Dismantling Large Bank Holding Companies

Mammoth bank holding companies (BHCs) have contributed to the 2008 crisis. Their “contribution” may stem from their structure.

Most BHCs are not banks but “financial malls,” of “shops” serving as brokers-dealers, underwriters, advisers (to mutual funds, trust funds, and wealthy individuals), banks proper, insurance, lending, “securitizers,” guarantors and traders for the BHCs’ own account, and more. A BHC owns the mall’s financial shops, collects their revenues, and raises funds from investors. Its management finances the shops and rewards shop managers. Managing the variety of shops that closely reflect the entire financial system is difficult. Not surprisingly, BHCs periodically produce enormous profits and bear enormous losses.

Compare BHCs structure to other malls: In business malls, mall owners serve all the shops’ needs. But these shops (pharmacies or restaurants) have different owners, customers, and regulators. Mutual fund “malls” are serviced by one adviser but owned by investors. Displeased investors can decimate their funds by redeeming their shares. Under the structure of Vanguard, the largest in the United States today, the shops—the funds (their investors) own the mall, and pay for its services. As to performance, each fund “sits on its own bottom,” judged by its shareholders, rather than by a management or a holding company’s shareholders. Yet, a fund’s failure does not shake the economy and taxpayers do not bear the cost.

The BHC structural model raises serious disadvantages for their investors, and for the financial system, against which current regulation does not effectively protect:

• Large risky BHCs pose risks to the financial system, especially if they interact with similar large BHCs. The failure of one can create a domino effect and raise risks for the entire financial system. A large apple can cause all good apples to rot.
• Bank regulation and regulators are not very effective in reducing BHCs’ risk taking. And the conclusion that concentration is associated with a lower probability that the country suffers a systemic banking crisis was proven to be less than accurate.
• The regulation of BHCs’ mall-structure reflects a weakness because some shops in the mall are regulated by the Securities and Exchange Commission based on disclosure and others by the bank regulators’ regulatory scheme based on substantive regulation to assume “safety and soundness.”
• Large BHCs defy effective management because they are complex, and engaged around the globe. Their managements are subjected to conflicting pressures because they draw on government insured bank deposits, and on BHC investors. One requires low risk and the other higher risk. The “Volcker Rule” which would prohibit or limit such BHC trading for their own account has met strong opposition and has not yet been implemented.

What should be done to protect the country from the risk of large BHC malls? I propose restructuring BHCs in my paper, Dismantling Large Bank Holding Companies for Their Own Good and for the Good of the Country. Eliminate the concentrated management power of BHCs and raise the investors’ power and market judgment of the BHC shops in the mall. Let the shareholders of each shop in the mall choose its management, judge its performance, and regulate it by market forces. Let each shop be regulated directly by its appropriate government regulator.

The pluses:

• Reduced danger of the few BHCs that are “too big to fail” and their enormous concentration of power over the financial system.
• Reduced conflict of interest within the BHC current structure.
• Reduced problem of faulty controls over the various units in the BHC.
• Facilitate and increase the markets’ regulation.

However:

• What if each mall elects the same directors? We have changed nothing.

Answer: Because the “shops” are already established, their shareholders participate in ongoing concerns. Therefore, the market prices of their shares may direct the units’ future management.

• Credit costs will rise with the dilution of the synergies from affiliates within a BHC structure.

Answers: Perhaps! Yet synergies may develop and exceed the current ones. There are 1352 stand-alone banks in this country and some are doing quite well; perhaps better than the BHCs colossus.

• Why not address the issue more directly, with targeted regulation?

Answer: Most rules have a weaker self enforcement than structure, and patterns of behavior. Large BHCs did not arise in a day and limits on risk did not flower instantly. Restructure, supported by market pressures, is more likely to change people’s interaction, favoritism, and fixed beliefs than regulation.

If the financial system were our playground we might try and use one structure and play it against a proposed new one to examine the results. In fact, we might use games on the Internet that offer virtual life to discover the results. However, neither the games nor experiments can give us a reliable answer.

• Do we need to resurrect the Glass-Steagall Act?

Answer: It might not be necessary. Regulation should reflect issues that arise with the different intermediaries’ services. Perhaps future legal issues will involve antitrust activities or areas that we do not now envision. Regulation should respond to problems, which may arise from old beneficial structures as well as from new ones.

The December edition of the Economist, entitled “The world in 2013,” dealing with “The Fall of the Universal Bank.” It predicts that “[t]he power of universal banks will be eroded by market forces. . . In 2013 most universal banks will continue to narrow their focus.” Traditional banks have moved too closely towards “transaction banking” and further away from “relationship-banking,” that is, deposit taking and servicing lenders. The movement toward market fund-raising and trading on BHC account was too strong. Deposit money-raising and contract lending—the main purpose of banks became too weak.

How should BHCs’ structure change? Regulators can command it, but it could be adopted voluntarily with minimal accommodating changes. Therefore, the purpose of this proposal is to induce and produce such a restructure and prevent the failures. One source of inducement is the shareholders of the BHCs, especially shareholders that constitute large institutions. Also, if a BHC posed dangers to the financial system, the FDIC is authorized to restructure the BHC complex.

But why should anyone holding a significant power over billions of dollars give it up to become subservient to those whom he or she managed before? Leaders, who question the benefits of regulation, may wish to demonstrate that the markets can solve the problems. Investors might flock to this structure, if well explained. To be sure, there are counter-pressures. As the Wall Street Journal reported, investors who sought to split J.P. Morgan’s top posts with the support of the employees’ union failed. But one failed attempt may show the way to successful ones.

The full paper is available for download here.