The Kanjorski “We’re Tough on TBTF” Headfake

Banking industry, Credit markets, Investment banks, Politics, Regulations and regulators Comments (0)

Dear God, if you read the media, you’d really think the Congressional huffing and puffing at the banking industry was going to solve the “too big to fail” problem, or even make much of a difference.

Folks, I hate to tell you, these remedies fall so far short of what it would take as to constitute a complete joke. And I am cynical enough to believe that the industry is secretly delighted, its bitter howls to the contrary (now it admittedly may be a shocker to them that they might have to be a wee bit inconvenienced in the interests of appeasing the public). Remember the lesson of the Barney Frank derivatives bill: even that weak offering was watered down to nothing. The Kanjorski salvo is the first round, and the banks are going to get this cut back, substantially. And Kanjorski has unwittingly played into their hands. But the theater certainly is impressive. From Bloomberg:

Seven Wall Street lobbyists trooped to Capitol Hill on Nov. 9, hoping to convince Representative Paul Kanjorski’s staff that his plan to dismantle large financial firms was a bad idea.

They walked out with a sobering conclusion, according to the accounts of two attendees who requested anonymity because the meeting was private. Not only was Kanjorski serious, he planned to offer the legislation as early as next week — and it just might pass.

Today marks a decade to the day that President Bill Clinton signed the repeal of the Depression-era Glass-Steagall Act that split investment-banking from lending and deposit-taking. The repeal allowed the creation of Citigroup Inc., the financial colossus now propped up by $45 billion in taxpayer rescue funds. Financial firms are scrambling to prevent Congress from re- imposing the act.

“We’re playing with live ammo,” said Sam Geduldig, a lobbyist at Clark Lytle & Geduldig who represents financial- services firms and wasn’t at the Nov. 9 meeting. “The banking community is rightfully concerned.”

Now admittedly, the Kanjorski proposal would reinstitute Glass Steagall by splitting commercial banking operations from investment banking and thus lead to some pretty dramatic surgery at JP Morgan (hiving off Chase Manhattan), Citigroup, and Bank of America. But while that would affect the scope of operations (and thus the pay packages for the CEOs, since top level pay is correlated with asset size of the entity) of the highest ranks, it would have comparatively little impact at the business unit level.

This is a 1930s remedy for 21st century banking. The Kanjorski proposal does remarkably little to reduce TBTF risk. The real problem is not size, and this approach puts the focus on completely the wrong issue. So if this solution does come to pass, Congress will have spent a huge amount of political capital on a largely ineffective solution.

A little quiz: what exactly got bailed out in the crisis? Yes, we had to resolve a few big sick banks, namely WaMu and Wachovia. But that happened pretty smoothly and was within traditional FDIC bounds.

The crisis bailed out the global capital markets. Look at where the Fed’s rescue the markets programs were directed. Once you got past the first, the Term Auction Facility, they were directed at credit markets that are the playground of a fairly small number of very influential capital markets firms (an indicative list: Goldman, JP Morgan, Citigroup, Morgan Stanley, the old Merrill part of BofA, plus the trading operations of major international banks like UBS, SocGen, Barclays, DeutscheBank). Simply splitting off capital markets businesses does absolutely nothing to reduce the risk they represent to taxpayers. A massive safety net has been thrown underneath them, and no one save Goldman’s PR department believes that they won’t be bailed out when one of them goes off a cliff again.

The Fed does require the granting of waivers for deposits to be used to support trading operations. I’ll confess I have not seen any data here, but my impression is that that is very limited (but one could argue that the big deposit base allows them to fund in the short-term borrowing markets more cheaply, which would benefit the trading operations. Eurobanks, by contrast, do permit deposits to be used to support the capital markets businesses, which does give them a funding advantage.

Remember, Bear Stearns, with a roughly $400 billion balance sheet, was too big to fail. We now have a comparatively small number of firms globally that are enmeshed via counterparty exposures in OTC trading markets. These products cannot be moved to exchanges (you need enough trading liquidity in the underlying instruments; there is a good reason that, for instance, corporate bonds, munis, and even Treasuries and FX are traded OTC). This is like pretending we are living in a world of mainframes, of isolated players, when the problem is an a network of distributed computers, where any one going down can and probably will bring the network down. And we can’t halt the network while we take it apart and rebuild it. You may not like my saying that, but these are design parameter problems.

How would you break up Bear Stearns? You can’t separate OTC derivatives from the related cash markets; that will cause havoc (you’d be putting the derivatives book in runoff mode while simultaneously making it monstrously difficult to hedge, and these books are dynamically hedged). The logical-looking ways of doing it (say having them separate equity markets businesses, which are exchange traded and did not require government support in the crisis, from the debt businesses) makes the firms smaller but still does not solve the TBTF problem, which is the OTC debt and related derivatives markets. Those have become crucial to credit intermediation.

Now there are a bunch of things the officialdom COULD do to reduce the size of the public’s exposure, and I see them nowhere on this list. One is to bar proprietary trading and monitor overnight positions to make sure banks don’t simply start taking significant (as opposed to short-term) directional bets on customer order flow desks. Second is to force any systemically important firm to get out of the commodities business. We have commodities exchanges that perform the socially useful function of commodities hedging for end users. There is no reason for governments to backstop that. Principal trading similarly not socially productive and should not be in firms that have recourse to the government checkbook. Capital markets players should also be prohibited from offering bridge loans to customers (that is consistent with the Glass Steagall idea).

So that is why the Kanjorski approach, despite the tough talk and possible disruption, is actually a win for the industry, even if a somewhat extreme version (remarkably) were to pass. It means no one is on the trail of the draconian measures needed to contain the risks the industry poses to the public at large.

The only viable solution to the misbranded TBTF problem is to require systemically important firms (one in the OTC debt businesses, which thanks to the development of “market based credit” is now essential to modern capitalism) to exit all activities that are not socially essential and therefore deserving of government support (pure fee businesses that pose no risk to the taxpayer would be allowed). The permitted activities are regulated intrusively, with tough rules on capital requirements, and product scope (new products would be subject to approval to make sure they were socially productive, that the regulators understood them, and they did not result in increased risk to taxpayers). In other words, an effective solution requires more extensive dismemberment than anyone plans right now, and still requires heavy regulation of the crucial bits that will inevitably be taxpayer backstopped.

November 12, 2009