Bipartisan Push For More Equity In Big Banks

By Simon Johnson

Proponents of the status quo in the financial sector just cannot catch a break.  Early August is supposed to be a time when regulators and markets slow down, or perhaps even take a break, but this year the news continues to be dominated by mismanagement or worse inside complex financial institutions.

It’s time for a new approach to bank capital.  As proposed by two U.S. Senators, this is not a panacea, but it would have a dramatic effect on big banks and how they operate.

Earlier this week, Standard Chartered, a large global bank (about $600 billion in total assets) based in the UK, was accused of breaking US law in its dealings with Iran and other countries with financial sanctions imposed by the US.  The complaint, lodged by New York’s Department of Financial Services, suggests that the bank’s executives deliberately intended to deceive regulators. 

“For almost ten years, SCB schemed with the Government of Iran and hid from regulators roughly 60,000 secret transactions, involving at least $250 billion, and reaping SCB hundreds of millions of dollars in fees. SCB‟s actions left the U.S. financial system vulnerable to terrorists, weapons dealers, drug kingpins and corrupt regimes, and deprived law enforcement investigators of crucial information used to track all manner of criminal activity.”

If these allegations are correct, someone was taking huge risks with the bank’s reputation by breaking the law.

StanChart, as the bank is sometimes known, is pushing back hard against these allegations.  This reminds me of Bob Diamond, the chief executive at Barclays who came under pressure and responded by attempting to take on the Bank of England – until he was forced out.  Bankers benefit from a great deal of state protection and subsidies.  It is unwise for them to break the rules and then turn on the people attempting to enforce the law.

Standard Chartered’s banking license in the United States could easily be revoked – and it should be revoked if the charges are correct.

At the same time, the near failure in recent days of Knight Capital further illustrates the risks inherent in running a complex securities trading operation.  Some sort of programming error resulted in the firm buying stocks that it did not want and quickly suffering large losses, put at $440 million .  The SEC, understandably, declined to let the firm have a “do over”, i.e., withdraw the trades.

Brad Hintz, a banking analyst at Sanford C. Bernstein & Co., drew one lesson.

“Knight Capital should remind investors how the investment banks became bank holding companies four years ago; markets froze, confidence was lost, funding dried up and a reluctant central bank was forced to step in to save the U.S. capital markets.”

Hintz is right that, “As investors learned in 2008-2009, the most significant risk to any major broker-dealer is a loss of confidence.”  But he then draws the policy conclusion that securities trading operations should remain inside megabanks, where they can be backed by essentially unlimited credit from the Federal Reserve.

But it’s precisely the prospect of unlimited and typically unconditional support from central banks that encourages moral hazard – meaning that bank management is not sufficiently careful.  If we increase the government backing and implicit subsidies for megabanks, will they take bigger or smaller reckless risks?  What would you do?

A much better approach would be to force large financial institutions to increase their equity funding relative to how to much they borrow.  When the business is riskier and when its failure would have more dire consequences for the economy, we want any potential bankruptcy to become much less likely.

Senators Sherrod Brown (D-Ohio) and David Vitter (R-La.) made this point in a powerful letter to Federal Reserve Chairman Ben Bernanke this week.  With regard to the Fed’s proposed rules for how large banks fund themselves, the Senators write,

“We urge you to revisit your proposed rule and modify it so megabanks fund themselves with proportionately more loss-absorbing capital per dollar of assets than smaller regional or community banks.  The surcharge on megabanks should be high enough that it will either incent them to become smaller or will help to ensure they can weather the next crisis without another taxpayer bailout.”

The letter is well argued and should be required reading for everyone concerned about financial sector stability.  “More capital” is sometimes used as a rhetorical smokescreen by people who actually do not want any reform; in contrast, Senators Brown and Vitter are pressing the Fed on the right specifics – and for amounts of equity funding that would really make a difference.

Highly leveraged financial institutions do not have the incentive to be careful – their executives get the upside when things go well, and the downside is someone else’s problem.  Executives and traders in megabanks are paid based on their return on equity unadjusted for risk.  As Anat Admati and her colleagues have been arguing, these executives want to have less equity and more debt – they don’t care about how this affects the rest of the financial system.

Bigger banks are more dangerous.  They should either have to fund themselves with much more equity or break themselves up.  Their executives can choose.

The financial sector should take up this issue because megabank behavior has become so bad that it damages everyone’s business.  Investor confidence has taken a beating precisely because highly leveraged financial institutions get into so much trouble.  As Dennis Kelleher of Better Markets put it on his blog,

“It’s not the fundamentals or computer trading or Wall Street misconduct or one scandal after another. It is the fundamentals and computer trading and Wall Street scandals and lots more. To ignore or deny the effect of the daily drumbeat of Wall Street mishaps and misconduct like the Knight Capital implosion, JP Morgan’s London Whale losses, the metastasizing Libor Scandal, HSBC and Standard Chartered criminal conduct, plus the Facebook and BATS listings debacles and high frequency trading incidents like the Flash Crash (not to mention the rot revealed by the 2008 financial crisis like no-accountability bailouts and Goldman’s Abacus deal) is to deny reality, how investors think and how markets work.”

“Fair or unfair, all of those incidents plus the lousy fundamentals combine to give people the impression or belief that the markets are a bad investment, that they are rigged, that the professional insiders have an advantage, that whoever has the fastest computer wins, and that individuals and ordinary investors just don’t stand a chance.”

As Senators Brown and Vitter suggest, we should increase the required equity funding for megabanks to make them safer, to improve their behavior, and to help restore investor confidence.

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