How the Financial Crisis of 2007-2009 has made the financial system more unstable and how a return to market segmentation in the industry can restore credibility to our present form of Capitalism
by
Thomas Schinkel
October, 2009
A central theme in the financial crisis of 2007-2009 is that many people in high places in the financial services industry assumed they were effective managers of risk. Ever more complex and impressive looking mathematical formulas assisted them in their quest to allocate and re-distribute the many risks associated with their actions. But those “post-modern methods of risk management” backfired and a taxpayer-financed bailout was required to prevent the entire system from certain collapse.
Two Remedies
To remedy the situation, two major ideas have come to the surface. One would place a cap on bankers’ bonuses. The other would prescribe strict limits on how much a bank can borrow against its own equity capital. The first idea is inspired by hopes that caps on bonuses will discourage bankers from taking exorbitant risks in the first place. This is pretty much a European idea, heralded by politicians from France and Germany, but also from the UK and elsewhere. The other main idea, with American roots, is to adopt strict rules on leverage. Leverage of course defines the amount of dollars or Euros banks borrow against their “at risk” capital. Such caps are interesting because several banks, such as Lehman, that got themselves in trouble had built up borrowings at 30 times and more of their own capital. And we are not even talking about the shadow bankers, the hedge funds and the like that saw leverage ratios even much higher than that. Going forward into the Fall of 2009, let’s assume that the Global Community actually can agree on some sort of a consensus and that it will embrace a little bit of both. Would that solve the problem of risk management and would that return the financial services community to a condition of health and stability?
Risk Management
Intuition and common sense seem to dictate that risk must be taken cautiously and the best way to guard against systemic failure would be to spread risk among as many parties as possible. What has entirely fallen off the table is the notion that with all the restructuring and the bailouts that we have witnessed, risk in the financial services community has not become less concentrated; it has become more concentrated! According to the Dallas Federal Reserve, before the crisis, the SIX largest financial conglomerates in the U.S. controlled approximately 50% of all financial assets in the country. With the consolidation that was set in motion since the crisis erupted that number today has dwindled to FOUR.
Four Financial Institutions control
50% of All Financial Assets
Before we come back to this challenge of consolidation, let’s take a look at leverage. Taking the financial statements of these four largest financial institutions in the country at face value, as of June 30, 2009 their combined leverage ratio amounted to approximately 11.0 times (total assets divided by total equity), and let’s assume by way of hypothesis of course, that under any new rules it would have to be 9x, a modest improvement.
As you can see from the above calculation, such a new rule would imply that these four financial institutions would have to raise some $147 billion in additional equity capital. Add this to the prepayment of $43 billion the FDIC is proposing to demand from the financial services industry (lest it go broke itself), and you can imagine the challenges here. Even if this could be done within a couple of years, the big question of course remains whether it would fix the problem! The challenge is hidden in the fact that there is no way these financial institutions’ balance sheets should be taken at face value! For years they have engaged in off-book transactions, creating and participating in companies with capital and risk exposures that are impossible to discern from their financial statements.
Off-book transactions
Wait a minute, where have I heard this business of off-book transactions before! Oh yes, of course, I almost forgot, Enron! Back in 2000, they were in a spectacular mess with off-book transactions in hundreds of companies without properly recording not so much the amounts of capital they had invested or how the deals were structured, but WITHOUT BEING ABLE TO DEFINE WHAT RISKS THESE VENTURES REPRESENTED! It seems to me that today, with the top-tier financial institutions we have exactly the same problem. In this context, it is puzzling in the extreme how the other day a firm like Goldman Sachs managed to publish a “buy” recommendation for some of the very same financial institutions we are talking about without saying a word about their off-book liabilities.
Breaking up the Banks
The systemic risk that resulted from the concentration of the bulk of financial assets in the hands of fewer and fewer institutions, would be addressed effectively if the regulatory regime focused on:
- breaking up the largest banks into smaller pieces;
- abolishing the practice of off-book transactions;
- setting specific rules for caps on market share in any specific class of financial activity; and
- prohibiting banks from engaging in combinations of activities that are known conflicts of interest.
In other words, relearn the lessons from the 1930′s, reintroduce the Glass-Steagall Act, a modern version of it anyway, and make sure that the top-tier banking industry does not get so powerful that any one component becomes too big to fail.
Anti-Trust Rules
Breaking up an industry is difficult but not impossible. Given what is at stake here, breaking up the system into smaller pieces should be given much more consideration. In the early 1980′s, Congress managed to break up AT&T’s monopoly in the telecommunications industry, making room for what became known as the “Baby Bells”. Microsoft has been subject to threats of a regulatory break-up for years. And European Competition Commissioner Neelie Kroes is going after Oracle with a vengeance. How come our regulatory bodies are so quiet about this set of tools at their disposal when it comes to dealing with the financial services industry?
Strict New Rules
A return to market segmentation, and limits on market share by product line would be a credible way to reduce the systemic risk that is now concentrated in ever fewer hands. It is such common sense segmentation and separation that would help return the system to stability. For example, the financial services industry could be divided into three groups: Insurance, Banking, and Securities.
A simple rule could be adopted that would prohibit any one financial institution from operating in more than one of these three segments. Companies that take deposits from the public and thereby come under the insurance umbrella of the FDIC would need to abide by even stricter rules. And no bank could have more than a certain market share in any one particular line of business, since it is this very concentration of power within markets that exposes the taxpayer to the mantra of TOO BIG TO FAIL.
Sorry folks, but to my way of thinking, in our capitalist system of free enterprise, no company should ever be too big to fail, and the taxpayer should never have to bail out any corporation (financial or otherwise) ever again!
Smoke and Mirrors
What is increasingly obvious though is that the industry, the regulators and the policy makers appear to have given up on consideration of this very simple method of risk management. It is no longer discussed. Supposedly, if we broke up the banks this would open the door to foreign competition. This of course, is nonsense since foreign banks that wished to operate in America would be subject to the same rules. Unfortunately, instead of providing firm new regulation, the powers that be, both in Europe and here in America, are stitching together a beautiful new wedding gown (in the form of bonus caps and leverage requirements), but it is for the same old, same old bride. Our prime creditors, the Chinese, have become very skeptical of the quality of Washington’s promises and the strength of its Treasuries. In a twisted paradox, these sentiments are increasingly shared with the American middle class. Real reform may restore the trust and faith in our present model of capitalism. It actually may provide the underpinning of an American Renaissance. Without it there may very well be taxpayer revolt, or worse.
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