How U.S. Financial Sector Could Be Downsized

By Marshall Auerback

I was heartened to hear that Alan Greenspan has repudiated the Too Big to Fail doctrine (as practiced in the Bush and Obama Administrations) in such unequivocal terms. He almost sounded like a Teddy Roosevelt trust buster.

Nevertheless, President Obama clearly believes the line fed to him by Wall Street. He is no Teddy Roosevelt. The question you should be asking is, will the tentative reforms proposed by the Obama Administration have any kind of positive effect? The answer is probably in a very temporary fashion, but that is more a function of the impairment of the capital markets themselves. However, if you don’t deal with a cancer fully, it comes back and spreads – even if you conduct surgery to take out some of the tumour.

Reform of the current US financial sector is neither possible nor would it ever be sufficient. It’s a bit like Lincoln saying, "Well, this slavery thing has a few problems, but we can ‘reform’ it and make it better.” As any student of horror films knows, you cannot reform zombies. Zombie banks must be killed. In other words, the financial system must be downsized.

Downsizing can begin with the following set of actions:

• All bank assets and liabilities must be brought onto balance sheets, and made subject to reserve and capital requirements and—more importantly—to normal oversight by appropriate regulatory agencies. Any assets and liabilities that are left off balance sheet will be declared null and void, unenforceable by US courts.
• All CDSs must be bought and sold on regulated exchanges; otherwise they will be declared unenforceable by US courts.
• Unless specifically approved by Congress, securitization of financial products such as life insurance policies will be prohibited and thus unenforceable by US courts.
• The FDIC will be directed to examine the books of the largest 25 insured banks to uncover all CDS contracts held. These will then be netted among these 25 banks, canceling CDS contracts held on one another. CDS contracts with foreign banks will be unwound. The FDIC will also examine derivative positions with a view to determine whether unwinding these would be in the public interest.
• In its examination, the FDIC will determine which of these banks is insolvent based on current market values—after netting positions. Those that are insolvent will be resolved. Resolution will be accomplished with a goal of i) minimizing cost to FDIC and ii) minimizing impacts on the rest of the banking system. It will be necessary to cover some uninsured losses to other financial institutions as well as to equity holders (such as pension funds) arising due to the resolution.

These actions should substantially reduce the size of the financial sector, and would eliminate some of the riskiest assets, including assets that serve no useful public purpose. The financial system would emerge with healthier institutions and with much less market concentration.

Failing that, we should at least have the government get into the insurance business as credit insurer of last resort. Private firms can’t do it, as they do not have the financial resources to meet the potential claims (see AIG). And private firms have a tendency to mis-price credit risk (again, see AIG), which creates further incentives to bad behaviour.

As "Credit Insurer of Last Resort" (see Professor Perry Mehrling’s paper inventing this term – .pdf), the government can charge proper premiums for it, which will have the additional impact of mitigating the worst behaviour of Wall Street. The government can put a floor on the value of the best collateral in the system. As Mehrling says (in a variation of the Bagehot rule – i.e. "lend freely but at a high rate during a crisis"): “Insure freely but at a high premium.”

Source

Shadow Banking: What It Is, How it Broke, and How to Fix It – Atlantic Magazine

Comments

[TTurk:]

Ed:

I agree with your analysis 100%.

The problem is that by exposing the undervaluation of the CDS's and other financial instruments on the bank's balance sheets, you may find that many of the top 25 banks have negative capitalization. The total value which is probably $300 billion or more.

That cost is financially and politically impossible to correct. So, we let the banks themselves value these assets at whatever value they want to use. The truth is that we don't want to know the truth, so we feed these institutions free money so that they can buy our government debt and hopefully earn enough money so that someday in our lifetime they have value again.

Using your zombie illustration, the cost of killing the zombies is considered greater than the cost of letting them wander around the countryside and slowly kill off small businesses by refusing to make loans.

Oct 18 10:39 AM

[markfl:]

Harrison wrote:
"The FDIC will be directed to examine the books of the largest 25 insured banks to uncover all CDS contracts held."

Still $600 trillion in the derivatives market, and we don't know which banks may have a potential AIG-breaking $3 trillion in exposure.

Oct 18 12:59 PM

[John Lounsbury:]

Edward - - -

We don't know yet where Obama is going. He has been in office for almost 9 months - Lincoln didn't issue the Emancipation Proclamation until 1863. The election was in 1860. Many abolitionists thought in 1861 and 1862 that he wasn't going to free the slaves because of his inaction.

Jackson, who opposed the Second Bank Of the United States from the start, didn't take action until the fourth year of his first term when he vetoed the renewal of its charter and the first year of his second term when he withdrew government deposits and spread them among the state banks.

I think you probably know that I feel the banking crisis has been mishandled so far, but this is an event that will be played out over years, not months. We are in the first scene of the first act of a three act play.

We need to keep on the ballfield. Just because the opponents scored a couple of runs in the first inning doesn't mean the game is over.

All that said, I want to say that I think you have written a good article. I don't want readers to think that what you have discussed has passed us by. You are talking about some of the things that can and should be done in the next 9 months. The "emancipation proclamation" phase of the crisis and the redefinition of the structure of the financial system may still come later, just as with Lincoln and Jackson.

Oct 18 03:06 PM

[maywander:]

Why quote Alan Greenspan so approvingly? He's the one who promoted the bubble. Why link Obama to the Bush administration - have you forgotten the repeal of Glass-Steagall - sponsored by three Republicans?

And where were you, in the days when financial engineers on Wall Street was creating our catastrophe? Where was your get tough commentary then, when it would have been worthwhile?

Oct 18 05:53 PM

[derryl:]

Edward,
I'm glad to see you've read Perry Mehrling. I haven't read the Atlantic article but a month or 2 ago a SA author linked to the same or a previous piece he had written that explained the entire history of securitization, and its failure, and his proposals for how to get it working again (the "gov't as insurer of last resort" was in that piece). The guy knows what he's talking about, whether or not you agree that securitization should be restarted.

Have you read Kansas City Fed President Thomas Hoenig's, "Too Big Has Failed"?

kansascityfed.org/spee...

He also advocates an orderly resolution of the insolvent big banks and has cited numerous examples in the US and other countries where large scale bank failures have been successfully dealt with. Hoenig's plan is a little more radical than yours (he sounds a lot like Volcker). I like your idea of exempting pension funds whose investments in these banks would be extinguished (along with all other capital) to cover the bank's loan losses. It serves no socially useful function to wipe out pension funds that we would just have to bail out with taxpayer money anyway, so leaving them whole would make sense. And covering liabilities to other banks could also make sense economically but maybe not politically.

When you downsize finance in this way you are extinguishing both the unrecoverable portion of the banks' loan losses (after liquidating their asset portfolio) and the "money" that is represented by shareholder equity and other capitalization of the bank.

So the original loans (borrowers' debts to the bank) are extinguished along with the money that is used to repay/cover those debts, and money supply shrinks by the amount of money that is so extinguished just as money supply was expanded when those loans were first made. Bank "deposit money" is created and destroyed in this way, either by repayment of loans by borrowers or destruction of bank capital to cover loan losses, but money destroyed must always be equal to money that was created.

Investors in these banks would be the people who suffer all the losses. TARP transferred those losses onto taxpayers, but FDIC receivership and formal bankruptcy dissolution would transfer the losses back to the owners of the insolvent banks. This is capitalist discipline. If you make a losing investment, even though you thought it was good as gold, you lose your money. I would also advocate going after the personal fortunes of the bank employees who paid themselves huge bonuses while they ran their banks into bankruptcy, as a further measure to cover their losses.

Oct 18 09:53 PM

[Michael2343:]

No one stops to question fundamentals when the economy is 'expanding'.

For example, if real productivity is debt financed - lets say, to fund the R&D for an improved product line, of a real physical product, and research pays off in profits, the lenders have made a sound investment and everyone involved in the transaction wins. If the research does not pay off, the company is still on the hook for the loan, and may even go out of business. Such is the reality of having winners and losers. The lender may be hit by a default, and loses out as well. Tough!

In the end, a better company and more savvy lender will pair up and actually succeed. The consumer will get a better or cheaper product. This is called reality, where execution matters and good ideas triumph over flawed ones. Try and circumvent this rule and it just comes back twice as hard later.

One of the things that caught my attention in gym class as a kid was when the teacher said something like, "everyone is a winner". I knew that wasn't right, but, I guess it sounded nice.

Fast forward 30 years and this is the kind of mentality that seems to permeate the financial world's approach to taking risk. All off that risk is pooled so that there is far less risk on any one venture. Loans are insured, hedged, and otherwise protected in so many ways that its profitable to extend as many loans as possible. With enough leverage and insurance, its possible to outpace the few defaults - so more or less every investment is a win. As this mental virus permeates the marketplace every lender is a winner! And every borrower – even the company that failed – well, they can just get another loan.

How could this possibly go wrong! Maybe "everyone's a winner" is the mentality that makes everyone a loser in the end.

Oct 18 10:15 PM

[Liz:]

What happens to all the CDSs on banks' balance sheets if we declare them unenforceable?


Someone, somewhere is going to have to write them off as a loss ... and it ain't gonna be pretty.

Oct 18 10:41 PM

[SW Richmond:]

1. Claw back TARP in its entirety.
2. Claw back any funds laundered through AIG, including TARP.
3. Claw back all new money created by the Fed.
4. Mark all bank assets to market and bring them on-balance sheet.
5. See who's still alive. Close the rest, break them up and sell them off.
6. Restate all earnings based on this new, actual financial condition. Claw back any bank salaries and bonuses revealed to be unearned.
7. Audit the Fed, publish all raw data.

Stand back and watch.

Oct 18 11:14 PM

[Kinabalu:]

The information on bank CDS contracts is readily available at the website of the Office of the Comptroller of the Currency, the federal regulator of national banks. The OCC’s quarterly report on bank derivatives activities and trading revenues is based on Call Report information provided by all insured U.S. commercial banks and trust companies. See the link:

www.occ.treas.gov/deri...


On Oct 18 12:59 PM markfl wrote:

> Harrison wrote:
> "The FDIC will be directed to examine the books of the largest 25
> insured banks to uncover all CDS contracts held."
>
> Still $600 trillion in the derivatives market, and we don't know
> which banks may have a potential AIG-breaking $3 trillion in exposure.

Oct 19 02:13 AM

[bbro:]

Sounds like 1893.....


On Oct 18 11:14 PM SW Richmond wrote:

> 1. Claw back TARP in its entirety.
> 2. Claw back any funds laundered through AIG, including TARP.
> 3. Claw back all new money created by the Fed.
> 4. Mark all bank assets to market and bring them on-balance sheet.
>
> 5. See who's still alive. Close the rest, break them up and sell
> them off.
> 6. Restate all earnings based on this new, actual financial condition.
> Claw back any bank salaries and bonuses revealed to be unearned.
>
> 7. Audit the Fed, publish all raw data.
>
> Stand back and watch.

Oct 19 10:14 AM