Big Bank Theory

Wall Street bankers, along with the rest of the players in the financial industry, like to think of themselves as swashbuckling capitalists. They battle cutthroat competition with one hand and oppressive government bureaucracy with the other. In reality, the financial industry is deeply dependent on the government. Far from the rugged, go-it-alone types they wish they were, they are more like well-dressed, coddled adolescents. And this is true in good times and bad.

The industry’s dependency takes five main forms:

an explicit safety net provided by government deposit insurance;
an implicit safety net provided by “too big to fail”;
a special privilege of being the only untaxed casino;
an open invitation to raid state and local governments for fees;
a right to change contract terms after the fact.

These dependencies are entrenched, and, despite loud protests to the contrary, the removal of government from the financial sector is not really on the agenda. The issue up for debate is not the virtues of the free market versus government regulation. The industry wants government regulation, just not in a way that curtails its profits.

In thinking about regulation, then, we need a fuller appreciation of the industry’s dependency on government. This will not tell us what to do, but it should open the door to a debate about regulatory reform that takes up the real question: will regulation be structured in a way that advances the public interest or in a way that allows the financial sector to profit at society’s expense?

• • •

Perhaps the most important financial reform to come out of the Great Depression was federal deposit insurance under the supervision of the Federal Deposit Insurance Corporation (FDIC). The FDIC largely protects banks from the sort of runs that led to the bank failures of that era.

Banks typically keep only a small portion of their customers’ deposits on reserve, and, even then, lend most of it at interest. This practice is reasonable because customers are unlikely to want all of their money at the same time. In fact, there may be as much money deposited as withdrawn on any given day.

But if depositors become concerned about the health of the bank, they may rush to pull money out. Those at the bank first will be able to get their money. Later arrivals will be out of luck, as the bank’s reserves will be depleted. Thus, before federal deposit insurance, runs were a logical response to the fear of bank failure.

The FDIC completely changes the logic. By insuring the bank’s deposits, the FDIC eliminates the incentive for depositors to rush to withdraw their money. They know that their funds (up to the insured level) are safe.

The FDIC lent an enormous amount of stability to the system, and the benefits are shared by depositors and banks alike. However, government insurance means that the market does not offer the normal discipline against risky behavior. Typically, a bank making high-risk loans must offer high interest rates in order to assuage wary depositors. But if the bank has government insurance, depositors need not worry about losing their money thanks to others’ unpaid loans. Thus, insurance allows the bank to attract deposits at relatively low interest rates and still incur high risk on loans. If a bank is in financial trouble and has little of its own capital at stake, the incentive to take large risks is even greater. And its customers, who are covered by deposit insurance, have no reason to be concerned about the soundness of a bank, even if the bank ends up suffering large losses and going out of business.

The government, as the insurer, must actively regulate insured institutions so that they do not take advantage of FDIC protection. The response to the Savings and Loans (S&Ls) crisis in the 1980s is a textbook example of what can happen when the government ignores this regulatory responsibility. Heading into that decade, thousands of S&Ls were essentially insolvent. Instead of shutting them down—the customary response to insolvent banks—the Reagan administration encouraged them to earn their way back to solvency. Many, logically, took large risks with insured deposits. In fact, they flaunted their access to deposit insurance by offering higher interest than their competitors in order to attract more money and grow more quickly. As a result, losses more than quadrupled over the decade, eventually costing taxpayers more than $120 billion ($190 billion in current dollars).

The story of the S&Ls is not a free-market one. Banks were exploiting the deposit insurance system. The lesson is simple: if the government insures the bank’s deposits, then it must also regulate the bank. Where the government grants insurance without oversight, banks take big risks at taxpayers’ expense.

In addition to monitoring risk-taking at FDIC-insured banks, the government is required to enforce minimum capital-reserve requirements. Together, these safeguards ensure that the banks’ shareholders will suffer the first losses. Only then will shareholders try to prevent the bank from making overly risky bets.

Maintaining a minimum level of capital is a difficult regulatory task. At any given time, banks have a wide variety of loans on their books. Some of these loans may be worth only a fraction of their original value, as is the case with many commercial and residential mortgages today. In principle, banks should mark these loans down to their true value so that their books represent ongoing profitability accurately and balance sheets reflect true net worth. However, banks have little incentive to write down a bad loan before absolutely necessary—showing a loss on their books is bad for stock prices and executive bonuses. Delaying write-downs also allows banks to misrepresent their capital position. If a bank has losses equal to 10 percent of its assets (the standard capital reserve requirement), then it has no real capital, since an accurate accounting would show that the loan losses wipe out their capital.

Only if regulators oversee banks’ behavior on an ongoing basis will banks disclose the true value of their bad loans. Otherwise, they will have too much incentive to hide their financial condition.

An insured bank must be a regulated bank; there is no way around this. An unregulated bank with government insurance has a license to rip off taxpayers, and unfortunately many banks have done precisely that. In particular, recent rule changes that allow banks to use “fair value” accounting instead of market accounting in assessing the value of their assets enable banks to bury large losses.

Some argue that because deposit insurance is paid for by banks it is not a subsidy and thus does not require oversight. This is true in normal times, although not in the extreme cases like the S&L crisis, and quite likely will not prove to be completely true in the current crisis. But even in normal times, when FDIC insurance does not act as a subsidy, the system needs regulation. If the government backed off regulation while still offering insurance, as it did with the S&Ls and is doing to some extent now in allowing fair-value accounting, the losses and therefore the cost of the insurance would skyrocket. The low-risk actors in the industry would bear the costs of the risky behavior of others and, in the end, the system of insurance become unworkable, as happened with the S&Ls.

Even if deposit insurance is privately provided, as is the case in some countries, government involvement is still necessary. Any insurance system that covers a large share of a country’s deposits has the implicit backing of the national government in the event of a crisis. No one would believe that the government would let a private insurer collapse if the simultaneous failure of many banks left it insolvent. The private insurer would be acting with an implicit government guarantee. This guarantee would entail regulation in order to prevent abuse.

• • •

FDIC offers banks an explicit safety net. Several large institutions also enjoy an implicit safety net because they are “too big to fail” (TBTF). This safety net allows them to borrow money (other than insured deposits) at a lower interest rate than would otherwise be the case because lenders know that the government will back up the institutions’ loans if necessary.

The implicit TBTF guarantee has become explicit in the current crisis: the government stepped in to back up debts to creditors when Bear Stearns, Fannie Mae, Freddie Mac, and AIG became insolvent. The government had no legal obligation to honor any of the debts incurred by these companies. It justified the intervention by claiming that failure to act would cause serious damage to the financial system and the economy.

The TBTF guarantee extends well beyond this list of failed institutions. Citigroup and Bank of America would almost certainly have faced insolvency had it not been for the extraordinary measures taken by the government to support them in late 2008 and early 2009. Their status even now is questionable, with both banks operating with government guarantees for hundreds of billions of dollars of bad assets. The 2008 Troubled Asset Relief Program (TARP), coupled with access to a special FDIC loan-guarantee program and Federal Reserve lending facilities, kept several other large and troubled financial institutions alive through the worst months of the financial crisis.

In other words, the implicit TBTF guarantee is real. After it allowed the huge investment bank Lehman Brothers to collapse, the government virtually promised that it would not allow another major financial institution to fail. Other large financial institutions took the promise seriously.

What is wrong with that? Because lenders knew that their loans to Goldman Sachs, Citigroup, Morgan Stanley, and other giants were effectively backed by the government, they offered these companies substantially lower interest rates than they offered smaller banks. While large financial institutions are always able to get funds at a somewhat lower cost than smaller institutions, the gap in the cost of funds between small and large banks grew by half a percentage point following the collapse of Lehman. Multiplied by the assets of these institutions, the increase amounts to a $33 billion-a-year subsidy at the expense of small institutions.

There is no reason to allow banks to reach the size of the TBTF institutions. Research on size and efficiency in the banking sector usually shows that all economies of scale can be fully realized at around $50 billion in assets—Bank of America and J.P. Morgan Chase have more than $2 trillion. That banks in the United States and elsewhere have grown so large may be an indication of the benefits of greater market power, political power, and, of course, the advantage of the TBTF subsidy itself.

Subsidizing the largest financial institutions to the detriment of their smaller competitors is not a free-market policy. Two options could restore the balance: break up the large banks so that they are not recognized as TBTF, or impose regulatory penalties, such as larger reserve requirements, that roughly offset the benefits of the TBTF guarantee. If some banks voluntarily break themselves up into smaller units to avoid the penalty, then we will know that the penalties are comparable in size to the implicit subsidy of TBTF.

• • •

Suppose the state of Nevada waived the 6.75 percent tax on gambling revenues for one casino in Las Vegas. That casino could promise better odds than its competitors and still have a larger profit margin. Wall Street financial institutions essentially enjoy this kind of advantage: they can profit from gambling opportunities unencumbered by the taxes paid on other forms of gambling.

Not all investment is gambling, of course, but most short-term trades, which comprise the vast majority of trading volume, are comparable. The payoff on a bet on an oil future or credit default swap is, to a large extent, random. Research may help Wall Street traders make informed bets, but it helps serious gamblers at the horse races too. A gambler who knows the stakes is still a gambler. Yet the racetrack gambler will pay 3-6 percent in taxes on her bet, and the Wall Street gambler pays none.

I use the term “gambling” seriously. Gambling may have a financial upside for the gambler, but it provides no benefit to the economy. If the gambler is successful—as a skilled poker player may be—he is simply taking wealth from others, not adding wealth to the economy. Short-term financial gains are similar.

A long-term investor, however, can rightfully claim that he is providing capital to businesses that increase societal wealth. And a successful long-term investor, such as Warren Buffet, can point to many cases in which his capital allowed companies to grow. These companies presumably provide goods and services valued by society and create jobs. Of course, there are cases in which a company’s growth may not be beneficial to society on the whole, but the point remains that long-term investment has the potential to benefit the economy by creating wealth.

Short-term speculation is unlikely to have this effect. For example, if a speculator correctly bets that oil futures will rise in price, she will have captured some of the gain that would have otherwise gone to the producer, which could have sold its product at a higher price. The speculator will probably also have imposed some cost on the purchaser (either an end user or another speculator) who will likely have to pay a higher price in the future than if the speculator had not been an actor in the market.

Speculators can help stabilize markets by forcing prices to adjust more quickly. But “noise traders,” who act largely on rumors and focus on anticipating the behavior of other actors rather than fundamentals of supply and demand, impose a cost to the economy by moving prices away from the levels that the fundamentals suggest, thereby destabilizing markets. They make markets give out the wrong signals. If ungrounded speculation drives up a price for oil futures, oil producers might initiate drilling in areas where they will not be able to cover the extraction cost when oil prices return to a non-inflated level. The oil companies will incur losses, and the economy as a whole will suffer a waste of resources.

Distinguishing noise trading from trades based on an assessment of fundamentals is not simple. But, as a general rule, short-term trades fall into the noise trading category more often than do longer-term trades.

If the government sought to level the playing field across casinos, it could impose a modest tax on each financial transaction. Such a tax would disproportionately affect noise trading, since short-term traders make more transactions than long-term investors. And it could lead to more efficient markets. Not only would fewer resources be wasted in carrying through the financial transactions that support the real economy, but we might see prices that more closely reflect the fundamentals of the market.

Despite being promoted by some of the world’s most prominent economists, such as Nobel laureates James Tobin and Joseph Stiglitz, financial-transaction taxes have not been put on the agenda in Congress. Tax proposals have been raised far more often since the fall 2008 bailout, but the industry has moved aggressively to squash any serious discussion of the per-transaction tax.

• • •

State and local governments need a wide variety of financial services. The big actors in the industry recognize this fact and promote their products to state and local government officials who often have little understanding of the services they are buying.

In many ways the marketing of financial services parallels the defense-procurement process: contracts and bidding are often shrouded in secrecy, and products and services are rarely standardized, so prices cannot be easily compared. In this environment political connections are extremely valuable—they often determine whose bid wins a contract. Just as defense contractors spend large amounts of money on lobbyists with close ties to key members of Congress or the military, the financial industry spends large amounts of money developing close ties to key officials in state and local governments. These governments hire financial-sector firms for pension-fund management, financing long-term investments such as school and road construction, and even managing the flow of spending and tax receipts. All of these subcontracted activities offer the financial industry large opportunities for profit and breed corruption.

The current value of state and local pension funds is $2.4 trillion, with management fees and transaction costs averaging 1-2 percent a year. The revenue generated from these funds for the financial industry is in the range of $25 billion to $50 billion a year—most of it a gift from taxpayers. Pension officials could simply put their money in a large index fund, such as Vanguard, whose mix of stocks closely tracks the overall stock market. The administrative cost of keeping money in Vanguard’s main index funds is typically about 0.15 percent annually; the difference in cost for state and local governments in managing their money would be $20 to $45 billion a year.

The industry has also earned substantial fees selling state and local governments complex financial products inappropriate for public buyers. Typically, if a state or local government wants to finance a major project, it issues a long-term bond, locking in an interest rate for perhaps 10-30 years. This way it can gradually accumulate the money needed to repay its debt. Over the last decade, however, several major investment banks made large sums selling “auction-rate securities” to these governments.

Instead of locking in a long-term interest rate, an auction-rate security breaks up the longer period into a series of short-term loans, typically 30-90 days in duration. At the end of each period, the bond is effectively refinanced for another period. The logic is that the short-term interest rate is generally lower than the long-term interest rate, so a bond financed through successive 30 or 90 day loans may require lower interest payments than ten-year or 30-year bonds.

In 2003 J.P. Morgan Chase used this argument to sell auction-rate securities to Jefferson County, Alabama. It also paid a bribe of $235,000 to Larry Langford, the president of the County Commission at the time. When interest rates subsequently increased, raising the cost of borrowing through auction rate securities, J.P. Morgan tried to extract a $647 million termination fee from the county in order to excuse it from its contract. Since the bribe became public and led to a criminal conviction of Mr. Langford, Jefferson County was able to get out of this contract without paying the termination fee.

The school district of Erie, Pennsylvania had similar dealings with J.P. Morgan. The district was persuaded in 2003 to sell complex derivative instruments, called “swaptions,” with the promise of $750,000 that could be used upfront for school repairs. A swaption is essentially a bet on interest rates, with the seller taking the risk. Three years later, when interest rates took an unexpected turn, the Erie school district had to pay J.P. Morgan $2.9 million to get out of its commitments. One hundred and seven school districts in the state of Pennsylvania also became involved in the swaption business.

These sorts of deals have become common for J.P. Morgan and other major banks. They have earned billions of dollars in fees selling derivative instruments to governments. In many instances the associated fees have little to do with markets. Large firms are preying on governments and, thereby, taxpayers. It is not clear that any of the reform proposals currently being considered by Congress will put an end to this practice.

• • •

In our daily lives, we regularly enter into business relationships that have the character of long-term contracts. For example, most families have cable and phone service, and they pay for them on a monthly basis. Service providers, can, and often do, change the terms of these contracts. In the cases of phone, cable, and other public utilities that are subject to government regulation, changes in the terms of contracts often require the approval of a regulatory agency, which, in turn, usually requires that clear notice be given to consumers. There is no such regulation in the financial industry.

The financial industry now draws much of its income from fees and penalties charged to customers who are late with credit card payments or overdraw their checking accounts. Banks are expected to earn $38.5 billion in 2009 on overdraft fees on debit cards and checking accounts and another $20.5 billion on credit card penalties. In 2007 these fees and penalties represented almost 20 percent of the sector’s before-tax profits.

In many cases customers were either not aware of the fees or they did not realize how damaging they would be. Customers are frequently charged fees about which they have never been clearly notified. For example, it is now standard practice for banks to provide overdraft protection on debit cards, whereby the bank will cover the cost of a purchase even if it exceeds the money available in the customer’s account. The fee is typically six to ten dollars, so debit-card users may find themselves paying a six-dollar overdraft fee to buy a two-dollar cup of coffee. Since few people would make this purchase knowing the fees involved, the banks obviously rely on their customers’s lack of awareness about the fee. Legislation passed by Congress in the summer of 2009 requires clear notification of the fees charged on checking accounts and credit and debit cards, although it provides the banks with nine month’s grace time, during which they can continue their current practices.

Prior to this legislation, the financial industry had a green light to change unilaterally the terms of long-term contracts in a manner enormously costly for their customers. The change notification might have taken the form of a short letter or paragraph included with advertising and other items and written in language likely to confuse anyone who does not work in finance. The government tolerates this kind of deception in few, if any, other industries. There is no reason—apart from the power of the financial industry—that rate increases or changes in terms for credit cards or bank accounts should be any less clear than the notifications required of utilities.

The recent legislation should limit the extent to which banks can change terms of their contracts in deceptive and ad hoc ways. While this is viewed as government regulation by the banking industry and its allies, in other sectors of the economy, parties do not generally have the ability to change contracts unilaterally. Congress is merely attempting to restore familiar contract law to the sector.

As non-standard as bank fees and penalties may seem, they do not even approach the level of exceptionalism ensured by the bankruptcy reform that the industry pushed through Congress in 2005. The central purpose of the bill was to make it more difficult for individuals to have debts reduced or eliminated through bankruptcy. The industry successfully framed proponents as enforcers of contracts, while the opponents, supposedly, wanted to excuse borrowers who were down on their luck.

Lenders, who had poorly judged credit risk, could just as easily be accused of running to the government for help in collecting their debts. The banks presumably understood the risk that they were taking in making loans in the first place. They are in the business of distinguishing good credit risks from bad. A financial institution that is unable to make such distinctions is misallocating capital. The economy would benefit if it went out of business.

But the bankruptcy reform went the other way, involving the government more deeply in the debt-collection process, thereby increasing the value of the bad loans issued by banks and other lenders. The new law did not just apply to debt assumed after 2005, but retroactively. Borrowers who had taken out credit card debt–loans under one set of bankruptcy rules were faced with a different, stricter, set of rules if they eventually fell on economic hardship. Again, not a story of the free market. This is a transfer of wealth from debtors to creditors—yet another case where the banks used their political power to override market outcomes.

• • •

The debate over regulation in the financial industry has been badly distorted. The government must be directly involved in the operation of the industry, most obviously through deposit insurance, but also through many other channels. Industry advocates want to end or weaken regulations that reduce their profits, but they are not willing to end the government supports that make their profit and survival possible.

The debate must be returned to appropriate grounds: a question of how best to structure regulation. Which regulations structure the financial industry so that it will serve the larger economy? This means providing incentives for the industry to better serve consumers and investors, rather than providing incentives to prey on them. There should not be large returns for writing deceptive contracts. Nor should short-term speculation be the most effective way to get rich.

The economy thrived in the three decades following World War II with a financial sector that was proportionately one-fourth of its current size. There is no reason that the financial sector should use up a larger share of the economy’s resources today than it did three decades ago. Effective regulation will restore the financial sector to its proper role in the economy.

DEAN BAKER is the co-director of the Center for Economic and Policy Research (CEPR). He is the author of Plunder and Blunder: The Rise and Fall of the Bubble Economy.

This article originally appeared in the Boston Review.


Dean Baker is the senior economist at the Center for Economic and Policy Research in Washington, DC.