Tuesday, January 22, 2013

Megabanks and Our Failing Banking System

Readers of this blog have seen many references to the work of President Richard Fisher and his research staff at the Dallas Fed.  The New York Times columnist Gretchen Morgenson cited a recent speech by Fisher, which reiterates themes expressed in the Dallas Fed's 2011 Annual Report.

Our last post on J.P. Morgan Chase concluded, based on the contents of JPM's own internal report, that the organization had become too risky to the financial system, and too complex to manage.

The work of the Dallas Fed comes at the megabank issue from the truly fundamental level: what are they doing with their privileged position in our financial system, to really help the economy?  The megabanks, according to the Dallas Fed research, are impeding both the transmission of monetary policy and the traditional path to additional lending and recovery.

Our banking industry post-crisis is more concentrated than ever, as shown by this chart from the Dallas Fed.

So, 0.2% of U.S. banks hold 69% of the industry assets.  This isn't good for systemic risk management, enterprise risk management, or for job creation and economic recovery.

The next point about this kind of system is that the resolution process for the 5,500 community banks can be completed in a weekend, and we've seen that happen in my home state, Minnesota.  The resolution process for banks with moderate asset size may take weeks or months, but we have a lot of experience with these too.  There is no workable resolution process for megabanks, and so they are guaranteed perpetual life support by the U.S. Federal Reserve Bank and the U.S. Treasury.  Their shareholders and creditors know this too.  There can be no "creative destruction" for JPM.

This "implicit subsidy" is extremely valuable to the managements, shareholders and creditors of the megabanks.  As a result,

"unsecured depositors and creditors offer their funds at a lower cost to TBTF banks than to mid-sized and regional banks that face the risk of failure. This TBTF subsidy is quite large and has risen following the financial crisis. Recent estimates by the Bank for International Settlements, for example, suggest that the implicit government guarantee provides the largest U.S. BHCs with an average credit rating uplift of more than two notches, thereby lowering average funding costs a full percentage point relative to their smaller competitors.[8] Our aforementioned friend from the Bank of England, Andrew Haldane, estimates the current implicit TBTF global subsidy to be roughly $300 billion per year for the 29 global institutions identified by the Financial Stability Board (2011) as “systemically important.”[9] To put that $300 billion estimated annual subsidy in perspective, all the U.S. BHCs summed together reported 2011 earnings of $108 billion.
The rating uplift, the significantly lower cost of funding, and the ability to leverage back office expenses on a huge asset base puts the other 99.2% of U.S. banks at a huge disadvantage in offering competitive products and services to their customers.   Paradoxically, the megabanks get this free ride despite the fact that they are inherently more complex to manage and to regulate.  They also pose the systemic risk.

Dodd-Frank, as we have said until we're blue in the face, adds nothing but complexity to what the British call "macroprudential regulation."  Here are some interesting charts, again from the fuller Dallas Fed study.

These are the deadweight economic losses from regulations like Dodd Frank, which are blunt instruments that weigh most heavily on those organizations for which existing regulatory and resolution mechanisms are both adequate and proven.

Finally, businesses need loans most urgently when times are tough.

This chart shows that the community banks, and the moderately sized banks are the ones which have maintained or expanded their business lending through and after the financial crisis.  Ultimately, this is why our nation needs a banking system, for maturity transformation and intermediation.  We don't need banks for proprietary trading.

Also, anyone who deals with one of the big twelve banks knows a few things about their business models:

  • Over a long period of time, most of their income has become fee income as opposed to net interest income from traditional lending.
  • Fees on traditional small checking and deposits have climbed into the stratosphere when measured against the risks and cost of funds.  
  • Seniors, students, new entrants to the work force, and new immigrants can't get a low cost, plain vanilla banking product without arbitrary limits and high fees.  Credit unions can't compete with limited locations and few ATM's.  
  • Megabanks are inexorably milking their former best customers with higher fees in the hope that they leave. The megabanks want to get into upmarket services like asset management accounts combining brokerage and banking with significant minimums.
  • The investment banks in these holding companies can take as much risk as they like to show attractive returns on equity.  
  • Traditional commercial and industrial loans are not attractive products for megabanks to offer, and their best customers, awash in liquidity themselves, have already floated large issues of fixed-rate term paper at historically low spreads for investment grade. 
Fisher's paper ends with the following quote,
"To us, the remedy is obvious: end TBTF now. End TBTF by reintroducing market forces instead of complex rules, and in so doing, level the playing field for all banking institutions."
Have a read through these materials linked above which are clear, well researched, and fundamentally sound.

Note: all charts and graphs above are from the hyperlinked Dallas Fed publications.

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