I am concerned that every reason I voted for Obama has been proven not to be justified by the current crisis. That being said I didn't say I love the republicans either, I am just saying he has failed my test with this current episode. Time for a third party.

Mar 23 04:34 PM

[Al-USA:]

"
I will also say that as far as I am concerned that every reason I voted for Obama has been proven not to be justified by the current crisis. That being said I didn't say I love the republicans either, I am just saying he has failed my test with this current episode. Time for a third party.
"

Indeed, it should be increasingly clear to most people, who care, that both Republicans and Democrats are merely the right wings of one party, the Capitalist Elite party; or the party of the rich and politically connected, if you will.

For the sake of the long term future of capitalism, the ruling class should indeed break up the banks, but, they are now so corrupt and secured in their power that, it seems to me, it will be up to the rising masses of the proletariat which will eventually do this work for them. That of course will also be the end of this ruling class as well as capitalism.

Banks Counted on Looting America’s Coffers
tinyurl.com/bkezmt
www.nytimes.com/2009/0...

"Fluke? Credit crisis was a heist"
tinyurl.com/cgugqm
articles.moneycentral....

"Following the A.I.G. Money"
tinyurl.com/d6xkbk
www.nytimes.com/2009/0...

"Economic Fascism and the Bailout Economy"
mises.org/story/3333

"Behind the Financial Market Crisis?"
mises.org/story/3111

Mar 23 05:59 PM

[The Cynic:]

Do you honestly expect Washington politicians whose activities are likely underwritten by those same big banks to do this??!! The quid pro quo for the banks underwriting the activities of the two main political parties is that the politicians will ride to the rescue of the bankers when they f**k up! So in my view the only way it'll change meaningfully is when Americans decide not to pay their taxes or at least make a credible threat not to pay their taxes.

Mar 24 11:47 AM

[John Lounsbury:]

Simon - - -

You are right on point. I left a lengthy discussion about this on James' article today and will not repeat it here. In short, the wrath on Main Street is demanding that there be some visible planning in this area.

We need action a la Teddy Roosevelt and Andrew Jackson, although with more modern finesse. The authority being sought by Treasury to have broader power to take over failing financial institutions, in addition to just banks, could be a step in this direction.

Mar 24 01:41 PM

[ArtfulDodger:]

Mr. Simon Johnson:

It looks to me that Master Bernanke has already implemented Plan B or Z: inflation, i.e., smoking the printing presses night and day.

Of course, what we needed in the first place was for the government not to have forced lending institutions to invent the subprime loan and for the Fed to have kept a "steady flow of funds going into the system" rather than turning the spigot on full blast after 9-11 and then shutting it off by raising rates 17 straight unprecedented times up to 5 1/4% a few years later.

The Fed did the same thing in the 1920s, having pumped money into the system for six straight years, and then in 1928 shutting the spigot off.

Look what happened each time the Fed opened up and then shut up.

You have to figure that they're either idiots or they're doing on purpose. I have no idea which it is.

This whole financial fiasco has the government's and the Fed's paw prints all over it, but neither one has taken the slightest responsibility for it. Rather, they're holding hearings today on measly bonuses to AIG employees, which is merely misdirection by the government to keep the masses occupied with nonsense.

John L., with all respect, I usually agree with you, but TR and AJ were the nation's first real interventionists. In my view, the government ought to take care of protecting its citizens, and keep the hell out of everything else.

But, of course, we have two generations behind us, X & Y, that have been raised to believe government should be in everything (and it is), and most of the Boomers who entered government (Clinton, Bush, Obama) aren't much better.

So there's much more of a chance of your wish coming true than mine.

I've watched the government pretty closely since Kennedy and I don't see anything it's done that the unintended consequences have not been overall negative.

As always though, JL, I appreciate your comments.

Thanks for the article SJ.

Mar 24 02:14 PM

[User 366653:]

Nice idea. Now, consider reality.

Assume the government takes control of Citigroup. Wipe out the common, preferred, and junior debt holders. Maybe even the senior debt. Great idea: destroy that last vestige of confidence that the average investor has in the financial markets.

What is accomplished?

First: Bloodshed on Wall Street that will make last September look like a sunday school picnic. Citi is six or seven times the size of Lehman. Do the math. Dow 3,000? 2,000? Who knows?

Second: the "toxic assets" on Citi's balance sheet don't go away. In fact, they become dramatically more toxic, along with the balance sheets of all the other banks, because the accompanying financial crisis will obliterate any residue of hope left in the markets. The cascading effect should pretty well finish JPM, BAC, WFC, and most, if not all, of the other banks.

Third, THE U.S. GOVERNMENT WILL BE RUNNING THE SECOND LARGEST BANK IN THE COUNTRY (and, quite possibly, the largest, third largest, fourth, and so on). At least temporarily, but probably for several months, until our system simply fails. The government will have three choices for disposing of the carcass of Citi: turn it over to JPM or BAC or WFC (if, by some miracle, one of them survives the above referenced bloodbath), split it into a couple of hundred divisions, and try to sell the pieces to one of the few regional banks still in business - or try to manage the company as a quasi-governmental agency, like, for example, Fannie or Freddie. Or the Postal Service. Have you stopped laughing yet?

The problem is very simple. "Bailing out" the banks is the worst possible solution, except for all of the other solutions.

This scenario is the reason that Roubini and Krugman and the other prominent proponents of "nationalization" or bankruptcy NEVER take the time to explain what happens next.

On Mar 23 08:58 AM Amouna wrote:

> We need to get rid of zombie institutions and let the free market
> forces purge the system of failures. We need to re-allocate capital
> efficiently and let the undeserving institutions fail. THis is the
> only way we can restore confidence in the markets and build a sounder
> foundation.
>
> Right now, the markets want a radical solution, and they want this
> solution. All stabilization plans devised by the government have
> proved worthless.

Mar 24 10:32 PM

[Allan Frain:]

Agreed, but let's not forget that these "Zombie Banks" are the puppetteers over our Congress. That is the most important reason that they must be allowed to fail. We cannot alllow our Sovereingty to be held hostage any longer.


On Mar 23 08:58 AM Amouna wrote:

> We need to get rid of zombie institutions and let the free market
> forces purge the system of failures. We need to re-allocate capital
> efficiently and let the undeserving institutions fail. THis is the
> only way we can restore confidence in the markets and build a sounder
> foundation.
>
> Right now, the markets want a radical solution, and they want this
> solution. All stabilization plans devised by the government have
> proved worthless.

Mar 25 09:28 AM