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Big Banks are Victims of Their Own Success

Note: The Trade is not subject to our Creative Commons license.

The biggest banks have done an excellent job of delaying and undermining the Dodd-Frank financial overhaul law and staving off criminal investigations into wrongdoing.

Maybe, just maybe, they’ve been too successful.

Senators Sherrod Brown, Democrat from Ohio, and David Vitter, Republican from Louisiana, introduced a bill last week that calls for two things: making the giant banks much safer and tying regulators’ hands to prevent them from using taxpayer money to save a failing financial institution.

If the bankers who blew up the financial world had been held accountable, the popular fury that fuels this bill would have dissipated by now. And if Dodd-Frank were fully in place today, instead of being bogged down in the courts and in the halls of Washington regulatory offices, there would be no political momentum behind such an effort.

Now, we will see whether the bill is simply a barbaric yawp of anger at the big banks or something with actual force. It probably won’t get passed, but its underlying premise cannot be dislodged from the Washington conversation.

The Brown-Vitter bill calls for the banks with more than $500 billion in assets — I’m looking at you JPMorgan Chase, Citigroup, Bank of America, Wells Fargo, Goldman Sachs and Morgan Stanley — to have capital reserves of 15 percent. That’s a much higher standard than exists today, especially because the current requirements have weak definitions of capital and total asset size.

The banks have rounded up a bunch of critics, led by the likes of the law firm Davis Polk & Wardwell and the lobbying firm Hamilton Place Strategies, the volume of their lamentations likely in direct proportion to the hourly rate they bill their clients. They invoke terrifying, talismanic statements: The bill is a “punishment” to big banks. It is simplistic, impossible, will render American banks “uncompetitive,” lead to financial crises and probably cause tooth decay.

This naïve bill would force the giant banks to raise too much capital and would hurt the economy as the companies were forced to shrink or break up. Standard & Poor’s is one of the observers warning of a financial crisis. And who better to know than the people who brought us the last one?

Goldman Sachs and S&P estimate the big banks might be forced to raise $1 trillion or more. That’s a lot, so much that the leviathans’ agents cry out that they couldn’t sell that much stock. But they don’t have to raise it all at once. And they can retain their earnings and stop paying dividends in addition to selling shares.

In putting that argument forward, they don’t realize they make Senators Brown and Vitter’s case for them. If investors are so terrified of the big banks that they won’t buy their stock, that’s a terrific problem. Most of the big banks trade below their net worth, an indication that investors don’t trust them. Brown-Vitter might actually help banks by restoring that trust.

The Brown-Vitter bill serves as a good time to remind defenders of big banks what bank “capital” is. As Professors Anat Admati and Martin Hellwig have pointed out in their indispensable book “The Bankers’ New Clothes,” capital is not a rainy-day fund. It’s not stored away in a vault somewhere, never to be touched. Capital — the rest of us know it as “equity,” like the down payment on a house — is simply money that absorbs losses. The more money a bank raises from shareholders, the more profit it keeps on hand, the less it has to borrow and the more solid it is. The bank can still lend that money. And if JPMorgan Chase doesn’t lend to some small business, perhaps a regional or community bank will.

There might be some trade-offs to higher capital requirements, but we know there are costs to lower ones: financial crises. Some try to argue that the banks faced a liquidity crisis in 2008, what we call a run on the bank. Yes, that was true in the autumn of 2008. But the crisis didn’t start then. It started in the late summer of 2007. If the banks had been more solidly capitalized, there would have been fewer panicked investors.

Banks desire as little capital as they can get away with. It’s easier to make higher returns on equity with greater debt. Often management is paid in stock. But society as a whole doesn’t benefit from banks that are running with too much leverage. They collapse.

So, it is better to have higher equity capital. But Brown-Vitter doesn’t go far enough. The bill’s definition of equity could be tighter. It still contains bookkeeping entries called intangible assets and deferred tax assets, which don’t absorb losses.

But, gratifyingly, Brown-Vitter does tighten up the definition of assets. Capital is the numerator and assets are the denominator. Both need to be made as solid and trustworthy — and resistant to manipulation by banks or regulatory capture — as they can be. When calculating assets, Brown-Vitter tightens up rules on things like how the banks measure their exposure to derivatives.

Oh, the critics shout, this is just a backdoor way of making banks smaller. The bill’s authors fail to understand that diversity of exposure saves gargantuan banks, they say. This requires a slap to the side of the head and a one-word rebuttal: Citigroup. Citi blew up because of its exposure to collateralized debt obligations. That exposure was dismissed and misunderstood by the top ranks because it was seemingly small as a portion of the bank’s balance sheet. It was wonderfully diversified into all kinds of investments, which didn’t help at all. Sure, small banks are less diverse. But when they collapse, the problem is more manageable.

Brown-Vitter inhibits regulators from using risk-weighting of assets, where banks and regulators determine which kinds of investments are safe and require little capital behind them. Davis Polk declared that getting rid of risk-weighting is “too blunt,” somehow immune to the absurd spectacle of lawyers opining on proper risk management.

In fact, risk-weighting has a storied history of blunder. Residential mortgages and sovereign debt, like that of, say, Greece, were once viewed as carrying little risk. Risk-weighting encourages banks to crowd into assets thought to be safe, in that way making them unsafe. It lulls them, and regulators, into a false sense of confidence. Perhaps throwing out risk-weighting might lead lots of banks to buy stuff that is known to carry risk. It’s far better to have them piling into investments that are known to be risky and count those purchases with a clearer, less manipulated number. Then, regulators need to pay attention, which, call me crazy, is their job.

Brown-Vitter also ties regulators’ hands on whether they can pour taxpayer money into failing banks. Here, it’s less plausible. Dodd-Frank has given regulators resolution authority, which gives them the power to unwind failing institutions and impose losses on the shareholders and creditors. Brown-Vitter tries to eliminate what Dodd-Frank skeptics see as too much regulatory flexibility.

It’s a noble idea. But the problem, as Paul A. Volcker has pointed out, is that if JPMorgan Chase is truly failing, it’s almost a certainty that Citi and Bank of America are going down, too. And taxpayers would then have to step in in some fashion.

So, taxpayers are implicitly on the hook for the financial sector, even with Brown-Vitter.

That’s why we need the biggest banks to have truly clear and understandable balance sheet fortresses.

ProPublica’s e-mail promoting this article reads “A new bi-partisan bill proposes to raise capital standards at the biggest banks. Their paid shills are whining but the arguments don’t hold water.”

Maybe Pro-Publica can be transparent and tell us all of the e-mial messages they may be sending to various users.

Whatever messages may be sent, the promotional material is part of the coverage, and the coverage - including the marketing material that disparages the subject of the story - is commentary, not news reporting. Ethical guidelines of the Society of Professional Journalism say commentary, analysis and news should be clearly separated and, if it’s not news but appears in a news format, should be labeled as analysis or commentary.

Jerry Buerge

May 1, 2013, 3:46 p.m.

But, where is there risk if banks of any size are free to send all their bad loans to Freddy and Fanny to churn their investment capital into profitable cream as they have in the past, based on bogus paper that carried them there?

Here’s hoping that this claimed to be new approach to common sense also retains a true sense of continuing legal responsibility for the accuracy of the claims of equity that justify a replacement of the capital they received upon the transfer of ownership of the mortgages they created or handled.

Jerry, are you one of the “shill”? Why should anyone care about your point as it has nothing to do with the point of the article?

In fact, I would urge you to take Fox news to task.

@Jerry:

Very good at regurgitating the 4 year-old line about Fannie and Freddie being the “real” culprits.  The CDOs and CDS behind the CDOs that multiplied risk 10 fold had nothing to do with it, right?  Oh, and did Fannie/Freddie create those CDSs?  Nope.  Goldman and company did.

I think Sherrod and Vitter are shills.  The DOJ already has authority, under the Sherman Antitrust Act, to begin unwinding these behemoths into smaller, less monopolistic entities.  This would be better for all of us. Of course, it will never happen, since the “too big to flails” are paying all the lobbying fees…using tax payer money.

My only hope is when the next financial debacle rolls around (and it will soon), at least this time our trusted elected officials won’t give a blank check to Wall Street.  And, “You are banned from any lobbying activity until you pay back every red cent of taxpayer money, whether direct or indirect” should be the minimum requirement.

I don’t understand all of this. I do think that Dodd-Frank was written to never be implemented. Volcker rule so complex that the regulations will take years to be written. Listen to a guy last night on CSPAN who believed capital requirements were a good thing but there must be a lender of last resort. That lender of last resort is government.

DOJ Holder said that to prosecute those at the head of institutions who took the too big to brink of failure would place the global economy at risk Didn’t that happen already?

No behaviors were changed and no zero in the Obama administration and certainly none in Congress.

Seems to me a clear statement backed by legislation that the government will not be ever a lender of last resort then the immoral, unethical behaviors would change.

I personally have little resources to lose. Congress and those in the Obama administration do. Therein lies the problem.

bogglesthemind

May 1, 2013, 8:34 p.m.

The inmates run the asylum.

Vellach Samie

May 2, 2013, 4:08 a.m.

@Frankā€¦ wow, your request to uphold journalistic standards to so bloody high a level brought tears to my eyes.
Wonder if you write the same to every Major News media in this country, since none of them have any credibility left.

And by the way, this is a column by Jesse. Not News.
Is somebody paying you to write such comments to instigate doubt or are you really nuts?

Not sure I agree with the title of the column. They’re victims now because they wrecked the economy and somebody is finally thinking that putting back the regulations is a good idea?

It’s more like the teenagers took the car out for a spin, caused a 1000 car pileup on the expressway and now they’re jumping up and down complaining because the adults are even discussing the possibility of taking back some control.

Anyway let’s not forget that this bill is being considered in the context of Obama’s just having put in charge of the SEC a person who was previously the ‘litigation chair’ of the largest and oldest NY law firm whose main business is to protect Wall St. banks from any sort of accountability.

Regulation is a good thing, not a punishment. We need to support these two courageous Senators, because the lobbying pressure for them to stand down is probably intense.

And now is the time for other courageous Senators to step up and co-sponser this bill.

The first two names that come to mind are Elizabeth Warren and Bernie Sanders.

Why are those two so-called ‘protectors of the common people’ not all over this?

Victims?  Huh?  Criminals.  Sociopaths.  Narcissistics.  Evildoers.  Whatever you want to call them.  But they are not victims. 

Might I suggest that if ProPublica is for the common good that you consider moving away from the false meme of private, for-profit banking.  There is no regulation in the world that turns evil into something that is just and true.  Why don’t you let me write a report on public banking and you put it on your front page.  You can obviously proof and edit it. 

This bill is a waste of time.  More lipstick on the nondemocratic pig.

Lots of bitterness above. Understandable, since it’s us little people who get shafted every time. The wealthy and powerful don’t typically go searching for answers on the internet. They don’t have problems that require answers. But I think the real point of this article is not “here’s the fix!” It seems doubtful this bill will pass because the ‘powers that be’ own our government. But it is a sign that some people are at least trying to make a difference, and that’s a good thing. Good signs precede good things. And since I’m a nobody, I will point out Matt Taibbi agrees (he’s a better-known nobody).

And taxpayers would then have to step in in some fashion.

That’s the real lesson in the near collapse orchestrated and driven by the big banks:  When they fail, they can force the taxpayer to bail them out.

After all, they fund both candidates in every election (and make sure we ignore everybody but the big two), so it’s not like the government is going to protect us at their expense…

If I’m going to step in, it’s going to be to kick them in the collective crotch, not to fund their predatory business models.

Following up (and partly echoing Grim Reaper’s comment), what the heck do banks do, exactly, anyway?  Not how do they work.  What public benefit to society do they provide?  They let us buy things we can’t afford, but I thought we all agreed that this was a bad thing that was destroying the economy…

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Jesse Eisinger

About The Trade

In this column, co-published with New York Times' DealBook, I monitor the financial markets to hold companies, executives and government officials accountable for their actions. Tips? Praise? Contact me at .(JavaScript must be enabled to view this email address)