The Wall Street Takeover and the Next Financial Meltdown: Problems and Solutions

Editor’s Note: This post comes to us from James Kwak, co-author of 13 Bankers: The Wall Street Takeover and the Next Financial Meltdown, and co-founder of the blog The Baseline Scenario.

13 Bankers, the book that I co-write with Simon Johnson, was released one month ago. The book has gotten more attention than I had anticipated, for which I am grateful. Senator Christopher Dodd even told Don Imus that he was reading “13 Banks, by this other fellow,” although he later said this to Ezra Klein:

“I’ve looked at the 13 Bankers book, and so forth, that approach, and I hear this, by the way, not just from them, but from CEOs of major corporations. This is not some left/right question. But I just don’t think that it makes a lot of sense. I don’t think it’ll prevail.”

By far the part of the book that has gotten the most attention is the recommendation, in the last chapter, that our six largest banks be broken up and capped in size at 4 percent of U.S. GDP (with a lower limit for riskier or more interconnected banks). This idea has also been the target of many criticisms, from Paul Krugman (“Breaking up big banks wouldn’t really solve our problems, because it’s perfectly possible to have a financial crisis that mainly takes the form of a run on smaller institutions.”), Larry Summers, and Tim Geithner, among others.

In my opinion, however, the call to break up megabanks is not the central point of the book. Breaking up big banks is a solution, and one that I favor, but the more important goal of the book is to get people to agree on how to think about the problem–the financial system must be seen through the lens of politics–and on what the problem is: a financial system that is too big, too concentrated, and too politically powerful. And this is a message that, while certainly not one that we invented (it is far too obvious for anyone to claim ownership), has resonated widely.

Krugman himself puts it this way: “My view is that I’d love to see those financial giants broken up, if only for political reasons: it’s bad to have banks so big they can often write laws.” (He disagrees that breaking up megabanks would make the financial system appreciably safer.) Rob Johnson says the problem is that we have one too many markets: a “market for the purchase of the rules of the game.”

The debate over how to address institutions that are “too big to fail” is itself a debate over politics. The administration’s position is that the bill currently on the floor of the Senate solves this problem by giving the government the power to liquidate megabanks in a financial crisis without endangering the larger financial system; as a result, the argument goes, large banks will no longer enjoy an implicit government guarantee and the competitive advantages that come with it.

Skeptics, however, point to the risk of relying on a solution that depends on political will. In 13 Bankers, we wrote, “Even leaving aside the issue of direct pressure from bank executives who happen to be major political donors, it would be politically difficult for any president to order a government takeover of an iconic American bank that was insisting through the media and its lobbyists that it was perfectly healthy” (p. 206). Noam Scheiber adds, “authority to dismantle a firm and impose losses isn’t the same as the will to use it. . . . I have an easy time imagining a future Citigroup pleading that it shouldn’t be resolved because it employs hundreds of thousands of people, many of whom will be thrown out of work.” In The New York Times, David Leonhardt quoted a former government official saying, “Don’t kid yourself into thinking that if J. P. Morgan were on the rocks, it would disappear.”

Simon and I favor breaking up the large banks now because it reduces our reliance on the backbone of a future administration facing the next financial crisis. Scheiber thinks that it is politically infeasible to break up the banks now, and so resolution authority is the best we can get. Leonhardt, along with the International Monetary Fund (and perhaps even Tim Geithner), favors a bank tax that will increase the cost of risk-taking and provide the funds to rescue creditors in a future crisis.

But these are the right debates to have. There is no chance that a perfect regulatory system will come out of this session of Congress, especially since no one can know with certainty what a perfect system would look like. If we can at least recognize the political roots of any financial system and agree on what its core problems are, we have a chance at gradually adapting regulation to the demands of today’s modern, sophisticated financial system. That alone would be progress.

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  1. Andrew Clearfield
    Posted Sunday, May 16, 2010 at 2:57 pm | Permalink

    I agree completely: there can be no ‘perfect regulatory system,’ which is why you don’t want to have financial entities so large that the failure of any one of them automatically endangers the whole economy. I observe that Nouriel Roubini is now adding his voice to the (still small) chorus of economists and ex-central bankers saying the same thing. I also agree that there is no commercial logic behind our financial supermarkets other than that they all deal in money, and can finance themselves easily enough that any of their operations can get into trouble.

    Over twenty years ago, in the aftermath of deregulation in the U.K., I witnessed how the merger of commercial banks, pure investment banks, stockbrokers, dealers, and investment managers caused a sharp decline in the quality of service and caused numerous conflicts of interest, some erupting in scandals of unprecedented size. Whoever benefited from all this removal of traditional barriers between businesses, it wasn’t the customers.

    One way to reduce systemic risk, and make the jumbo mega-banks more manageable, would be to divide the banks up along rational lines again, and stop pretending that traders can coexist with salesmen, investment bankers with portfolio managers, or any of the above with lending officers. These are different businesses, with different attitudes toward risk, requiring different personalities to manage them, and conflicts of interest are fundamental to any such amalgamation.

    Of course, industry representatives will scream—until they discover that they can make just as much money as before in separate business entities. Those JP Morgan partners who quit to found Morgan Stanley complained bitterly about Glass Steagall until they found out that they could do even better running an investment bank without corporate lending. It’s the “no new worlds to conquer” types who keep wanting to do ever bigger deals, until they create mergers of utterly incompatible businesses, and then weep about excessive regulation ruining free markets. Actually, it is the merged conglomerates that ruin free markets!

  2. Cate Long
    Posted Sunday, May 16, 2010 at 10:24 pm | Permalink

    “Richard W. Fisher, president and chief executive of the Federal Reserve Bank of Dallas, told a gathering of economists and financial experts Wednesday that “a truly effective restructuring of our regulatory system will have to neutralize what I consider to be the greatest threat to our financial system’s stability… ‘too big to fail’.”

    “First, these large institutions are sprawling and complex — so vast that their own management teams may not fully understand their own risk exposures, providing fertile ground for unintended ‘incompetence’ to take root and grow. It would be futile to expect that their regulators and creditors could untangle all the threads, especially under rapidly changing market conditions,” Fisher said as he began his defense of his position.

    “Second, big banks may believe they can act recklessly without fear of paying the ultimate penalty. They and many of their creditors assume the Fed and other government agencies will cushion the fall and assume some of the damages, even if their troubles stem from negligence or trickery. They have only to look to recent experience to take some comfort in that assumption,” he said.

    Then, Fisher went after the heart of the Obama administration’s and Wall Street’s central argument — that the U.S. needs megabanks to compete on a global stage.

    “Some argue that bigness is not bad, per se. Many ask how the U.S. can keep its competitive edge on the global stage if we cede LFI [large financial institutions] territory to other nations — an argument I consider hollow given the experience of the Japanese and others who came to regret seeking the distinction of having the world’s biggest financial institutions.

    I know this much: Big banks interact with the economy and financial markets in a multitude of ways, creating connections that transcend the limits of industry and geography.

    “Because of their deep and wide connections to other banks and financial institutions, a few really big banks can send tidal waves of trouble through the financial system if they falter, leading to a downward spiral of bad loans and contracting credit that destroys many jobs and many businesses, creating enormous social costs. This collateral damage is all the more regrettable because it is avoidable.”

    [Thomas] Hoenig similarly discarded arguments favoring megabanks, referring to the ideas supporting them as “a fantasy — I don’t know how else to describe it.”

    “These costs are rarely delineated by analysts,” Fisher said. “To get one sense of their dimension, I commend to you a thought-provoking paper recently written by Andrew Haldane, executive director for financial stability at the Bank of England.

    “Haldane pulls no punches,” Fisher said in a clear endorsement of Haldane’s arguments. “He considers systemic risk to be ‘a noxious by-product’ or a ‘pollutant’ of an overconcentrated banking industry that ‘risks endangering innocent bystanders within the wider economy.’ He points out that the government’s fiscal transfers made in rescuing or bailing out too-big-to-fail (TBTF) institutions — whether they are repaid at a profit or not — are insufficient metrics for tallying both the cost of the damage caused by their mismanagement and their subsequent rescues.

    “Like me, he puts things in the perspective of the entire cardiovascular system and the body of the economy. He concludes: “…these direct fiscal costs are almost certainly an underestimate of the damage to the wider economy which has resulted from the crisis.”

    In fact, Haldane argues that “evidence from past crises suggests that crisis-induced output losses are permanent, or at least persistent, in their impact on the level of output.” The “world economic output lost relative to what would have obtained in the absence of the recent crisis might be $60 trillion or more,” Fisher said, referencing Haldane. “That’s $60 trillion with a “T” — more than four years’ worth of American economic output.”

    While Haldane “may significantly overstate the real social costs of TBTF… the message is clear: The existence of institutions considered TBTF exacerbated a crisis that has cost the world a substantial amount of potential output and a whole lot of employment,” Fisher said.

    He went on to cite Haldane’s study of the funding advantage enjoyed by TBTF institutions — “which has widened during the crisis” — and quoted a figure calculated by Dean Baker, co-director of the Center for Economic and Policy Research in Washington, who said that advantage amounts to a $34-billion-a-year taxpayer-provided subsidy for the 18 largest U.S. banks.

    Haldane’s study “simply adds grist to the mill of my conviction,” Fisher said. “[B]ased on my experience at the Fed… the marginal costs of TBTF financial institutions easily dwarf their purported social and macroeconomic benefits. The risk posed by coddling TBTF banks is simply too great.”

  3. ivo paparela
    Posted Wednesday, May 19, 2010 at 4:43 am | Permalink

    I)a) if growth of financial sector/markets is bigger than “real money input” is it basically a Ponzi scheme . b)the problem is not big but honest; c) lawyers know that all economic transactions are legal ( or illegal or moral hazard ) acts: Are business friendly laws counterproductive? Their costs are for the USA in constant $ like those of WWII but without positive effects on real economy. Greece= Marchall Plan for Europe ( of 1948 and after)inconstant$:with devastating socio economic effects !!! What is per capita ratio of Marchall plan & bail out of the Greek greed ?
    d) EU banks with large “Greek” portfolio are too big to fall !!!!?? Who can tell to the Balkan countries that Commission in Bruxelles had no idea what has been going on in Greece for years?

    II) a)Big or mega banks are controlled by by real people who are NOT owners& who look after their bonus . They, via ignorant(?) law makers, introduced the ideology of corporate governance
    without any regards to the fact that creditors, employees etc are also stakeholders for their own sake ( bonus). They act for shareholders like communist party acted for the world proletariat .b) auditors must do their job professionally & not like musical critics: “sorry we did not hear “les fausses notes” c) criminal law procedures should be modified in the corporate /financial market wrongdoings in the sense that onus probandi is on the accused managers ; d) etc…..

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  1. […] The Wall Street Takeover and the Next Financial Meltdown: Problems and Solutions – via HLS – In my opinion, however, the call to break up megabanks is not the central point of the book. Breaking up big banks is a solution, and one that I favor, but the more important goal of the book is to get people to agree on how to think about the problem–the financial system must be seen through the lens of politics–and on what the problem is: a financial system that is too big, too concentrated, and too politically powerful. And this is a message that, while certainly not one that we invented (it is far too obvious for anyone to claim ownership), has resonated widely. […]

  2. By » Blog Archive » Agreeing on the Problem on Tuesday, May 18, 2010 at 6:46 pm

    […] wrote a guest post for the Harvard Law School Forum on Corporate Governance and Financial Regulation, a group blog, on this broader issue and some of the other solutions that have been floated. As […]