Feb. 6 (Bloomberg) -- In a report last week, the Financial Services Roundtable boldly stated that the financial-services industry “has made significant changes since the crisis and is safer and stronger than ever.” The message from the lobby group, which represents 100 of the largest U.S. financial companies, is clear: When it comes to the risks posed by big banks, don’t worry, be happy.
I’m not sure which planet these financial-sector lobbyists are on, but it’s not this one.
The motivation for such optimism is obvious: If the industry can convince the public that large financial firms have sorted themselves out, regulators might back off. The roundtable echoes other industry lobby groups, such as the Securities Industry and Financial Markets Association, which argued in a recent congressional hearing that the Volcker rule, which forbids most proprietary trading by banks, isn’t needed.
If the financial sector is indeed fixed, the argument goes, there is no need for anything like the Volcker rule, higher capital requirements, or any of the new regulations emerging as part of the Dodd-Frank reforms. Leading this charge are the remaining Republican presidential candidates. If there’s one issue they all agree on, it is to repeal Dodd-Frank.
The roundtable report illustrates exactly what’s wrong with the industry and raises serious concerns about the people in charge. It should be read carefully and quoted extensively by anyone who seeks to reduce the dangers posed by banks that are perceived as “too big to fail.”
The report seems oblivious to the incentives driving the executives of banks whose assets are large, relative to the U.S. economy. Their interests are not the same as the public’s. No one running a bank cares sufficiently about the effect their failure would have on the rest of the system. In candid moments, even people who are sympathetic to the industry concede that bankers don’t internalize the impact of their fragility on the system.
As a result, regulators have long required banks to have a minimum level of equity funding to provide a buffer against losses and to reduce the probability of collapse and systemic crisis. Bank executives and boards, though, prefer to have less equity and more debt; that very combination gives them a higher return on equity during boom periods. For large banks, it tilts the payoff so that executives (and sometimes shareholders) get more upside when all goes well, while taxpayers are handed losses when a bank is unlucky.
Megabanks receive large, opaque and unfair government subsidies. They can borrow more cheaply, for example, because creditors see them as less risky due to an implicit government guarantee. This support is also dangerous because it encourages excessive risk-taking and the boom-bust-bailout cycle, or what the Bank of England has taken to calling the “doom loop.”
Most large bank executives prefer a debt-to-equity ratio -- the amount of borrowing relative to the amount of equity -- that is too high from a social or taxpayer point of view. This is perhaps the most fundamental fact to understand about banks and the hardest lesson we have learned from more than 200 years of bank failures.
If you don’t understand this point, you should read the work of Anat Admati and her colleagues at Stanford University, as well as the compelling recent book, “Zombie Banks,” by Yalman Onaran (a Bloomberg News correspondent). I am continually amazed by how many senior people in the industry, as well as regulators, legislators and other Washington officials, seem to be unaware of these analytic and historic basics.
Or perhaps they are fully aware of the issues, but seek to distract us with sleight-of-hand? That is my interpretation of the Financial Services Roundtable report.
The group claims that U.S financial-services companies now have “the highest capital level in history.” But aggregate capital levels mean little. What’s lacking on the balance sheets of large, global banks is loss-absorbing capital -- share capital plus retained earnings.
Incredibly, the report barely mentions that Europe is in the grip of the most serious sovereign-debt crisis since the 1930s. And there is nary a word on the risks inherent in the euro interest-rate swaps market, which could threaten the creditworthiness of all major European counterparties. (See my recent paper with Peter Boone for more detail.)
The roundtable cites a September assertion by the Clearing House Association, another bank lobby group, that no banks will fail in the future because of a lack of capital. The association made that claim just before Dexia SA, the Belgian bank, collapsed due to inadequate capital. Dexia’s failure, by the way, came less than three months after sailing through the European Union’s stress tests with supposedly high levels of capital.
The report also fails to mention that Greek banks are on the brink of failure due to credit losses, mostly on government bonds, or that banks in France, Italy, Portugal and Spain are carrying on their books large amounts of sovereign debt that has lost much of its value. The roundtable report cites Federal Reserve stress tests, conducted at the end of 2011, but they look far too mild relative to recent events and European realities.
One glaring example: The tests assume Europe goes into a recession, but not a 1930s-style wave of sovereign defaults. And yet a European recession is now in the International Monetary Fund’s baseline scenario. Stress tests are supposed to be about assessing downside risks, not mapping out what everyone expects to happen already.
The roundtable claims that “Banking practices that contributed to the 2008 crisis have been eliminated.” History shows that, in the aftermath of a big financial crisis, the survivors are more careful -- for a while. But the fundamental incentives to take excessive risk remain the same, and the roundtable’s points about changes to executive compensation are neither here nor there. Management might be more aligned with shareholders -- at least this is the claim -- but shareholders also benefit from too-big-to-fail subsidies.
The only sensible public-policy response for the U.S. is to suspend the payment of bank dividends and share repurchases, thus forcing banks to build equity as the probability of another crisis grows. (For more on this, see additional work spearheaded by Admati here and here.)
The roundtable’s argument that “bailouts have been repaid and eliminated” is disingenuous. The bankers know that the damage to the federal government’s balance sheet has been profound. The U.S. will end up with about a 50 percentage-point increase in debt relative to gross domestic product as a result of the deep recession caused by the financial sector.
As I testified to the Senate Budget Committee last week, the Congressional Budget Office should factor into its scoring system the damage that banks with inadequate equity could cause the U.S. budget. An unstable financial system is more likely to run into trouble, trigger a recession and a loss of tax revenue, and expand deficits and debt. An honest scoring of the connection between financial-industry and fiscal risk would concentrate the minds of lawmakers and regulators.
One of the roundtable’s core principles is: “We are committed to building long-term stability for the financial system, and our actions will emphasize long-term instead of short-term gain.” It is hard to see this report as a reflection of such principles.
The report reads more like a sophisticated propaganda campaign by a powerful lobby group demanding that its members continue to receive large subsidies. The people who run financial institutions definitely know what they are doing -- picking the pocket of the American taxpayer. The question is: Will we fall for it again?
(Simon Johnson, who served as the chief economist of the International Monetary Fund in 2007 and 2008 and is now a professor at the MIT Sloan School of Management as well as a senior fellow at the Peterson Institute for International Economics, is a Bloomberg View columnist. The opinions expressed are his own.)
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