The Real Problem with the Big Banks

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The New Yorker
By:  James Surowiecki
February 19, 2013

Ask what's wrong with America's banks, and you're likely to hear that they're just too complicated, too opaque. Banks are doing too much trading and not enough traditional lending, and their speculation with complicated financial instruments (like the ones that led to J. P. Morgan losing six billion dollars with its "whale" trade last year) is a recipe for disaster, with the financial crisis of 2007-2008 seen as proof positive of the dangers of too much complexity and too little disclosure. (Thus Jesse Eisinger and Frank Partnoy argue in last month's Atlantic that the panic of 2008 resulted "from a lack of transparency.") And so we get calls for banks to simplify their operations--to go back to what's often called "plain vanilla" banking--and to disclose more about what they're doing. This quest for simplicity and transparency is understandable in a world of collateralized-debt obligations and endlessly proliferating derivatives. But it doesn't actually get at the heart of the issue. The fundamental problem with the banks isn't that they look (and act) more and more like hedge funds. The fundamental problem with banks is what it's always been: they're in the business of banking, and banking, whether plain vanilla or incredibly sophisticated, is inherently risky.

Now, it's certainly true that when you look at the country's biggest banks, trading and speculation have become an ever-bigger part of their business. But the financial crisis was not the product of too much trading or too little disclosure. It was the product of a massive credit bubble, during which banks all across the country, and investors all across the world, handed out trillions of dollars in loans on massively overvalued assets, much of it to people who were unlikely to ever be able to pay them back. This bubble was certainly exacerbated by the spread of securitization, which created the illusion that risk was diversified and made it easier for lenders to hide the sheer crappiness of the loans they were making, and credit-default swaps, which allowed banks to delude themselves that they were insured against risk. But the fundamental source of the crisis, and of the banks' troubles, was the orgy of irresponsible lending. And while uncertainty did help fuel panic in the fall of 2008, even if banks had been as transparent as possible, there would still have been a panic. Indeed, given the disastrous state of bank balance sheets then, honesty might have made people more panicked, not less.

That bad loans were, ultimately, the problem can be seen in the fact that, as the economists Christian Laux and Christian Leuz write, "of the 31 bank holding companies that failed and were seized by U.S. bank regulators between January 2007 and July 2009, loans and leases accounted for roughly three-quarters of their balance sheets, and trading assets essentially played no role." These banks were not playing around with complicated financial instruments. They just lent themselves right into insolvency. And while the biggest banks were carrying lots of trading assets on their books, Laux and Leuz show that, at the height of the bubble, straight loans and leases still constituted roughly half of their assets, while a sizable chunk of their tradeable assets were things like mortgage-backed securities, which ultimately derived their value from the (often worthless) mortgages that underlay them. In other words, it was the housing bubble that was the source of the problem. You can see this even more clearly abroad, where both Spain (which Nick Paumgarten writes about in this week's issue) and Ireland saw the bursting of housing bubbles lead to devastating financial crises and massive economic trouble, despite the fact that the banks in these countries were, for the most part, not especially complicated or hard to understand.

The point, as Anat Admati and Martin Hellwig put it in their crucial new book "The Bankers' New Clothes," is that "Although risk and losses from excessive market speculations are bigger media events, traditional lending can be just as risky and can lead to very large losses." The rhetoric of "plain vanilla banking" makes it sound as if making traditional loans is relatively risk-free. Yet historically, it's traditional lending gone wrong that's led to financial crises. In fact, since the late nineteen-seventies, out-of-control lending led to three different banking crises in the U.S. (the sovereign-debt crisis of the nineteen-eighties, the S&L debacle, and the commercial and business real-estate bubble of the late eighties), even before the housing bubble hit. Disclosure, and limits on trading, are good things. But even simple, open banks are, as history shows, risky. The key is ensuring that banks are more resilient to the possibility of failure, and that they bear more of their own risks, rather than sloughing them off on the rest of us.

What does this mean in practice? Well, the biggest issue with the way banks work these days is that they're funded almost entirely by debt--in other words, nearly all of the money they lend out is itself borrowed. This has a number of negative consequences. First, it encourages recklessness, since the banks are in effect gambling with other people's money. Second, it means that banks have very little cushion if they make mistakes--even relatively small declines in the value of their loans can put them on the verge of technical insolvency. And since some of the biggest holders of bank debt are other banks, the heavy reliance on borrowing means that if one institution gets into trouble, its problems can easily cascade through the system, weakening other banks as well.

As it happens, though, there's a way to change this--as Admati and Hellwig persuasively argue, we should simply require banks to hold more equity capital, and less debt. (Equity isn't the same thing as reserves; banks can raise equity either by selling more shares to the public or just retaining earnings and investing them in the company.) Bankers hate this idea when it's applied to them, because they think it will reduce their profits, and therefore their salaries. But the irony is that when it comes to the loans they make, most of them understand the value of equity perfectly well. If you want to start a restaurant, and you ask a bank for a loan, any sensible banker is going to insist that you put a sizable amount of money down--that is, that you have a significant chunk of equity in the business--before they lend you any money. They do this because they know that if you don't have real equity in the business, they'll be running almost all of the risk, while you'll be making most of the profits, which will encourage you to take reckless gambles. (This is also why, these days, the only way banks will issue low-down-payment mortgages is if they're insured by the federal government). Yet when it comes to their own operations, banks want to put as little down as possible--they want to be "equity-light."

It's easy to understand why banks take this approach--not only does it seem to be a way of supercharging their return on investment, but equity looks more expensive than debt, particularly when bank stocks are depressed. But having more equity does not wreck profits--in fact, plenty of American corporations, including companies like Apple and Google, are funded almost entirely by equity rather than debt. And in any case, bank debt is cheap because of what you might call the socialization of risk, particularly with the big banks: debtholders are willing to lend money cheaply to them because they think they're too big to fail. That means the money is falsely cheap--the government is, in effect, subsidizing bank borrowing. And this falsely cheap debt, in turn, encourages banks to think that they're smarter, and safer, than they actually are.

Requiring banks to have more equity, by contrast, would make them reckon with the real risks they're running. As for transparency, forcing banks to rely more on equity funding might help with that too: they'd probably have to be more transparent, too, in order to win shareholders over. Most important, it would give banks a much bigger margin of error, and make it less likely that taxpayers would end up on the hook when things went wrong. Congress has given regulators the authority to impose tougher capital requirements on the banks. Now would be a good time for them to use it.

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This page contains a single entry by CFED published on February 20, 2013 4:27 PM.

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