What's Next for Banks?

By Simon Johnson

The case for keeping banks in something close to their current structure begins to take shape. It’s not about traditional claims that big banks are more efficient, or Lloyd Blankfein’s argument that this is the only way to encourage risk-taking, or even the House Financial Services Committee view that immediate resumption of credit flows is essential for preserving jobs.

Rather, the argument is: those opposed to banks and bankers are angry populists who, if unchecked, would do great damage. Bankers should therefore agree to some mild reforms and more socially acceptable behavior in the short-run; in return, the centrists who control economic policymaking will protect them against the building backlash. This is a version of Jamie Dimon’s line: “if you let them vilify us too much, the economic recovery will be greatly delayed.”

There are three problems with this argument: it is wrong, it won’t work, and it doesn’t move the reform process at all in the right direction.

The “center vs. the pitchforks” idea fundamentally misconstrues the current debate. This is not about angry left or right against the center. It’s about centrist technocrat (close to current big finance) vs. centrist technocrat (suspicious of big finance; economists, lawyers, nonfinancial business, and - most interestingly - current/former finance, other than the biggest of the big, particularly people with experience in emerging markets.)

Just as an example, a broad range of entirely centrist people (including in and around the IMF; former Treasury; you’d be amazed) are expressing support for the ideas in our Atlantic article. People on the left are, not surprisingly, also in line with this view; but we’re also hearing convergent thoughts from some on the right - many who emphasize improving the environment for entrepreneurship don’t see big finance as their friend. So far, the only person who called to complain works for an “oligarch.”

You might think the “anti-pitchfork” strategy might work, particularly as it has in the past (e.g., in the early Clinton years). The problem for this strategy now is not just the fragile state of banks - by itself this can be ignored for a long while through forbearance, behind a smokescreen of complicated schemes with confusing acronyms - but the ways in which the markets they created now operate.

Just as global financial liberalization created the potential for capital to move violently across countries and greatly facilitated speculative attacks on currencies, so financial deregulation within the United States has made it possible for capital markets to attack - or, in less colorful terms, go short or place massive negative bets on - the credit of big banks and, in the latest developments, the ability of the government to bailout/rescue banks.

The latest credit default spreads data for the largest banks show a speculative run underway. As the system stabilizes, it becomes more plausible that a single big bank will fail or be rescued in a way that involves large losses for creditors. This would like trigger further speculative attacks on other banks, much as the shorting of countries’ obligations spread from Thailand to Indonesia/Malaysia and then to Korea in fall 1997.

The government’s own policies are facilitating these attacks, because as the Fed and Treasury make progress towards easing credit conditions, this makes it easier and cheaper for large hedge funds and others to take large short positions. And keep in mind the underlying loss of confidence is self-fulfilling: as you lose confidence, you want to go short, and selling the credit causes further loss of confidence - and banks are forced out of business.

The government’s entirely reasonable and long overdue request for a resolution authority will set up runs on that authority. If the authority is not granted, the runs will be on the government’s low and failing ability to save banks - given that the trust of Congress has been lost and no more cash for bailouts is likely forthcoming (presumably until there are large further shock waves or until Goldman Sachs itself is on the line.)

The continuing pressure on banks has nothing to do with populism and everything to do with the internal contradictions of the house of cards they built. Now they will scramble to limit short selling or find other emergency measures that will protect their credit. Such partial fixes would do nothing to stop the underlying deterioration of their credit; think about how countries facing currency attacks throw up futile defenses, try to change the rules, and squander their reserves on the way down.

You can see where this is going, but do not cheer. The likely result will be misery for many and further financial chaos around the world.

The big issue is of course the financial sector reform process. Some of my colleagues expressed great satisfaction with the progress made by the G20. But progressing down a blind alley is not something to be pleased about. I have yet to hear a single responsible official in any industrial country state what is obvious to most technocrats who are not currently officials: anything too big to fail is too big to exist.

If the bankers were just stupid, as suggested by David Brooks, then regulatory fixes might make some sense. But we know that bankers are smart, so it is their organizations that became stupid. What is the economic and political power structure that made it possible for such stupid organizations to become so large relative to the economy? Answer this and you address what we need to do going forward.

At a high profile conference in the run-up to this crisis, someone destined to become a leading official in the Obama Administration responded to a sensible technocratic critique of the financial system’s incentive structure (from the IMF, no less) by calling it “Luddite”. By all accounts, this is the prevailing attitude in today’s White House.

But the right metaphor is not breaking productive machines, or peasants with pitchforks, or even the poor vs. the rich. It’s as if the organizations running the nuclear power industry had shown themselves to be stupid and profoundly dangerous. You might wish to abolish nuclear power, but that is not a realistic option; storming power plants makes no sense; and the industry has captured all regulators ever sent after them.

The technocratic options are simple: (1) assume a better regulator, of a kind that has never existed on this face of this earth, (2) make banks smaller, less powerful, and much more boring.

Comments

[Fitz919:]

Seems strange you didn't mention what Wells Fargo did today, and how, and why it did it.

They are projecting a $3 Billion profit in the 1st Quarter. How are they doing this? Mark to Market accounting rules were just relaxed, so they are marking up the value of the Mortgage Backed Securities which they were previously marking down and taking losses on. Why did they do it? To convince everybody that their bank is fixed now, and everything is rosy again.

This is how an insolvent zombie bank comes back to life...on paper...not in reality.

Apr 09 11:28 AM

[Socialism c...:]

All we have to do is refuse to do business with "the Bigs". I, for one, am making that personal committment. I view it as necessary for the good of my country. There are plenty of well-run, solvent community banks, regional banks, and credit unions -- ZERO need to run to a big bank. Additional pluses include better service and less abusive practices, IMO.

Apr 09 11:38 AM

[Stone Fox C...:]

the negativity is off the charts and out of whack with the market. WFC had a splendid quarter due to lots of activity in the mortgage markets and basically free money from the govt. Also, the Wachovia portfolio was written down prior to the merger so it greatly helped reduce loses going forward.

With free money from the govt, I don't understand why everybody is still so negative on the banks. Don't fight the Fed. Even Whitney realizes that the game as changed. Banks will have issues for a long time but most of them aren't zombies. They are lending to all the prudent customers that come into the bank and at higher prices due to lower competition.

Apr 09 11:55 AM

[Mark Bern:]

According to the Wells Fargo report, the change in MTM accounting rules had very little effect on their 1st Qtr results. Let me interpret what that means: WF did not have to take the write downs on assets that they otherwise would have and so the effect was minimal.

Write downs were in the range of $3 Billion this quarter instead of $6 Billion in the previous quarter. Had the rules not changed the number may have been higher that $6 Billion. That would have wiped out their profits for the entire quarter. But since profits were not wiped out, there was very little impact on results.

Also, WF probably received payments from AIG, as did other major U.S. banks, in the unwinding of CDOs by AIG. Those payments would have included significant profits that would have boosted earnings, possibly in the $ Billions. Those results will undoubtedly be lumped in with other operating results so as to appear as ongoing. Take those profits out and we may have a loss.

Add the lower write downs and subtract the one-time profits from AIG transactions and you'll get the real operating results.

WF and other banks are all going to report profits and surprise to the upside, boost their stock prices, then do secondary offerings to raise additional capital. After that the Treasury will report aggregated findings from the stress tests so that we can't tell which banks are healthy and which ones are not. Then WF and others will accept additional capital infusions from Treasury.

After that, the big banks will "invest" in the PPIP funds using their toxic assets (FDIC head has indicated that she would consider this option), sell their toxic assets to the PPIF at above market rates because their own PPIF will bid up the price using government money. They will pocket the proceeds and let the PPIF fail.

This is called recapitalizing our financial institutions. It's really a transfer of wealth - from the poor and middle class back to the wealthy. We won't get the bill for all this until about 2011 or so. But the installments will go on forever.

Then we'll have to save the insurance industry, too. What will we call those payments? Why not "Eternal Life" payments since that's how long this debt build-up is going to last for everyone currently living or ever born in the furute in this country.

Apr 09 11:57 AM

[Tom Armistead:]

It's not about peasants with pitchforks, or Luddites, or let them eat cake financial aristocrats.

It's about CDS, at best a zero sum game, at worst, a Ponzi scheme. CDS are insurance and should be regulated as such, with a requirement of insurable interest for buyers and adequate capital for sellers. The banks highlighted in this discussion are all large players in the game, and potentially victims as the process feeds on itself.

I am not a peasant with a pitchfork, I am a private investor who is tired of operating in a system that also houses a gambling casino.

Apr 09 11:57 AM

[CautiousInv...:]

I think there are a number of considerations that are restraining the the consideration options outside of the current regime.

1) The status quo offers the least resistance and represents a known

2) Allowing one or more of the big banks to fail would roil global markets and create havoc in the bond markets were bonholders to take a haircut.

3) If one or more large baks allowed to fail it could lead to further industry concentration absent policies to foster growth of large regional banking centers

4) As the author has noted, the heads of banks belong to a privileged oligarchy whose other members would be admitting intellectual defeat in admitting the current system is broken

and 5) There is a real belief the troubles assets will simply go away with the benefit of time and price appreciation. The hold to maturity argument.

Apr 09 12:02 PM

[BigJake:]

I sold my house in miami back in 07 to someone who was pulling all sorts of shennanigans to get a loan. Wanna take a guess at which bank finally extended them credit? You guessed it - todays bank sweetheart Wells Fargo. Time to enter your short positions folks!

Apr 09 12:20 PM

[everyotherc...:]

No doubt here where Mr. Johnson and Mr. Blankfein stand: Leave the rules for investment banking pretty much alone! Good grief.

Let's back up a little. For several years, off-chanel(mortgage brokers, as opposed to traditional bank lenders) real estate lending exploded. It was inspired by the investment banking firm's discovery of the mortgage securitization business and its enormous potential. Well, potential it was, and Wall street proceeded to paper the world with junk and set off a historic financial crisis. Due diligence on Wall Street's behalf? MIA. Period. Excuses? Plenty: ""The rating agencies made us do it!" Bull.

Look, the SEC saw fit to allow Wall Street to leverage itself to the moon in an environment of no oversight of asset quaity whatsoever. Wall street did just that.

Regulation of investment banking is called for Mssrs. Johnson and Blankfein. Capital leverage. Asset quality oversight; yes, asset quality oversight----Fed reponsibility for asset quality, and regular examination and risk rating of assets.

Congress: Yes, the buck does indeed stop with you. Forget the pressure from Wall Street and ignore the "philanthropic" donations to your campaign funds. You've already brought our country and most of the rest of the world to our financial knees, and we're a long way from escaping the woods. Do the right thing. Forget the politics, the pressure, and yes, your re-election. Please.

Apr 09 12:26 PM

[schlumpf:]

its time to go short

Apr 09 12:46 PM

[Ibuild:]

The masses will not pay attention to anything that is not spelled out for them in monosyablic words of usually three letters or less. Those that have will take advantage of this to increase power.

Apr 09 12:51 PM

[McPhilip:]

You've completely misinterpreted Mr. Johnson's stance. He's calling for smaller, more 'boring' banks and recently wrote an article for The Atlantic exposing the similarities between the U.S. banking oligarchs and the crisis prone banking oligarchies in many emerging markets.

I don't disagree with many of the ideas you expressed in your comment, but your criticism of Mr. Johnson had no basis.

On Apr 09 12:26 PM everyothercatstaken wrote:

> No doubt here where Mr. Johnson and Mr. Blankfein stand: Leave the
> rules for investment banking pretty much alone! Good grief.

Apr 09 01:31 PM

[User 353732:]

Forcibly changing the structure of a major industry requires legislation and implementation by the Executive Branch. As everyone knows , such legislation has been passed and is being implemented.
This legislation is called the Big Bank Bailout. Its objective is to make banks that Washington and Wall Street have decided are too big to fail, even bigger and therefore even less threatened by failure; make banks that already dominate credit card and mortgage lending even more dominant; make banks already opaque even more opaque; make the already powerful and privileged nexus between Big Banks and Washington even more potent and exclusionary.
Further, Congress has already decided that ordinary Americans via a combination of instruements(e.g National debt, taxes, infaltion, compression of the middle class) will pay and pay again to finance implementaion of its legislation. It does seem, at least to me, that the debate is over .
What we now have is extravagant political theater to divert attention from the truth that the big decisions have been made and are being implemented. The people still debating the issue with great skill , earnestness and clarity are not, however, the people who have any power to make the big decisions.
This is also known as separation of State from the Middle Class.

Apr 09 02:03 PM

[Gary A:]

We have a one world financial system. The bankers control us. They are gambling that the middle classes will bounce back after they are done raping our treasury and stealing from our children and grandchildren. They are morally bankrupt.

Apr 09 02:21 PM

[Arete:]

There are a lot of good thoughts in here, but you don't quite persuade me.

A vital point--that if government obtains a new resolution authority then there will be "runs on that authority" (and that this will somehow retard the intended effect of the existence of the authority)--is relegated to a sentence of description and no real argument is given to back it. Perhaps it's simply obvious to a more astute student of financial economics, but I don't see it.

I'm also not sure your CDS data (why not include data about short interest in the stocks?) backs your argument as much as you think. Those rather violent movements reflect more factors than simply the current betting line on default, including the availability of competing, similar products, the available demand for those products, the supply of the products in question, etc., yes? I'd be more persuaded if you showed me some CDS data from firms that you'd consider stable, especially from within the financial sector, to provide some contrast, and included a longer timeline for all this. Even if they did reflect only that factor, to my eyes it appears that there is simply still shifting uncertainty about the future of certain debt of the highlighted banks--not a massive speculative run that will turn out to be self-fulfilling.

In my humble, amateur, and uninformed opinion, massive short bets that are self-fulfilling would likely require two factors to work: 1) substantial uncertainty about the current state of the instrument in question, and 2) substantial weight of negative over positive data about that instrument. Let me stress that these are just necessary, not sufficient, factors. And they can be fully addressed by less drastic regulatory measures than you seem to suggest. Moreover, they can be counteracted by positive news (a government backstop, a lending facility, a resolution authority, etc.), more recent, transparent disclosures, etc.

Apr 09 04:12 PM

[Speedspirit:]

I agree with Husker Mark and disagree with those who say short the banks. If they are playing with thier books and the Govt is leading them along where is the short play. Do we believe that rightousness will prevail that quickly. The trade is to go along with the pops and right our congressman on how wrong this fix is for our country. For the short plays to work congress has to have our backs.

Apr 09 04:44 PM

[Arete:]

Why not simply strengthen disclosure requirements and institute a federal mechanism to resolve institutions that are too interconnected, complex, and multi-jurisdictional, to enter into an ordinary bankruptcy? This way we continue to allow firms to take risks--and some will take bad risks--we allow investors to better understand the risks that THEY are taking when they invest in firms, and we remove any moral hazard produced by the current bailout by giving government a mechanism to wind up a firm that made too many bad bets (no more "too big to fail").

The flip side of the bubble is the panic--and just as many smart economists and financiers were not immune to the cognitively distorting effects of the bubble, I think many smart economists and financiers are not immune to the cognitively distorting effects of the panic.

On Apr 09 12:26 PM everyothercatstaken wrote:

> . Asset quality oversight; yes, asset
> quality oversight----Fed reponsibility for asset quality, and regular
> examination and risk rating of assets.

Apr 09 10:27 PM

[John Lounsbury:]

Fitz919 - - -

An oversimplified argument can be made that the $3 Billion WFC eranings this quarter was attributable to $190 Billion in new mortgage originations using (at 7.6 to 1 leverage of reserves) the $25 Billion Tarp money they received. Of course the accounting rule changes allowed this to become earnings instead of just being applied against mark-downs.

Mark Bern addressed the effect of the accounting changes very well.

McPhilip - - -

Thanks for your comment clarifying Simon Johnson's position.

Simon - - -

Another good article. I keep hoping that the administration will start moving in the "boring bank" direction. Maybe they are just trying to line up their ducks so that reform can be started without undue disturbance to the economy. Or maybe they just don't get it. I hope for the former and fear the latter.

Apr 10 01:56 PM

[Steve W fro...:]

From an investment standpoint it makes no sense to bet against the combined power of the Fed and Treasury that are now firmly arrayed behind the big banks. The big bank share prices will likely go higher particularly those beaten down the most over the last year.
That said it is a "fixed" game and could cost the average taxpayer grievously. The bet (using our money!) on the part of the Obama administration is that not bailing out the banks has more adverse consequences than bailing them out. What those who argue for letting them fail are really saying is that now is the time to institute a fundamental restructuring of the US economy to make it more biased towards the middle class and smaller banks and other financial players. Perhaps this IS the correct path but I think that most of us, if forced to make the choice, might also think that tinkering with the fundamentals of our economy during such perilous times is far too risky.
It is not like ANYONE really understands how the economy works and can easily design a better one.
The Obama administration is unlikely to switch horses in midstream and completely renounce their current plan so look for continued support of "Big Banking".
Lets hope it works.

Apr 11 12:13 PM

[Fitz919:]

Remember the Obama Administration is all about "change". So far their rescue plans: Use of TARP, Stimulus, etc has been more of the same. So changing course in mid-stream would be change Obama style. He will soon realize that leading big banks, big insurers, and the auto industry into bankruptcy is the only choice.


On Apr 11 12:13 PM Steve W from Ford wrote:

> From an investment standpoint it makes no sense to bet against the
> combined power of the Fed and Treasury that are now firmly arrayed
> behind the big banks. The big bank share prices will likely go higher
> particularly those beaten down the most over the last year.
> That said it is a "fixed" game and could cost the average taxpayer
> grievously. The bet (using our money!) on the part of the Obama administration
> is that not bailing out the banks has more adverse consequences than
> bailing them out. What those who argue for letting them fail are
> really saying is that now is the time to institute a fundamental
> restructuring of the US economy to make it more biased towards the
> middle class and smaller banks and other financial players. Perhaps
> this IS the correct path but I think that most of us, if forced to
> make the choice, might also think that tinkering with the fundamentals
> of our economy during such perilous times is far too risky.
> It is not like ANYONE really understands how the economy works and
> can easily design a better one.
> The Obama administration is unlikely to switch horses in midstream
> and completely renounce their current plan so look for continued
> support of "Big Banking".
> Lets hope it works.

Apr 12 12:25 AM