While much of the early stages of the public hearings by the US Financial Crisis Inquiry Commission was a review of the causes and consequences of the crisis, the more interesting discussion was conflicting views on the ‘too big to fail’ issue and a consensus that simple leverage was a major factor in the crisis.
The way those institutions – the too big to fail’s – are ultimately dealt with will have enormous implications for competition, innovation and the structure of the global financial services sector.
Not surprisingly, the two big commercial banks, JP Morgan Chase and Bank of America – both too big to fail (TBTF) – had a different perspective on how to address the implications of banks that can’t be allowed to fail to those of non-bank analysts who testified before the commission.
Bank of America chief executive, Brian Moynihan, argued that the issue was over-stated and misunderstood. The institutions that failed or nearly failed, he noted, were monoline investment banks or mortgage lenders.
Those arguing for a return of the Glass-Steagall division between commercial banks and investment banks were, he said, effectively arguing that Bear Stearns was a more stable entity than JP Morgan Chase. One could, he said, argue persuasively that the mistake in the legislation that repealed the remnants of Glass-Steagall in 1999 was in not requiring investment banks to affiliate with banks and become regulated bank holding companies.
He said it was inter-connectedness and not “bigness” that led to the need to taxpayer bailouts and that requiring banks to shed economies of scale or permitting them to service only part of a customer’s needs would adversely affect customers and undermine the competitiveness of US institutions again foreign competitors.
JP Morgan Chase’s Jamie Dimon made the same point as Moynihan – that many of the institutions which failed were small or mainly engaged in one business – but said that the solution to the TBTF problem wasn’t to cap the size of firms but instead a better regulatory framework for managing their failure without putting taxpayers or the broader economy at risk.
Interestingly, both CEOs – along with their counterparts at Morgan Stanley and Goldman Sachs, John Mack and Lloyd Blankfein – conceded a significant cause of the institutional failure and distress was simply too much leverage.
A disconcerting insight into that aspect of the crisis was provided by the managing partner of the global asset manager Hayman Advisers. J Kyle Bass noted that under current regulatory guidelines a bank was deemed well-capitalised with tier one capital of 6 per cent of risk-weighted assets and adequately capitalised with tier one capital of 4 per cent.
That meant a well-capitalised bank leveraged its tier one capital 16 times and an adequately capitalised institution 25 times. Of the 170 banks that failed during the crisis, the average loss to the Federal Deposit Insurance Corporation was, he said, well over 25 per cent of assets – more than six times their minimum levels of regulatory equity.
Bass produced an analysis of on and off balance sheet leverage for major US financial institutions that showed gross leverage to tangible common equity ranging from about 25 times to 68.4 times for Citibank.
He advocates separating commercial banking from most proprietary capital transactions and imposing new leverage ratios and standards on the banking system as well as a threshold of size after which an institution would be forced to divest assets and unwind positions.
Higher minimum capital levels and the introduction of simple leverage ratios are envisaged by global banking regulators in response to the crisis.
The TBTF issue is dividing regulators, although the European Commission and the UK authorities are forcing some big European and UK banks that were bailed out by taxpayers to downsize and reduce their complexity.
There is a solid argument that institutions TBTF ought to meet higher standards; that they should hold more capital and liquidity and be regulated more intrusively to insure against the moral hazard they might otherwise generate.
One could also argue for some quarantining of their commercial banking business from their securities and proprietary trading activities so that depositors and taxpayers were protected but shareholders remained exposed to the riskier activities.
There was a consensus within the testimony to the hearing – and a global consensus among regulators – that leverage has to be lower, transparency improved and pro-cyclical accounting and provisioning replaced by counter-cyclical approaches.
The big US financial institutions are fiercely resisting the prospect of radical and costly changes to the way they are regulated. If they are forced to hold a lot more capital and liquidity, take less risk and do less trading on their own account, their returns to shareholders, and the remuneration of their executives, will suffer significantly.
The fallout from the crisis will, however, will weigh on the US and the other worst-affected western economies for a very long time. It will inevitably force now heavily-indebted nations such as the US and UK into unpleasant and growth-depressing long-term cutbacks in services and lead to increases in taxes.
The constituency for major and punishing changes to the way institutions deemed as TBTF are allowed to operate is therefore very large and angry and the inquiry, of which findings are scheduled to be released in mid-December, will provide a forum and focus for the disaffected in the US.
While the early focus is mainly on the origins of the crisis, inevitably the more significant discussion will be about the legislative and regulatory responses and ultimately the extent to which that is reflected in actual changes to the US settings beyond those now moving glacially through the global financial regulation reform processes.
This article first appeared on Business Spectator.
James was the editor and publisher of SmartCompany and LeadingCompany for five years. He is now the Australian Financial Review‘s companies & markets editor, and a former BRW editor.
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