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Top Fed Official Wants To Break Up Megabanks, Stop The Fed From Guaranteeing Wall Street's Profits [EXCLUSIVE]

Thomas Hoenig

First Posted: 06/02/10 06:12 AM ET Updated: 05/25/11 05:00 PM ET

Click on the next page and scroll down for audio of the interview

The U.S. should bust up its megabanks and impose strict laws curbing the size and complexity of financial institutions, a top Federal Reserve official told the Huffington Post.

In a 45-minute interview this week, Federal Reserve Bank of Kansas City President Thomas M. Hoenig, who's emerged as one of the few influential voices calling for a fundamental redesign of a broken U.S. financial system:

  • Lambasted the tilted playing field that benefits Wall Street banks over Main Street banks;
  • Called the idea that the U.S. needs megabanks to compete globally a "fantasy";
  • Said Congress should mandate simple, easily understood and enforceable rules -- rather than guidelines -- so regulators can restrain financial firms and rein in the financial system;
  • Prodded the Senate to get tougher on permanently ending Too Big To Fail by enacting laws that would take away much of the discretion currently held by policymakers (who bailed out financial firms when confronted with these decisions in late 2008);
  • And criticized the Federal Reserve's ongoing policy to keep the main interest rate near zero because it "guarantee[s] a spread to Wall Street", enabling unearned profits and "encourag[ing] speculation."

Hoenig's criticisms echo those made by reformers pushing to remake a financial system that melted down in 2008 after years of excessive risk-taking and loose regulation finally took its toll, causing the worst economic collapse since the Great Depression and costing the nation more than 8 million jobs.

But Hoenig isn't just any reformer -- he's the longest-serving Fed policy maker; a voting member of the Fed's main policy-making body, the Federal Open Market Committee; and his credentials as a deficit- and inflation hawk are unparalleled.

In February, Simon Johnson, former chief economist of the International Monetary Fund, professor at the MIT Sloan School of Management and contributing editor to the Huffington Post, wrote a post on his blog titled "Tom Hoenig for Treasury," putting him forward as one of just a few viable candidates to succeed current Treasury Secretary Timothy Geithner should he step down.

And unlike top officials in the Obama administration, Congress and his colleagues at the Federal Reserve, Hoenig is calling for perhaps the most significant changes in the U.S. financial system: breaking up the big banks and imploring Congress to establish tough rules so that bank regulators will never again be put in a position to bail out troubled firms.


Breaking Up Megabanks


For example, one of the effects of Too Big To Fail, Hoenig said, "has been that the concentration of financial resources in this country has nearly doubled over the last 15 to 20 years. That's what we have to end."

The banks owned by the four largest financial firms in the U.S. -- Bank of America, JPMorgan Chase, Citigroup and Wells Fargo -- collectively account for about 45 percent of all assets in the U.S. banking system, according to a HuffPost analysis of Federal Deposit Insurance Corporation data.

The top 12 banks in the U.S. control half the country's deposits. By comparison, it took 25 banks to accomplish this feat in 2003 and 42 banks in 1998, according to a Jan. 4 research note by Jason M. Goldberg of Barclays Capital.

Those four megabanks collectively hold about $7.4 trillion in assets, according to the most recent regulatory filings with the Federal Reserve. That's equal to about 52 percent of the nation's estimated total output last year.

"The fact that they needed to be supported by TARP tells me that they're too big," Hoenig said. "I think that that's a very clear signal that they're too big. The fact that they had to be bailed out under those circumstances suggests they are too big, and that needs to end."

In response, he says policymakers should simply break up the megabanks and split them off into their component parts.

"I think they should be broken up," Hoenig said. "I think there's no reason why as we've done in other instances of [sic] finding the right mechanism to break them into their components.

"Underwriting [securities], hedge fund activities, trading for their own accounts -- that should be in a separate institution," Hoenig said, referencing the proposals that have become popularly known as the Volcker Rules, named after their original proponent, former Fed chairman Paul Volcker. "And in doing so, I think you'll make the financial system itself more stable. I think you will make it more competitive, and I think you will have long-run benefits over our current system, [which] mixes it and therefore leads to bailouts when crises occur."

By first breaking up the firms, the market will then decide what's an appropriate maximum size, Hoenig said.

"...We've provided this support and allowed Too Big To Fail and that subsidy, so that they've become larger than I think they otherwise would," Hoenig said. "I think by breaking them up, the market itself would begin to help tell you what the right size was over time."

In a March 24 speech in Washington, Hoenig said that the TBTF subsidy "provides a direct cost advantage to these firms."

"Without the fear of loss to creditors, these large firms can use higher leverage, which allows them to fund more assets with lower cost debt instead of more expensive equity," he said.

That allows them to get even bigger, leaving their smaller competitors behind who need to worry about raising equity before they can fund more loans.

"If the top 20 firms held the same equity capital levels as other smaller banking institutions, they would require $210 billion in new equity or reduced assets of over $3 trillion, or some combination of both," he said.


Bringing Back Glass-Steagall


The U.S. should revive parts of Glass-Steagall, the Depression-era law that long prohibited banks from underwriting securities and engaging in other Wall Street-like activities, to break up megabanks, Hoenig told HuffPost. The law was repealed during the Clinton administration. The Obama administration has shown no desire to bring it back.

"At the moment I would be inclined to break them up along those lines of activities, and then let the market define what the right size is, and it will be, I suspect, smaller, much smaller, given our recent experience," he said.

"When Glass-Steagall was set aside and Gramm-Leach-Bliley [the law that repealed it] was introduced, I gave a speech which raised the concern that we would encounter mega-institutions," Hoenig said. "People would say... 'They're not too big to fail', but when the crisis came they would be too big to fail, and that's what we've gotten.

'So I am partially in favor of re-establishing elements of Glass-Steagall that separates the very important commercial banking that is so critical to our economy and our payment system from what I call high-risk activities in investment banks and hedge funds.

"I have nothing, nothing at all against high-risk activities in hedge funds and so forth, but they should not be part of our commercial banking payment system."


On Whether The U.S. Needs Megabanks


Asked if he believes in a popular notion shared by top policymakers, legislators, and those on Wall Street -- that the U.S. needs megabanks to compete globally, Hoenig said:

"That is a fantasy -- I don't know how else to describe it. Our strengths will be from having a strong industrial economy. We will have financial institutions that are large enough to give us influence in the markets but not so large that they're too big to fail.

"The outcome of that is that strong banks [and] strong economies bring capital to themselves, and they are by themselves competitive.

"The United States became a financial center not because we had large institutions but because we had a strong industrial economy with a good working financial system across the United States -- not just highly-concentrated in one market area," he said in an apparent reference to Wall Street.

JPMorgan Chase Chairman and Chief Executive Officer Jamie Dimon defended megabanks in his annual letter to shareholders this week, arguing for the economic benefits of outsized financial institutions.

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