Are banks out of control?
Photo: Nightscream. Source: Wikimedia
Many people are still hurting as a result the Financial Crisis. And there’s a lot to be upset about. By some measures upwards of $5 trillion in wealth was destroyed. The crisis triggered the Great Recession of 2008-9, and led to government bailouts and fiscal stimulus packages around the world.
At the heart of the crisis was our overly complex banking system. Fundamentally, banking is pretty simple: move money from people who have it to people who need it. People need money for lots of reasons: buying a home or car, starting and running a business, financing large projects like roads, bridges, or fiber optic cables. People have money from their long-term savings, their transaction accounts, and from the “rainy day funds” they need to set aside
This is pretty basic, but it gets lost in the arcane world of mortgage-backed securities, venture capital funding, and collateralized debt obligations. Banks have always been regulated – after all, establishing sound money is an essential government function – but in our global financial system regulatory difference between countries encourage large financial institutions to game the system. And the more rules there are, the more gaming that takes place.
This is why smaller banks are almost always a lot simpler than big banks. The big banks have Caiman Island subsidiaries, Eurodollar deposits, and foreign exchange desks that small banks don’t. These are necessary to serve the needs of their clients, but they also become profit-centers in their own right. It’s easy to look at these operations and say that they’re too risky, full of moral hazard. And wasn’t it trading in sub-prime mortgages that led to the failures of AIG and Washington Mutual and Lehman?
Not really. The institutions that traded these toxic financial instruments only lost a few hundred million dollars. That’s a lot, but it’s not enough to take down the system. It was the banks that bought and held the products—you know, long-term investing, the kind that politicians and pundits are always praising but never seem to support with their policies—that collapsed.
In the aftermath, Congress passed the Dodd-Frank bill, many of the details of which are still being hashed out more than five years after its passage. The devil is in the details, though, and the lack of clear direction by Congress gives regulators some pretty wide-ranging authority. Currently, the regulators are floating a rule to control the compensation of senior bank managers as well as the bank’s traders—the ones who make markets in government bonds and foreign exchange.
There’s a “Bootleggers and Baptists” problem here, where it’s in the big banks’ interests to have the regulations as complex as possible. In the short-run, these rules cost them money. But they cost everyone money—and the largest institutions can afford the systems and risk-management staff and legal counsel to make sure they comply, while smaller firms struggle. So the system devolves into an oligopoly, and too-big-to-fail banks become bigger and bigger.
Source: St. Louis Fed
The answer isn’t having even more complex rules. It’s having clear, unambiguous legislation with more specific direction by Congress – leaving less to regulatory discretion – which often appears capricious and contradictory. You can’t regulate your way to simplicity. But you can make simplicity more profitable. And let the market make it less risky.
Douglas R. Tengdin, CFA
Chief Investment Officer