A Systemic Risk Regulator and a Compensation Tsar? Larry Summers and Ben Bernanke Must Be Kidding

With the announcement of record Wall Street bonus pools and rising credit card fees, it is time to sit back and see where we go from here.

In the wake of the near collapse of the US financial sector one year ago, Hank Paulson and Ben Bernanke took extraordinary measures to avert collapse. Turning caution to the wind, they arranged shotgun mergers, decided who would live and who would die, and brought the word trillions into our every day vocabulary. By the time they were done, the landscape of American banking was transformed. Today, the six banking organizations that received $160 billion -- JP Morgan, Bank of America, Citigroup and Wells Fargo, and the former investment banks Goldman Sachs and Morgan Stanley -- are now looking to a future in which they can dominate the financial services landscape.

But perhaps the term financial services is misleading in this context. After all, as bank earnings reports were rolled out for the most recent quarter and news headlines announced the record bonus pools that the banks were preparing to pay, it became clear that these earnings derived from trading activities, rather than traditional commercial bank lending activities. Before our eyes -- and with the full support of the Federal Reserve and the US Treasury -- the transformation that we have witnessed is not of the conversion of major investment banks such as Goldman Sachs and Morgan Stanley into commercial banks, but rather of each of these firms into government guaranteed hedge funds.

I readily concede that I am using the term hedge fund loosely. After all, hedge fund is a generic term for a relatively unregulated investment vehicle that is permitted to invest in a wide range of unregulated derivatives and other investments, and whose returns are dedicated to a limited universe of investors. And certainly, the practices of JP Morgan or Goldman Sachs, who undertake massive proprietary trading activities, run huge derivatives books, and dedicate the preponderance of their earnings to senior employees, should not be lumped into the same category.

But on the other hand, if it walks like a duck...

Today, the commercial banking world is sharply divided. With over eight thousand commercial banks and savings institutions, these six firms hold less than 50% market share. Therefore, by traditional measures of market concentration, they are far from monopolistic. But as individual firms, their size dwarfs their cohorts, even considering that two of them, Goldman and Morgan Stanley, are not traditional depository institutions. Together, the six boast total deposits of $2.7 trillion, or an average of $444.8 billion per firm. This compares with an average of $107.2 billion for the next six largest banks, and $76.0 billion for the following six. The fiftieth largest -- well within the top 1% among all banks -- Associated Bank of Wisconsin, has deposits of $16.4 billion.

At the same time, as JP Morgan and its brethren have increasingly concentrated on derivatives trading, loan securitization, securities underwriting and proprietary trading and as these activities have contributed disproportionately to profitability, the share of bank assets dedicated to traditional commercial bank lending--the type that is most directly linked to the local economy in towns across the nation -- has similarly decreased. Therefore, it is not a stretch to suggest that even as the Federal Reserve and Treasury have concentrated for the past year on addressing the risks to the financial system that largely emanated from the largest firms, these firms have at the same time migrated the farthest from the tradition public mission of the commercial banking industry.

It may be hard in the face of the drumbeat of stories about the banks and their problems and their bonuses to remember that commercial banking is an industry with a specific public mission: To take deposits and make loans. It was in the wake of the Great Depression that the Glass-Steagall Act was passed to restore confidence in the commercial banking industry. Glass-Steagall forced the separation of commercial banking (lending) and investment banking (trading, underwriting), and created the FDIC to insure the deposits of commercial banks.

Beginning around 1980, the banking industry began a steady assault on Glass-Steagall, as investment banking firms sought access to the large pools of commercial bank deposits and commercial banks sought to expand into trading activities that would allow each type of firm larger profit and bonus opportunities. These efforts finally culminated in the Financial Services Modernization Act of 1999, which finally ended the Glass-Steagall restrictions and allowed the complete merger of investment and commercial banking organizations. However, the 1999 Act left FDIC insurance in place, resulting in the hybrid creature that emerged, able to attract government-insured deposits and utilize those deposits across a range of lending, securities trading, and newly emerging derivatives trading activities.

Today, the financial policy brain trust of Ben Bernanke, Larry Summers and Tim Geithner have rejected calls for structural reforms to the banking system and to reinstate the Glass-Steagall restrictions. Despite the experience of the past several years, culminating in the financial crisis one year ago, they are suggesting that the concentration of power represented by these six firms is acceptable and desirable, and reform efforts should focus instead on the creation of a single systemic risk regulator to oversee those institutions deemed too big to fail.

Standing alone against Bernanke, Summers and Geithner within the Obama administration is former Fed chairman Paul Volcker. Volcker continues to call for the reinstatement of the Glass-Steagall restrictions, and recognizes the imperative of maintaining the link between deposit insurance and commercial bank lending.

It is hard to imagine what Bernanke, Summers and Geithner are thinking, and how they can look at the devastating experience of the past two years, and not conclude that something is fundamentally wrong. Financial modernization did little to help those thousands of commercial banks who have stuck to their knitting and who now have been sorely disadvantaged by the federal bailouts of their large competitors. Proponents of financial deregulation argue that Volcker and other advocates for turning back the clock are recalcitrant Luddites, yet they have been hard pressed to demonstrate how the creation of the new class of hybrid commercial-investment banks and unregulated derivatives trading have added value to the economy.

Can Bernanke, Summers and Geithner seriously believe that a systemic risk regulator can control the risks that are embodied in these massive firms? Recent history suggests that the risks entailed in the trading strategies, quantitative models, complex derivatives and contract risks were never fully understood by the risk managers, bank CEOs and directors of their own organizations. Bank regulators were captive of the banks themselves as they sought to understand the information that was provided to them. Capital requirements and other traditional tools for containing risk proved to be of only marginal value in the face of derivatives with nearly unlimited leverage, and collateralization requirements buried deep in unregistered and unregulated contracts.

Furthermore, political influence over regulators is a fact of life in Washington, and over time will undermine whatever independent structure these three wise men might have in mind. One need only point to Summers' own success in 1998 in silencing Brooklsey Born -- the head of the independent Commodity Futures Trading Commission -- when she argued the inconvenient truth of the growing systemic risks presented by the unregulated derivatives market, at a time when Summers and the Clinton administration were arguing the merits of financial deregulation.

It is mind boggling that we can continue down this road. Paul Volcker must be applauded and supported for his unflagging efforts to bring attention to this issue. He is a wise man standing against smart men. And he is right.

 

Comments

[LHB58]

As if there aren't enough problems when it comes to proposing a sound regulatory structure to reduce the systemic risk of hybrid investment­/commercia­l banks--or better still--do away with them entirely, the discussion invariably turns to arguments about what money "really" is, what it is not, and what should therefore be forbidden by law to act as a medium of exchange.

Money is a matter of social consensus, not the result of any "intrinsic" value that a certain class of metals posesses. The fact that most people are perfectly willing to accept fiat money or credit money in exchange for goods and services has absolutely nothing to do with the current breakdown of our financial system, and its ongoing failure to perform it's primary function of channeling savings from surplus to deficit spenders through responsible lending.

Reforming the monetary system away from paper or credit money has always been a fringe argument made by people who have just enough understanding of the way the payments system works to be dangerous, and distracts attention away from regulatory reform that would encourage financial institutions to reduce their risk exposure from speculative trading activities and engage in more lending to creditworthy producers of goods and services in the non financial sectors of the economy.

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[DiogenesOfAlaska]

The point of the systemic risk regulator is not to replace or outdo the risk managers at the individual banks. It is to do what they have a hard time doing: to aggregate the data of institutio­n-specific risk into a measure that at least aims at capturing systemic risk.

Of course you can argue that the Fed won't be able to do that, because it's too difficult.

If everybody could agree on that outcome, it would be awesome. Because the very instant this is agreed upon, the whole edifice of the lobbyists in favor of the current grand dominant players will be in shatters: if it's impossible to calculate systemic risk, the only non-childish implication is that transparency, risk management competence and a rule of law that curbs bargaining power are each lacking.

At which point the obvious would have finally been proved. Which would be progress... cos you gotta be modest and patient with kids and their caprice.

[hopefull252]

I did not agree to the deregulation Paul Volcker did in the 1980's, but Paul Volcker realizes that today's arrogance and greed could derail the entire system. The Fed could be closed by the people if pushed to far and investigations could reveal the truths of the system. Either of which would hurt the top 1%.

[sonofsamphm1c]

You are exaggerating the distance between Volcker and the other members of the Obama economic team. If you push Volcker hard enough, he will side with them, not you.

[iridium53]

Longfellow wrote, "We judge ourselves by what we feel capable of doing, others judge us by what we have already done."

Obama and his surrogates - Summers, Geithner and Bernanke - have a unique point of view on the economy from the central banks. They heed not and care not at all about he effects of their policies on the average taxpaying citizen or the unemployed. All the celebration and self-congradulatory backslapping aside - small businesses and consumers still cannot get a loan. And, unemployment is still on the rise. But, their banking buddies are all taken care of.

Executive optimism bias is the cause of most failures of success.

Given the track record of Bernanke and Geithner at understanding the risk and avoiding it - they didn't - how can they be trusted?

Interestingly, over the weekend I saw the Philadelphia Mayor speaking about the success of the stimulus plan. He's carrying water for the Administration as hard as he can. But, when it came to actual numbers - the City of Philadelphia was allocated $154M of the stimulus funds, and eight months after passage has received $14M - less than 10%. The Obama Administration just isn't executing with urgency.

[artgurrl]

I am officially re-registering to vote. This time it will be as an Independent voting for the most Progressive candidate on the ballot, more than likely from a 3rd political party. It is quite obvious that neither party really cares about the middle class electorate. Both parties are still working for Wall Street, Goldman Sachs, Citibank, B of A and Wells Fargo, the health insurance industry, big pharma and the military industrial complex. I'll continue to protest, take to the streets, call my congress person and senator, but neither party deserves my vote at this point in time. And, my Congress person and Senators will continue to not pay attention.

[Sean 6399]

We have to relearn what the founders of the U.S. knew:

Politicians do not deserve our trust, nor do they deserve power to control all the people's wealth through fiat paper currency. It is this system of monetary control that allows elites in D.C. to bail out their favored friends by stealing purchasing power from the holders of U.S. currency worldwide.

The founders demanded that the US government only emit money made of gold and silver of honest measure. But this constraint of reality was found to be too burdensome to the movers and shakers and so now the whole world economy is now based upon a mass shared delusion that paper is wealth. It's much easier to print pretty paper and decree that it is wealth than it is to actually create value. It's rank authoritarianism that cloaks itself in platitudes about maintaining stability, or a "flexible" currency. Really what it is is a scheme for people with power and guns to seize even more power. They literally feel that individuals have no right to control their own wealth or have any right to keep their property. All those little people must be forced, through a manipulated currency scheme, to serve the wishes of their betters who really understand how all that labor and wealth should be allocated.

Fiat currency is the antithesis of liberty, and has no place in a republic that espouses a belief in individual freedom.

[guard]

Totally agree. No amount of tinkering with banks or the financial system will accomplish anything unless the fake money system is eliminated. The central fact is that the fake money system is simply a method of theft.

[sonofsamphm1c]

Gold and silver are not money. They never have been and they never will be. We could collect all of the gold and silver that exist on the face of the earth and send it into outer space, and money would not notice the absence.

[jimbrick]

Nothing will be fixed. Every 80 years the human race, like lemmings, gets the insatiable urge to cast themselves off a financial cliff. An episode of mass suicide.

Here we are, running along, squeaking and shoving each other towards that cliff.

Next year it will implode, and it will make the first collapse look like a walk in the park. Geithner, Summers, and Bernake will be cast as villains.

Depression. World War. Anti-Semitism. All enabled and amplified by the internet and Globalization.

Whee.

[Paul Abrams - Huffpost Blogger]

Excellent piece. I wrote about this, far less less eloquently, in "Make Banking Boring, Again", followed by an op-ed by Paul Krugman with the same title in the NYT a week later.

But, we need to act, not just talk.

We have set up a website, www.breakupthebigbanks.com ,to rally and focus support for the only solution to the financial crisis.

Please join. Your voice will add considerable weight to the site.

Paul Abrams