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By Mark Harrison, CFA

MIT Sloan School of Management Professor Simon JohnsonIn the opening session of the fourth annual CFA Institute European Investment Conference today in Paris, MIT Sloan School of Management professor Simon Johnson didn’t equivocate on the perils of the current global economic environment. “We have built a dangerous financial system in the United States and Europe,” said the former chief economist at the International Monetary Fund. “We must step back and reform the system.”

Professor Johnson cited alarming parallels with October 1931, when “people thought the worst was behind them, but the smart people were wrong and instead the crisis just broadened.”

Johnson began his talk by pointing to the recent failure of MF Global (MF) as good news because it “barely caused a ripple in markets, despite its $40 billion balance sheet.” But he contrasted this with the conundrum of “too-big-to-fail” banks in the financial system, which have all benefited hugely from an implicit state guarantee. Citigroup (NYSE:C) survived even with $2.5 trillion of liabilities at the time of its rescue, Johnson noted, and the U.S. government-sponsored enterprises Fannie Mae and Freddie Mac lobbied hard to pump up their risk — but both had to be rescued by the U.S. taxpayer.

Johnson says these large institutions get a 50 basis point benefit on their debt costs from the implicit U.S. government guarantee. “The last crisis cost 50% of GDP and involved the socialization of losses,” Johnson said, “but even that has failed to address the fundamental issues. We are looking straight into the face of a great depression.”

The MIT professor sees everywhere an unjustified deference towards the big banks and an aversion to doing anything that would be contrary to their interests. Pointing back in time, Johnson cited the example of U.S. President and “trust-buster,” Teddy Roosevelt, the first American President to successfully invoke the Sherman Antitrust Act against monopolies in the early part of the twentieth century. In contrast to this decisive action, Johnson bemoaned the failure of the Brown-Kaufman Amendment to the Dodd-Frank Act, which was voted down last year in the U.S. Senate. This Amendment would have addressed at least some of the structural issues.

“The biggest banks are larger today than they were three years ago,” said Johnson, who thinks they are basically carrying too little equity capital. Even Germany’s Deutsche Bank, regarded as a strong bank, currently carries a €1.85 trillion balance sheet on the basis of equity capital of only €60 billion, a multiple of 31 times leverage. “The dark magic in banking math is risk-weighted assets,” said Johnson. “It is an illusion to say we can calculate a risk free-rate on the basis of sovereign debt, which defaults on a regular basis.” Agency issues such as executive appetite for risk in banks, highlighted by a recent academic paper by a trio of researchers, serve to pump up the risk in large banks.

For Johnson, recent financial reforms are not enough. Proponents of Dodd-Frank might point to measures by the Federal Deposit Insurance Company (FDIC). But Johnson thinks this U.S. institution has been shown as incapable of dealing with global cross-border institutions. The Lehman failure was certainly complicated by uncertainty surrounding overseas operations.

Johnson argued for a sea change in the consensus around our financial structure. Banks need more equity and higher capital requirements. The largest banks should be smaller with a size-cap relative to gross domestic product. But Johnson acknowledges this is not going to happen anytime soon.

Paraphrasing Eugene Fama, the legendary efficient market economist, Johnson pointed out that having banks that are too big to fail is perverting activities and incentives in financial markets — giving big financial institutions a license to increase risk even though taxpayers will bear the downside and financial firms will reap the upside.

Johnson contended there are no economies of scale in banking beyond a size of $100 billion, perhaps even $10 billion, and any subsidy for high leverage and risk-taking will cause massive damage to our society unless we stop it.

Instead of beginning a conversation about restructuring away from debt and towards more robust equity capital, Johnson thinks we are simply reinforcing the institutions that got us into trouble in the first place. “Building our societies on debt is very dangerous,” says Johnson. “The asset side fluctuates whilst liabilities are fixed. We need to restructure away from debt and towards greater equity capital.”

Concluding on a more optimistic note, Johnson said that he hopes

“the moment for reform will soon arrive, and likely before we see the massive damage and dislocation that was a feature of the Great Depression of the 1930s.”

Source: Simon Johnson: 'We Are Looking Straight Into The Face Of A Great Depression'