Johnson and Kwak's '13 Bankers' Makes an Important Contribution to the Free Market Debate

 |  Includes: BAC, C, GS, JPM, MS, WFC
by: The Rational Walk

Every Friday in recent months, the Federal Deposit Insurance Corporation (FDIC) has announced a list of bank failures along with plans for resolution of the failure. The shareholders and management of these banks may look with envy at the elite group of banks in the United States that are considered “too big to fail” and enjoy protections that are unavailable to smaller financial institutions. Appalachian Community Bank, which failed last Friday, was simply closed by regulators who arranged to have customer deposits assumed by another bank. In other cases, such as the failure of Advanta Bank, the FDIC is unable to find another financial institution to take over deposits. In most cases, managers lose their jobs, shareholders are wiped out, and uninsured creditors lose some or all of their investment.

The privileged bankers who run institutions that are considered to be “too big to fail” do not suffer the same fate as their smaller counterparts, as Simon Johnson and James Kwak describe in their forthcoming book 13 Bankers: The Wall Street Takeover and the Next Financial Meltdown. Although the book is not a comprehensive account of the financial crisis or a “behind the scenes” epic story like Andrew Ross Sorkin’s Too Big To Fail, the authors present a compelling case in favor of not allowing financial institutions to reach the point where they pose systemic risks.

Historical Context

The authors begin with a brief review of the history of America’s financial system dating back to the debate between Thomas Jefferson and Alexander Hamilton. Jefferson’s idealistic vision of America as a decentralized agrarian society and Hamilton’s preference for a strong central government that actively supports economic development were at odds from the earliest days of the republic. Hamilton and his allies eventually won the debate despite Jefferson’s belief that the Bank of the United States violated the Tenth Amendment which specifies that the Federal government may only engage in activities specifically enumerated by the Constitution. President Washington eventually came to the conclusion that the bank was permitted under the Constitution’s commerce clause.

If this debate sounds familiar, that is because the same arguments are often made today regarding the proper role of the Federal government in society. An excellent example is the constitutional question brought up by opponents of an “individual mandate” to purchase health insurance. This is not an enumerated power in the Constitution but may be justified by a broader interpretation of the commerce clause if we accept the argument of supporters.

The broader point that the authors bring up is that Jefferson was one of the first of many to oppose the existence of large institutions in society that could generate overwhelming economic and political power. The authors proceed to take us through a brief history of the 19th century, culminating in the concentrations of power at the turn of the 20th century which led to broad anti-trust action against oil and railway interests. The Panic of 1907 forced a policy debate that led to the establishment of the Federal Reserve in 1913. The authors then provide a brief overview of the Great Depression laws such as Glass-Steagall that shaped much of America’s postwar financial landscape.

The End of “Boring Banking”

The authors trace the problems facing the system today to the deregulation that began in the 1970s and culminated in the late 1990s with the repeal of Glass-Steagall which removed the last barriers between commercial and investment banking. Along the way, the reader also has the benefit of a brief review of the savings and loan crisis of the late 1980s and early 1990s and the growing political power of the banking industry as bankers and politicians increasingly “cross pollinated” between the Washington – New York corridor. Regulatory capture is the obvious problem that can occur when an industry is regulated by individuals who used to work in the industry or hope to do so again in the future.

Policy Prescriptions

The authors advocate an end to the “too big to fail” problem by prohibiting financial institutions from growing beyond a certain size and breaking up existing ones that are already beyond size limits. In addition, broad consumer protection legislation is called for in an attempt to curb some of the abuses of the mortgage meltdown of the past several years.

Many opponents of this point of view argue that very large institutions are required for America to compete in a modern economy and we cannot “turn back the clock” on the system. The authors propose a hard cap on size where no institution can have more than 4 percent of GDP in assets, which would amount to approximately $570 billion today. Furthermore, due to the riskier profile of investment banks, the authors call for size limits of 2 percent of GDP, or approximately $285 billion.

“A 4 percent cap would only roll back the clock to the mid-1990s. At that time, the largest commercial banks — Bank of America (NYSE:BAC), Chase Manhattan, Citibank, NationsBank — each had assets roughly equivalent to 3-4 percent of U.S. GDP. On the investment banking side, Goldman Sachs (NYSE:GS) and Morgan Stanley (NYSE:MS) only passed the 2 percent threshold in 1997 and 1996 respectively; at the time, they were the two premier investment banks in the world, and no one thought they were unable to meet their clients’ needs.” pg 216, pre-publication galley.

Six banks would be affected by this proposal: Bank of America, JPMorgan Chase, Citigroup (NYSE:C), Wells Fargo (NYSE:WFC), Goldman Sachs, and Morgan Stanley.

Of course, it is impossible to ignore the fact that regulators have been moving in exactly the opposite direction in recent years. The “solution” to the meltdown in the fall of 2008 was to encourage or force financial institutions to combine with each other, leading to ever-larger banks that are even further into the “too big to fail” category.

Regulation in a Free Market

The authors of the book lean to the political left, particularly in their recommendations for consumer protection laws that are designed more to protect individuals from themselves rather than to safeguard the financial stability of the system as a whole. From a free market perspective, full disclosure of consumer products and bans on deceptive or fraudulent lending practices are perfectly appropriate but outright bans on financial products should draw scrutiny. Protecting informed individuals from their own poor decisions is a questionable use of regulatory power.

On the other hand, regulations intended to prevent a meltdown of the financial system as a whole are firmly within the appropriate powers of government because the alternative is to continue engaging in taxpayer funded bailouts. Blocking regulations such as prohibiting the merger of two institutions that would lead to a group that is too big to fail, or even the breakup of existing institutions, can be justified as a means of preventing greater harm to society. Furthermore, such blocking regulations reduce the need for “regulation by micromanagement” that would otherwise be needed to prevent the failure of large institutions.

Free market advocates (which firmly include the author of this article) need to realize that our current system is not a true “free market” because institutions that are too big to fail enjoy upside benefits while downside risks are socialized through taxpayer bailouts. A free market must include the consequences of failure and advocates of free markets should support regulatory efforts that move in this direction. It is not clear whether the authors of 13 Bankers have come up with the best policy solution but they have made an important contribution to the debate.

Note to Readers: This book was reviewed based on a pre-publication galley provided by the publisher in February 2010. The publisher notes that the galleys are subject to revision and all quotations or attributions should be checked against the final bound copy of the book. The book is scheduled for publication on March 30.

Disclosure: The author owns shares of Berkshire Hathaway (NYSE:BRK.A) which holds investments in Bank of America, Wells Fargo and Goldman Sachs.