Article - Spring 2013

Good Fences Make Good Bankers

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Too Big to Fail Becomes Too Big to Jail: an Update

By William J. Quirk


 

“Public confidence in bankers and banking has been shaken to its roots.”
—Parliamentary Commission Investigation of LIBOR, December 21, 2012

 

In December, U.S. and New York State prosecutors announced that HSBC, a multinational bank based in London, had admitted that over the past decade it had helped Mexican drug cartels launder money through U.S. financial institutions and facilitated transactions for Saudi Arabian banks with ties to terrorist groups. HSBC agreed to pay $1.92 billion in penalties—a slap on the wrist for a bank of its size. The U.S. Justice Department did not indict the bank, according to The New York Times, because it was so large and interconnected that criminal charges could destabilize the global financial system—in other words, the bank was “too big to indict.” HSBC rolled over the rule of law. All it has to do besides pay up is not break any laws for five years.

Good luck with that. Everywhere you look, the big banks continue to wallow in scandal. Bank of America, JPMorgan Chase, Wells Fargo, Citigroup, and others are being sued by prosecutors, regulators, and investors for an estimated $300 billion for fraud involving mortgage-backed securities. These are the bizarre “innovations” at the heart of the housing crisis that nearly brought down the economy in 2008, creating an international recession from which the world still suffers. On top of that, in early January of this year, 10 banks settled for $8.5 billion with federal regulators for mortgage foreclosure abuses. JPMorgan Chase, Bank of America, Wells Fargo, Citigroup, and Ally Financial agreed to pay regulators and state attorneys general $26 billion last year for the same foreclosure abuses. In November, a London jury found a bank trader guilty of the biggest banking fraud in British history; he had lost $2.3 billion in rogue trades. In December, an Italian court ruled that JPMorgan Chase was guilty of fraud in the sale of derivatives to the city of Milan.

Banks have not always caused so much trouble. The last time they did so—in the 1920s and early ’30s—Congress passed the 1933 Glass-Steagall Act to prevent them from doing it again. Before writing that law, Congress convened the Pecora Investigation to inquire into the causes of the collapse. Glass-Steagall separated securities trading from traditional commercial banking—taking deposits and making loans. Heavily regulated and their deposits insured, commercial banks performed the important job of allocating capital to productive purposes. Investment banks, by contrast, could buy and sell securities. They might make a lot of money or lose a lot, but they were on their own; they kept their gains and ate their losses.

What Glass-Steagall said, as former Federal Reserve Board chairman Paul Volcker has put it, was very simple: “A bank can’t trade.” Glass-Steagall rested on the idea that greed, although too strong to be regulated, should be isolated—sealed off from the banking system. Because lending money and protecting savings are essential to the working of a capitalist system, Glass-Steagall required that deposit-taking banks stay out of any other business, essentially functioning as utilities. And the Glass-Steagall barriers worked. As long as the act was in effect, the country had no systemic commercial bank problems.

Following the 2007–2008 collapse—the greatest financial crisis since the Great Depression—Congress inexplicably reversed its usual procedure of studying a problem before acting. First, lawmakers passed the supposed legal solution and then they received a report from the Financial Crisis Inquiry Commission explaining its causes. Great Britain, in contrast, examined the causes of the problem and then drafted a statutory solution. In June 2010, the Chancellor of the Exchequer created the Independent Commission on Banking, chaired by Sir John Vickers. It issued an interim report in April 2011 and a final report, including recommendations, in September 2011. The Vickers Commission embraced a straightforward guiding principle: “The risks inevitably associated with banking have to sit somewhere, and it should not be with taxpayers.”

In July 2012, after the astounding rate-rigging scandal involving the London interbank offered rate (LIBOR), Parliament created another commission made up of four members of the House of Lords and five of the House of Commons. LIBOR, the standard for setting rates on hundreds of trillions of dollars of personal and commercial mortgages, credit cards, and other loans, averages 16 big banks’ estimates of what it would cost them to borrow from another bank. In an ongoing worldwide probe, London-based Barclays, the Royal Bank of Scotland, and UBS, a Swiss bank, have admitted to manipulating the rate to fix outstanding bets they had made on derivatives. During the conspiracy, one broker emailed a derivatives trader he was helping to enrich at UBS: “Think of me when yur on yur yacht in monaco won’t yu.” A Royal Bank of Scotland trader emailed, “Its just amazing how libor fixing can make you that much money.” The Parliamentary Commission on Banking Standards reported in December that its investigation had “exposed a culture of culpable greed far removed from the interests of bank customers, corroding trust in the whole financial sector.”

Both the Vickers and the Parliamentary commissions recommended what they called ring-fencing, a measure like the Glass-Steagall Act, which would separate critical banking functions from trading and other risky activities. The Parliamentary Commission concluded that ring-fencing could improve financial stability and help “to address the damage done to standards and culture in banking.” Paul Volcker told the Parliamentary Commission in October that the Vickers Commission similarly sought to separate the two types of banking functions, and “it is just a question of how you do it.”

One member of the Parliamentary Commission, Justin Welby, the Bishop of Durham, asked Volcker whether the crisis was due to “technical misjudgments by well-meaning people” or “a cultural failure within the banking world.” Volcker responded, “It’s a cultural problem.” Commercial banking, he continued, “is a simple proposition. You have customers, or hope to over a period of time … and [you] are profitable. The quid pro quo is that you are not going to screw the customer, to put it simply.” Elsewhere in his testimony, Volcker said that trading, “proprietary trading activity in particular, does not carry any sense of fiduciary responsibility. You are trying to out-trade the other guy … somebody wins and somebody loses” on every transaction. The nature of the bank’s duty to its customer is at the center of Volcker’s view that trading activities should be separated from commercial banking. Because bank traders are compensated by “unimaginably large” bonuses, Volcker testified, the culture of the whole institution is infected by greed: “It was not prop trading that was the problem. It was the culture of prop trading that infected the banks.”  For example, in 2007 Lloyd C. Blankfein, chairman and CEO of Goldman Sachs, earned $69 million, thought to be a record for a banking executive. (In 2012 his pay was down to $21 million.)


Ring-Fencing versus Glass-Steagall

When, in 2010, President Obama signed the Dodd-Frank Wall Street Reform and Consumer Protection Act, which calls for massive new regulations, he promised that “the American people will never again be asked to foot the bill for Wall Street’s mistakes. There will be no more taxpayer-funded bailouts. Period.” Most observers, however, believe Dodd-Frank has legitimized and expanded the Too Big to Fail problem. If Congress had been serious, it would have cut down the size of the banks until they were no longer so big that the government would have to protect them to save the international financial system. Separation of banking from other activities, as the Parliamentary Commission reports, makes shutting down bad banks easier, without leaving the taxpayer holding the bag. The Dodd-Frank Act does not alter banking structures but purports to ensure their stability with thousands of pages of regulations. Relying on regulations was an approach rejected by the British commissions. The Bank of England’s Governor Mervyn King testified that, in practice, the regulatory process “turned out to be a negotiation between” regulators and bankers. “There is only one winner in that,” he said, “and that will be a very bad outcome.” Or, as the Bank of England’s Andrew Haldane testified: “fifty regulators sitting on site strikes me as a failure, not success. That is what happened with the U.S. banking regulators pre-crisis. They did not catch the mice.”

A British regulator has noted a further advantage to the proposed ring-fencing of functions in the event that a bank goes belly up and the government must take part in the “resolution” or distribution of its assets:

One of the biggest problems we have today with contemplating resolution of major banks is that we have a whole range of activities on the balance sheet of the same legal entity. … Today, we would have to pursue a resolution approach that was driven by the highest priority within that set of activities, but it would effectively be a common resolution approach, because we would have no effective means of splitting things up.

“A ring-fence attempts to secure some of the benefits of structural separation,” according to the Parliamentary Commission report, “while maintaining some of the alleged benefits of synergy and diversification.” Ring-fencing is Glass-Steagall lite. Proposals vary widely in Britain and also in Europe about what to do, but all accept the idea that some separation is necessary. Dodd-Frank’s only nod to separation is the Volcker Rule, which was intended to prohibit proprietary trading—that is, trading for the bank’s own account. As written, however, the Volcker Rule is likely to be ineffective, since it is hard to distinguish proprietary trading from market making, in which a bank buys and sells a security to create a market in that security. Market making is allowed. The law is so complicated that it is not clear whether the JPMorgan Chase derivative loss of $6 billion in May 2012 (blamed on the so-called London Whale, the trader responsible for the bad bets) would have violated the Volcker Rule, had it been in effect. Dodd-Frank turned the apparently simple distinction between proprietary trading and market making into a complex 35-page statute with an accompanying 35 pages of metrics. The Volcker Rule passed in 2010, but because of the peculiar effective-date provisions of Dodd-Frank, it has not yet become the law.

The big banks, since the crises, have dramatically increased in scale and concentration. The Too Big To Fail banks, because of the expectation of taxpayer support, enjoy lower funding costs. The Bank of England’s Andrew Haldane estimates the implied taxpayer subsidy to the world’s largest banks at over $700 billion in 2009.


The Parliamentary Commission viewed the sale of derivatives within a deposit-taking bank as something that would likely endanger the ring-fence. What it called simple derivatives (such as an airline’s purchase of an option on oil at a future date) could be permitted with adequate safeguards. But “a large derivatives portfolio would still pose an unacceptable risk to the stability and resolvability of ring-fenced banks.” Complex derivatives are a problem because no activity can be successfully regulated unless it is fully understood and the effect of the regulation is completely clear. At least one member of the Parliamentary Commission, John Thruso, in reference to the $60 trillion credit default swap market (through which financial institutions supposedly insure their investments by spreading the risk), questioned whether there was any “actual or practical common-sense commercial purpose” for these complex derivatives. Thruso continued,

Does that activity multiply risk in the system rather than spreading it? … There is this bubble at the end where a bunch of guys are selling things that nobody wants or needs, that are not useful and do not contribute to commerce. It is a bit like the horse racing industry here running horses and the bookie industry over there just betting on it and making money. To date we are talking about how we contain and control that, but no one seems to be asking the fundamental question of whether it should happen at all in the first place.

Volcker believes that derivatives have “led at the very least to these greatly feared interconnections” of financial institutions. “It is certainly a big amount of trading that involves many institutions. … When the derivative goes bad, God knows how many other people are involved.”

Would it help to bring back Glass-Steagall? The advantage of full separation over ring-fencing, as Volcker testified to the Parliamentary Commission, is that ring-fences tend to become “permeable over time. If you really want to separate some operations very clearly and decisively, you put them in different organizations. In my experience, you do not put two functions in the same organization and say that they cannot talk to each other or interact.”

The Parliamentary Commission admits that, at best, the ring-fence approach is untested. It agreed to try ring-fencing because Vickers had already set the approach in motion, but Parliament added some safeguards, particularly the regulatory power to split up the banks if poor behavior persisted—if banks were found “burrowing under the ring-fence and rendering themselves unresolvable,” as a Bank of England executive testified. One member of the House of Commons Financial Policy Committee, Michael Cohrs, noted,

I think that Vickers is a step in the right direction. To me, however, it is only a step in the journey because I think a modern Glass-Steagall will ultimately see total separation. … I think that we are on a journey, and Vickers is a good path for us to follow.

Even John Vickers himself added, “If the industry turned out to be unreformable … it is possible that total separation would turn out in due course to be the better step to take.” The Parliamentary Commission agreed, concluding that “there is a strong case for the proposition that full structural separation would be the wisest course to take.”


Too Big to Indict Is Too Big to Exist

The Parliamentary Commission points out that the difficulties in separating the banking and trading functions come from both the nature of financial crises and “the nexus between banks, politicians and regulators.” Glass-Steagall is an elegant solution to these challenges. It avoids negotiations between the banking industry and the government, which invariably turn out badly for the taxpayer. It eliminates any need for a bailout of the financial system. And it denies banks the nuclear option, preventing politicians who are vulnerable to too-big-to-fail blackmail from having to act.

When the House first rejected the $700 billion Troubled Asset Relief Program (TARP) in September 2008, the financial markets tanked and the doomsayers had their day. Politicians, afraid that they would be blamed if they refused a bailout and bad times followed, made an about-face and passed TARP because they would rather spend taxpayers’ money than risk their political careers. The TARP bailout allowed everyone to say we had prevented another Great Depression, an assertion that is impossible to prove. Even Andrea Orcel, the chief executive of UBS, which was fined $1.5 billion in December for LIBOR rate-rigging abuses, testified to the Parliamentary Commission in January that “We all got probably too arrogant, too self-convinced that things were correct the way they were—I think the industry has to change.”

American bankers tell us they must be big to compete with state-supported European banks. Andrew Haldane’s October 2012 speech entitled “On Being the Right Size” reports that economies of scale do not exist over $100 billion. American banks were big under Glass-Steagall, and they would be big if Glass-Steagall were restored. And they would not be so fragile. Their balance sheets would not be so complicated. They would no longer be threatened with losses from proprietary trading, market making, and derivatives dealings. Indeed, the trillions of dollars bet on derivatives could well shrivel up were we to remove the implied guarantee that the government will bail out the banks. We did not need bailouts when Glass-Steagall was the rule, but the need for government funds and assistance rose as the banks chipped away at Glass-Steagall: recall Less Developed Country loans (1982–92), Continental Illinois (1984), Citibank (1990–92), the Mexican peso (1994–95), Asian currency (1997), and Long-Term Capital Management (1998).

The U.S. government moved heaven and earth to prop up our profligate bankers, and it continues to do so. Now the banks are Too Big to Indict. The Department of Justice won’t proceed against a criminal conspiracy supporting drug dealers and terrorists for fear of harming the economy. Former Assistant Attorney General Lanny Breuer recently told PBS’s Frontline that his decisions about whether to indict Wall Street executives responsible for the 2008 meltdown took into consideration the effects on the economy of a criminal prosecution against a major bank. “I think I am pursuing justice,” said Breuer, but “in any given case” if there’s going to be a huge economic effect, “it’s a factor we need to know and understand.”

Glass-Steagall was strong because it was simple. It could be easily enforced. It changed incentives by fostering a culture of stability and reasonable returns. Parliamentary Commission Chairman Andrew Tyrie recommends that if banks’ bad behavior continues, British regulators have the power to split them up: “Banks need to be discouraged from gaming the rules. All history tells us they will do this unless incentivized not to.” The ghost of Glass-Steagall is knocking at the door.

William J. Quirk is a professor at the University of South Carolina School of Law and a former contributing editor of The New Republic.


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