Big Banks: Resolving the “Too Big to Fail” Issue

Tackling the Too Big to Fail (TBTF) institutions will not be an easy task. But the job must be done.

Critical to this task is dealing with financial derivatives. Despite almost blowing up the world economy in 2008, derivatives scandals continue unabated.

Little understood as this is by the wider public, the LIBOR scandal that threatens to engulf an increasing number of banks had its real roots in the business “need” for rigging the interest rates set on trillions of dollars of loans and derivatives.

Or how about the $5.8 billion (and counting) derivatives loss incurred by proprietary traders at JPMorgan Chase? Or MF Global’s illegal transfer of almost $900 million of segregated customer funds to cover its proprietary trading losses? And how about the 24,000 Peregrine Financial fraud victims still waiting for return of their money?

The BIS — the Swiss-based Bank of International Settlements, known as the “central bank of central banks” — most recently estimated the global gross outstanding of over-the-counter (OTC) derivatives at $647.8 trillion as of the end of 2011.

While that is down somewhat from the previous report six months earlier, it remains almost nine times the size of world GDP. And it could still reach the practically unimaginable amount of a quadrillion dollars (a thousand trillion, in case you were wondering).

Of course, there are those who contend that what really matters is the net, not gross, number. These supposed experts miss the point: Lest we forget, counterparties must be solvent for the gross to become the net — a lesson we should have all learned from AIG.

That such scandals — or “tips of the derivatives iceberg” — keep emerging from the darkness of the shadow banking system underlines the extent to which derivatives have grown to an unmanageable size. They are now too large to be controlled by either regulators, bank managers or, sometimes, even the traders themselves.

That we seem not to send bankers to jail for losing billions of dollars underscores the immense power of bank lobbyists to neutralize those seeking to rein in one of the banking’s most profitable businesses. The problem is that the rest of us are the passengers on this derivative Titanic — with no lifeboats.

Ending TBTF

Richard Fisher, the president of the Federal Reserve Bank of Dallas, notes in his letter in the bank’s most recent annual report that “more than half of banking industry assets are on the books of just five institutions…. They were a primary culprit in magnifying the financial crisis and their presence continues to play an important role in prolonging our economic malaise.”

Fisher advocates “downsizing” the TBTF banks so they can be more “prudently managed and regulated across borders.” Put plainly, they need to be broken up. The big banks must be denied the ability to privatize their profits and socialize their losses.

Given the complexities involved in breaking up the banks, here are some of the things we need to start doing now for what will be a decade-long process to unwind TBTF:

1. As the Volcker rule advocates, the legal entity of the bank that assumes the deposit-taking function, and which benefits from the taxpayer-funded FDIC guarantee, must be firewalled from the rest of the bank.

   Instead of the contortions required for regulators to determine what “risky activities” need to be carved out, we should simply give TBTF banks a fixed time frame (two years) to move those FDIC-insured deposits to an entity that does only basic banking. Any deposits outside that entity would not benefit from FDIC insurance.

2. The size of a bank’s balance sheet must be capped at some rational relationship to its capital base. Leverage of 15 to 30 times should never be permitted — no matter what the activity.
3. All non-balance sheet transactions should be cleared and held through a transparent, public-regulated exchange with few or no exceptions. The increased costs due to margining requirements will be offset by lower execution costs as transparency and competition will tighten bid/offer spreads.
4. Design a 21st-century form of Glass-Steagall that incorporates Volcker’s principles and repeal those portions of Dodd-Frank that actually subsidize TBTF.

Those who argue that we cannot undo Wall Street’s innovations of the past decade might want to reflect on Paul Volcker’s view that banking innovation reached its peak with the invention of the ATM.

William K. Black, a former bank regulator and major figure in exposing the Savings and Loan scandal two decades ago, may have said it best:

These [TBTF] institutions are not massive because greater size brings efficiency. They are massive because size brings market and political power. Their size makes them inefficient and dangerous…. A bank that is too big to fail is too big to operate safely and too big to regulate….They are ticking time bombs — except that many of them have already exploded.