Banking Bill Invites the Next Global Meltdown: Roy C. Smith

The financial overhaul bill set for passage sometime next week is supposed to “bring accountability to Wall Street.” In announcing an agreement between the House and Senate last week, Senator Christopher Dodd noted that “the American people have called on us to set clear rules of the road for the financial industry to prevent a repeat of the financial collapse that cost so many so dearly.”

The final bill, though, does little to prevent a systemically important bank from failing, and makes it far more difficult for regulators to assist one seeking to avoid failure. This all but insures that the system-wide calamity the bill should be trying to prevent will, in fact, occur again.

Most of the systemic risk in the U.S. is now carried in the six largest bank-holding companies (Bank of America, JPMorgan Chase, Citigroup, Wells Fargo, Goldman Sachs and Morgan Stanley). The bill lets them off easy: none is to be broken up and the effort to lower the risk they take on was diluted.

They will still report to the same regulators as before, whose effectiveness in averting prior crises was negligible. To impose serious sanctions on the banks, the regulators will have to go through a lengthy process involving a two-thirds vote of the new ten-member Council of Regulators, which is subject to appeal in the courts. They still won’t have to pay for the cheap-money subsidy that being a large bank provides, nor for the untaxed windfall profits from government guarantees and market intervention over the past two years.

Live With It

They will probably have to face tougher capital adequacy standards in the future but not for at least two years. They will be subject to more consumer-products regulation in the future but will probably be able to pass the cost on to their clients. On the whole, this is a bill the big banks can live with. They will not have to change much of they now do.

What they now do is pursue a universal-banking strategy aimed at maximizing shareholder value through market dominance. They operate all over the world in fast-changing, highly competitive markets that push them to take on high risk in search of high returns. When they are running on all cylinders in rising markets, they are very impressive and highly profitable.

Global Peril

But when they aren’t running smoothly, or trying too hard to increase market share or improve profitability they can make mistakes that seriously disappoint their shareholders and can imperil the global financial system.

Repeatedly since the repeal of the Glass-Steagall Act in 1999, increased competition has driven the banks to giant, unexpected trading losses, harsh public criticism and large regulatory and litigation settlements. This has eroded confidence in their managements and their stock prices are now close to or below book value, placing little value on their once-mighty franchises and talent pools. From the recent history of such eminent firms as Citigroup, UBS, AIG, Merrill Lynch and Bear Stearns, you can only conclude that the business model they followed was not only too big to fail, it was also too big to manage.

Out there is another accident waiting to happen. When that occurs, as inevitably it will, the consequences for the financial system are hard to imagine, given the requirements of the new bill to prevent taxpayer-funded bailouts.

Facing Facts

What the large banks should do now is accept the fact that their business model hasn’t been working, and try to figure out what to replace it with. In principle, they all need to simplify their management structures and reposition their riskier activities elsewhere to provide steadier, more predictable income for their investors.

Academic research has shown no benefit to banks for excessive size or having many different lines of business. Now, bank-holding companies will be subject to somewhat higher costs of capital for all their businesses, particularly the riskier ones that must compete with hedge funds not subject to such requirements.

Some part of the trading and asset-management businesses might be better off outside the banking rules, by selling them or spinning them off to shareholders. Goldman Sachs now houses vast proprietary trading, hedge fund and private equity businesses; it might be able to separate these units without harming its investment-banking market share. Split up, the value of the firm might be worth more than the two combined, as often has been the case.

Case for Breakups

Further, some of the large banks might be better off disposing of ill-fitting activities. Bank of America, fundamentally a retail bank, may decide that the acquired wholesale banking activities of Merrill Lynch require risk-management capabilities it doesn’t have. Citigroup, already being broken up, might decide to go all the way back to John Reed’s model in which investment banking was minimal.

Equally important is the need to restore the public trust of these once-admired firms. The most valuable corporations have always been those with the most pristine reputations, and the last several years have certainly taken their toll on the reputations of all of the leading banks.

Even without this bill, these banks will face a long period of intense scrutiny from regulators and from potential litigants. It will be hard to escape this condition without changing the model, which could be a fresh start for everyone.

(Roy C. Smith, author of “Paper Fortunes: Modern Wall Street: Where It’s Been and Where It’s Going,” is a finance professor at New York University’s Stern School of Business. The opinions expressed are his own.)

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