What to do about US banks that are too big to fail, to regulate, to understand, to manage or, given their importance in national income growth, to compromise their ability to grow? Two solutions are on the table: one high in regulation and the other high in disruption. Both aim to remedy the US taxpayer subsidized risk-taking that led (in part but not in isolation) to the 2008 financial crisis.
The Dodd-Frank bill (also known as The Volker Bill) tries to separate banking and investment banking activities of the large bank holding companies, as they were pre-Clinton. The regulation is so weighed down in complexity — running about 850 pages and driving 9,000-some pages of regulations — it will require over 24 million hours by federal regulators to enforce it.
Even IF the bill works, Dodd-Frank keeps in place a business model that at its core creates unacceptable risks for taxpayers. This becomes clear if you understand the culture of a publicly traded company from the inside, a window we peeked into reading about how JPMorgan Chase – the bank with the best risk management system in its industry – dealt with the derivative trade that went some $6B into the red. The US Senate’s investigation of the JPMorgan Chase concluded (in a nutshell) that JPMorgan Chase bankers acted in ways that made their numbers look good until they couldn’t hide the truth anymore.
Why would executives act this way? Because shareholders expect publicly traded companies to deliver earnings growth. And when this growth is threatened, they penalize stock prices, which hurts bankers’ bonuses and, far worse, the value of their stock options.
With Dodd-Frank, bankers will supposedly lose significant access to investment banking as a driver of earnings growth. So how can bankers ensure they make their growth rate targets and therefore retain their bonuses and the value of their stock options?
It won’t be easy. The bigger the bank, the bigger the growth target in absolute terms and the more challenging the growth task.
I suspect the too-big-to-fail bankers will do two things. First, we’ll see the final rounds of industry consolidation, as new regulations will be too costly for smaller banks and they’ll be forced to sell. But this only worsens the size problem for the big acquiring banks.
So watch bankers promote riskier loans that pay higher rates. That’s the only way to grow return in an economy that is growing less rapidly than shareholders demand for earnings growth. We know where this leads — e.g., to secure higher-returns some too-big-to-fail bank commercial lenders became complicit in the Enron fiasco, leading to record penalties for their banks.
The net outcome therefore of Dodd-Frank is undue risk in an unsustainable banking business model. Bigger size, more need for earnings growth, more risk to bank capital and US taxpayers.
There is another option. Richard Fisher, who heads the Federal Reserve Bank of Dallas, smartly recommends something far simpler but more dramatic:
- Limit federal deposit insurance and access to the Fed’s discount window (for reserves) to only commercial banking operations that intermediate short-term deposits into longer-term loans (i.e., that do traditional banking). Any other depositor, lender or investor would sign a disclosure acknowledging and accepting there are no government guarantees.
- Restructure the largest financial holding companies into distinct entities, each with a speedy bankruptcy process.
- Re-size the banking entity(-ies) with access to the Federal Reserve reserve window and deposit guarantees within the financial holding company so that they are too small to save. This would essentially break up the likes of Wells Fargo, Citibank, JPMorgan Chase, etc. into smaller banks the way AT&T was broken up into the Baby Bells. The downsized banks, in Fisher’s words, “would then be just like the other 99.8 percent, failing with finality when necessary.”
Fisher has a lower-cost solution for government that is better for our nation’s banking system. Today, money is a commodity and, like energy, the businesses that store it and lend it should act more like utilities — publicly regulated, safety conscious institutions that deliver predictable dividends to shareholders.
Fisher’s proposal brings back the boring banking business model of years past. Bring it on.