Perhaps we shouldn’t be all that surprised that the vexing conundrum of “Too Big to Fail” is back in the headlines once more. After all, not only is it the week that most of the nation’s biggest banks have released their quarterly earnings, but we have witnessed the very unexpected and precipitous departure of Citigroup (C) CEO Vikram Pandit, along with his right-hand man. Pandit’s ouster has once again put the question of a possible breakup of Citigroup on the front burner – at least among analysts, investors and pundits.
Politicians from both sides of the aisle have chosen this time – only weeks before the presidential election – to do battle over the question of whether regulatory reforms enacted under President Barack Obama will be adequate to ensure that no financial institution will ever become “too big to fail” and require a taxpayer-funded bailout again, as occurred during the 2008 financial crisis.
Unsurprisingly, Rep. Barney Frank of Massachusetts, the senior Democrat on the House Financial Services Committee, takes the view that the bill that bears his name – the Wall Street Reform and Consumer Protection Act, better known as Dodd-Frank – is perfectly up to the task. It specifically outlaws bailouts, Frank argues, and “ensures that the largest, most interconnected firms are less likely to fail, not by preventing them from taking risks, but rather by making sure that they manage risks prudently and are capable of absorbing losses when they make mistakes.” It protects the financial system, but not any individual firm, he argues.
The view of Committee Chairman Spencer Bachus, a Republican from Alabama, couldn’t be more different, to the point where reading one of their comments after the other might leave you wondering whether the two men were talking about the same piece of legislation.
“The Dodd-Frank Act most certainly did not end bailouts; instead, it institutionalized them and made them permanent in the form of the ‘Orderly Liquidation Authority,’” Bachus said. “American taxpayers are no better protected against bailouts than they were in 2008: if anything, they are even more exposed to the danger that government bureaucrats will pick their pockets to bail out the creditors of the next ‘too big to fail’ institution that finds itself on the brink of failure.”
The problem for anyone trying to reconcile these two conflicting viewpoints is that both men are at least partly right. Bachus is correct in noting that by the mere fact of identifying a particular bank as “systemically significant,” regulators are effectively saying that they can’t afford to let the free market take its course because of the threat to the financial system that a Lehman Brothers-style collapse would cause. But that label (regardless of whether it is or isn’t interpreted as some kind of de facto government guarantee) isn’t necessarily the reason that creditors fund the likes of JPMorgan Chase (JPM) more cheaply than their smaller counterparts.
Small doesn’t automatically mean less risky. As JPMorgan’s “London Whale” debacle demonstrated, no institution is immune from making mistakes, but those creditors may prefer to bet on a large bank that is more likely to have cutting-edge technology and risk controls than a smaller one, and whose broad array of businesses (in both geographic and functional terms) offers a kind of diversification that no local bank can provide as a kind of downside hedge.
For his part, Frank is correct to point out that critics are confusing correlation with causation when they argue that Dodd-Frank made the big banks to get bigger. Rather, it’s more likely to be the laws of the financial jungle at work.
When JPMorgan Chase acquired two failing firms, Bear Stearns and Washington Mutual, it instantly and vastly expanded the range of its business operations. Let’s just consider the league tables for a second, where JPMorgan leads the pack: With both Bear Stearns and Lehman Brothers gone, with the European banks immersed in their own problems, is it any wonder that JPMorgan Chase has become so ubiquitous and so powerful?
That’s not Dodd-Frank; that is the events of the pre-Dodd Frank era and the macro business environment in which all banks are doing business. At the same time, Frank appears to be downplaying the extent to which the bank funding disparity I referred to above may be due to the perception that the government stands behind the creditors of these mega institutions. He refers to one large bank CEO as believing that Dodd-Frank provides the tools to end “too big to fail”; this is actually quite amusing, given that the probability of a giant bank’s CEO making the contrary case (if that was what he happened to believe) would be precisely zero.
I’m not questioning anyone’s honesty here, merely suggesting that to the extent that any CEO of one of the supersize-me banks finds anything attractive about Dodd-Frank, it is likely to be the perception of such a de facto guarantee and whatever flows from it; why would such an individual then publicly imperil his protected status in the current political environment?
The biggest problem of all is that we won’t know whether Dodd-Frank will work to address the “Too Big To Fail” conundrum until it’s too late – until it is tested and found either to work in preventing bailouts (as Frank claims) or found defective, and either jeopardizes the system or forces the Treasury into another costly bailout. Because the provisions of the act haven’t been tested, we simply don’t know; Dodd-Frank is like any other experiment that so far exists only on paper.
The reason that Dodd-Frank exists is that it’s so hard as to be practicably impossible to regulate Wall Street’s behavior. If we could count on financial institutions to act in a rational manner – and by rational, I mean not running idiotic risks that jeopardize the financial system purely because they can and feel they should in order to maximize their own firm’s profits – there would be far less to worry about with respect to mega-banks. There would still be a valid reason to argue in favor of breakups of Citigroup and other giant institutions, but that would be because these institutions, as well as being large, tend to be extremely complex. (Dodd-Frank doesn’t resolve the question of complexity.)
But the odds that a rogue trader or a megalomaniac CEO, intent on grabbing a disproportionate share of the market in a new product (and on ensuring his bonus is bigger than Goldman Sachs CEO Lloyd Blankfein’s), would take down the entire financial system could be diminished significantly if the incentives were better aligned with desirable outcomes that included maintaining the health of the system.
Perhaps, just perhaps, a new generation of Wall Street leaders can find a way to address that conundrum.
Meanwhile, what happens to the megabanks that may or may not deserve to bear the moniker “Too Big to Fail” must be left to shareholders to resolve. The whole process of cobbling together the patchwork quilt of Dodd-Frank was prolonged and difficult. That’s not a reason for lawmakers to duck the challenge of moving on to a bank breakup bill – but is that the best use of their time, skills and negotiating abilities at a time when the world is waiting to see whether they can accomplish something as basic and critical as a budget package?
Frank and Bachus, for now, need to leave this to investors to deal with. No Citigroup shareholder, still reeling from the loss of 92% of his or her investment in the megabank over the last five years, is going to be anything but skeptical in the face of claims by the bank that being big is automatically a good thing. In the wake of the “London Whale,” big JPMorgan investors may well be pondering similar questions.
Yes, we all have a lot at stake, but shareholders may well have the tools to act more rapidly and effectively. And there’s a bonus here: Boards in whose hands the decisions rest are legally required to listen to their shareholders. They can hire lobbyists to push back against regulators and lawmakers, but they have a fiduciary duty to act according to the wishes of their shareholders. Well-informed investors may well be the best allies of those arguing that the Dodd-Frank act is fatally flawed.