President Barack Obama’s pledge to impose business line restrictions on banksappeared to catch the market by surprise yesterday, judging from the 200 point tumble in the Dow. Whether or not one supports these measures in concept, the announcements themselves were ill-advised.
The President proposed new and significant restrictions on the size and investments of banks, as well as elimination of proprietary trading, forced retention of securitized risks, and other populist edicts, which if enacted, would require a massive restructuring of the banking industry.
Certainly, the market reacted to the implied abruptness of the changes. Such restructuring could not realistically be enacted in the near term. Indeed, the statements also appeared to catch his own party faithful off guard, prompting House Banking Committee Chairman Barney Frank (D-Mass.) to declare that nothing of the sort was going to take place until he says so, and even then, only in very small steps, and only after three to five years of transition time.
But timing aside, the fundamental question is whether such restrictions would be in the nation’s interest? Are we better off with only banks “small enough to fail”, limited to the business of deposit gathering and lending, and prohibited from investing in complex instruments that Main Street deems potentially dangerous or incomprehensible? Can we go back in time to the financial system of the mid-twentieth century? Is that the goal of Obamanomics?
We certainly cannot return to the banking industry of 1950, even if we wanted to. The twenty-first century banking system is global, just as commerce and industry are global. Most major banks are not U.S. domiciled. Canada, an economy perhaps ten percent of ours, has as many global money center banks as we do. Spain, Japan, China, the U.K. and France are homes to global financial institutions that dwarf most U.S. banks. Like it or not, the global economy is completely dependent upon these global giants. We could no more operate as a nation of small banks than we could as a nation of small airlines or small retail outlets.
Scale provides competitive advantage to money center banks. The heft of their balance sheets and talent pool means that big banks can offer innovations. Credit cards, ATMs, and Mobile Banking exist because large banks had the resources to improve the products and services we receive. Were we a nation of small banks, we might still face three o’clock closing times and hold passbook savings accounts.
What about the other tenets of Obamanomics?
On Thursday, he proposed that institutions be required to retain on balance sheet of at least 10% of risks they securitize, restructure, and sell. This has a certain appeal to the layman, after all, if you think a product is good enough for you customers, why shouldn’t you be willing to retain some of it?
But here again, the White House seeks to substitute edict for transparency. A customer, or trading partner, has the right to full disclosure related to any exchange. Indeed, the very foundation of trade is the different value each party places on the traded instrument. But a 10% retention is both illogical and unworkable under almost any imaginable capital structure for institutions. How long would the 10% need to be retained? How could a trading firm with five to ten percent capital actually function if they needed to retain 10% of every deal?
Many of the products that are securitized are the very credit cards and mortgages we all hold. Would banks be required to retain these on balance sheet? If so, the availability of such vehicles would quickly dry up. The concept is simply unworkable, and about as sensible as one requiring Home Depot to only sell products that are used in building its stores.
Incredibly, shrinking the banks and mandating risk retention are incompatible goals. If banks were to retain 10% of all their deals, their balance sheets would grow, not shrink. Retaining assets rather than selling them off in the capital markets would require banks to increase liabilities and capital to balance the asset retained.
At the volume of business currently handled in our capital markets, retaining 10% of the deals would mean that money center banks would need to be many times their current size, not smaller. Securitization is the way the banks participate in the capital markets without having to grow multi trillion dollar balance sheets.
What about the Financial Crisis Responsibility Fee? Shouldn’t the banks be forced to pay for the loans they got from the government? Of course, the largest US banks (with some exceptions) have already paid the TARP funds back, with interest, and in some cases, under usurious terms. Most of the outstanding monies and exposure remain with the auto companies, AIG, Freddie, and Fannie, all of whom would be exempt from the penalty. Those banks least likely to repay TARP are the small uncompetitive banks, also exempt from the fee. In reality, this fee is simply a extraction of tax from the stronger and more successful institutions. Perhaps it is necessary, but if so, we should be honest about it, and not position it as punishment for acts not committed.
Obamanomics is a chilling experiment.
Markets get jittery when leaders stir up populist resentment, and make abrupt declarations to restructure galactic sectors of the economy. Executives decelerate capital investments when revolution is in the air. The proposed restructuring of the healthcare system has proven to be riddled with devilish details, that increasingly appear ill-advised, yet healthcare is “only” a domestic issue. Banking is global. Restructuring the U.S. banking system runs the risk that we become less globally competitive as well as domestically impeded.
The nation already has various systems of enterprises that do little but take deposits and make small loans: Thrifts, Savings and Loans, Community Banks, and Credit Unions all serve those purposes. There are thousands of these in the U.S. We hardly need more. We certainly don’t need Chase bank to be turned into a collection of “too small to matter” banking outlets.
Ironically, it is often political deal making that limits the ability of regulators to regulate, not the absence of regulation. Under the financial reform legislation already approved in the House and pending in the Senate, regulators can already impose significant size, risk and trading restrictions as needed, on a bank-by-bank basis. Regulators can demand that banks act prudently, and impose draconian restrictions when one doesn’t. We pay our regulators to protect our banking system; that is why they exist. Regulators in turn need transparency of information, freedom from pressure of politicians who too often try to protect their wayward constituents, sufficient resources to do their jobs, and clear rules. Limit any of the above and we can be certain to see more crises and investor jitters.
Finally, in the blame game, let’s not give the politicians such an easy pass. The Freddie and Fannie failures and the sub prime loan disasters were crises of politics as much as markets. The spotlight thus far has focused on ill-disciplined industry participants, without sufficient investigation of the political class that fostered and enabled the deeds.
In the meanwhile, the White House might consider using the bully pulpit more to restore confidence, rather than vent anger or promote resentment against the employees of a critical industry. Bank investors, and employees, do not deserve another beating.
Dave Kaytes is a Managing Director and Founder of Novantas. He has worked with more than 100 financial institutions in strategic assignments involving pricing, product design, marketing and distribution. He is a board member for USHealth Group, a CS First Boston company, and is a widely quoted and published author. A graduate of Yale and Columbia University Business School, he is a guest lecturer at the Wharton Business School, an instructor for the CBA Graduate School of Banking at University of Virginia, and a Davenport Fellow at Yale University.