Three Reasons Why “Too-Big-to-Fail” Banks Need to Be Broken Up

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The Federal Deposit Insurance Corporation (FDIC) and the Federal Reserve Board jointly released a statement last week that showed that five of eight systemically important banks have failed to provide “credible” living wills. “Living wills” or resolution plans are a part of the 2010 Dodd-Frank Wall Street Reform and Consumer Protection Act and require big banks to provide a plan that ensures that bankruptcy procedures will be carried out in an orderly fashion as per the US Bankruptcy Code in the event of a financial failure.

The banks that have to adhere to a resolution plan include bank-holding companies with total consolidated assets of $50 billion or more and non-bank financial companies designated by the Financial Stability Oversight Council. Big banks that have not met the standards of Section 165(d) of the Dodd-Frank Act are Bank of America, Bank of New York Mellon, JPMorgan Chase, State Street and Wells Fargo. The banks have been given a deadline of October 1, 2016, failing which they may face “stringent prudential requirements.”

This news of five banks’ failure to produce a credible living will came a week after JPMorgan chief executive Jamie Dimon mentioned in a 50-page letter that JPMorgan held enough capital to absorb “all the losses, assumed by [the Comprehensive Capital Analysis and Review], of the 31 largest banks in the United States.” The Comprehensive Capital Analysis and Review’s stress tests are conducted to check that big banks have sufficient capital to fall back on in unfavorable economic scenarios.

These failures have put the “too-big-to-fail” banks under deep scrutiny. In a statement on February 16, 2016, the Federal Reserve Bank of Minneapolis president, Neel Kashkari, emphasized the risk that the biggest banks pose to the US economy. He said that despite the introduction of the 2010 Dodd-Frank law, the big banks remain “too big to fail” and hence should be broken up.

The Dodd-Frank law laid down strict regulations for the financial industry so that the 2008 events were not repeated. But even though Kashkari’s comments come as a surprise (since he was a former Goldman Sachs employee and administered the 2008 bailout fund), it discloses an important concern: The biggest banks still remain “too big to fail,” even after eight years of the crisis. They are still likely to be bailed out in a future financial disaster because the systemic risk associated with them has not ended.

In response, the Federal Reserve Bank of Minneapolis launched a major initiative to address the ongoing issue of “too big to fail” (TBTF). The plan comes with a hashtag, #EndingTBTF, and as the name suggests, aims to end the TBTF problem by sharing ideas and proposals through public input.

Big banks have been the focus of many ongoing debates since the 2008 financial crisis. The 2016 Democratic presidential candidates have proposed different measures to address the “too-big-to-fail” issue, but their approaches have been very different. While Bernie Sanders has taken an aggressive stance to quickly dissolve the power of these big banks through reinstating Glass-Steagall and breaking them up, Hillary Clinton has called for milder reforms, such as the imposition of new risk fees, the reinstatement of rules “governing risky credit swaps and derivatives at taxpayer-backed banks” and the strengthening of a rule that prohibits an insured depository institution from engaging in proprietary trading.

Many economists and analysts have argued that small banks can pose the same amount of risk to the economy as large banks and create bank failures like those of the 1930s. Between 1921 and 1929, on average, more than 600 banks failed, and these were primarily small and rural banks. In a 2010 New York Times op-ed, Paul Krugman wrote, “Breaking up big banks wouldn’t really solve our problems, because it’s perfectly possible to have a financial crisis that mainly takes the form of a run on smaller institutions.” Hence, downsizing big banks may not be of much help.

But the counterargument against Krugman’s assertion is that very few small banks (including community banks) have actually indulged in investment or shadow bank-like activities, or been a part of a multibillion-dollar scandal. In comparison to community banks, big banks have had a larger number of scandals, involving billions of dollars. Additionally, it is highly unlikely that the failure of smaller banks would take down an entire economy or prompt closures of additional systemic financial intermediaries.

There are three big reasons that indicate that breaking down some of the largest banks would be a step in the right direction.

Too Big, Too Risky

In 1999, President Bill Clinton passed the Gramm-Leach-Bliley Act, which allowed the integration of basic banking activities with investment banking. At that time, the Glass-Steagall Act (established in 1933 in response to the Great Depression) had already been repealed as a result of lobbying efforts by some of the biggest banks. These lobbying efforts had significantly increased from the 1970s, and the bill to repeal the Glass-Steagall Act was passed in the 1980s.

On March 27, 2008, in his speech at the Cooper Union, then-presidential candidate Barack Obama said, “A regulatory structure set up for banks in the 1930s needed to change. But by the time the Glass-Steagall Act was repealed in 1999, the $300 million lobbying effort that drove deregulation was more about facilitating mergers than creating an efficient regulatory framework…. Unfortunately, instead of establishing a 21st-century regulatory framework, we simply dismantled the old one, thereby encouraging a winner-take-all, anything-goes environment that helped foster devastating dislocations in our economy.”

Critics of the Glass-Steagall Act were of the opinion that the act could not have prevented the financial collapse in 2008, since the “real” offenders of the financial crisis were not the banks, but non-banks like Bear Stearns and Lehman Brothers, which had “bank-like” qualities. Supporters of the Glass-Steagall Act say that if the act had stayed in its place, banks wouldn’t be permitted to indulge in speculative trading in the shadow of traditional banks and such loans would not have been made.

Prof. Robert Reich, who was US secretary of labor under President Clinton, has argued that the non-banks received funding from big banks through such means as mortgages and letters of credit. Reich maintained that if the Glass-Steagall Act had been in effect, then the big banks could not have given funding to non-banks. He further adds that it might have prevented the crash. The quick rise of shadow banks (firms with bank-like activities) gave way to risky activities and could have been regulated only if the Glass-Steagall Act were not repealed.

Too Big, Too Powerful

Lobbyists legally tend to influence a decision-making body for their own special interests through campaign finance. Some of the biggest banks have been associated with large political donations and campaign donations. A study, titled “A Fistful of Dollars: Lobbying and the Financial Crisis,” published in 2011 by the National Bureau of Economic Research, reports that “the political influence of the financial industry played a role in the accumulation of risks, and hence, contributed to the financial crisis.” An example cited by the report shows that Citigroup had spent $3 million on lobbying against the Predatory Lending Consumer Protection Act of 2001 that never became a law. Citigroup received $45 billion worth of bailout funds.

Huge lobbying efforts come easily to big banks due to a large capital base, which can potentially influence the process of the financial regulatory system. The implications of lobbying efforts on financial regulation can be huge, and lobbying has influenced laws like the Glass-Steagall Act and slowed the process of the Dodd-Frank Wall Street Reform and Consumer Protection Act. An apt example of huge lobbying efforts was the repeal of Glass-Steagall that was backed by a $300 million lobbying effort. After the 2008 crisis, strong lobbying efforts were made to slow down the passage of the Dodd-Frank bill. The Nation reported that more than $1 billion was spent on lobbying against the Dodd-Frank bill.

A letter released in November 2015 by Sen. Elizabeth Warren (D-Massachusetts) and Rep. Elijah E. Cummings (D-Maryland) revealed that portions of the Dodd-Frank Wall Street Reform and Consumer Protection Act were repealed in 2014. This repeal allows FDIC-insured banks to hold $10 trillion in “risky swap trades.”

According to the Center for Responsive Politics, the securities and investment industry spent nearly $74 million on lobbying in the first three-quarters of 2014. In 2013, The Nation reported that as many as 3,000 lobbyists were sent in “hopes of killing off pieces of the proposed bill” (now known as the Dodd-Frank Act). In the 2013-14 election cycle, Wall Street banks and financial interests had reportedly spent more than $1.2 billion to influence decision-making in Washington, according to Americans for Financial Reform.

Too Big to Jail

A report released by Elizabeth Warren in 2015 shows how “federal regulators regularly let big corporations and their highly paid executives off the hook when they break the law.” Some of the many banking scandals, including many G-SIBs (global systemically important banks) have dated back to the subprime mortgage crisis. According to Reuters, a state and a federal working group has reached settlements with four major financial institutions since 2012: JPMorgan Chase ($13 billion), Bank of America ($16.6 billion), Citibank ($7 billion) and Morgan Stanley ($3.2 billion). Because big banks have complicated banking structures and are interconnected with risky activities, their exposure to multibillion-dollar scandals is not a surprise. According to a report by Labaton Sucharow LLP, one-third of bank employees with less than 20 years in the industry are willing to engage in “insider trading to make $10 million, if there was no chance of being arrested.”

The sizes of some of the largest banks are so huge that they surpass the GDPs of certain countries, and convictions for such crimes are numbered. Since the banks are huge, it is difficult and complicated to retrace the origin of banking crimes. With billions being lost in scandals, the ones found guilty pay huge fines to settle the charges against them, with very few convicted. Typically, following such settlements, the bank executives at high positions step down. On April 11, 2016, the US Department of Justice, along with federal and state partners, announced a $5.06 billion settlement with Goldman Sachs related to its role in the “packaging, securitization, marketing, sale and issuance of residential mortgage-backed securities (RMBS) between 2005 and 2007.”

Breaking Up Big Banks

Breaking up big banks will not only curb the high levels of unregulated risky trading but also reduce moral hazard. Moral hazard is one of the most common problems that exist when banks are so large and interconnected that they can cause a chain of financial collapses in the system. It allows big banks to indulge in risky trading simply because they are assured that in the case of any crisis, they will be bailed out.

Repealing the Gramm-Leach-Bliley Act or passing the 21st Century Glass-Steagall Act will ensure that banks will keep their basic functions separate from speculative risky trading. The Glass-Steagall Act will considerably restrict the influence of big banks by disconnecting their basic traditional activities from risky investment banking like derivative trading. A separation of both the activities will not only reduce risk, but also allow easy supervision by regulatory authorities.

Breaking up the banks will help in reducing their power over politics by contracting their asset base. It will considerably lessen the influence big banks have on the regulatory process. Sen. Bernie Sanders highlighted this issue in a speech in 2014, and said, “If Wall Street lobbyists can literally write a provision into law that will allow too-big-to-fail banks to make the same risky bets that nearly destroyed our economy just a few years ago, it should be obvious to all that their incredible economic and political power is a huge danger to our economy and our way of life.”

Ending the period in which some banks are deemed “too big to fail” and breaking up big banks could simplify the business models of banks and allow room for regular assessments and close monitoring for inaccuracies. Breaking them up would give way to stricter supervisory policies and help in detecting fraud at an earlier stage.

Bottom Line

According to data compiled by Bloomberg in 2013, strict accounting rules for derivatives and the off-balance sheet assets could make many US banks “twice as big as they say they are — or about the size of the U.S. economy.” The data shows that the US accounting rules for netting derivatives allowed banks to erase about $4 trillion in assets. This simply could mean that the off-balance sheet items may reflect the true debt position, and banks can potentially hide big risks behind a cloudy and a financially strong-looking balance sheet. In his interview with Bloomberg, Thomas Hoenig, vice chairman of the FDIC said, “Derivatives, like loans, carry risk … To recognize those bets on the balance sheet would give a better picture of the risk exposures that are there.”

The regulators need to bear in mind that when a firm becomes “too big to fail,” it either becomes too systemically important, too politically important or too big to be jailed.