July 30 (Bloomberg) -- The largest U.S. banks are accused of causing problems in markets ranging from energy to aluminum. Regardless of whether they’re guilty of market-rigging, as critics say, the charges raise another question: Why are the banks active in these businesses in the first place?
Part of the answer is a point we’ve stressed before: They’re among the country’s most subsidized enterprises. The Federal Deposit Insurance Corp. and the Federal Reserve, both backed by taxpayers, provide an explicit subsidy by ensuring that banks can borrow money in times of market turmoil. Banks that are big and connected enough to bring down the economy enjoy an added implicit subsidy: Creditors will lend to them at low rates on the assumption that the government won’t let them fail.
The subsidies arose because banks perform a special public service. The lending they do and the payments they process are crucial to the functioning of the economy. Problem is, access to cheap, subsidized financing gives banks a big advantage if they move into markets beyond their core business. That’s great for the banks, but it distorts the competitive landscape.
Consider the recent mini-scandal in the aluminum market. Taxpayer subsidies gave the banks an edge in holding the metal. Subsidized financing -- made particularly cheap by the Fed’s efforts to stimulate the economy with near-zero interest rates -- encouraged banks and their clients to build bigger stockpiles than they otherwise would have, tying up supplies. If the bets were to go wrong and lead to distress at a big bank, the Fed would have to provide emergency financing for an activity that taxpayers never intended to support.
Commodities are just one area in which the largest U.S. banks have sought to expand at taxpayer expense. Aside from trading and issuing securities and derivatives, they have gotten into water utilities, electricity generation, natural-gas distribution and even the operation of Chicago’s parking meters. The full extent of the sprawl is hard to assess due to a lack of public disclosure.
There’s no good economic reason for banks to be in such businesses. All they bring to the table is their privileged access to cheap financing. The solution is twofold: Reduce the subsidies and confine them as much as possible to the lending and payments businesses that legitimately require taxpayer backing.
In principle, much can be achieved within the framework of existing legislation. Regulators can reduce the implicit subsidy by requiring banks to fund themselves with more loss-absorbing equity, thus making them less likely to require government bailouts. The so-called Volcker rule, mandated by the Dodd-Frank Wall Street Reform and Consumer Protection Act, can limit banks’ ability to use the remaining explicit subsidies for speculative trading. The Fed also has great leeway in deciding what activities it considers complementary to, or naturally flowing from, the core business of banking.
So far, regulators have interpreted the law generously -- but this may be changing. The Fed has said it will soon reconsider whether bank holding companies should be allowed to trade in raw materials. That would still leave open a lot of areas in which federally insured banks have no business operating.
If regulators prove unable to rein banks in, options that are more extreme are still under consideration: Congress could, as Senators Elizabeth Warren and John McCain have proposed, revive the Depression-era Glass-Steagall Act, which would strictly limit all federally insured banks to the businesses of taking deposits, lending and processing payments. Such a move would force the breakup of JPMorgan Chase & Co., Citigroup Inc., Bank of America Corp., Goldman Sachs Group Inc. and other large diversified financial institutions.
Bankers lobbying against the Volcker rule and other less forceful limits on their activity should ask themselves if that is the course they want bank regulation to take.
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