But Do We Really Want Smaller Zombie Banks?

Your humble blogger is headed to DC today to participate in a General Accountability Office session on the US banking industry.  In a letter last month to Gene L. Dodaro, Comptroller General of the United States, Senator Sherrod Brown (D- OH) and Senator David Vitter (R-LA) complain that despite the passage of the Dodd-Frank law, the largest US banks continue to grow and remain “too big to fail.”  They write:

“Though Congress has enacted financial sector reforms that its supporters, both in Congress and the Administration, intended to mitigate the TBTF problem, we are concerned that these measures may not be sufficient to eliminate government support for the largest bank holding companies.  Federal Reserve Board Governor Daniel Tarullo recently lamented, ‘to the extent that a growing systemic footprint increases perceptions of at least some residual too-big-to-fail quality in such a firm, notwithstanding the panoply of measures in Dodd-Frank and our regulations, there may be funding advantages for the firm, which reinforces the impulse to grow.’”

And this statement is true.  But when you look at why the TBTF banks are so large, much of the blame lies with Washington.  In fact, Congress itself is probably the leading reason for the odious doctrine called “too big to fail.”  Congress has mismanaged the finances of the US Treasury and has thus given the bankers who service the nation’s debt big leverage, even extortionate powers.  The US government cannot strike down the bankers without killing the ability of the government to finance its debts – at least absent the intercession of the Federal Open Market Committee.

As I noted in a comment for IRA this week, “Mutually Assured Destruction: The Legacy of Timothy Geithner -- and Robert Rubin,” the real reason that the DOJ does not go after the big banks is the same reason why the Fed has always pandered to the zombie dance queens, namely the overriding concern about the market for Treasury debt. In the minds of Washington's ministerial class, systemic risk trumps securities fraud -- or anything else. The TBTF banks and three or four other players are all that remains of the primary dealer community. Mess with the remaining big banks, so the story goes, and the world really does end.”

Of course, the problem with the whole issue of “too big to fail” is that the large banks are net takers of resources from the economy.  The hundreds of billions of dollars per year in subsidies that flow through the largest banks c/o the Fed and various federal agencies far exceed the nominal profits reported by the entire banking industry.  Consider, for example, that the total interest expense for the US banking industry was just $16 billion in Q3 2012 compared with almost $100 billion in Q4 2007.  Add in the debt leverage and the annual subsidy to the banks from the Fed for just QE alone is hundreds of billions per year.  

As I told the GAO:

“The subsidy value of the SIFI/TBTF designation is enormous and basically gives the TBTF bank a funding profile similar to a US government agency. Thus the most obvious value of the SIFI label is the economic benefit in terms of funding cost. If market participants really believed that a TBTF bank could, in fact, fail and default in a legal sense, then the funding costs would reflect that perception.   The list of subsidies that flow to the TBTF banks includes the Fed’s zero rate/QE policies, the cartel pricing profits from agency mortgage originations, and the exemption from the automatic stay in bankruptcy for OTC derivative contracts.  My rough guess as to the size of the annual subsidy for the five largest US SIFI institutions would be $500 billion annually or more.”

It may even be hypocritical for members of Congress to complain about the zombie banks given the degree to which large banks have become instruments of public policy.  The subsidies for TBTF banks reflect policy decisions made in Washington by Congress, such as tying monetary policy to “full employment,” a notion that goes back to WWII and the Great Depression.  The large banks simply align themselves to make maximum profit from America’s decidedly socialist the public policy goals.

The wisdom that allows Congress to subsidize the housing market to the tune of several points worth of annual interest expense implicitly endorses the role of the TBTF banks.  There is no higher risk adjusted return for banks than making a residential mortgage loan that is covered by the FHA, extracting fees from the borrower, then selling that loan into the TBA market for a several point profit.  Uncle Sam holds the first lost risk and the bank holds the servicing on the loan.  

At least that was the plan until the Dodd-Frank legislation.  Now the TBTF banks are headed into a brave new world where much of the subsidies from housing are being offset by a new tax called Basel III.  Under the foreign-inspired capital rules, large banks will be forced out of the mortgage market and will no longer be able to retain large portfolios of loan servicing.  Over time, this change in the cost of capital for large banks could see them shift their activities even more toward capital markets and derivatives.  The irony of Dodd-Frank and Basel III is that it may make the TBTF banks more risky and unstable. 

Indeed, even as members of Congress fret about the problem of TBTF, a move is afoot to repeal the Volcker Rule as part of continuing financial reform.  I have never been a fan of the Volcker Rule, a part of the Dodd-Frank law that prohibits banks from trading for their own account.  The London Whale trade at JPMorgan was an example of a prohibited activity under the Volcker Rule, one reason that the bank had started to terminate employees in the CIO office in 2011, prior to the supposed bad acts.  

The trouble with the Volcker Rule is that is completely misses the point of the subprime crisis, namely securities fraud at the syndicate desk.  The fact of banks trading their own book is trivial compared to the vast larceny that took place across the trading floor on the new issue desk.  Of course, former Fed Chairman Paul Volcker understands this very well.  As I have noted before, Volcker has never seen a TBTF bank he would not bail out given the chance.  Indeed, the public paragon Paul Volcker is the father of too-big-to-fail, as I noted in my 2010 book “Inflated.” 

So while the attention of Senators Brown and Vitter is commendable, somebody needs to take them aside and tell them the punch line to the joke.  The TBTF banks are big because of excessive risk taking, not because of leverage per se, and much of this risk is underwritten by Washington.  You can increase capital requirements in a static sense, but it is the type of business model decisions taken by these banks which is the real issue for the public.  As I told the GAO:

“When a bank hides risk, as in the case of the Citigroup SIV example, the problem is internal systems and controls, not capital.  In the JP Morgan episode with the “London Whale,” the problem likewise was internal systems and controls, not capital.  The JPM example with the London Whale apparently involved deliberate risk taking, not hedging, but regulators seem willing to accept the bank’s version of why this loss event occurred.” See my earlier ZH comment in terms of what did or did not happen in 2010, “A few more questions for JPMorgan on the London Whale.”

The problem with “too-big-to-fail” is first and foremost the behavior of our beloved political leaders in Washington.  Our love-hate relationship with the big banks is a legacy of WWII and the fiscal depravity which has followed ever since.  When we start to shrink the federal government and our chronic deficits, the large banks will get smaller.   The zombie banks feed from the public trough in many ways.  Just don’t assume that when Washington screams “no, no” to more zombie love that those protestations are entirely genuine.