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Global Banking: A Failure of Structural Integrity
by
Thomas M. Hoenig, Vice Chairman,
Federal Deposit Insurance Corporation
Presented to
the Institute of International and European Affairs;
Dublin, Ireland
December 13, 2013
Introduction
Over several years preceding the recent economic crisis, the U.S. financial safety net of
deposit insurance, Federal Reserve lending and Treasury direct investments was
expanded to include activities far beyond the core business of commercial
banking.1 The effect was to erode the very economic stability being sought. More
disturbing, however, is that the weakened financial structure and crisis that followed
these changes made it necessary for policymakers to do “whatever it takes” to stabilize
a system on the brink of collapse. Within the boundaries of the safety net, the
government provided enormous amounts of money and guarantees, and arranged and
financed numerous mergers and buyouts, in its efforts to save a struggling industry and
global economy.
It is no coincidence, therefore, that these events coincided with the evolution of an
industry that is far more concentrated, complex, and government dependent than at any
time in recent history. In 1990, for example, the five largest U.S. financial holding
companies controlled only 20 percent of total industry assets. Today that number is 55
percent and will likely increase.
Ironically, these events also have left the U.S. economy increasingly vulnerable to
industry mistakes. For example, the single largest financial holding company in the
U.S., using international accounting standards, now holds more than $4 trillion of
assets, which is equivalent to 25 percent of nominal GDP. 2 The eight largest U.S.
global systemically important banking firms (G-SIBs) hold in tandem nearly $15 trillion of
assets, or the equivalent of 90 percent of GDP. Thus, whether resolved under
bankruptcy or otherwise, problem institutions of this influence will have systemic
consequences and affect far more stakeholders than simply these firms and their
shareholders and creditors.
The ability of ever-more concentrated and complex financial firms to conduct a broad
array of activities while the government backstops their mistakes remains a generous
subsidy. 3 Over time it most certainly undermines market discipline, distorts firm
behavior, and slows economic growth. It protects some creditors and creates a moral
hazard problem within financial markets, and it bestows a competitive advantage to one
segment of the financial industry over another. Thus, the benefits that the economy
might receive from subsidizing this banking structure are often outweighed by the
negative effects that eventually are borne by other sectors of the economy and the
public.
With this in mind, this afternoon I will briefly review some of the principle benefits that
would likely flow to a host of stakeholders if the safety net was scaled back and the
structure of the banking industry was rationalized around essential core functions.
Narrowing the Safety Net
I will begin by briefly defining what I mean by core functions and scaling back the safety
net. First, commercial banking organizations that are afforded access to the safety net
would only be permitted to conduct the following types of activities: commercial banking,
certain securities underwriting and advisory services, and asset and wealth
management services. Other underwriting and broker-dealer activities would be
conducted outside of firms that hold a commercial banking charter and thus outside the
safety net. 4
Second, the shadow banking system and its use of bank-like funding to intermediate
long-term assets would be reformed and subject to greater market discipline.5
This proposal recognizes that recent and proposed regulatory actions, such as the
Volcker Rule, serve to lessen the moral hazard issues and misaligned incentives that
contributed to the recent financial crisis. However, while useful, they do not fully
separate the host of trading and market-making activities of broker-dealers from the
bank holding company and the overarching benefit of the safety net. The fundamental
restructuring I propose would more fully address this problem. It would separate
complex financial firms along business lines and into separate corporate entities. It
would unequivocally preclude bank holding companies from engaging in activities that
are distorted when they receive coverage,and it would impede the use of excess
leverage in funding such activities.
In the end, separating commercial banks and broker-dealers would benefit all parties
affected by the conduct of complex firms -- including the public, the broader banking
and financial industry, institutional borrowers, and the very firms that were at the center
of the crisis. While any reform involves trade-offs, the benefits of subjecting a highly
subsidized and artificially created system of complex firms to the forces of the market
and away from government dependency deserves discussion.
Beneficiaries of a More Rational Structure
Financial Conglomerates and Improved Performance
There is increasing evidence that the largest, most complex financial firms would benefit
significantly from the structural changes outlined above. These conglomerates control
assets in the trillions of dollars and involve structures that include thousands of
subsidiaries, complex and varied activities with significant risks, and hundreds of
thousands of people. Firms with these characteristics inevitably suffer serious financial
setbacks as their leadership cannot manage their culture and because individuals within
the firm too easily circumvent overly complex and centralized controls. Managing them
requires enormous amounts of information, knowledge, and skills that test any CEO’s
capacity.
The constant drum beat of scandal and mediocre performance of the past half-decade
suggests that some financial firms have reached that point where they are too large and
complicated to be led successfully. Management diseconomies appear to be
overwhelming the economics of scope and scale. Unfortunately, in an environment in
which the safety net protects these firms from outright failure, there is limited outside
discipline or other mechanism to “right size” the firms and, as a result, market
inefficiencies multiply.
Confining the safety net and statutorily separating activities along business lines would
make the largest financial conglomerates more manageable and would enhance the
market’s role in disciplining behavior. It would require simpler and more reliable control
systems. And should management fail in its job, the firms could be resolved more
successfully. No firm can survive incompetent management; however, those firms
where a competent CEO’s span of control is consistent with the demands of the day are
far more likely to achieve consistent high performance over time.
The market in its pricing of these firms also seems to be signaling this
conclusion. Some of the largest banks have earned poorly over the past decade as
they have dealt with a host of asset and performance problems. Some of the largest,
most complex firms are trading at a discount from book value, suggesting that the
market is not confident in their future performance. Market analysts are publishing
reports suggesting the value of some of these companies would be greater if they were
broken up. Should the performance of these largest firms continue to show
substandard results, market pressure to simplify their structure will almost certainly
increase.6
There is, of course, strong disagreement with this view from those managing the largest
firms. Nevertheless, their firms’ performance through the crisis and its aftermath, and
their reliance on the safety net, raise legitimate questions as to the role of such
conglomerates in the future.
Commercial and Industrial Companies and Dependable Credit
It is argued that large industrial companies require large, highly complex financial firms
to meet their global credit needs. Having a single banking firm and its resources
immediately available to meet global payments and credit requirements is an invaluable
resource, it is said. This argument continues that financial conglomerates also serve
the role of counterparty for hedging transactions or interest swaps to assure reliable
cash flow.
However, the chart titled, “Consolidation of the Credit Channel” 7 shows how overstated
this story line is. In 1984 the aggregate distribution of assets among four size groups of
U.S. banks, ranging from less than $1 billion to more than $100 billion, was nearly
equal. This changed dramatically over the next three decades, to where the
overwhelming control of credit resources now lies with the fewest mega-banks. To
suggest that this redistribution of assets among domestic financial firms has served a
greater international competitive purpose or enhanced individual economic interest is to
deny the events of the past five years.
In private, the CEOs of many industrial companies indicate that they do not want to be
dependent on a single banking firm for all of their financing needs. They are aware that
during the crisis, credit lines were too often pulled without regard to the need or length
of the credit relationship. The Alliance for American Manufacturing has noted that
commercial and industrial loans declined from $l.6 trillion in 2008 to $1.24 trillion in
2011, and it suggests that this represents not only a decline in demand but also a
significant decline in the supply of credit as well. In reporting this figure, the Alliance
added that before the advent of conglomerate financial firms and their control of such
vast resources, capital markets were the servants of manufacturing companies,
whereas today they are the masters.8 The fact that one industry is so widely expressing
its frustration is worth noting.
Economic theory and practice suggest that institutional borrowers and businesses
benefit from a highly competitive market. For decades in the United States, a
decentralized commercial banking system provided payments services and individual or
syndicated credit services to industrial companies with vast global
operations. Investment banks successfully provided to these same firms underwriting
and market-making services, and engaged in trading activities – all without the safety
net subsidizing their operations. These activities were also conducted with far fewer
conflicts of interest than witnessed since the merging of commercial banking and
broker-dealer activities inside the safety net.
Given the experience and market evidence following from the most recent crisis, there
is a strong case that the business and institutional client would benefit from a less
subsidized and more competitive, more specialized, more market-driven structure than
that which brought forward the Great Recession.
Independent Broker-Dealers and Enhanced Competition
We are also told that it was not the largest banks that caused the crisis, but brokerdealers or mono-line firms. Such a statement ignores a great deal about commercial
bank activities leading up to the crisis.
In 1999, with the passage of the Gramm-Leach-Bliley Act, commercial banks were
formally permitted to expand into activities traditionally conducted by broker-dealers,
and they were able to do so without having to relinquish their access to the public safety
net. This provided them a competitive advantage that cannot be overstated. U.S.
broker-dealers could not successfully compete with complex banks that, due to the
safety net, had almost unlimited access to low-cost funds and the ability to rely on
extreme leverage to expand their balance sheets.
Knowing this, investment houses opposed repeal of Glass-Steagall when it was first
discussed. 9 However, once Gramm-Leach-Bliley was enacted into law, the competitive
advantages it offered were so significant that firms outside the safety net were
compelled to get within it to survive. They gained access either by merging into a
commercial bank or by increasing their risk profile using more volatile funding and
increased leverage, just as the commercial banks were doing with the support of the
safety net.
Firms like Bear Stearns, Merrill Lynch and Lehman Brothers chose the latter option in
their ultimately failed effort to stay relevant. They issued significant amounts of shortterm liabilities, such as repos, to fund longer-term assets. And because financial
regulations were changed to enable them to access short-term sources of funds, they
became commercial banks in practice, leveraging their balance sheets and
intermediating short-term liabilities and longer-term assets. Given these structural
changes, it should surprise no one that when the crisis occurred, it was necessary to
also bail out these firms, greatly expanding the explicit use of the government
guarantee.
Today, apart from a handful of boutique firms that compete with a different business
model in a specialized market, traditional broker-dealers either have merged or
transformed themselves from shadow banks into bank holding companies.
If commercial banking and its safety net were unquestionably separated from
investment and broker-dealer activities, independent broker-dealers would again
compete for capital and business clients within an open market. Investment banks
could provide non-subsidized underwriting, trading and market-making services, and
these activities would be conducted with far few conflicts of interest than is currently
being experienced.
Prior to Gramm-Leach-Bliley no market in the world was more innovative and
competitive than that of the United States with its specialized loan and capital markets.
Individual firms could succeed -- and they could also fail -- without bringing the entire
financial system down with it. It was, in practice, a financial model that provided better
outcomes than we have experienced since its demise.
Banking Industry and Regulatory Burden
Following each crisis new laws and regulations inevitably follow, and this most recent
crisis is no exception. The Dodd-Frank Act subjects the banking industry to hundreds of
pages of laws requiring thousands of pages of rules. These laws and regulations
operate as a fixed cost for all financial firms. No matter the size of the firm, rules must
be read and implemented, staff must be trained, and lawyers must be consulted to
assure proper compliance. As with any set of fixed costs, their averages decline as
these costs are allocated over more assets. Thus, the advent of substantial new
regulations, with their high fixed costs, encourages the process of consolidation as firms
must manage costs down.
As firms consolidate and some become too important to fail, they also receive an
advantage to fund assets with far greater amounts of debt and at a lower cost than that
available to other regional or community banks. For example, the leverage ratio -- the
ratio of tangible capital to total tangible assets -- for the eight largest banks in the U.S.
at the end of the second quarter of 2013 was 4.3 percent, using international accounting
standards. 10 This is approximately half the tangible capital to assets held among other
U.S. banks.
In targeting a specific expected return on equity (ROE), therefore, the ability to hold half
as much capital against the cost of deposits or borrowed funds results in a significant
pricing advantage in the competition for loans.
Comparing ROEs among bank groups, it should surprise no one that the ROE for the
largest banks in the U.S., even with their current issues, is higher than banks not
considered too big to fail. 11 This disadvantage makes it proportionally more difficult to
attract capital to banks not geared toward consolidation.
Thus, pulling back the safety net to commercial banking activities could have several
beneficial effects for regional and community banks. It would reduce the need for evermore complicated and burdensome regulations that raise the cost of doing business
and encourage further industry consolidation. It would reduce the perception that some
banks cannot be successfully allowed to fail, which enhances their access to lower-cost
capital and provides them a competitive edge in pricing products. Finally, returns to
shareholders would be determined by market performance and less by regulatory
circumstance.
The Public and Economic Stability
Finally, and most importantly, rationalizing the financial industry’s structure would serve
the interest of the public. While there were many contributing factors to the most recent
crisis, the safety net’s extension to an ever-wider array of activities, which encouraged
excessive leverage and unmanaged asset growth, played a central role. When the
leverage boom ended and the world discovered that there wasn’t enough bank capital
to absorb unexpected losses, these large, complex, and highly leveraged firms brought
our economic system to the brink of collapse.
As a result, governments were required to commit trillions of dollars of public resources
as they struggled to stabilize global banks and economies. Even these efforts could not
prevent the loss of millions of jobs and the onset of the Great Recession.
The U.S. has a long history in which its financial structure included firms ranging from
many large commercial banks to medium and small banks, and independent investment
houses serving a broad range of customers with varying credit and funding
requirements. This decentralized structure contrasts with today’s small number of large
financial firms, which too often become single points of failure, as we recently
experienced.
In a private capital financial system there always will be business cycles, business
failures, and financial losses. When financial resources are concentrated in only a few,
protected firms, the impact of any one failure is almost necessarily systemic and
sometimes catastrophic. Rationalizing the structure won’t end failure, nor should it, but
it will make failure more manageable and less likely to become catastrophic to the
public interest. Adam Smith in his Wealth of Nations recognized this more than 200
years ago and argued, as many argue today, for a decentralized, less concentrated,
and less government-dependent banking system.
Conclusion
In the quest to improve financial industry stability, behavior and performance, it is
unfortunate that we choose complicated administration over structural change. It is the
financial structure that is inherently unstable, yet it remains mostly unchanged from that
which existed prior to the crisis. The safety net and its subsidy have expanded in
scope. Firms have grown larger and more complex. The issue of single point of failure
and its effect on the economy has increased in prominence, and the competitive
inequities that follow from these circumstances remain mostly unaddressed.
We share a common goal: to have a system where financial firms are well run and
successful; where the market and customers drive behavior and enhance firms’
performance; where financial returns are competitive, reliable and therefore able to
attract capital. It is time to change the current structure to achieve this common goal.
###
FDIC Vice Chairman Thomas M. Hoenig is formerly the President of the Federal
Reserve Bank of Kansas City and a former member of the Federal Open Market
Committee. More information about his policy positions on reforming bank structure
and strengthening capital, including his white paper “Restructuring the Banking System
to Improve Safety and Soundness,” can be found
at http://www.fdic.gov/about/learn/board/hoenig/
1
The Gramm-Leach-Bliley Act of 1999 allowed bank holding companies, investment
banks and insurance companies to engage in all activities previously permitted to each
group. This was a significant expansion of the safety net's protection to creditors,
increasing the coverage beyond the safety net's historic purpose of assuring a reliable
payments system and a reliable intermediation process of transforming short-term
liabilities to longer-term assets. It thus extended the related morale hazard problem to a
significant degree.
2
Global Capital
Index http://www.fdic.gov/about/learn/board/hoenig/capitalizationratios2q13.pdf
3
Literature review of TBTF subsidy. http://www.fdic.gov/news/news/speeches/literaturereview.pdf
4
“Restructuring the Banking System to Improve Safety and Soundness” by Thomas
Hoenig and Charles Morris. May 2011; revised November
2013. http://www.fdic.gov/about/learn/board/hoenig/Restructuring-the-BankingSystem,Hoenig,Morris,Nov.2013.pdf
5
Money market mutual funds and other investments that are allowed to maintain a fixed
net asset value of $1 should be required to have floating net asset values. Shadow
banks’ reliance on this source of short-term funding would be greatly reduced by
requiring share values to float with their market values and be reported accurately. In
addition, bankruptcy laws should be changed to eliminate the automatic stay exemption
for mortgage-related repurchase agreement collateral. This exemption resulted in a
proliferation in the use of repos backed by mortgage related collateral. One of the
sources of instability during the recent financial crisis was repo runs, particularly on repo
borrowers using subprime mortgage-related assets as collateral.
6
“Break Up Banks: Show Me My Money,” Credit Agricole Securities - Mike Mayo.
January 2013.
7
See attached Chart 1 titled Consolidation of the Credit Channel.
8
Alliance for American Manufacturing. June 28,
2011. http://ourfinancialsecurity.org/blogs/wpcontent/ourfinancialsecurity.org/uploads/2011/07/SCOTT-PAUL.pdf
9
Statement of Robert F. Shapiro, Chairman of the Securities Industry Association, to
the Senate Banking Committee Hearings on Comprehensive Reform in the Financial
Services Industry. June 11, 13, 18, 19 and 20, 1985.
10
Global Capital Index, column
8 http://www.fdic.gov/about/learn/board/hoenig/capitalizationratios2q13.pdf
11
See attached Chart 2 titled Return on Equity Based on Bank Size.
@FedFRASER