Federal Reserve opposed as big bank savior by odd allies

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An unusual alliance of conservatives and liberals is pushing to break up or downsize banks deemed “too big to fail,” rather than create a new regulatory regime led by the Federal Reserve to try to keep them from getting into trouble again.

Public anger toward bailouts and the central bank’s role in rescuing big institutions like American International Group Inc. and Bank of America Corp. are fueling growing opposition to the Fed-led oversight plan advocated by the Treasury Department and House Financial Services Committee Chairman Barney Frank, Massachusetts Democrat.

In Europe, regulators are moving to break up megabanks like ING Group, KBC and Lloyds that became government wards after last year’s global financial meltdown. An increasing number of legislators, political activists and financial specialists in the U.S. want to move in the same direction for troubled institutions such as Citigroup and Bank of America.

Critics contend that these banks have learned little from the crisis and are milking the substantial funding advantage they have gained as a result of their government backing to go into risky ventures that pumped up their profits this year, but might be setting the stage for speculative bubbles and financial crises down the road. The Fed, they say, failed to see these problems before and would probably miss them again.

“The real culprits in this crisis were the large and mostly regulated banks in the United States and Europe. The size and extreme risk-taking by these institutions were among the key factors behind the depth of the crisis,” said Nariman Behravesh, chief economist at IHS Global Insight.

“Unfortunately, the problem has become worse. Consolidation through distressed mergers and acquisitions in the wake of the events a year ago has made the concentration in the banking industry even greater,” he said, “setting the stage for future banking crises if appropriate steps are not taken to either break up the large banks or to regulate them even more tightly.”

Peter Schiff, president of Euro Pacific Capital and a Republican economic adviser, questioned whether it is desirable to allow banks to become too big to fail in the first place and then try to rein them in through regulation.

“If the government did not provide these bailouts or guarantees, then the market itself would ensure such organizations did not grow beyond their ability to attract capital,” he said. “It is only when fear is overcome by government guarantees that systemic risks can arise.”

While the Fed has sought recently to burnish its regulatory credentials by showing that it can be tough on big banks, proposing for the first time to regulate executive pay at the 28 largest firms, many legislators and analysts point out the Fed already had authority to regulate Citigroup Inc., Bank of America and other giant banks, but failed to foresee problems or take pre-emptive action while the crisis was developing.

Critics say the Fed may be too conflicted to crack down on big banks, since the Fed’s 12 reserve bank presidents are elected by top bank executives who typically sit on the reserve banks’ boards of directors. Before he went to Treasury, Secretary Timothy F. Geithner himself was selected by top New York banks like Citigroup and JPMorgan Chase & Co. to fill the critical post of New York bank president, the Fed official who interacts most closely with the big banks and Wall Street markets and who arranges most of the bailouts.

“Anointing the Fed as the systemic-risk regulator will make what has proven to be a bad bank regulator even worse,” said Sen. Richard C. Shelby, ranking Republican on the Senate banking committee. “It was the Fed that failed to adequately supervise Citigroup and Bank of America, setting the stage for bailouts in excess of $400 billion. It was the Fed that failed to adopt mortgage underwriting guidelines until well after this crisis was under way. It was the Fed that said there was no need to regulate derivatives.”

Opposition to giving the Fed even greater power has led Financial Services Committee Republicans to endorse enhanced bankruptcy or government resolution procedures to handle large failing banks, along with other incentives that prompt the banks to essentially downsize themselves. Tough measures such as prohibitively high capital and deposit-insurance premiums that reflect the greater risks they take would force the banks to consider whether it’s worth growing so large in the first place.

While conservatives and liberals have little else to agree on these days, on the “too big to fail” question, Republicans increasingly find themselves reading from the same page as Ralph Nader, the AFL-CIO and an array of other progressive organizations that have also concluded that the best way to prevent future bailouts is to downsize the huge banks that now dominate everything from credit cards to mortgages and emerging market investments.

“It is hard to look at what was done over the past year and a half and conclude it was anything less than disastrous,” said Robert Weissman, president of Mr. Nader’s Public Citizen group. “The bailout strategy is unacceptable. It unjustifiably plunders the public treasury to support failed, reckless enterprises while reinforcing the cycles that lead to periodic failure and ever-larger bailouts.”

The Nader group is recommending breaking up firms that are too big to fail and reinstating Depression-era rules that prohibit commercial banks from engaging in speculative investment activities, as well as empowering the government to close down such firms in an orderly way if they fail in the future.

“Congress should take a page out of the book of antitrust law,” he said. “The antitrust approach asks not how regulatory agencies can monitor the mammoth financial institutions, but whether those institutions should exist at all.”

Congress and regulators can begin to curb the excessive size of financial firms by enforcing existing limits on the concentration of banks and other depository institutions — which would put a lid on further acquisitions by megabanks such as Bank of America and JP Morgan, he said.

“If it’s too big to fail, it’s too big to exist,” said Rep. Bernard Sanders, Vermont independent, who has introduced legislation directing the Treasury to identify and break up “too big to fail” banks within 90 days.

The banks maintain that their enormous balance sheets of $2 trillion or more are needed to compete effectively with foreign banks in multi- trillion-dollar global markets, even though European regulators are moving to break up some of their biggest competitors and Fed studies have shown that banks need assets of only about $50 billion to operate effectively in international markets.

The big banks, long a potent funding source for political campaigns, are waging a major lobbying campaign that appears to have been successful so far against efforts to break them up. Particularly effective in pushing the industry’s point of view has been Jamie Dimon, the chief executive of JP Morgan, the one big bank whose reputation emerged relatively unscathed from the crisis. His frequent meetings with President Obama and other top Washington officials has given him the moniker “Obama’s favorite banker.”

Mr. Dimon is one of the top contributors to federal campaigns, having made contributions of $50,000 or more, according to OpenSecrets.org, which also list as top contributors executives from Goldman Sachs Group, Citigroup, AIG, Freddie Mac, Morgan Stanley, Bank of America, MBNA Corp. and other big financial firms.

“We do not think that legislation forcing the break-up of large banks is likely to be enacted” despite some “headline risk” for the big banks in coming weeks, said Brian Gardner, a Washington analyst with Keefe, Bruyette & Woods, an investment firm specializing in banks.

Mr. Geithner has defended his plan to regulate the big banks before Congress and insists that he would choose to close most failing institutions rather than try to keep them alive. Nevertheless, in negotiations with Congress, he has insisted on maintaining the option of bailing out faltering giants. One source close to the negotiations said he even refused to put a $1 trillion limit on the cost of future rescues that the Treasury and Fed deem to be necessary to protect the economy.

Mr. Geithner maintains his proposal is designed to encourage banks to downsize themselves by imposing higher capital requirements on large institutions, as well as stiffer regulations, including oversight of executive pay, and requiring them to write “living wills” outlining how to close the banks down in case they fail.

But analysts say the requirements are not stringent enough to offset the great advantage the banks reap every day from lower borrowing costs as a result of their implicit government backing.

Currently, large banks with more than $100 billion in assets can borrow at rates one-third of a percentage point below their smaller counterparts, more than quadrupling the advantage large banks had before the crisis a year ago, according to the Federal Deposit Insurance Corp.

The cost-of-funds advantage that the big banks have is comparable to that which enabled Fannie Mae to grow into the world’s largest financial company. Fannie Mae borrowed at rock-bottom rates and invested in a huge portfolio of risky but lucrative mortgage securities — an arbitrage tactic that was highly profitable for the company for years, but blew up and became the source of huge losses during the mortgage crisis.

After being crippled by the crisis, Fannie last year became a ward of the state, and along with Freddie Mac, has drained government coffers of $120 billion so far.

“The administration’s plan would create what are essentially government-sponsored enterprises like Fannie Mae and Freddie Mac in every sector of the financial economy — insurers, securities firms, finance companies, bank holding companies and hedge funds” by designating them as too big to fail, said Peter Wallison, financial analyst at the American Enterprise Institute.

“The result will be devastating for competition. Larger firms will squeeze out smaller ones,” he said, including the nation’s 8,000 community banks, which already are suffering and being closed down by the dozens in the wake of the crisis precipitated by their larger brethren.

The Independent Community Bankers of America, which represents small banks and is a powerful lobbying force in its own right, has called on Congress “to either downsize these mega-institutions or require them to divest sufficient assets so they no longer pose risks to the entire financial system.”

But the big banks’ views appear to be holding sway with a majority of House Financial Services Committee Democrats, even as European nations move to break up some of their biggest banks, said Joshua Rosner, partner at Graham Fisher & Co., an independent Wall Street advisory firm.

European countries, including Iceland, Ireland, Switzerland and Britain learned during the crisis that hosting banks that had assets as much as four times the size of their own economies posed huge risks and ultimately backfired by creating severe financial crises and plunging their economies into deep recessions.

The burden of rescuing large banks was far greater for the governments of small European countries than it was for the United States, to the point that it raised questions of solvency for some of those nations and forced them to consider the more drastic strategy of downsizing the banks.

A senior Treasury official suggested that the relatively easier burden of maintaining large banks in the U.S. is one reason the administration does not think it needs to drastically downsize U.S. banks. The largest U.S. banks — Bank of America with $2.3 trillion in assets, and Citigroup with $1.9 trillion — represent at most 15 percent of economic output, he said, making their rescue affordable by comparison.

Moreover, the U.S. has moved to modestly downsize both Citigroup and Bank of America in recent months in connection with the Treasury’s extraordinary $45 billion rescue programs for both firms, which gives the government greater latitude over the companies than other large banks, such as JP Morgan, that did not receive such extraordinary assistance. JP Morgan, Goldman Sachs and other large banks have repaid their government assistance in an attempt to get out of the government’s reach.

Citigroup recently decided to jettison its Phibro commodity trading unit rather than subject it to the stringent restrictions on executive pay imposed by the Treasury’s pay czar, Kenneth Feinberg, and it is considering divesting units in Brazil and Mexico. Bank of America recently agreed to sell First Republic bank, as well as Wilshire Credit Corp. and Columbia Management, while AIG — with about $1 trillion in assets — shed its Nan Shan Life Insurance unit.

“The financial supermarket concept has been proven a failure,” said Mr. Rosner of Graham Fisher. “There is no longer any evidence that, beyond a cost-of-capital advantage that comes with implied government support, there are sustainable and tangible economies of scale arising from being the largest. … The only ones who benefit are the high-level executives” and the legislators in “Washington’s political class” who benefit from the banks’ largess.

If Congress enacts a regulatory regime that codifies the role of the large banks, “these companies will provide all legislators, regardless of their political affiliation, with a constant stream of lobbying dollars in return for help in stymieing regulators,” he predicted.

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