Beginning of the end for big banks?

If the biggest banks are too big to fail, too connected to fail, too important to prosecute, and also too complex to manage, it would seem sensible to scale them down in size, and to reduce their centrality and the complexity of their positions. Simon Johnson has an encouraging article suggesting that at least some of this may actually be about to happen: 

The largest banks in the United States face a serious political problem. There has been an outbreak of clear thinking among officials and politicians who increasingly agree that too-big-to-fail is not a good arrangement for the financial sector.

Six banks face the prospect of meaningful constraints on their size: JPMorgan Chase, Bank of America, Citigroup, Wells Fargo, Goldman Sachs and Morgan Stanley. They are fighting back with lobbying dollars in the usual fashion – but in the last electoral cycle they went heavily for Mitt Romney (not elected) and against Elizabeth Warren and Sherrod Brown for the Senate (both elected), so this element of their strategy is hardly prospering.

What the megabanks really need are some arguments that make sense. There are three positions that attract them: the Old Wall Street View, the New View and the New New View. But none of these holds water; the intellectual case for global megabanks at their current scale is crumbling.

Most encouraging is the emergence of a real discussion over the implicit taxpayer subsidy given to the largest banks. See also this editorial in Bloomberg from a few weeks ago:

On television, in interviews and in meetings with investors, executives of the biggest U.S. banks -- notably JPMorgan Chase & Co. Chief Executive Jamie Dimon -- make the case that size is a competitive advantage. It helps them lower costs and vie for customers on an international scale. Limiting it, they warn, would impair profitability and weaken the country’s position in global finance.

So what if we told you that, by our calculations, the largest U.S. banks aren’t really profitable at all? What if the billions of dollars they allegedly earn for their shareholders were almost entirely a gift from U.S. taxpayers?

... The top five banks -- JPMorgan, Bank of America Corp., Citigroup Inc., Wells Fargo & Co. and Goldman Sachs Group Inc. - - account for $64 billion of the total subsidy, an amount roughly equal to their typical annual profits (see tables for data on individual banks). In other words, the banks occupying the commanding heights of the U.S. financial industry -- with almost $9 trillion in assets, more than half the size of the U.S. economy -- would just about break even in the absence of corporate welfare. In large part, the profits they report are essentially transfers from taxpayers to their shareholders.

So much for the theory that the big banks need to pay big bonuses so they can attract that top financial talent on which their success depends. Their success seems to depend on a much simpler recipe.

This paper also offers some interesting analysis on different practical steps that might be taken to end this ridiculous situation.

Elements of a stable financial system

It's hardly a hell raising demand for revolution, but this speech by Michael Cohrs of the Bank of England is worth a quick read and offers some pretty encouraging signs that authorities -- in the UK, at least -- are moving (slowly) toward financial regulations that seem pretty sensible and might really help avoid future crises or make them less frequent. I read it as a kind of wish list, but of wishes that are fairly realistic.

On a theoretical level, perhaps the most important thing Cohrs calls for is greater awareness of economic and financial history, with the idea that we might prepare our minds better for the natural instabilities that seem to create crises so frequently:

At the heart of much of the current policy debate is how the FPC, PRA and FCA develop better processes for anticipating the next problem – whether the problem is an asset bubble, poor risk mismanagement or a flawed or misunderstood financial product. And these are important steps to take. But it seems to me there is an inherent tendency for policymakers to re-fight the last war. As I said above, I am a believer that understanding the past provides a foundation on which to assess the future. But we shouldn’t pretend we can eliminate financial crises completely. Nor that the next crises will necessarily be a carbon copy of the last one.

My anxiety about getting financial regulation to better mitigate future risks has its roots in the issues one sees in the financial crises of the past couple of hundred years or so. Virtually every type of financial institution has been the cause of a crisis at some point in history – country banks back in 1825, universal banks in 1931, small banks in the 1970s, savings and loan companies in the 1980s, international banks in the 1980s and 1990s (debt crises in Latin America and Asia respectively), and even a hedge fund in 1997.

Pretty much all types of financial institution got involved in the problems of 2007/2008. The roll call included insurance companies (although thankfully not those in the UK) alongside investment banks as well as some more traditional commercial and mortgage banks. I find it hard to see a common thread (other than high leverage ratios) amongst the types of institutions that struggled or the mistakes that they made. It is not clear that the reforms we are putting into place today would have, or could have, averted all the problems faced in these crises. Therefore, experience tells me its origins are unlikely to be in an institution and from a product that is obvious to us now. ... I realize this uncertainty is rather unhelpful.

Actually, I think it is very helpful. Nothing is more dangerous than belief that now , as we know how things can go wrong, we can probably perform a few engineering tricks and hence avoid further problems in the future. This was the facile belief furthered in the decade prior to the past crisis, especially in basic textbooks of economics and finance and research papers furthering belief in the inevitable "spiral to efficiency" of modern markets (infamously described in this rather embarrasing 2005 paper by Robert Merton and Zvi Modie, which was published even as the markets were on the verge of collapse!).

Cohrs goes on to discuss a number of ideas all being pursued with the idea of making finance more "sustainable." These include establishing simple rules by which large institutions can be wound down and let fail safely when they ought to (this might include using penalties or taxes to establish insurance funds beforehand to handle such events), making financial institutions LESS CONNECTED and changing the culture of finance as well so that financial institutions themselves "ensure they can be regulated." Ok, that final one may be a rather huge challenge.

The good thing is that people from the Bank of England are going around saying these things. Let's hope they can manage to put some of these principles in place, especially in some globally consistent way.