Breaking up the big banks continues to get serious attention in the media and among politicians. People don't like big banks to begin with.
"The banks are made of marble,
With a guard at every door,
And the vaults are stuffed with silver,
That the people sweated for,"
I heard Pete Seeger sing many-a-time in my youth. It still resonates with Bernie Sanders and his followers. I don't blame them. The big banks of America have not done right by consumers for the last 40 years or so. They have charged high fees for small infractions, defrauded borrowers and investors, and in general have lorded it over small folk. They have earned their reputations and the people's enmity.
In the fall of 2007, when hundreds of thousands of American homeowners needed help to avoid defaults and foreclosures on mortgages, many of which had been sold to them deceptively, the government refused to help. Instead, the government sought to help the banks by shoring up the value of the mortgage assets on their books, although that actually never happened because Congress wouldn't go for it.
But to many observers, including me, the situation cried out for assisting the homeowners -- and through assisting them, assisting the banks by forestalling the foreclosure tsunami. No one listened to us. Even The New York Times wouldn't publish my op-ed pieces. A great deal of the pain was avoidable by prompt action at that time.
So when the Bush Administration decided to support the largest banks with money from the TARP legislation in October 2008, it is not surprising that populist journalists screamed "bailout!" or that for the last eight years the drumbeat about bank bailouts has continued or that populist leaders want to break up the big banks.
But let's get the facts straight.
The Situation in 2008
In 2008 there were two kinds of big banks: Commercial/universal banks supervised mainly by the Federal Reserve Board (of which there were five -- JPMorgan Chase (NYSE:JPM), Wells Fargo (NYSE:WFC), Citi (NYSE:C), BofA (NYSE:BAC) and Wachovia) and investment banks that did not take deposits and were supervised mainly by the SEC (of which there also were five-Goldman Sachs (NYSE:GS), Merrill, Morgan Stanley (NYSE:MS), Bear Stearns and Lehman Brothers). Bear Stearns failed in March and was sold to JPMorgan with a minimum of federal assistance ($25 billion of asset guarantees). That was a great deal for Bear Stearns' creditors, for the U.S. government and for the American people. It was pretty good for JPMorgan as well.
Had Bear Stearns gone into bankruptcy, its creditors would have received fractions on their investments, the financial markets would have been in turmoil, and the loss of revenue to the government likely would have been more than $25 billion as a consequence of the losses being deducted from income tax returns. The risk of $25 billion was small change to prevent all that. (The downside of the deal was that JPMorgan got bigger and that a big player in some areas of investment banking and trading was eliminated, further concentrating an already concentrated market.)
A September Not to Forget
In September, from the 7th through the 16th, two quasi-federal agencies (Fannie and Freddie), Lehman Brothers (one of the big five investment banks) and AIG (one of the nation's largest insurance companies) all failed. Fannie and Freddie were taken into government conservatorship and were supplied with government capital. Lehman was allowed to fail (I won't get into the relative efficacy of that here), and AIG was provided with a loan to ride it through a liquidity crunch brought on by collateral calls on derivative instruments.
The government could not have allowed Fannie and Freddie to fail because their liabilities were believed by the whole world to be guaranteed by the U.S. government. By what mechanism the failure should have been redressed, we could debate, but not as part of this discussion. The AIG loan was a bit bizarre, but the consequences of an AIG bankruptcy were unknown though clearly very severe for many in the financial world, as well AIG's creditors and, who knew, even policyholders.
The Bush Administration people were in shock. They had not been prepared for this carnage, but they had not done too badly considering that. They could see, however, that contagion was taking hold, and that the next weakest banking institution, of whichever type, was likely to suffer a run on its short-term liabilities. They already had practically ordered Merrill Lynch, the next in the chain after Lehman, to merge with Bank of America on the weekend of the Lehman failure. Goldman and Morgan Stanley, being well advised, had sought help from the Fed to become bank holding companies and therefore eligible for Fed advances in the event of a liquidity crisis. So of the original big five investment banks, none were left.
But Wachovia was in danger, in part because it had acquired the second largest S&L in a deal announced two years earlier but only recently closed. B of A was weak, largely because it had acquired Countrywide, the largest mortgage bank, even though it was known to be troubled at the time (bad judgment), and Citi's capital was believed to be suspect, so it was thought to be vulnerable to a run.
Slightly out of chronological order, Washington Mutual Bank (WAMU, the nation's largest thrift institution) was taken over by the FDIC and sold to JPMorgan on September 25, with relatively minor assistance from the FDIC, again increasing banking concentration. But only a very big bank could absorb the giant WAMU that itself was an amalgam of dozens of S&Ls.
The Administration judged correctly that it would be a bad thing for Wachovia, BofA or Citi (or all of them) to fail. On September 21, it therefore presented Congress with a four-page bill (the bill that eventually became the TARP) that was designed to permit the government to buy distressed mortgage assets from the banks, which, the theory went, would assure the market that the banks' asset values as carried on their books were sound. Congress summarily rejected the bill on September 29, and the stock market immediately swooned. (Yes, that chronology is correct. The stock market did not swoon when Lehman failed. It swooned when Congress thumbed it collective nose at the Bush Administration.)
Congress may have been right to reject the Administration's bill, however. The basic idea behind the bill had been bandied around, supported by the major banks, for more than year. It amounted to a bailout of the banks by buying assets that the banks should not have created in the first place at prices set by the government, not by the market.
October Was a Little Better
On October 2 a revised and beefed up version of the TARP legislation was enacted. By then, everyone who had anything to do with anything financial was in shock.
The major change in the TARP, apart from technical matters, was a provision inserted at the request of Senator Chuck Schumer of New York to the effect that the money that was allocated (more than $700 billion) could be used by the government to buy equity securities of banks. Schumer's move, which the Administration had opposed, made it possible for the Administration to prevent bank runs by recapitalizing banks rather than by inflating (or backstopping) the value of their assets. The government could demand fair value for its investments in bank capital.
The next day, however, before anything had been done with the TARP money, Wachovia agreed to be bought by Wells Fargo. (Citi had made a bid for Wachovia with FDIC assistance and the FDIC had approved that bid, so Wachovia was in need of a stronger partner, but again, this deal increased the concentration of the industry. We could argue about this deal 'til the cows come home.)
On Veterans Day, October 13, a federal holiday, Treasury Secretary Paulson summoned the CEOs of JPMorgan, Citi, BofA, Wells Fargo, Morgan Stanley, Goldman, Merrill, Bank of New York and State Street. In some ways, it was a strange amalgam. Bank of New York and State Street were not in the same size category as the others and were primarily custodian banks; Merrill, which had agreed to merge with BofA, was invited, but Wachovia, which had agreed to merge with Wells was not invited. Whatever the reasons, one thing was clear: Secretary Paulson had determined that all would take capital from the government under the TARP so that the weakest (and most in need) would not be singled out. Whether that was necessary or not, all the banks complied.
(The chronology described above is summarized at the beginning of my book Debt Spiral: How Credit Failed Capitalism and is spelled out in greater detail as Part II of that book. The sources are in the notes to Part II.)
Capital Infusions under TARP
The capital infusions made by the government were on terms more favorable to the banks than some of them could have achieved in the market, but they were such that if public confidence could be restored, the government would make money. And that was how it worked out. The government made money on every single one of the capital infusions, confidence eventually was restored, and the creditors of the banks did not lose a penny.
It was the creditors who were protected. The creditors, who were insurance companies, endowments, retirement funds and individuals' IRAs were the most direct beneficiaries. Avoiding additional big bank mergers was another public policy benefit. But the biggest benefit was the eventual restoration of calm in the markets after the first bank stress test results were announced in May 2009.
The CEOs of Citi and BofA, the two weakest of the big banks that received capital assistance, walked the plank. The stockholders of the weak banks also suffered significant losses, as they should have.
The U.S. government (and taxpayers) did not lose a single penny by buying the capital securities. One wonders, therefore, why all the hubbub about bailouts and Too-Big-to-Fail, except as acting out the justifiable hatred of big banks that I outlined at the beginning of this article.
Dodd-Frank, Banking Culture, and the Strength of Big U.S. Banks
Yes, overhaul and strengthening of the regulation and supervision of big banks was needed -- badly needed. But Congress did that in the Dodd-Frank Act in 2010. Yes, Dodd-Frank has its political excesses, but if one looks at the basic problems that led to the boom and bust that culminated in 2008 and the attendant lack of confidence that the public had in the soundness of major banking institutions at the time, Dodd-Frank did the job pretty well.
The litigations in which major banks have paid tens of billions in settlements also have done a pretty good job of demonstrating that deceptive practices don't pay in the long run.
These factors have combined to create a better climate for a culture of more care for customers and better regulatory compliance. One should not underestimate the benefits of the renewed focus on culture.
Dodd-Frank did several things that promoted the culture change and reduced the likelihood that a large American bank will fail: (1) annual stress tests that forced a focus on risk management not only among risk managers but at every level of the bank; (2) establishment of the Consumer Finance Protection Board (CFPB), which has primary responsibility for consumer protection in the financial field without the conflicts of interests naturally experience by the banking regulators; (3) the Volcker Rule that removed proprietary trading from bank holding companies, thereby facilitating the cultural reform that I referred to above, and reducing the level of risk in banks' assets; (4) enhanced capital requirements for large banks, which addressed the major weakness that permitted mortgage losses to turn into a financial debacle in 2008; and (5) living will requirements for large banks, which while perhaps unnecessary, are having the salutary effects of increasing liquidity in stressful situations and decreasing organizational complexity and thereby making big banks more possible to manage.
Those are not minor changes. They may not have done away with the idea that a bank can be too big to fail, but they have made large American banks safer, better for customers, more competitive globally (because they are stronger and more customer-oriented), and far less likely to fail, even in a very deep recession.
I have discussed the value of stress tests in many articles, but I cannot stress their value too much. Understanding the value of stress tests begins by admitting that banking is a dangerous business -- and by this, I mean that traditional commercial banking is a dangerous business. It is a business in which the bank is expected to lend money for long periods to borrowers who are more risky than the banks themselves. Those loans are illiquid, have no market values, and tend to go into default all at once when recession visits the world, the nation or the region. The stress test seeks to tell the bank, the regulator and the public what that impact would be and to evaluate whether the bank's capital nevertheless would be adequate. The dynamic stress test process has reduced the basic danger of banking by making regulatory capital requirements forward-looking.
Consumer protection also is a step forward in the promotion of bank safety and in the nation's economic security. Better consumer protection could have prevented many of the loans that enabled the prices of real estate to get out of control in the 2004-2006 period.
Many of the benefits of the living will process have nothing to do with bank failures. The process has forced bankers to review the complexities and vulnerabilities of their corporate structures and those reviews have caused major simplifications and reallocations of responsibilities and financial vulnerabilities. Take a look at Davis Polk partner Randy Guynn's PLI slides on the living will process.
Would the Living Will Structure Work?
If there is a major bank failure at some time in the future despite the new protections, I do not know whether the living will process will make dealing with the failure easy or will dissuade the government at that time from preventing the failure. But that risk should not be regarded as a major risk to the U.S. or its citizens. As the above description of the events of the fall of 2008 should show, the U.S. did not lose anything by saving BofA and Citi from possible runs. Yes, the fact that no holder of major bank bonds lost anything does expose the markets to moral hazard and does imply that very big banks can borrow at lower rates than smaller banks. But the living will process should be seen as having largely addressed that issue by explicitly providing that Total Loss Absorbing Capital (T-LAC), including senior debt, can be accessed as part of the bank resolution process. That may leave a few basis points on the table for the big banks, but they may not even pay for the expenses of maintaining the stress test process and the living will process -- a fair trade-off, it seems to me.
Breaking up the Big Banks is Not Necessary
So I come back to the TBTF hubbub and the calls to break up the big banks. I am no fan of oligopolies. Competition is what makes market economies work in consumers' best interests. And large aggregations of money, such as large banks, do acquire political power through making contributions and paying for lobbyists, but none of the proposals that I have seen are designed to create more competition or to break banks up into such small pieces that they would not have political clout. They had political clout when each one was smaller. They just got together to protect their common interests, as every kind of business does in a democracy.
In conclusion, we all should readily understand why many people hate big banks. They are not lovable at all and in many ways do not deserve the public's respect. But breaking them up on that account would be bad policy when so many of the problems have been soundly addressed by Dodd-Frank and the supposed evils of bank bailouts in 2008 did not exist. (For a different approach with a similar conclusion, see Aaron Klein's Brookings post of April 4.)
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.