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"Understanding the Great Depression
 & Failures of Modern Economic Policy"
 by Dan Blatt - Publisher of FUTURECASTS online magazine.

 Explaining the Great Depression and failures of "New" Keynesian interest rate suppression policy without ideological clap trap, theory confirmation bias or political spin.

Table of Contents & Introduction
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FUTURECASTS JOURNAL

Financial Oligarchs

(with a review of "13 Bankers: The Wall Street Takeover and the Next Financial Meltdown,"
by Simon Johnson and James Kwak.)

March, 2013
www.futurecasts.com

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Six mega banks:

They are financial "oligarchs" exercising dominant political influence.

  The nation's major banks are coming under increasing attack. Critics view their top management personnel as financial "oligarchs" that benefit from "too big to fail" credit subsidies and that exercise dominant political influence.  Critics charge that the privileged status of the mega banks undermines the political system and creates moral hazard incentives that inherently threaten the stability of the economy.
 &

The major banks have taken advantage of the recent financial turmoil to consolidate even further, vastly increasing in size and financial importance.

 

The banks have created an ideology in Washington that considers the nation's economic prosperity as dependent on the continued success of the mega banks. In other words: "What's good for the mega banks is good for the U.S.A.!"

 

The moral hazard credit guarantee was extended to the point where it became one of the major fundamental causes of the recent housing and mortgage market boom and bust. It was joined by an onslaught of other noxious government policies.

 

The costs and constraints of Dodd-Frank regulations threaten to overwhelm smaller banks, force even more consolidation and reduce small business access to credit.

  In "13 Bankers: The Wall Street Takeover and the Next Financial Meltdown," Simon Johnson and James Kwak set forth the extensive ties between Washington and the nation's major banks. The authors explain the history of the expansion of the six mega banks and their role in the recent housing bubble and credit crunch recession.
 &
  The major banks have taken advantage of the recent financial turmoil to consolidate even further, vastly increasing in size and financial importance. Now numbering just six mega banks - Bank of America, JPMorgan Chase, Citigroup, Wells Fargo, Goldman Sachs, and Morgan Stanley - they have created an ideology in Washington that considers the nation's economic prosperity as dependent on the continued success of the mega banks. In other words: "What's good for the mega banks is good for the U.S.A.!"
 &
  The authors compare the top managers of these banks to the robber baron industrialists of the J. P. Morgan era a century ago. They are "the new American oligarchy -- a  group that gains political power because of its economic power, and then uses that political power for its own benefit."

  FUTURECASTS has repeatedly emphasized the right to fail as equal in importance to the right to succeed for the proper functioning of capitalist market systems. See,  Moral Hazard & Conflicts of Interest in the Credit Crunch. Government moral hazard credit guarantee subsidies may not cause too much damage when confined to small deposits in heavily regulated savings institutions, but that policy cannot be substantially scaled up without destabilizing the financial system. The credit market vigilantes are supposed to guard the system against excessive leverage and impose increased borrowing costs and credit controls on risky business models. However, they are magically transformed by the moral hazard credit guarantees into credit market enablers eagerly chasing the highest yields on offer regardless of the level of risks created by the business models of the borrowers.
 &
  Only the right to fail can balance ambition with caution -
optimism with pessimism - greed with fear - to generate economic action that is confined within prudent limits. "The only thing we have to fear" is the absence of fear in economic markets. The moral hazard credit guarantee was extended to the point where it became one of the major fundamental causes of the recent housing and mortgage market boom and bust. It was joined by an onslaught of other noxious government policies that

  1. undermined prudent lending standards in favor of other political objectives,

  2. employed government sponsored entities like Fannie Mae and Freddie Mac to distort the housing and mortgage markets,

  3. disabled the essential market disciplinary mechanism of market interest rates and,

  4. provided housing market subsidies and other tax, credit and fiscal subsidies that disabled the fundamental supply and demand balance of the markets.

  Beyond question, the credit crunch boom and bust was the result primarily of such government policies, but the banking industry was far from blameless. See, Understanding the Credit Crunch and The Government Directed Business Cycle. The subsidy of the moral hazard credit guarantee provides the mega banks with tremendous advantages worth billions of dollars while leaving them free from the credit market disciplines that are most sensitive to leverage excesses.
 &
  Without market disciplines
- admittedly imperfect as they may be - only regulatory oversight and business cycle contractions impose essential discipline. Regulatory oversight is an inherently weak reed, and business cycle contractions generally arrive on the scene only after much damage has been done. The regulator is unavoidably an industry booster as well as an industry cop. Regulators are unavoidably dependent on industry personnel for needed expertise, leaving the regulatory agencies vulnerable to capture by the regulated industries. Financial regulation persistently runs behind the power curve of the rapid changes in industry practices.
 &
  The new Dodd-Frank financial regulations, for instance, have not even been fully promulgated as yet and are already inadequate. Action is picking up in the "shadow banking system," including repurchase and repo markets and money market funds, now in excess of $10 trillion, with some entities reaching sizes that render them "too big to fail." With the  policy of artificially low interest rates extending into many years, there is not even the restraint of market interest rates to inhibit the instances of excess that will be revealed when interest rates again rise towards market levels, as eventually they must.
 &
  More to the point of this article, the costs and constraints of Dodd-Frank regulations threaten to overwhelm smaller banks, force even more consolidation and reduce small business access to credit.

The U.S. government's response to the housing and mortgage market boom and bust has been to almost completely shelter most of the financial elites.

  The authors assert that the industry thus remains ripe for excess and will generate some future credit market boom and bust. They support their views with examples from financial busts in foreign nations during the last twenty years, especially with respect to Korea, Indonesia and Russia, and an account of the failure of Long-Term Capital Management in the U.S. The U.S. and IMF recommended that financial elites should take a major hit for the financial crises they contributed to abroad. However, the U.S. government's response to the housing and mortgage market boom and bust has been to almost completely shelter most of the financial elites. (FUTURECASTS finds much to commend in the authors' criticism of these policies.)
 &

The decentralized U.S. banking system was swept by waves of bank failures during each downturn of the business cycle, but its national political system was free to develop without the threat of dominance by powerful financial interests.

 

It was not until the Great Depression and the New Deal administration of Franklin D. Roosevelt that federal regulatory constraints were imposed on the banking system.

 

There was still ardent opposition to a central bank. The Federal Reserve System was created by the 1913 Federal Reserve Act, but was limited to several central banking roles.

  Powerful banks have always been viewed with suspicion in the U.S. The authors provide a brief history of the waxing and waning of the major national banks.
 &
  Establishment of the first nationally chartered Bank of the U.S. was supported by Alexander Hamilton but was opposed by Thomas Jefferson and his followers. James Madison was a Jeffersonian and allowed the bank's charter to lapse in 1811. The financial strains of the War of 1812 changed Madison's view of the matter, and the Second Bank of the U.S. was chartered in 1816. Andrew Jackson, however, was also a Jeffersonian and allowed the bank's charter to lapse in 1836 after a political struggle described by the authors. The result was a depression that was both long and deep.
 &
  Until World War I, the nation remained without a powerful national bank that could fulfill the central banking role. Its decentralized banking system was swept by waves of bank failures during each downturn of the business cycle, but its national political system was free to develop without the threat of dominance by powerful financial interests. With the industrial revolution, however, the robber baron industrialists and financiers like J. P. Morgan became increasingly dominant both economically and politically. The threat of the monopolistic industrialists was met by antitrust legislation enforced by Theodore Roosevelt and successor administrations. However, it was not until the Great Depression and the New Deal administration of Franklin D. Roosevelt that federal regulatory constraints were imposed on the banking system. The authors provide detail concerning the New Deal regulatory effort.

  Unfortunately, the authors include a badly flawed explanation of the causes of the Great Depression. See, Blatt, "Understanding the Great Depression and the Modern Business Cycle," Introduction and Table of Contents, and the eight articles of the Great Depression Chronology, beginning with "Great Depression, The Crash of '29,"

  The panic of 1907 was particularly hair raising and was only contained when J. P. Morgan played the central banking role by organizing a rescue package. There was still ardent opposition to a central bank. The Federal Reserve System was created by the 1913 Federal Reserve Act, but was limited to particular central banking roles. It was designed to assure sufficient "elasticity of currency" to avoid panics such as had occurred in 1907, to act as lender of last resort in such a crisis, and to provide sufficient funds to finance the movement of the fall harvest at stable interest rates. It was also (at last) intended to assure adequate supervision of its member banks, and to rediscount eligible commercial paper to facilitate commerce. (For thorough coverage of these issues, see the three articles beginning with Friedman & Schwartz, Monetary History of U.S., Part I, "Greenbacks and Gold," and the eight articles beginning with Meltzer, History of Federal Reserve, v. 1, Part I, "The Search for Monetary Stability.")
 &

Only a part of this expansion was due to the expansion of debt capital in the "real" economy.

 

Average compensation in the banking sector which had remained little more than that of the nonfinancial sector for decades grew to about double that of the nonfinancial sector, with vast gains concentrated at the top.

  The recent growth and consolidation of the big banks has been enormous. However, this was in response to the enormous growth of the financial sector in the nation's debt-fueled economy. In the three decades from 1978, commercial bank assets increased from 53% of GDP to 84% of GDP. Securities broker assets increased from 1.4% of GDP to 22% of GDP. Asset-backed securities grew from practically nothing to 32% of GDP. "All told, the debt held by the financial sector grew from $2.9 trillion, or 125% of GDP, in 1978 to over $36 trillion, or 259% of GDP, in 2007." The financial sector's contribution to GDP grew from 3.5% to 5.9%.
 &
  Only a part of this expansion was due to the expansion of debt capital in the "real" economy. Adjusted for inflation, financial sector profits grew by about 800% in the quarter century from 1980, while nonfinancial sector profits were growing just 250%. Average compensation in the banking sector, which had remained little more than that of the nonfinancial sector for decades, grew to about double that of the nonfinancial sector with vast gains concentrated at the top. The recent financial crisis has just caused a temporary blip in this pattern of growth.

  "[Most] of the growth in the financial sector was due to the increasing 'financialization' of the economy--the transformation of one dollar of lending to the real economy into many dollars of financial transactions. In 1978, the financial sector borrowed $13 in the credit markets for every $100 borrowed by the real economy; by 2007, that had grown to $51."

Regulatory constraints were removed initially to permit flexibility in brokerage commissions and in the hope that the faltering savings and loans could some how find ways to save themselves from the difficulties that rapid price inflation inflicted on their rigidly regulated business models.

 

Banking industry personnel serving in policymaking positions in government began promoting legislation that permitted them to strip away and neuter the regulatory apparatus.

 

Markets can hardly be expected to be efficient when so extensively politicized and stripped of their essential disciplinary mechanisms.

  Deregulation has been a fundamental factor in these changes. At first, deregulation was driven by the regulatory difficulties created by increasing Keynesian inflationary volatility during the two decades from 1960. The regulatory straitjacket was simply too rigid to permit adequate response to the volatile financial conditions. Regulatory constraints were removed initially to permit flexibility in brokerage commissions and in the hope that the faltering savings and loans could some how find ways to save themselves from the difficulties that rapid price inflation inflicted on their rigidly regulated business models.
 &
  However, the ideology of deregulation soon pushed much further. It was buttressed by the "Efficient Market Hypothesis," premised on a high degree of market perfection. Despite considerable skepticism among professional economists, banking industry personnel serving in policymaking positions in government began promoting legislation that permitted them to strip away and neuter the regulatory apparatus. 

  Markets can certainly work far better than almost any administered alternative, but the notion of perfection in such complex endeavors is absurd. It can be supported only by simplistic and clearly invalid mathematical models.
 &
  Capitalist markets are in fact creatures of government policy, and regulations that facilitate market mechanisms have often provided effective, even elegant solutions to market problems and imperfections, but government policy and regulation are also inherently flawed. See, Scott, "Capitalism:  Its Origins and Evolution as a System of Governance," Part I: "The Concept of Capitalism."
 &
  Unfortunately, the removal of regulatory constraints coincided with a string of government policies that disabled essential market disciplinary mechanisms. Ambition was no longer to be constrained by caution, pessimism was banished as a constraint on optimism, and greed could be pursued without fear. Whereas foreign nations adopted many laudable reforms in response to their financial crises, the U.S. government has greatly extended the moral hazard credit market guarantees - Fannie Mae and Freddie Mac still massively distort the housing and mortgage markets - artificially low interest rates continue not just for months but for years - major housing market tax subsidies remain - and financial industry lending practices are still subject to extensive political distortion. Markets can hardly be expected to be efficient when so extensively politicized and stripped of their essential disciplinary mechanisms.

These new credit instruments, like most credit instruments, were accompanied by the temptations of excessive speculation, and each played a major role in the nation's financial troubles. However, many have in fact proven greatly useful and, now hopefully properly constrained, remain in use.

 

As corporations, they could acquire banks that made available access to the Federal Reserve's discount window. They successfully lobbied for removal of constraints on collateral acceptable to the Federal Reserve to increase access to Fed lender-of-last-resort operations.

  With an increasingly deregulated and undisciplined financial system, the financial industry began creating a variety of new credit instruments accompanied by gross underestimates of risk levels. There was a market for "junk" low grade bonds, private mortgage-backed securities, quantitative arbitrage trading, and modern derivatives like interest rate and credit default swap insurance instruments. The financial industry profited mightily from these new business lines. These credit instruments, like most credit instruments, were accompanied by the temptations of excessive speculation, and each played a major role in the nation's financial troubles. However, many have in fact proven greatly useful and, now hopefully properly constrained, remain in use.
 &
  Meanwhile, deregulation and the new opportunities from the new lines of business fueled a surge of financial industry growth and consolidation. (Obviously not unaware of the risks involved, the nation's premier investment banks that had long operated as partnerships opted to incorporate so the personal wealth of the partners was no longer at risk in the business.) As corporations, they could acquire banks that gave them access to the Federal Reserve's discount window. They successfully lobbied for removal of constraints on collateral acceptable to the Federal Reserve to increase access to Fed lender-of-last-resort operations.
 &
  By 2004, these mega banks were employing their deepening access to market credit and "diversification benefits" to pursue the new higher yielding but riskier lines of business. The authors describe how increasing profits were transformed into increasing political influence. There were massive increases in political contributions and the persistent interchange of high level personnel between the financial industry and the financial regulators and financial policy making agencies during both Democratic and Republican administrations. The authors insist that the size and influence of the banks not only threaten the nation's entire financial system but also exercise undue influence over its political system. (See, Scott, "Capitalism, Origins and Evolution, Part II, "Oligarchs, Stakeholders and Other Issues of Political Economy," at segment on "Financial oligarchs.")
 &

Housing policy:

 

 

&

  Treas. Sec. Robert Rubin and Fed Chairman Alan Greenspan were the most influential administration officials during this period. Under Greenspan, the Fed refused to regulate the new financial instruments and poured fuel on the fire with years of artificially low interest rates. Also influential during the Clinton administration were Larry Summers and Tim Geithner, as well as Wall Street professionals Lee Sachs and Gary Gensler.
 &

  In particular, the banks supported the expansion of the government's homeownership policies. These policies were employed to justify massive increases in mortgage credit availability. Of course, the expanded access to mortgage credit provided vast possibilities for financial industry profit. Industry and government authorities persistently insisted that the markets could deal with any growth of credit risks. 

  However, the markets had been neutered by the disabling of their disciplinary mechanisms. Most influential in the 1990s in the stripping away of market constraints on mortgage access were the top management of Fannie Mae and Freddie Mac supported by such legislative heavyweights as Reps. Barney Frank (D-Mass.) and Henry B. Gonzalez (D-Tex.) and Sen. Christopher Dodd (D. Conn.). See, Morgenson & Rosner, "Reckless Endangerment." The authors provide practically no coverage of this aspect of the story, concentrating reasonably on the way the banks became the dominant factor after 2000, by which time, the authors assert, the GSEs were just "another way that Washington provided fuel for that machine."
 &
  The narrow focus of the book is understandable. A work covering all aspects of the complex of factors leading up to the Credit Crunch recession would have to be far longer than the approximately 220 pages of this book. The banks and GSEs share the blame with real estate industry, government political and ideological interests and private policy activists. FUTURECASTS thus provides the several articles and book reviews herein cited for a more complete coverage of the multifaceted nature of the crisis.

Financial industry regulatory constraints were removed or substantially reduced. Banks were even forced to lower their mortgage lending standards to achieve political housing policies. Fannie Mae and Freddie Mac were "required" to lower their mortgage standards.

  The "Wall Street-Treasury complex" was in charge of the nation's financial and housing policies by the end of the Clinton administration. The widespread and politically influential real estate industry provided powerful support. The authors describe how financial industry regulatory constraints were removed or substantially reduced. Banks were even forced to lower their mortgage lending standards to achieve political "affordable housing" policies. Fannie Mae and Freddie Mac were "required" to lower their mortgage standards. (However, they were complicit in the pertinent regulatory proceedings and in getting Federal regulatory agencies to preempt state efforts to restore traditional conservative lending standards.)

  "The major banks, including both traditional investment banks and commercial banks that expanded into securities and derivatives, had spent the last two decades opening and exploiting vast new mines filled with money. They had funneled millions of dollars of that money to key congressmen who could make or break legislation affecting the financial sector. The treasury secretary was a former chairman of Goldman Sachs, the assistant secretary for financial markets was a former Goldman partner, and the Federal Reserve chairman was an ardent fan of Wall Street. The Clinton administration, which had tied its fortunes to keeping Wall Street bond traders happy, was deep into a multiyear campaign to boost homeownership rates and was depending on the financial sector to make it possible."

As long as housing prices kept rising, the risks could be presented as practically nonexistent. Whatever risks remained could by covered by the insurance mechanism of credit default swaps. Unfortunately, there were no reserve requirements for these insurance instruments.

  The authors summarize the new subprime mortgage market instruments and the credit market instruments that were designed to spread the resulting risks by removing them from the books of the banks. They describe the essential role played by the rating agencies. As long as housing prices kept rising, the risks could be presented as practically nonexistent. Whatever risks remained could by covered by the insurance mechanism of credit default swaps. Unfortunately, there were no reserve requirements for these insurance instruments. They thus could be and were transformed into a mechanism for colossal levels of speculation.
 &
  There were early warning signs, but these were explained away or simply ignored by the prevalent authoritative word from Washington and Wall Street. Foreign markets were periodically roiled by financial crises. In the U.S., the derivatives scandals of 1994 and the collapse of Long-Term Capital Management in 1998 were viewed as evidence that any problems that occurred could readily be dealt with. The dot-com bust of 2001 and 2002 revealed vast frauds, most spectacularly involving Enron and WorldCom, but remedial legislation was narrowly focused on corporate reporting requirements. The SEC even managed to overlook Bernie Maddoff's decades-long $65 billion Ponzi scheme despite receiving repeated warnings and explanations from Wall Street professionals. Above all, the government had bought into the theory of market self-regulation - ignoring the extent to which the markets had been neutered by the disabling of their essential disciplinary mechanisms.
 &

Bailout

 

 

&

    Government and private policies and the events leading up to the crisis are explained by the authors. When the housing bubble collapsed, so did not only the mortgages and mortgage backed securities but also the massively speculative credit default swaps. Easy credit conditions also left related leverage and asset inflation problems in commercial real estate and corporate takeovers.
 &

The banks were lulled by their own propaganda and also had to retain some of the risk of their new securities to demonstrate to their customers their confidence in the quality of the securities.

  Moreover, the banks still held massive levels of toxic assets on their books when the music stopped. They retained some of the risk of their new securities to demonstrate to their customers their confidence in the quality of the securities. They were also lulled by their own propaganda. They owned or were obliged to retain  responsibility for Structured Investment Vehicles that they had sponsored to absorb securities they could not sell. By the time the bubble burst, leverage among the major investment banks were in the 30-to-1 range.

  For Fannie Mae and Freddie Mac, it was 50-to-1 - but their creditors feared not since they knew the taxpayers would be on the hook in case of default.

Although the bailout of General Motors was accompanied by the removal of the CEO and major losses for the creditors, the bank creditors suffered no losses, and the top management of the banks remained in place.

 

Bailout funds for AIG flowed through to the large banks that were the primary counterparties to its default swap insurance contracts.  "This was cash that these banks would not have received had AIG gone bankrupt, or had it been subjected to an FDIC-style conservatorship." 

 

"A casual observer would be forgiven for thinking that Washington has behaved like an emerging market government in the 1990s -- using public resources to protect a handful of large banks with strong political connections."

  The bailout was a sweetheart deal for the banks, the authors explain. The implicit "too big to fail" credit guarantees had become explicit, the banks were provided cheap injections of capital, and losses were limited to the substantial but temporary declines in the price of their stock. Although the bailout of General Motors was accompanied by the removal of the CEO and major losses for the creditors, the bank creditors suffered no losses, and the top management of the bailout program banks remained in place.
 &
  The authors explain the weaknesses in the bailout schemes. In essence, the government filled the gaping holes in bank balance sheets with torrents of taxpayer money. Government bailout funds for the insurer AIG flowed through to the large banks that were the primary counterparties to AIG default swap insurance contracts.  "This was cash that these banks would not have received had AIG gone bankrupt, or had it been subjected to an FDIC-style conservatorship."  

   "While some fabled institutions have vanished, the survivors have emerged larger, more profitable, and even more powerful. The vague expectation that the government would bail out major financial institutions when necessary has become official policy. The connections between Wall Street and Washington have become stronger. A Democratic administration has done everything in its power to restore a private, profitable financial sector. A casual observer would be forgiven for thinking that Washington has behaved like an emerging market government in the 1990s -- using public resources to protect a handful of large banks with strong political connections. Whether this was due to political capture or to unbiased economic policymaking, the result was the same: Wall Street only became stronger as a result of the financial crisis."

  TARP was followed by asset guarantees, the AIG bailout, PPIP "Public-Private Investment Program," the acceptance of creative accounting schemes by the accounting regulators, and the SCAP "stress tests." 

  "Effectively, the government's strategy was to bail the banks out of their problems by helping them make large profits, juiced by reduced competition and cheap money, to plug the ever-widening hole created by their toxic assets."

The government is to an ever increasing degree socializing losses and privatizing gains.

  The government made it clear that no major bank would be allowed to fail, that they would be bailed out in their existing form with their creditors protected and their existing management in place. The government thus succeeded in ending the panic and prevented an economic collapse, but its unconditional support for the financial system "only exacerbated the weaknesses and incentives that had created the crisis in the first place." The government is to an ever increasing degree socializing losses and privatizing gains. Meanwhile, instead of funding recovery, much of the Federal Reserve's frantic multiple trillion dollar debt monetization effort disappeared into bank reserves.
 &

The takeover option

 

 

&

  The authors believe that a temporary takeover of the stricken banks would have been the far superior option for both the immediate crisis and as a policy for the future. There should have been management shakeups and considerable losses imposed on creditors to reinvigorate the credit market vigilantes and reintroduce the fear needed to balance the greed in the financial markets.
 &

"On issue after issue, the big banks got what they wanted, and the taxpayer got the bill."

 

The banks received antitrust exemptions for their newly dominant positions in a variety of financial markets, were able to borrow at rates 0.78% cheaper than banks that were not "too big to fail" and reaped massive profits that justified extraordinary salaries and bonuses for their management personnel.

 But the takeover option was adamantly rejected by the Obama administration and all other efforts to constrain the policies of the big banks were beaten back by the industry. The authors show that Wall Street personnel and interests were just as deeply imbedded in the Obama administration as in the Bush (II) administration. "On issue after issue, the big banks got what they wanted, and the taxpayer got the bill."

  Of course, management of any such takeovers would be extraordinarily complex and require the expertise of people with Wall Street and banking experience. It would inevitably have had at least for a short period a considerably negative economic impact, and perhaps a considerably longer negative impact on political incumbents.

  The crisis leaves the nation with a massively increased debt and a debauched currency. However, the banks received antitrust exemptions for their newly dominant positions in a variety of financial markets, were able to borrow at rates 0.78% cheaper than banks that were not "too big to fail," and reaped massive profits that justified extraordinary salaries and bonuses for their management personnel.

  "Economic policy in 2009, just as in 2008, was set by a group of people who, despite their considerable intelligence, experience, and integrity, seemed to believe that the banks were fundamentally sound and only needed an injection of confidence; that each subsidy to the banking sector was justified because the costs of not making the subsidy would be worse; that government takeover of major banks was so anathema to the American way that it would trigger panic; that meaningful constraints on banks' activities would inhibit economic growth; and that meaningful constraints on bankers' compensation would send them fleeing to unregulated hedge funds or overseas, leaving the American economy to suffer as a result. But this is not surprising, because everybody believed all these things -- everybody, that is, in the New York and Washington elite."

  The banks had worked hard and provided massive amounts of campaign funds to establish that attitude. "In 2008 and 2009, it all paid off."
 &

This hidden subsidy was calculated to be worth "up to $34 billion for eighteen large banks in 2009, accounting for roughly half of their profits."

  The authors passionately advocate financial reforms that would constrain reckless borrowing and lending activities, and, most important, eliminate the "too big to fail" banks. "Excess optimism, debt bubbles, and overextended banks will be with us forever; our goal must be a financial system where those banks can fail without being able to hold up the entire economy." They strongly support the Consumer Financial Protection Agency and deplore efforts to constrain its remit. They summarize the problems caused by the mega banks.

  • A "too big to fail" bank" cannot be allowed to go into an ordinary bankruptcy procedure because its creditors and counterparties would be cut off from their money for months, which could be fatal."

  • These mega banks "have a strong incentive to take excess risks, since the government will bail them out in an emergency. - - - There is of course some chance that top executives would lose their jobs in a bailout, but this is more than balanced by the increased upside they gain from taking on more risk."

  • The mega banks "are bad for competition and therefore bad for the economy. Bond investors - - - are willing to lend them money at lower interest rates than their smaller competitors," regardless of the risks of the banks' business models. This hidden subsidy was calculated to be worth "up to $34 billion for eighteen large banks in 2009, accounting for roughly half of their profits." "This subsidy makes it harder for smaller banks to compete, deterring new entrants and only strengthening the long-term process of consolidation and concentration in the financial sector."

  Unfortunately, the increased regulatory constraints and burdens of Dodd-Frank are likely to land most heavily on the smaller banks that will have the most trouble absorbing their costs.

Resolution authority has trouble with large banks that have substantial international operations as each nation has its own bankruptcy laws and will want to keep control of all assets within its jurisdiction.

  The various regulatory approaches being considered all have major weaknesses. Capital requirements as high as 11% are being considered, but that was the level maintained by Lehman Brothers just prior to its collapse. In a panic situation, certain kinds of assets - like credit default swaps - can collapse suddenly and completely. "Contingent capital" bonds that convert into equity in an emergency just advertise a firms weakness when the conversion takes place, causing a flight of capital from the firm. Resolution authority has trouble with large banks that have substantial international operations as each nation has its own bankruptcy laws and will want to keep control of all assets within its jurisdiction.

  "More important, solutions that depend on smarter, better regulatory supervision and corrective action ignore the political constraints on regulation and the political power of the large banks. The idea that we can simply regulate large banks more effectively assumes that regulators will have the incentive to do so, despite everything we know about regulatory capture and political constraints on regulation. It assumes that regulators will be able to identify the excess risks that banks are taking, overcome the banks' arguments that they have appropriate safety mechanisms in place, resist political pressure -- from the administration and Congress -- to leave the banks alone for the sake of the economy, and impose controversial corrective measures that will be too complicated to defend in public. And, of course, it assumes that important regulatory agencies will not fall into the hands of people like Alan Greenspan, who believe that government regulation was rendered largely unnecessary by the free market."

The problem of "too big to fail" banks is precisely their size, not the problems of regulation. Even an effective resolution authority does not protect the taxpayers from major losses.

  The political implications of the takeover of a large bank are daunting. Under the administration's proposal in 2009, when this book was being written, it would require approval by the treasury secretary, consultation with the president, and approval by two-thirds of the Federal Reserve Board. Unlike the small banks that the FDIC takes over when they are deemed in a failing condition, big banks like Lehman Brothers have the economic and political power to contest and delay such an action until the point of collapse.
 &
  However, the problem of "too big to fail" banks is precisely their size, not the problems of regulation. Even an effective resolution authority does not protect the taxpayers from major losses.

  "Although the government might be able to impose small haircuts on creditors and counterparties, they would have to be small, since large losses would trigger the domino effect that has to be avoided at all costs, and taxpayers would be left bearing most of the losses. In short, [the regulatory] approach assumes that ["too big to fail"] institutions must exist, and then attempts to deal with them as well as possible -- and not very well at that."

"If they are too big to fail, they are too big."

 

The competitive advantage of the "too big to fail" credit guarantee undermines market mechanisms. Raising capital requirements or increasing fees or tax burdens is not enough.

   The banks and their supporters argue strenuously against any breakup, but there are heavyweight supporters of breakup or the imposition of hard constraints on the risks they can assume in their business models. The authors quote Paul Volcker who would exclude these mega banks from risky activities such as internal hedge funds, internal private equity funds, and proprietary trading. Such activities are all best left to smaller entities in the capital markets. Mervyn King, head of the Bank of England, advises a separation of proprietary trading from the "utility" aspects of banking such as processing payments and transforming savings into investments. Regulating large banks strictly in the nature of utilities and confining them to the less risky traditional banking functions has widespread support.

    For those FUTURECASTS readers who haven't as yet guessed, FUTURECASTS is inherently skeptical of regulatory schemes intended as administered alternatives to market mechanisms. However, as FUTURECASTS has repeatedly pointed out, the right to fail is absolutely as important for a properly functioning capitalist market as the right to succeed. There is, of course, real need for the risk management services of investment bankers. However, any institution that is deemed too-big-to-fail must be either broken up or regulated heavily in the nature of a public utility. They must have considerably higher capital requirements than smaller financial entities, and must be forbidden high risk business plans. It would even be wise to impose higher fees on these entities to cover the extensive costs of the regulatory apparatus they require.
 &
  Such costs would easily be covered by the massive benefits of the too-big-to-fail credit subsidies. If management nevertheless finds this regulation too expensive and confining, maybe that will be incentive for voluntary downsizing so their firms are no longer too-big-to-fail. Personnel who want to pursue the rewards possible for success in such high risk activities should create or move to smaller financial entities that are not too-big-to-fail, or should once again conduct such activities as partnerships with all their personal wealth at risk.

  Even Alan Greenspan now believes: "If they're too big to fail, they are too big." The competitive advantage of the "too big to fail" credit guarantee undermines market mechanisms. Higher capital requirements or fees or tax burdens is not enough. The authors explain their views:

  "If there are no financial institutions that are too big to fail, there will be no implicit subsidies favoring some banks as opposed to others; creditors and counterparties will play their necessary role of ensuring that banks do not take on too much risk; banks will be less likely to engage in the excessive risk-taking that could cause the next financial crisis; and banks that do fail will not have to be bailed out at taxpayer expense."

  This will not eliminate the need for suitable financial regulations, but the breakup of the major banks "will help level the playing field and make the financial system better able to withstand the next crisis."
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There is just no proof that the size of the mega banks provides any economic, financial or societal  benefits that come close to outweighing their costs.

 

Just as the nation benefited from the breakup of the great industrial trusts a century ago, it would equally benefit from the breakup of the six mega banks that inherently pose massive risks for the economy and dominate the financial markets today.

  The authors deal with several of the arguments that support the existence of large banks.

  • The mega banks are not essential for the needs of large international corporations, since even today these needs are met by groups of cooperating banks. Corporations seek the services of banks with expertise in particular markets and geographic regions. "It would defy business logic" for a large corporation to become dependent on the services of one bank.

  •  Economies of scale exist only up to about $10 billion in assets. Furthermore, there are observable "offsetting diseconomies" as the complexity of these mega banks reach a size and scope that makes them increasingly difficult to effectively manage.

  • Certain types of trading businesses such as customized over-the-counter derivatives used for hedging business risks do require institutions of significant size, but the leading investment banks of the 1990s were perfectly capable of providing these services when they were a minor fraction of their current size.

  There is just no proof that the size of the mega banks provides any economic, financial or societal  benefits that come close to outweighing their costs. As of the second half of 2009, the assets of Bank of America equaled about 16% of GDP, that of JP Morgan Chase 14%, that of Citigroup 13%, that of Wells Fargo 9%, that of Goldman Sachs 6%, and that of Morgan Stanley 5%. Just as the nation benefited from the breakup of the great industrial trusts a century ago, it would equally benefit from the breakup of the six mega banks that inherently pose massive risks for the economy and dominate the financial markets today.
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Even if there are size limits imposed on the banking system, financial regulation would remain a highly complex and uncertain activity.

  The problems of devising and implementing effective regulations are covered by the authors at some length. Even if there are size limits imposed on the banking system, financial regulation would remain a highly complex and uncertain activity. Nor would this eliminate the risks posed by large foreign banks and their subsidiaries in the United States. However,  these subsidiaries, too, would have to be in compliance with U.S. law, and at least the burden of bank failure would fall primarily on the foreign nations that permit the existence of these mega banks.

  The practical limits of the regulatory approach, especially when designed as an administered alternative to market mechanisms, has also been a longstanding feature of FUTURECASTS online magazine. Market disciplinary mechanisms may be far from perfect, but they generally can be far more efficient and effective than administered alternatives. Unfortunately, the most important market disciplinary mechanism, involving the "credit market vigilantes," is disabled by the "too big to fail" moral hazard credit guarantee.

  The authors recognize that finance will never be just another industry. However, there are nevertheless many reasons for advocating the breakup of the mega banks. The authors sum up:

  "The end of 'too big to fail' will reduce large banks' funding advantage, force them to compete on the basis of products, price, and service rather than on fee-driven businesses such as securitization, trading, and derivatives, putting pressure on large banks' profits. A larger group of competitors will also make it harder for major banks to divert such a large proportion of their profits to employee compensation; bonuses for traders and investment bankers should fall from the historically obscene to the merely outrageous. With more competition, it will be harder for a handful of firms to dominate the cultural landscape - - - and maybe smart college graduates will find Wall Street a little less compelling. - - -
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  "This will create a virtuous cycle. As the major banks become a little poorer, their domination of the campaign finance system will wane, as will the allure of the revolving door. As high finance becomes less glamorous and a little more like just another business, its ideological sway over the Washington establishment will begin to fade. Fewer top administration officials will come from a handful of mega banks, and more will come from other parts of the financial industry, or from nonfinancial industries."

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