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Thursday, April 22, 2010

No More "Too Big to Fail": Cap Bank Assets at $100 Billion

Troy Jones, Bill Fleming, and I are working on building some consensus toward serious, effective financial reform. The Senate Ag Committee, community banks, and I maintain that regulating derivatives is a key part of that reform. And if, as finance professional Jones contends, derivatives are too complicated for most people to understand, that strikes me as all the more reason we should restore some stiff regulations on them.

But just like our Republican and Democratic counterparts in the Senate, Troy and I may be a lot closer to agreement on financial reform. Jones wants to break up the megabanks so no one is "too big to fail." I'm all about that idea. So is Robert Reich, who lists these three big things the pending financial reform bill really really needs to do:

1. Require that trading of all derivatives be done on open exchanges where parties have to disclose what they’re buying and selling and have enough capital to pay up if their bets go wrong. The exception in the current bill for so-called “unique” derivatives opens up a loophole big enough for bankers to drive their Ferrari’s through.

2. Resurrect the Glass-Steagall Act in its entirety so commercial banks are separated from investment banks. The current bill doesn’t go nearly far enough. Commercial banks should take deposits and lend money. Investment banks should be limited to the casino we call the stock market, helping companies issue new issues and making bets. Nothing good comes of mixing the two. We learned this after the Great Crash of 1929, and then forgot it in 1999 when Congress allowed financial supermarkets to do both.

3. Cap the size of big banks at $100 billion in assets. The current bill doesn’t limit the size of banks at all. It creates a process for winding down the operations of any bank that gets into trouble. But if several big banks are threatened, as they were when the housing bubble burst, their failure would pose a risk to the whole financial system, and Congress and the Fed would surely have to bail them out. The only way to ensure no bank is too big to fail is to make sure no bank is too big, period. Nobody has been able to show any scale efficiencies over $100 billion in assets, so that should be the limit [Robert Reich, "A Short Citizen's Guide to Reforming Wall Street," blog, 2010.04.20].

Now if we can get Congress to listen to a bipartisan coalition of Troy Jones and Robert Reich, we've got a winner of a bill!

Read more!
  • Mr. Jones forwards this NYT article noting growing support among Dems and the GOP for breaking up banks. It also notes that, since the 2008 credit collapse, our policies have made the banks that are too big to fail even bigger. The six biggest banks—Bank of America, Citigroup, JPMorgan Chase, Wells Fargo, Goldman Sachs and Morgan Stanley—now have assets equal to 63% of the U.S. GDP, compared to 17% back in 1995.
  • Jones also forwards this fruitful series of NYT essays from some folks with serious econ chops on what's missing from the financial reform bill.
  • Robert Reich also notes that Senator Dodd's bill does go the wrong direction, giving big banks even more advantages over small banks. Let's fix that! Remember: community banks are the best place for your business!


  1. Cory,

    A derivatives discussion is complex and is like trying to talk calculus to an art major which makes it hard to discuss my thoughts in a forum like this. I wouldn't know where to start so it makes sense.

    For our discussion, I'm going to use crop derivatives as South Dakotans understand this because so many of know something about agriculture.

    Essentially, derivatives is a financial instrument where one party fears a future event and another doesn't so they agree for a price to transfer the risk of that future event.

    In agriculture, it is a derivative contract that protects a farmer from having the price of his crop dropping below the cost of production. The farmer gives up the upside if the price goes way up at harvest.

    The system depends upon two people having a different tolerance for the risk of the event occurring. And each of them negotiate a price acceptable to them for the derivative.

    When I say the derivatives are too complex, I don't mean to say individual contracts are complex but assessing the risk is very complex.

    My question on this whole thing is what is going to be regulated. The risk, the price, what?

    And what is the value of it being on open exchanges?

    Some propose a prohibition of banks being involved. This is unrealistic because they have the capital and infrastructure to manage the risks undertaken. To take them out of the business will only hurt those who have need to shed risk. And to hurt these people (i.e. farmers) will impact their access to capital.

    Some propose an increase in capital for those who take on this risk. An increase in capital requirements decreases the return on taking on the risk which will either increase the cost (to the farmer) or result in less option for shedding risk.

    The essence of the problem (and interest of the government to care about derivatives) is the risk they pose to the system as a whole. We can't be concerned that those who take on the risk end up losing money. That is inherent to what their business-risk taking.

    If we break up the concentration of the big banks and introduce more competition, we accomplish all the goals you want (lower prices to those desiring to shed risk and remove systemic risk to the entire system).

    You also need to consider the fact you have a "solution" without a problem. Derivatives had nothing to do with the meltdown in the fall of 2008. Granted, it brought down AIG but if we hadn't been in the midst of all the other problems unrelated to AIG, we could have just let AIG fail.

    Unfortunately, we were on the precipice of a disaster and confidence was absolutely critical at that moment so Paulson/Geithner acted.

    Let's attack the fundamental problem and not chase our tale on derivatives. They are not the problem and anything proposed is worse than the disease.

  2. A couple of other items:

    1) I'm not so sure I support a arbitrary cap on size. What might be appropriate is a sliding scale with regard to FDIC insurance rates and capital requirements to mitigate the risk to the taxpayer and system.

    2) I don't support going back to full Glass-Steagal which came out of the depression but to pre-Gramm-Leach of 1999. The 1984 modification of Glas-Steagal was good.

    3) The reason for "unique derivatives" being left out of the open exchanges is not a loophole but an acknowledgement that there are so many reasons to transfer risk and the best way to do is so diverse, there would be no way to "marketize" them on an exchange. You might as well just ban them which serves no purpose.

    4) Further fodder with regard to the current bill points in the wrong direction from National Public Radio today. The 2009 problem was caused by two things:

    The government was underwriting through Fannie/Freddie the inflation of housing values at the same time big banks were suffering from group think this inflation in values would continue ad infinitum. There was another complicating factor. Paulson discloses in his book that while he was at the Olympics, the Chinese told him the Russians had approached the Chinese to collude to dump US Treasuries prior to the September debt offering of our government.

    Better managed Freddie/Fannie and no Gramm Leach. No financial crisis.


  3. Great applause for Troy in speaking sensibly about finances on Cory's blog. I only wish Cory (or Robert Reich) could as well ;)

    1)There is nothing inherently wrong with derivatives. When the 'crop' that virtually nobody imagines will ever fail does, those left holding the bag lost a gamble no different than any other gamble on wall street. However in this case the insurer covered the bet with another bet by buying insurance from a third party at a lower price...who bought some from a fourth and so on. For an actual farmer the risk is high enough that chain is short, probably just one link. But when the crop is a company nobody actually thinks will ever fail the chain goes on and on. That's ridiculous. I don't know if an open market is feasible in all cases as Troy indicates. I think whatever solution we might need relies on mandating the purchaser of the insurance has an interest in the product insured other than insurance they sold for it themselves. They don't have to have the capital for it, but they do need to actually hold the risk.

    2) Unravel Fannie-Mae and Freddie-Mac from all government connections or allow them to fail as they should have.

    3) No bank caps. No bank breakups. There is no such thing as too big to fail. We regulate and chop up monopolies, not growth. Congress never had to bail any bank out, or let them fail either. Temporarily relaxing government regulations already in place at the time such as mark-to-market and capital requirements in combination with creating federal mortgage insurance (instead of buying the securities themselves) would have more effectively mitigated the systemic risk than the bailouts they came up with.

    3) No reason for zombifying Glass-Stegall. The crash of 1929 had nothing to do with investment banking and commercial banking operating together. The Great Depression was not caused by the stock market crash. There were fewer total failures in 1929 than in several years during the roaring 20's. Massive bank failures were later caused by the Fed policy of restricting the money supply to fight inflation in the middle of a depression that was deepened and lengthened by other government regulations such as wage controls and the Smoot-Hawley tariff. Government regulatory incompetence: just what we need more of now.


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