Brexit And Bank Regulation: Poor Governance Has A Price

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Includes: JPM, MS
by: Kurt Dew

Summary

Regulation succeeds when tied to a principled core, subject to public scrutiny.

When regulation is hidden from public sight, it ultimately meets government, not public, purposes.

In governance of the EU and of US banking, legislators and regulators avoid public scrutiny.

These regulations destroy market value.

Let me live. Please let me live.

Oh yeah baby, let me live.

- Queen

The market implications of this article are these:

  1. The implication for Brexit is that European governments need to urgently take direct control of their relationships with other countries in Europe. Popular faith in Brussels is shattered throughout the zone. The point of Brexit was not to dissolve the economic union. The British want to be consulted politically. And they are not alone.
  2. If Brussels reacts vindictively, isolating Britain, the commercial worst case will result, creating recession throughout Europe.
  3. The implication for US bank regulation is similar. The current performance of TBTF US banks is dependent on US regulation that, like Brussels, is not publicly accountable. A continuation of this policy will be destructive of TBTF bank value.

Brexit

No one knows the full explanation for Brexit. But front and center is governance. Both EU politicians and US bank regulators have separated governance from democratic principle. And both the EU and US banking are gradually being destroyed by that fact.

Consider Brexit governance. Britain, the origin of modern law, economics, and governance, can be excused for finding the Eurocrats in Brussels undesirable. Brussels passes rules without basis in law - enabled by remoteness from the electorate - enough to make the descendants of the signatories to the Magna Carta scream.

In the words of Nigel Farage, the leader of the anti-European, anti-immigrant U.K. Independence Party and a longtime member of the European Parliament, citing the problems in the eurozone and the refugee crisis, at the first post-Brexit meeting of the EU parliament:

"You [EU government] as a political project are in denial… But the biggest problem you've got -- and the reason, the main reason, the United Kingdom voted the way that it did -- is that you have, by stealth, by deception, without ever telling the truth to the British or the rest of the peoples of Europe, you have imposed upon them a political union."

In other words, it is not necessarily the decisions of the EU that caused Brexit. It's the sense that these decisions were made without popular assent by a remote Brussels elite. In the wake of Brexit, a number of the unpopular decisions of the EU -- most prominently, immigration -- seem negotiable, if we are to take the recent post-Brexit remarks of "Leave" leaders at face value. But the decision-making process is unacceptable to the British.

TBTF regulation

The key similarity of Too Big to Fail (TBTF) US bank regulation to Brexit is that TBTF regulation lacks regulatory principle and public awareness. The motive is the same - the possibility that the regulations would not survive public scrutiny.

This analysis borrows heavily from "Bank Regulation and Supervision: What Works Best?" an article written by Barth, Caprio, and Levine (BCL) that may be found here. Their article uses a new database on bank regulation and supervision in 107 countries to assess the relationship between specific regulatory and supervisory practices and banking-sector development and fragility. This article is one of many by these scholars, but its focus on the relationship between the bank regulations and their effects is unique among their works.

The authors, and others they cite, find that global bank regulation may be divided into two approaches:

  1. The "helping hand" approach.
  2. The "grabbing hand" approach.

In the words of BCL:

Pigou's (1938) classic treatment of regulation holds that monopoly power, externalities, and informational asymmetries create a constructive role for the strong helping hand of government to help offset market failures and thus enhance social welfare... Applied to banking, this view of government considers official supervision of banks, limits on bank activities, restrictions on bank entry, and a deposit insurance scheme as (potentially) appropriate policies that alleviate market failures and improve resource allocation."

The grabbing-hand alternative is based on the assumption that government failure is at least as important as market failures. Accordingly, the grabbing-hand theory predicts that countries with powerful official supervisors, limits on bank activities, and restrictions on entry will tend to have higher levels of corruption with no corresponding improvement in bank performance or stability. This view therefore predicts that governments focusing more on empowering private-sector control of banks are more likely to promote bank development than governments taking a more hands-on approach to regulation."

Taken together with BCL's observation of banking crises across the globe, they conclude "regulatory and supervisory practices that (1) force accurate information disclosure, (2) empower private-sector corporate control of banks, and (3) foster incentives for private agents to exert corporate control work best to promote bank performance and stability."

Is US TBTF bank regulation "grabbing" or "helping?" We consider the "living will" requirement. It exemplifies both a "helping hand" and a "grabbing hand" form of bank regulation.

The "helping hand" is the intent of the regulation. Living wills have a reasonable objective: Assurance of bank bankruptcy planning, so that a single bank cannot destroy the entire financial system.

The US government came by this regulation honestly enough. When the lawyer who represented Lehman Brothers' estate in bankruptcy was phoned by Lehman executives and told of the company's plan to file for bankruptcy a few days before the actual filing, he asked the executives, "When did you create your bankruptcy plan?" The response, "We started thinking about it ten minutes ago."

A bank regulator cannot be blamed for finding this Lehman attitude toward bankruptcy planning unacceptable. And therefore, a government requirement that TBTF banks be required to form a living will seems quite reasonable.

But "helping hand" becomes "grabbing hand" when these conditions apply:

  1. Unnecessary power in regulator hands.
  2. Lack of transparency in regulatory decision-making.

Bank regulation became "grabbing hand" regulation in the living will process in part because TBTF systemic risk has a government source, not a private source. That required confidential living wills.

TBTF has its origin in the partnership between big banks and Congress that created the distinction between a big bank failure and that of any other bank. In the years of the run-up to the Crisis, the dealer banks saw the building of systemic exposure of their derivatives positions. As a result, they successfully lobbied Congress for changes in the bankruptcy code - a slow legislative invasion.

Under the new code, the collateral backing swaps and repo may be seized, valued by the creditor, and liquidated within days of a bankruptcy filing, without a nod to the bankruptcy judge. And the use of the word "swap" in the code is so broad that it includes instruments not yet created but that a banker might decide to call a swap in the future. For the history of Congress's modification of the bankruptcy code to benefit portfolios of derivatives and repos, see an excellent history by Schwarcz and Sharon, here.

This all came to light during the Lehman crisis. The Lehman failure taught the world an unpleasant lesson. While the government's change in the bankruptcy code had protected solvent banks from attack, it had made insolvent banks such as Lehman vulnerable to attack from a sort of financial equivalent of the Donner Party, where dealer banks and other derivatives counterparties, freed from judicial supervision, gorge upon the collateral of their failing brethren without third party interference, on the first day of the failure.

Regulators would not benefit from a public discussion of the government's creation of systemic risk, one possible motive for living will secrecy. Regulators may also not want a public discussion of the desperate plans for preventing a system collapse in the event of a TBTF bank liquidity problem.

The reason is that the government is not prepared for a TBTF liquidity problem. Lehman's failure showed the need for immediate government action to prevent a Donner attack. The Fed has advanced such a plan, but it has not become a regulation and requires cooperation from other bank regulators. And Congress shows no sign of authorizing the immediate funding that the Fed procedure requires. This is classic "grabbing hand" regulation.

This confidentiality has a number of damaging effects on regulatory accountability typical of "grabbing hand" regulation:

  • Nobody identifies the person or persons who actually determine that a TBTF bank has an unacceptable living will.
  • Nobody explains what is wrong with failing living wills.
  • Nobody explains how a bank can change its living will to become acceptable.

In one common interpretation attributed to John Adams, good governance is

a government of law, not of men.

Post-Dodd Frank living wills, by design, are governance by men, not laws. Anonymous people decide whether to pass living wills for unknown reasons.

Indeed, there is even tacit acknowledgement, for example by Fed chair Janet Yellen, that these rules are intended to force TBTF banks to shrink. Since legislators have run for office attacking Wall Street, there is no penalty for such regulatory overreach. In the US, we are quick to forget that government destruction simply doesn't work, when it seeks to destroy that which economics has created. The country tore Morgan into three parts following the Depression. How did that go?

Now there are two of them [JPMorgan Chase (NYSE:JPM), and Morgan Stanley (NYSE:MS)]. Morgan has come back again because that's what the economics dictated. We will not destroy too big to fail by destroying TBTF banks.

But we are doing a really outstanding job of destroying the market value of banking equity among TBTF banks in the United States by trying.

Disclosure: I/we have no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours.

I wrote this article myself, and it expresses my own opinions. I am not receiving compensation for it (other than from Seeking Alpha). I have no business relationship with any company whose stock is mentioned in this article.