The Banking Emperor Has No Clothes

An article from The Baseline Scenario

The Banking Emperor Has No Clothes

Posted: 09 Jun 2011 03:10 AM PDT

By Simon Johnson

In a major speech earlier this week to an American Bankers Association conference, Treasury Secretary Tim Geithner laid out his view of what went wrong in the financial sector prior to 2008, how the crisis was handled 2008-10, and what is now needed with regard to implementation of reforms. As chair of the Financial Stability Oversight Council and the only senior member of President Obama’s original economic team remaining in place, Mr. Geithner’s influence with regard to the banking system is second to none.

Unfortunately, there are three major mistakes in Mr. Geithner’s speech: his history is completely wrong; his logic is deeply flawed; and his interpretation of the Dodd-Frank reform does not mesh with the legal facts regarding how the failure of a global megabank could be handled. Added together, this suggests one of our most powerful policymakers is headed very much in the wrong direction.

On history, Mr. Geithner places significant blame for the pre-2008 excesses on the UK and other countries that pursued light-touch regulation. This is reasonable – apart from the fact that he is apparently unaware that the US led the way in lightening the touch of regulation, at least since 1980. A senior British official retorted immediately, “Clearly he wasn’t referring to derivatives regulation because as far as I can recollect, there wasn’t any in America at the time” (Financial Times, June 8, p.1).

More broadly, Mr. Geithner seems to have forgotten how big banks were saved – by government intervention, at his urging. He should probably watch Too Big To Fail, now playing on HBO, or peruse Andrew Ross Sorkin’s book, on which it is based – just look in the index for “Geithner” and trace the arguments that he made for repeated and unconditional bailouts of big banks and their creditors from mid-September 2008. (Sorkin’s book ends in fall 2008 while Mr. Geithner was still head of the New York Federal Reserve Bank; for more on what happened after he became Treasury Secretary, see my book with James Kwak, 13 Bankers.)

On logic, there is a major non sequitor in Mr. Geithner’s thinking when he continues to deny that the size of our largest banks poses a problem.

“Some argue that the U.S. financial system is too concentrated, which could promote systemic risks. But the U.S. banking system today is less concentrated than that of any other major country.”

But big banks in almost all other major countries have run into serious trouble, including the UK and Switzerland – where policymakers are now open about the scope for further potential disaster. French and German banks made large amounts of reckless loans to peripheral Europe and have strongly resisted higher capital requirements – helping to create the current potential for contagion throughout the eurozone (and explaining why the Europeans are so keen to keep control of the IMF). The Japanese banking system has been in terrible shape for two decades.

Larry Summers, Mr. Geithner’s former mentor, likes to point out that “big banks” in Canada were not in serious trouble during the global recession. But whatever your view of whether Canada has good regulation or was mostly lucky – put me in the skeptical camp, after talking recently with their senior officials – the simple point is that big banks in Canada are actually quite small in comparison with US and other global banks. The largest five Canadian banks have a headcount combined roughly equal to that of Citigroup (just under 300,000 people) and even the biggest of them has only about 1/3 the assets of JP Morgan Chase.

Mr. Geithner’s thinking is completely flawed on bank size. The right lesson should be: big banks have gotten themselves into trouble almost everywhere; U.S. banks are very big; these banks have an incentive to become even bigger; one or more of these banks will reach the brink of failure soon.

On the basic facts, Mr. Geithner’s most serious mistake is to believe that we can handle the failure of a global megabank within the Dodd-Frank financial reform framework. He argues that expanded powers for the Federal Deposit Insurance Corporation mean that banks can be allowed to fund themselves with more debt relative to equity than would otherwise be the case – because the FDIC can supposedly impose losses on creditors in the “resolution” scenario, i.e., when the bank fails, so management and lenders will be more careful.

“But given the other protections here, including our resolution authority, we do not need to impose on top of that requirement any of the three other proposed forms of additional capital.” (Italics added.)

I’ve talked with senior responsible officials both in the United States and in other countries repeatedly about the U.S. resolution authority. I’ve also discussed the issue directly with some of the top legal minds on Wall Street – people who work closely with big banks. Mr. Geithner’s interpretation is simply wrong. (To be clear, I’m a member of the FDIC’s newly established Systemic Resolution Advisory Committee, an unpaid group of 18 experts that meets for the first time on June 21, but my assessment here is purely personal.)

There is no cross-border resolution mechanism or other framework that will handle the failure of a bank like Citigroup, JP Morgan Chase, or Goldman Sachs in an orderly manner. The only techniques available are those used by Mr. Geithner and his colleagues in September 2008 – a mad scramble to find buyers for assets, backed by Federal Reserve and other government guarantees for creditors.

The right conclusion for Mr. Geithner should be: huge cross-border financial operations are immune from orderly resolution; such firms should therefore be run on a completely segmented basis, with separate capital requirements and no recourse to parent companies (including through potential reputation effects – e.g., UBS in Switzerland might support an entity called UBS-UK, even if there were no formal cross-guarantees.)

Consequently capital requirements should also be much higher than currently proposed by any official – this is the buffer that stands between bad management decisions and taxpayer bailouts when bank resolution is not possible. Real estate trusts that are not too big to fail routinely fund their assets with 30 percent equity and 70 percent debt; in a volatile world, this makes complete sense. We should move all our big banks, as well as the rest of our financial system, in that direction.

An edited version of this post appeared this morning on the NYT.com’s Economix blog; it is used here with permission. If you would like to reproduce the entire column, please contact the New York Times.