Too-big-to-fail Q&A. Get the facts | Sober Look

Interesting pro-bank piece by Sober Look. I have added my comments in italics.

The debate around “too big to fail” of the US banking system is often infused with political rhetoric and media hype. Let’s go through some Q&A on the subject and discuss the facts.

Q: Did large banks take disproportionate amounts of real-estate related risk vs. smaller banks prior to the crisis?

A: No. That’s a myth. Smaller banks were much more exposed to real estate (see discussion).

The issue is not real estate lending, but risky lending.

Q: Who had their snouts in the sub-prime trough, big banks or small banks?

A: Big banks.

Q: Which “too big to fail” banks were directly bailed out by the US federal authorities during the 2008 crisis?

A: While hundreds of banks were forced to take TARP funds, only Citigroup (among US banks) received an explicit bailout to keep it afloat. Note that Bear Stearns (and Lehman), AIG, GM/GMAC, Chrysler, Fannie and Freddie were not banks. Neither was GE Capital and other corporations who relied on commercial paper funding and needed the Fed’s help to keep them afloat. Wachovia may have become the second such large bank if it wasn’t purchased by Wells.

Q: Which “too big to fail” banks were indirectly bailed out by the US federal authorities during the 2008 crisis?

A: All of them

Q: Why did Citi fail in 2008?

A: Citi ran into trouble because of a massive off-balance-sheet portfolio the firm funded with commercial paper. In late 2007, when the commercial paper market dried up, Citi was forced to take these assets onto its balance sheet. The bank was not sufficiently capitalized to absorb the losses resulting from these assets being written down.

Citi was not the only TBTF bank that was inadequately capitalized to deal with losses.

Q: What were the assets Citi was “warehousing” off-balance-sheet?

A: A great deal of that portfolio was the “AAA” and other senior tranches of CDOs that Citi often helped originate (including mortgage related assets). Rating agencies were instrumental in helping banks like Citi structure these assets and keep them off balance sheet in CP conduits.

Q: Who paid the rating agencies?

A: The TBTF banks.

Q: Why did Citi (as well as many other banks) hold so much off-balance sheet?

A: Because they received a significantly more favorable capital treatment by doing so (the so-called “regulatory capital arbitrage” – see discussion from 2009).

Q: Did Citi break any state or federal laws by doing what it did?

A: No. All of this was perfectly legal and federal authorities were aware of these structures.

We need to fix the law so this cannot happen again.

Q: Did derivatives positions play a major role in Citi’s failure? Were other large US banks at risk of failure due to derivatives positions?

A: No. That’s a myth. The bulk of structured credit positions (tranches) that brought down Citi were not derivatives (just to be clear, CDOs are not derivatives).

Q: What has been done since 2008 to make sure the Citi situation doesn’t happen again?

A: The US regulators now have the ability to take over and manage an orderly unwind of any large US chartered bank. Banks are required to create a “living will” to guide the regulators in the unwind process. The goal is to force losses on creditors in an orderly fashion without significant disruptions to the financial system and without utilizing taxpayer money.

Large banking institutions are now required to have more punitive capital ratios than smaller banks.

Capital loopholes related to off-balance-sheet positions have been closed.

Stress testing conducted by the Fed takes into account on- and off-balance sheet assets, forcing banks to maintain sufficient capital to be able to take a hit. US banks more than doubled the weighted average tier one common equity ratio since the crisis (see attached).

Dodd-Frank has been “nobbled” by Wall Street lobbyists. Stress tests by captive regulators are not to be trusted. Increase transparency by supporting the Brown-Vitter bill.

Q: Do large US banks have a funding advantage relative to small banks?

A: Not any longer. According to notes from the meeting of the Federal Advisory Council

and the Board of Governors (attached – h/t Colin Wiles ‏@forteology), “Studies point to a significant decrease in any funding advantage that large U.S. financial institutions may have had in the past relative to smaller financial institutions and also relative to nonfinancial institutions at comparable ratings levels. Increased capital and liquidity, in addition to meeting the demands of many regulatory bodies, has largely, if not entirely, eroded any cost-of-funding advantage that large banks may have had.”

And we should believe them?

Q: Why do TBTF banks dominate the financial landscape?

A: Because of their taxpayer-subsidised funding advantage.

Q: What is the downside of breaking up banks like JPMorgan?

A: Large US corporations need large banks to provide credit and capital markets access/services (Boeing is not going to use Queens County Savings Bank). Without large US banks, US companies will turn to foreign banks and will be at the mercy of those institutions’ capital availability and regulatory frameworks. Foreign banks will also begin dominating US capital markets primary activities (bond issuance, IPOs, debt syndications, etc.) And in an event of a credit crisis foreign banks (who are to some extent controlled by foreign governments) will give priority to their domestic corporations, putting US firms at risk.

Agreed. Large corporations need large banks — or at least syndicates of mid-sized banks. Brown-Vitter does not propose breaking up any TBTF banks, merely requires them to clean up their balance sheets and carry adequate capital against risk exposure.

Q: How large are US largest banks relative to the US total economic output? How does it compare to other countries?

A: See chart below (the chart contrasts bank size as percentage of GDP of Swiss and UK banks to US banks)

Swiss and UK banks have global reach so rather compare absolute size rather than relative to GDP where the bank is headquartered.

So before jumping on the “too big to fail” bandwagon, get the facts.

via Sober Look: Too-big-to-fail Q&A. Get the facts.

I had to smile at the From our Sponsors Google ad at the end of the article, suggesting I open a business account with one of the major banks.

Can two senators end ‘too big to fail’? | The Big Picture

Barry Ritholz writes:

The idea that two senators from opposite sides of the ideological spectrum can find common ground to attack a problem with a simple solution is novel in the Senate these days. If Brown and Vitter manage to end the subsidies to banks deemed “too big to fail,” they will have accomplished more than “merely” preventing the next financial crisis. They will have helped to create a blueprint for how to get things done in an era of partisan strife.

Read more about the progress of the Brown-Vitter (TBTF) bill at Can two senators end ‘too big to fail’? | The Big Picture.

In Brown-Vitter Bill, a Banking Overhaul With Possible Teeth | NYTimes.com

Jesse Eisinger from ProPublica skewers big banks’ objections to increasing capital buffers as proposed by the bipartisan Brown-Vitter bill:

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 Senator Brown’s and Senator 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.

Read more at In Brown-Vitter Bill, a Banking Overhaul With Possible Teeth | Deal Book | NYTimes.com.

Two Senators Try to Slam the Door on Bank Bailouts – NYTimes.com

This is a show-down between Wall Street and the voting public. Gretchen Morgenson at NY Times writes:

THERE’S a lot to like, if you’re a taxpayer, in the new bipartisan bill from two concerned senators hoping to end the peril of big bank bailouts. But if you’re a large and powerful financial institution that’s too big to fail, you won’t like this bill one bit.

The legislation, called the Terminating Bailouts for Taxpayer Fairness Act, emerged last Wednesday; its co-sponsors are Sherrod Brown, an Ohio Democrat, and David Vitter, a Louisiana Republican. It is a smart, simple and tough piece of work that would protect taxpayers from costly rescues in the future.

This means that the bill will come under fierce attack from the big banks that almost wrecked our economy and stand to lose the most if it becomes law.

For starters, the bill would create an entirely new, transparent and ungameable set of capital rules for the nation’s banks — in other words, a meaningful rainy-day fund. Enormous institutions, like JPMorgan Chase and Citibank, would have to hold common stockholder equity of at least 15 percent of their consolidated assets to protect against large losses. That’s almost double the 8 percent of risk-weighted assets required under the capital rules established by Basel III, the latest version of the byzantine international system created by regulators and central bankers.

This change, by itself, would eliminate a raft of problems posed by the risk-weighted Basel approach……

The outcome is far from clear. The financial muscle of Wall Street can buy a lot of influence on the Hill. But my guess is that they are too smart to incense voters by meeting the bill head-on. Instead they will attempt to delay with amendments and eventually turn it into an unwieldy 1000-page unenforcable monstrosity that no one understands. Much as they did with Dodd-Frank.

If they win, the country as a whole will suffer. Maybe not today, but in the inevitable next financial crisis if this bill does not pass.

Read more at Two Senators Try to Slam the Door on Bank Bailouts – NYTimes.com.

Fixing the Banking System for Good

I believe we have a crisis of values that is extremely deep…. because the regulations and legal structures need reform. I meet a lot of these people [from] Wall street on a regular basis. I’m going to put it very bluntly: I regard the moral environment as pathological…… I have never seen anything like it. These people are out to make billions of dollars and nothing should stop them from that. They have no responsibility to pay taxes. They have no responsibility to their clients. They have no responsibility to ….counterparties in transactions. They are tough, greedy, aggressive and feel absolutely out of control…… They have gamed the system to a remarkable extent. And they have a docile president, a docile White House and a docile regulatory system that absolutely can’t find its voice. It’s terrified of these companies……

Professor Jeffrey Sachs of Columbia University speaking at the “Fixing the Banking System for Good” conference on April 17, 2013.

Time to clean up the Banks

Gabriele Steinhauser at WSJ writes:

A group of key crisis managers believes cleaning up weak banks is the only way to get Europe’s economy to grow again, after superlow interest rates and large-scale liquidity injections from the ECB have failed to produce the desired results. These officials see continued doubts over the health of many lenders as the main reason banks are reluctant to lend to companies, especially in the continent’s weaker countries.

“We’ve been stuck in this rubbish for five years, because we’ve been doing everything to prevent the banks from being recapitalized properly and the stress tests from being stringent enough,” said a senior EU official. “If we don’t do this, we will stay in this trap until 2020.”

The time has come to clear up the mess from the GFC and strengthen bank balance sheets — not only in Europe — so that a similar financial crisis is unlikely to ever happen again. Moves are also afoot in the US where Senators Sherrod Brown (D-Ohio) and David Vitter (R-La.) are working on a bipartisan bill to end too-big-to-fail banks. The bill does not attempt to break up big banks but focuses on improving bank capital ratios. Risk-weighted capital ratios as suggested by Basel III disguise banks’ true leverage and encourage risk-taking. Australian banks are particularly exposed to low risk-weighting of residential mortgages. Eliminating risk-weighting would force banks to strengthen their underlying capital base and discourage risk concentration in low risk-weighted areas.

The biggest obstacle to change, however, is the banks who benefit from an implicit taxpayer-funded guarantee in the event of failure. Being able to rely on a bailout enables them them to take bigger bets than their balance sheets would otherwise allow. Columbia University’s Charles Calomiris points out that the banks are able to get away with this because they are supported by populist democratic governments who trade off banking instability in return for political (and financial) support.

Read more at New Drive for Tougher Testing of European Banks – WSJ.com.

Fed's Fisher: Too-big-to-fail banks are crony capitalists | Reuters

Pedro Nicolaci da Costa reports

The largest U.S. banks are “practitioners of crony capitalism,” need to be broken up to ensure they are no longer considered too big to fail, and continue to threaten financial stability, a top Federal Reserve official said on Saturday……

[Richard Fisher, president of the Dallas Fed] said the existence of banks that are seen as likely to receive government bailouts if they fail gives them an unfair advantage, hurting economic competitiveness.

Read more at Fed's Fisher: Too-big-to-fail banks are crony capitalists | Reuters.

Five steps to fix Wall Street

Some more thoughts on the five steps former FDIC chair Sheila Bair suggested to reform the financial system.

  1. Break up the “too big to fail” banks

    My take is that breaking up may be difficult to achieve politically, but raising capital ratios for banks above a certain threshold would discourage further growth and encourage splintering over time.

  2. Publicly commit to end bailouts

    Just because the bailouts were profitable isn’t a good reason to give Wall Street an indefinite option to “put” its losses to the Treasury and to taxpayers.

    As Joseph Stiglitz points out: the UK did a far better job of making shareholders and management suffer the consequences of their actions. Sweden in the early 1990s, similarly demanded large equity stakes in return for rescuing banks from the financial, leading some to raise capital through the markets rather than accept onerous bailout conditions.

  3. Cap leverage at large financial institutions

    I support Barry Ritholz’ call for a maximum leverage ratio of 10. That should include off-balance sheet and derivative exposure. Currently the Fed only requires a leverage ratio of 20 (5%) for well-capitalized banks — and that excludes off-balance-sheet assets.

  4. End speculation in the credit derivatives market

    Bair pointed out that we don’t get to buy fire insurance on someone else’s house, for a very good reason. How is speculating using credit derivatives any different?

    Again Ritholz makes a good suggestion: regulate credit default swaps (CDS) as insurance products, where buyers are required to demonstrate an insurable interest.

  5. End the revolving door between regulators and banks

    When regulators are conscious that, with one push of the door, they could end up working for the organizations they are today regulating – or vice versa – “it corrupts the mindset”

    A similar revolving door corrupts the relationship between politicians and lobbyists. Enforcing lengthy “restraint of trade” periods between the two roles would restrict this.

via 5 Steps Obama or Romney Must Take to Fix Wall Street.