Sunday, March 31, 2013

Banks Still Too-Big-To-Fail: Six Things The Fed Must Do

We can’t solve problems by using the same kind of thinking we used when we created them.
Albert Einstein

At a news conference last Wednesday, Ben Bernanke, the chairman of the Federal Reserve, conceded that the problem of too-big-to-fail is “still here”.  If new rules and international cooperation did not solve it, he said, “additional steps” will be needed. Chairman Bernanke didn’t say what “additional steps” he has in mind. Since neither Dodd-Frank nor conclaves of central bankers are getting the job done, let’s give the chairman some help, by pointing out six things the Fed must do.

Abandon nostalgia for a world that no longer exists


Let’s start with some popular non-starters. Simon Johnson, former chief economist of the International Monetary Fund, and a Professor of Entrepreneurship at the M.I.T. Sloan School of Management, writes in the New York Times writes that  “the clearest possible statement of how to think about the modern financial system – and make it less risky” lies in a speech by Richard Fisher, president of the Federal Reserve Bank of Dallas, entitled “Ending Too Big To Fail.”
Fisher argues that “the largest financial holding companies be restructured so that every one of their corporate entities is subject to a speedy bankruptcy process, and in the case of the banking entities themselves, that they be of a size that is ‘too small to save.’ …The downsized, formerly too-big-to-fail banks would then be just like the other 99.8 percent [of banks], failing with finality when necessary—closed on Friday and reopened on Monday under new ownership and management in the customary process administered by the FDIC.”
The world that Fisher yearns for—a banking system composed of small banks that are easy to regulate: closed down on Friday and reopened on Monday under new ownership and management—was a comfortable cozy world for regulators that existed for many decades. It was one in which the central bankers were unquestionably in charge. The problem is that that world no longer exists.
There is no way that the Fed is going to be able to slice a bank like JPMorgan Chase [JPM] with 260,000 employees operating in sixty countries in a multitude of different businesses, or a bank like Citigroup [C] with 200 million customer accounts in 160 countries and processing $3 trillion in transactions every day,  into sets of small, independent, easily monitored entities that can be closed down on Friday and reopened on Monday with scarcely a ripple on the surface of the financial ocean. Fisher’s world no longer exists. There is no way it can be re-created. Efforts to re-create it will be counter-productive.

Don’t apply linear solutions to complex problems

The Fed should thus observe the first lesson in coping with complexity: the principle of obliquity. Efforts to impose linear thinking on complex situations typically lead to the opposite of what is intended. Where explicit articulation of a goal will result in the complex environment pushing back in the opposite direction, an oblique approach will often be more effective.
The banks may be too big, but an effort by the Fed to break them up by direct action is likely to have the opposite effect, for a number of reasons. First, there is no consensus that size is the issue. Even a liberal critic like Nobel-Prize winning economist, Paul Krugman, has argued that size isn’t the problem. Second, even among those who think that size is the issue, there is no consensus on how big is too big. Third, studies suggest that larger banks are more robust in coping with crises. Fourth, all the financial crashes have been sparked by problems in smaller financial institutions, not big banks. Finally, the financial sector will exploit all the preceding issues in a furious counter-action that would end up discrediting the Fed if it were to launch an explicit effort break up the big banks.

Reinventing central banking: from inspections to managing complexity

Historically, banking regulators have always worked as a secretive bureaucracy, working quietly behind closed doors, concealing problems from the public, so as to avoid the kind of panic that might aggravate the very problem they are trying to avert, and issuing their unchallengeable decisions with imperial force: “This bank will close” and “That bank will stay open.”
The approach of secret inspections and controls is no longer adequate to cope with the forces of “innovation” that have been unleashed by the modern financial sector. The inspectors are always several steps behind the “innovators” aka rogues, such as the London Whale.
As my colleague Richard Straub points out, we need to keep in mind Albert Einstein’s dictum:  “We can’t solve problems by using the same kind of thinking we used when we created them.” To solve today’s problems, the Fed has to think differently.

The Fed’s most powerful and most under-used tool: knowledge


Although the conventional wisdom is that the Fed has done all it can to resuscitate the economy by pumping money into the banking system and hold down interest rates, the reality is that the Fed has barely begun to use one of its most powerful tools: knowledge. Knowledge can mobilize the forces the marketplace to achieve the Fed’s ends.
Whatever one might think about the policy approach of the Fed, few have ever questioned its professionalism. The problem is that the professionals have been largely keeping this expertise to themselves, instead of sharing it with investors who can also act on it. Instead of having a few inspectors trying to catch up with rogues like the London Whale, we need millions of investors with the knowledge to follow what is going on and to act on the consequences.
Investors have the power and the smarts to shift their money out of JPMorgan Chase if it behaves recklessly. The sanctions of the marketplace are swift and decisive—if the right knowledge is available. There are six things the Fed must do to enable this to happen.

1.      Expose the banks’ hidden $5 trillion in derivatives assets

For starters, stop letting the big US banks hide half their assets off their balance sheets—some $5 trillion in derivative assets, according to a recent report from the Milken Institute, That happens now because “generally accepted accounting principles” in the US (GAAP) allow banks to conceal trading in derivatives. Other countries follow International Financial Reporting Standards (IFRS) rules which would require those derivative assets to be included on bank balance sheets.

Accounting principles that allow half of the assets of the banks to be hidden are unacceptable. It is time that US banks are required to adopt International Financial Reporting Standards (IFRS) rules and make full disclosure of their assets in derivatives. Much of the rest of the world does it. Why not the US?
This would have another salutary effect: it would reveal the true book-to-market ratios of the banks. The ratios of all the biggest banks, except for Wells Fargo, are less than 1.0. In other words, Wall Street is saying: the big banks would be worth more broken up, than they are in their current form. If the banks’ accounts included their derivative assets, the correct book-to-market-value ratios would be very much less than 1.0, thus increasing the pressure of market forces to break up these banks, which are too big, not only for society but for the good of their own shareholders.

Memo to the Fed: A principal cause of the 2008 meltdown was regulatory inaction when commercial banks were keeping over half of their assets off balance sheets. Dodd-Frank does nothing to change this. The global derivatives market is now 30 percent larger than it was in 2008, and that much more dangerous. It is a dereliction of the Fed’s duty to permit this hiding of derivative assets to continue. Bringing accounting practices up to international standards is a minimal first step.

2.      End the banks’ deceptive accounting practices

As The Atlantic pointed out last December, “At the heart of the problem is a worry about the accuracy of banks’ financial statements.” The Atlantic took apart the Wells Fargo’s [WFC] 2011 annual report. On the surface the accounts appear to be about a traditional kind of bank, with income divided into the usual three categories: “interest income” (i.e. traditional banking), “non-interest income” (i.e. services) and “other” (i.e. presumably an unimportant category of minor residuals).

Department of Deceptive Terminology: When The Atlantic dug into the details the 2011 annual report of Wells Fargo, it found that the reality was very different.
  • The term “interest income” sounds like innocuous traditional bank lending. It’s not. When you read on, you find that “interest income” includes almost $1.5 billion from “trading assets”; and another $9.1 billion results from “securities available for sale.”
  • The term “non-interest income” sounds like customer fees. It’s not. “Non-interest income” includes $1 billion in “net gains from trading activities” and another $1.5 billion is income from “equity investments.”
  • In Wells Fargo’s report, the income category “other” sounds like a minor insignificant detail. It’s not. It amounted to $6.6 billion of Wells Fargo’s income in 2011, or more than a third of Wells Fargo’s income. It would take an extremely diligent reader another fifty pages to discover that the bank derives that most of the “other” income is again from “trading activities.”

Department of missing information: Information on critical aspects of Wells Fargo’s activities is missing.
  • Economic hedging” might be benign or not. Is Wells Fargo’s “economic hedging” like buying straightforward insurance? Or was it more like speculation—what the London Whale at JPMorgan did? Wells Fargo’s annual report provides no information.
  • Collateralized debt obligations (CDOs)”: There is no full disclosure of what Wells Fargo is doing in collateralized debt obligations (CDOs)—the derivatives that led to the 2008 meltdown. Instead there is just a brief but alarming reference at the bottom of page 164: “In 2011, we incurred a $377 million loss on trading derivatives related to certain CDOs.” Once upon a time, a loss of this magnitude would have been headline news. Now, it’s hidden from view. Worse: there is no way of knowing how much of this is going on at the bank or how much risk is involved.
  • Customer accommodations” is another innocent-sounding category on which Wells Fargo made more than $1 billion in 2011. How did it make so much money merely by helping customers? Later in the report, we learn the truth. Customer accommodation consists of “security or derivative transactions conducted in an effort to help customers manage their market price risks and are done on their behalf or driven by their investment needs.”
  • The risks from trades: The Atlantic asks: “How much risk is the bank actually taking on these trades? For which customers does it place a requested bet, then negate its risk by taking an exactly offsetting position in the market, so that it is essentially acting as an agent simply taking a commission? And for all these trades, what risk is Wells Fargo taking on its customers? Many of these bets involve the customers’ promises to pay Wells Fargo depending on how certain financial numbers change in the future. But what happens if some of those customers go bankrupt? How much money would Wells Fargo lose if it “accommodates” customers who can’t pay what they owe?” We simply don’t know.
When relevant accounting information is systematically missing, the issue goes beyond missing information: it turns into something else: deceptive accounting.
Kevin Warsh, a former Federal Reserve Board member appointed by George W. Bush, says woeful disclosure is a major problem. “Investors can’t truly understand the nature and quality of the assets and liabilities. They can’t readily assess the reliability of the capital to offset real losses. They can’t assess the underlying sources of the firms’ profits. The disclosure obfuscates more than it informs, and the government is not just permitting it but seems to be encouraging it.”

Memo to the Fed: The continuation of deceptive accounting practices is a dereliction of the regulators’ duty to the public. In collaboration with the SEC and OCC, the Fed should expose these practices for what they are and require the banks to present non-deceptive information to investors. Banks that don’t comply should be classified by the OCC as “unsatisfactory management”. The SEC should reject submissions that continue these deceptive practices.

3.      Expose the continuing use of special purpose entities

Of particular concern is the re-emergence of “special-purpose entities” i.e. the infamous accounting devices that Enron employed to hide its debts. These deals were called ‘off-balance-sheet’ transactions, because they did not appear on Enron’s balance sheet. They have now re-emerged, even in Wells Fargo, under the new name of “variable interest entities”. The Atlantic calls them “an even lower circle of financial hell” than proprietary trading. The article likens variable interest entities to “a horror film, which the special-purpose entity has been reanimated… The problem is especially worrisome at banks: every major bank has substantial positions in VIEs.”
As of the end of 2011, Wells Fargo, the “extremely safe bank”, reported “significant continuing involvement” with variable-interest entities that had total assets of about $1.5 trillion. The ‘maximum exposure to loss’ that it reports is much smaller, but still substantial: just over $60 billion, more than 40 percent of its capital reserves. The bank says the likelihood of such a loss is ‘extremely remote.’ As The Atlantic comments: “We can hope.”
Worse: “Wells Fargo… excludes some VIEs from consideration, for many of the same reasons Enron excluded its special-purpose entities: the bank says that its continuing involvement is not significant, that its investment is temporary or small, or that it did not design or operate these deals. (Wells Fargo isn’t alone; other major banks also follow this Enron-like approach to disclosure.)… The presence of VIEs on Wells Fargo’s balance sheet ‘is a signal that there is $1.5 trillion of exposure to complete unknowns.’”

Memo to the Fed: Do your job: expose these activities for what they are and require full continuous disclosure.

4.      Expose the banks’ role in the real economy

Chairman Bernanke has made job growth the Fed’s top priority for the first time in its 100-year history. The New York Times reports: “At his news conference last week, he spoke about the issue in personal terms. Asked when he last had spoken to an unemployed person, he said that one of his own relatives was out of work.  “I come from a small town in South Carolina that has taken a big hit from the recession,” Mr. Bernanke said. ‘The last time I was there, the unemployment rate was about 15 percent. The home I was raised in had just been foreclosed upon. I have a great concern for the unemployed, both for their own sake but also because the loss of skills and the loss of labor force attachment is bad for our whole economy.’”
Chairman Bernanke is thus very conscious that the Fed’s strategy of shoveling money into the banking system has yet to have much positive effect the real economy. The banks are better off. The big firms’ profits are up. The top executives are sitting pretty. But the real economy in which most people work is still struggling.
Why might that be? Could it that when even conservative banks like Wells Fargo make around two-thirds of their income from trading and derivatives the best minds in the banks are deployed, guess where? In trading and derivatives.
When I read JPMorgan’s own report on the London Whale, I was struck, not just by the arrogance and the errors, but also by the quantity and quality of brainpower being deployed in socially useless activities, i.e. managing billions of dollars or gambling on an obscure stock index. Just imagine what this talent could accomplish if it was deployed on expanding opportunities and reducing risk for the real economy?
Have not these big banks become similar to those Mafia families that had a legitimate business as a mere front (such as commercial banking) while their real business was out the back: gambling (derivatives trading)? Doesn’t the FED have a responsibility to track and make explicit to the public what proportion of these banks’ efforts are engaged in promoting the real economy and how much is devoted to socially-useless gambling? Isn’t “making money from money” without connection to the real economy what has been the cause of major financial crashes in the past?

Memo to the Fed: Monitor and publish an index tracking the proportion of effort devoted by the big banks to the real economy.

5.      Help expose the theory that causes the problems

Why have the banks lost sight of their primary function of expanding opportunities and reducing risk for an ever wider circle of citizens and enterprises and turned themselves into a vast gambling casino of no social value to society? The story is a complex one, but a principal thread is the idea that became prevalent in the early 1980s: “The object of a firm is to maximize shareholder value, that is, to make money for the firm.”
In the ensuing single-minded search for profits, banks started pursuing what are known as “bad profits”. These practices were not illegal, but they were not in the best interests of customers or society, and included price gouging, gaming the system, toll collecting, zero-sum trading and excessive compensation.

At first, these “bad profits” were achieved through practices that were shady but not strictly illegal. But in due course, the temptations became too great and the “bad profits” turned into practices that were illegal, including price fixing of LIBOR, abuses in foreclosure, money laundering of drug dealers and terrorists, assisting tax evasion  and misleading clients with worthless securities.
Beyond banking, the goal of maximizing shareholder value has also had disastrous economic consequences. It has ended up having the opposite effect of what was intended. Paradoxically, the goal of maximizing shareholder value has resulted in lower shareholder value in the medium term. Returns on assets and invested capital are in steep and steady decline, as Deloitte’s study of 20,000 US firms from 1965 to 2011 shows (the Shift Index).
The bottom line is that the shareholder value theory hasn’t worked, even on its own terms. In banking, shareholder value has not only led the banks into activities of dubious social benefit, of great risk to society, loss of trust and eventually illegality. What is important for today’s discussion is that it also had high opportunity cost for the banks. Pursuing profits has distracted banks from their true social purpose of reducing risk and increasing opportunities for an ever wider circle of citizens and enterprises. Innovation has been taking place in banking, but not in a way that provides sustained benefits for either the banks or society.

Memo the Fed: Help expose the false theory that has led to such disastrous economic consequences. Help document its origins. Track its impacts. Publish research comparing the financial results for shareholders of banks that pursue shareholder value and banks that pursue delighting customers profitably.

6.      Shift the Fed’s thinking from inspection to enablement

The Fed must shift its own thinking from a 20th Century perspective of secret inspection and controls to a 21st Century modality of open information and enablement. Basic change happens, not when vested interests are defeated, but when different strategies are used to pursue those interests. The Fed can play a major role in facilitating this change in mindsets and attitudes.
Dani Rodrik makes the case in a terrific article, “The Tyranny of Political Economy” that the trick in getting difficult political change is persuading the elites that it’s in their own interests. In effect, banks would be more profitable for shareholder and for the economy if they systematically pursued adding profitably value for customers, rather than pursuing short-term profits for themselves. The fact that that the smaller regional banks are more profitable on average than the big banks already proves the point.
The Fed needs to help persuade the leadership of the big banks their future depends on growing the real economy, not on hanging on to the illegitimate way they are making profits today. It must help show that while it may take more effort in the short term but it will eventually increase their power, wealth and prestige.
The Fed can encourage these forces in the financial sector by focusing its research on these key issues and sharing its knowledge with the world.

Other more difficult actions

There are other actions that might help if successful, but these would be much more difficult and much less likely to be successful.

a.      Break up the big banks:

As noted above, direct action is likely to be counter-productive. It would waste precious reputational capital in a battle which it would in the end lose.

b.      Measure the subsidies to the big banks

Governor Fisher, Simon Johnson and others are intrigued by measuring the exact subsidy that the big banks enjoyed, apparently in the hope that if the exact figure were known, it would help spur action on too-big-to-fail. The realization of that hope isn’t obvious. First, the exact figure will always be an estimate and estimates will inevitably differ depending on the assumption. Even if it were known exactly, it would still raise all the above issues of what to do about it.

a.      Smash the Dodd-Frank logjam

A massive and well-funded counter-campaign is under way by the financial sector to prevent the Dodd-Frank regulations from ever being completed, let alone taking effect. The disgraceful story is brilliantly documented in article by Haley Sweetland Edwards in the Washington Monthly. It’s horrifying reading, but it’s not obvious what the Fed can do to intervene. More on that shortly.

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