Stop the Big Banks Before They Can Lend AgainCaroline Baum
May 24 (Bloomberg) -- If only the Volcker rule had been in place. If only the Dodd-Frank law had an additional 1,000 pages of rules. If only there had been more regulators at JPMorgan Chase & Co. If only the regulators had done a better job.
Then what? The response to JPMorgan’s May 10 announcement of an initial $2 billion loss on a derivatives hedge and/or bet that was being run out of the bank’s Chief Investment Office produced a predictable response: We need more rules and regulations.
Why? We have plenty of both already. Pressing the more-regulation default button creates the impression that human beings can anticipate the next new product, asset class or financial innovation and write rules to prevent the next blowup. It also ends up deflecting attention from the real goal of financial regulation, which is not to protect the banks but to shield taxpayers from the cost of any institutional failure.
“Banks’ equity capital protects the general public from financial losses much more effectively than regulation,” Allan Meltzer, a professor of political economy at Carnegie Mellon University in Pittsburgh, wrote in a May 17 Wall Street Journal op-ed.
Increasing equity capital to a maximum of 20 percent of assets for the largest banks would serve a double duty, Meltzer explained to me over the phone. It would protect the public and “make banks think how large they want to be,” he said.
He’s right, just as he was years ago when he said, “If a bank is too big to fail, it’s too big.” The best way to counter the trend toward ever-larger banks is to reduce their profit potential by requiring them to hold more capital as a share of their assets. Instead, courtesy of the 2010 Dodd-Frank Wall Street Reform and Consumer Protection Act, we have “systemically important financial institutions” instead of TBTF; a new resolution process outside of bankruptcy protection; enhanced supervision and regulation; and behemoths for banks, such as JPMorgan, with $2.3 trillion in assets.
When Dodd-Frank talks about creating an “advance-warning system” to identify and address systemic risks posed by large, complex companies before they threaten the stability of the economy, one has to laugh. I was under the impression that regulators were already charged with that function.
The Office of the Comptroller of the Currency is the main regulator for nationally chartered banks, such as JPMorgan, and federal savings associations. The OCC has 60 to 70 regulators assigned to each of the big banks at all times. They live there. The OCC supplements its resident supervisors with economists, lawyers and other examiners on a case-by-case basis.
The Federal Reserve has oversight responsibility for state-chartered banks and bank holding companies. The Fed has some 30 to 40 regulators at JPMorgan.
One wonders why it took 100 examiners staked out at each of the big banks to oversee the near-collapse of the financial system in 2008. What about just one good numbers guy parsing the banks’ P&L each night?
Yes, I know. Banks are complicated. And I’m being facetious. But banks will find ways to exploit new rules as quickly as lawmakers can write them. More capital -- a rules-based solution -- seems like a surer bet than discretion: substituting the judgment of a regulator for that of a banker, according to Meltzer.
And what’s the crime in a bank losing money, as long as the shareholders, not the taxpayers, take the hit? JPMorgan’s loss is an earnings event. It’s also a market event: Investors shaved $25 billion off the value of the company’s outstanding shares in the last two weeks. Instead it’s being portrayed as a sign that the Volcker rule, which is still being written, should be stricter.
Hedging a Bet
The aim of the Volcker rule, named for former Federal Reserve Chairman Paul Volcker, is to prohibit banks from speculating with federally insured deposits. In theory, it makes sense. As a practical matter, it’s hard to differentiate between a hedge against a specific or aggregate position and a proprietary trade.
Those writing the rules have acknowledged the risky nature of banking and the need for financial institutions to safeguard against those risks. They have already included exemptions for certain securities (Treasuries, for example) and in connection with certain activities (underwriting and market making). Transgressions would be determined on a case-by-case basis, which means lots of room to look the other way for favored constituencies.
What’s the difference between a bank that takes risks on asset markets and one that takes risks lending to risky companies? Meltzer said.
Home-mortgage lending, with a 20 percent down payment and the house as collateral, was traditionally considered to be a low-risk proposition. Absent that cushion and in the face of a nationwide collapse in home prices, we now know differently.
Banking is one of the most highly regulated industries, yet history is littered with examples of banking blunders. In the 1970s and early ’80s, banks overextended credit to the oil patch. At about the same time, they “diversified” their risk, making sovereign loans to Latin America’s “less-developed countries.” A decade later, banks lent hand over fist to Asia’s “emerging markets”; only the name had changed. Banks have had repeated go-rounds with real estate, both commercial (the savings-and-loan crisis of the late 1980s, early ’90s) and, most recently, residential. In all these cases, it was overzealous lending, not prop trading, that got banks into trouble.
And yet once again we are pinning our hopes on a new set of rules to save us from the next banking crisis. Maybe it’s time, as Meltzer said, to rely on the rule of law, not the rule of regulators.
(Caroline Baum, author of “Just What I Said,” is a Bloomberg View columnist. The opinions expressed are her own.)
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