Wednesday, March 31, 2010

Breaking Up Banks

Jeff Hummel has a post on Liberty and Power about proposals to break up the big banks. He points out that some "market-oriented" economists have supported this proposal as a way of avoiding "too big to fail."

Hummel points out that the U.S. banking industry is very fragmented, with many more banks than typical in industrialized countries. He points out that restrictions on bank branching, dating to before the Civil War, have been responsible for the huge number of tiny banks in the U.S. And further, that these regulations are responsible for the record number of bank panics in the U.S.

This argument is very traditional for advocates of free banking, and it is one that I have made often in the past, and one that I still consider sound. Most of the 8,012 depository institutions in the U.S. should be taken over by much smaller number of nationally-branched banks. How many exactly and what market share each should have is something that can only be discovered by the competitive market process--a process without regulations aimed at protecting small community banks.

Given that caveat, I have always had a vision of 20 nationally-branched banks with market shares averaging 5 percent, running between 10 percent and 2 percent. So, given the current size of the banking industry, that would be an industry made up of large banks with assets of between one and two trillion and small banks with assets between $100 and $200 billion. Looking at the top bank holding companies, number one Bank of America, whose holding company has $2.2 trillion in assets, and number 4, Wells Fargo, with $1.8 trillion, are on the big side. A bank like BB&T, at number 17, with assets of $166 billion, is getting on the small side.

The problem with the 7,340 "small" banks, with assets less than $1 billion is lack of geographic diversification. Why have such banks have prospered, even after branching restrictions have been removed? One reason is moral hazard. Depositors have no reason to worry about geographic diversification if they are insured by FDIC.

Worse, one aspect of loan securitization has been that banks and thrifts make local loans, sell them to investment banks who pool them across geographic regions, and then create asset backed securities, some of which are are then sold back to the banks and thrifts that originated the loans. The process does allow community banks to reduce their local risk exposure, but at the expense of a complete loss of control of credit risk. A nationally-branched bank would automatically avoid idiosyncratic geographic risks without any need for convoluted asset-backed securities.

Another element of the banking system that evolved in the U.S. is that some the banks whose "locality" was Wall Street became giant "money center banks." Chase Manhattan, which merged with investment bank J.P. Morgan, is now number 2, with $2 trillion in assets. Citibank is number 3 with $1.85 trillion in assets. These banks don't have branches across the nation. Traditionally, they have obtained huge amounts of "brokered" deposits and made large loans. At least some of that funding comes from the thousands of small banks.

This is one element of systematic risk that has been long standing. A money center bank fails, and all of the small community banks that lent it money suffer losses too. If the losses are severe enough, they can fail. And problems can occur in the other direction. If enough small community banks have difficulties--either depositors withdrawing funds or bad loans, then they will cease lending money to the money center bank. If that endangers the money center bank, then other community banks are at risk.

To confuse matters, there are the "investment banks" Are banks "too large?" Are they "too big to fail?" Often the "banks" being discussed are investment banks, such as Goldman Sachs, Morgan Stanley, Merrill Lynch, Bears and Stern, and Lehman Brothers. While Goldman Sachs currently has assets of "only" $850 billion, it had $1.1 trillion at the end of 2007. Similarly, Morgan Stanley is down to $775 billion, but had over $1 trillion at the end of 2007. Merrill Lynch also had more than $1 trillion. These were very large institutions: only Citibank, Bank of America, and JP Morgan Chase were larger in 2007. Further, their total size was 20 percent of the size of the commercial banking industry.

The core business of an investment bank is underwriting securities. The people responsible for organizing "deals" with governments and large firms needing to raise money are called "bankers." However, the firms also serve as broker-dealers, and the people who arrange trades of securities--stocks and bonds--are called "traders."

Governments and large corporations interested in obtaining large amounts of money can go to a commercial bank, presumably a money center bank like Citibank or Chase Manhattan, and obtain a loan. Or, they can speak to a "banker" at an investment "bank" like Goldman Sachs. The investment bank will help them issue bonds or stocks. Since these are just different ways of raising money on Wall Street, they are all "banks" from the point of view of major corporations or governments that need the funds.

What is different, of course, is that these "investment banks" don't have deposits. When they underwrite securities, they are immediately funding the governments or businesses, but as the securities are sold, then the investors who purchase those securities provide the funding to the particular government of business issuing the bonds or stocks.

The broker-dealer operations of these "banks" involve trading stocks and bonds. Since underwriting securities involves selling newly issued stocks and bonds, there is an obvious synergy between the two branches of the business. The "bankers" make deals with governments and businesses that need funds, and the "traders" find investors who are interested in purchasing the bonds and stocks that are issued by the governments or firms.

Broker-dealers trade huge volumes of stocks and bonds, often with large institutional investors and hedge funds. Selling the stocks and bonds underwritten by their own "bankers" is only a small part of their business.

Because of clearing arrangements, the traders can and do buy securities with money they don't have and sell securities they don't have. They just have to come up with sufficient money or securities to meet clearing obligations. In order to make large and rapid trades, their counter-parties must have confidence that they will be able to obtain sufficient money or securities to meet clearing obligations. If, say, Morgan Stanley is not confident that Lehman Brothers will be able to deliver funds or securities as promised at clearing time, then it won't trade with them. If Lehman Brothers cannot trade with the other broker-dealers, then it won't be able to do business with institutional investors and hedge funds. Lehman Brother's broker-dealer business will dry up and it will be ruined.

There is substantial "systemic" risk involved. Suppose a hedge fund sells some stock to Lehman brothers and then uses the funds to purchase some bonds from Merrill Lynch. And then Merrill Lynch buys some other stock from Bear Stearns. If Lehman Brothers can't come up with the funds at clearing time, then the hedge fund doesn't have the money. And Merrill Lynch doesn't have the money for the bonds it sold to the hedge fund. And Bear Stearns doesn't have the money for the stock it sold to Merrill Lynch. Since hedge funds, especially, need to make large, timely trades, having these markets "freeze" is a "disaster." Well, a disaster to hedge funds. For institutional and individual investors following a sensible buy and hold strategy, it means modest delays in obtaining needed funds.

As part of the process of underwriting securities, investment banks have always borrowed short term funds. They pay out the borrowed funds to the firms and governments whose securities they are underwriting and then as their traders sell off those securities, the borrowed funds can be repaid. Of course, since they try to operate as continuing businesses, the investment banks are borrowing short term funds all the time.

Similarly, the broker-dealer operations borrow short term to obtain funds to meet clearing demands. (And they borrow securities as well.)

Over the last decade, these investment banks began to hold large portfolios of mortgage backed securities. So, just as some community banks were using their deposits to fund "safe" geographically-diversified mortgage backed securities, the Wall Street banks were using short term funding to finance holdings of mortgage backed securities.

So, along with underwriting securities and operating as broker-dealers, they were operating as commercial banks. But because the financial commercial paper they used for funding is not called "deposits," they weren't legally operating as commercial banks. They were "shadow banks."

When home prices began falling, ultimately by 30 percent, mortgage backed securities lost value. The newish "shadow bank" side of the "investment banking" business lost money. Since the broker-dealer side of the business requires trust by counter-parties, especially other broker-dealers, these losses from the shadow bank operations threatened to put the broker-dealer operation out of business. And a failure by a major broker-dealer would create "systemic risk" because those who did trade with them and then trade with securities or funds that had yet to be delivered would not be able to complete trades they had made based upon money or securities that had not been delivered.

Meanwhile, Citibank, currently number 3, but at the height of its folly, the largest commercial bank in terms of assets, was using large amounts of brokered deposits to fund portfolios of mortgage backed securities, often organized as "Structured Investment Vehicles." It was undertaking the same activity as the "shadow bank" operations of the investment banks.

Citibank didn't count the assets or liabilities of the SIVs on its balance sheet. If Citibank's risk was limited to its investment in the SIV, then that would have been reasonable. What that would mean is that when the mortgage backed securities lost value, the investors in the SIV would take most of the loss. Incredibly, when the mortgage backed securities lost value and the investors in the SIVs demanded payment, Citibank lent the money need to cover withdrawals and took all the assets. In other words, all of Citibank's capital was at risk!

At the end of 2007, Citibank had $2 trillion in assets. That was about 15 percent of the commercial banking industry and 10 percent of all financial firms (including investment banks and insurance companies.) I believe that the key to Citibank's survival was hiring Robert Rubin, former Secretary of Treasury of the Clinton administration, who happened to have been, along with Larry Summers, the mentor of Tim Geithner, President of the New York Fed during the crisis and now Secretary of the Treasury in the Obama administration. Today, it is down to number 3, but it was "bailed out." All of those who provided the uninsured brokered deposits to fund Citibank avoided losses. As did those who invested in the SIVs. (In my opinion, there should be some Citibank executives in jail. SIVs are fine if the investors take a loss. If Citibank brings them back on its balance sheet, it was a fraud against those holding brokered deposits issued by Citibank proper, as well as FDIC who must cover any losses on insured deposits.)

JP Morgan Chase combined an investment bank, JP Morgan, more or less like Goldman Sachs, with a money center bank, Chase Manhattan, more or less like Citibank. It was number 3, at $1.5 trillion in 2007 and is now number 2 with $2 trillion. While it took its "bailout" like the rest, it did not make the errors of the stand alone investment banks or the other money center commercial bank, Citibank.

Bank of America was a large, nationally branched commercial bank. In 2007, it was number 2, with $1.7 trillion. In early 2008, it purchased Countrywide, a thrift that had lent heavily into the speculative bubble in housing. While Countrywide only had $211 billion in assets, it was servicing $1.9 trillion in mortgages. In late 2008, Bank of America purchased Merrill Lynch, which had over a $1 trillion in assets in 2007. Whatever problems Bank of America already had with real estate loans and mortgage backed securities, it spent 2008 adding to its problems. Of course, it is now number one with $2.2 trillion in assets.

Wachovia was the 4th largest commercial bank in 2007 and the 9th largest financial institution. It was nationally (or, at least, regionally) branched. It had $782 billion in assets, and so was well behind investment banks like Goldman Sachs, Morgan Stanley and Merrill Lynch, money center banks Citibank and JP Morgan Chase, and Bank of America, the other nationally-branched commercial bank. In 2006, it purchased Gold West, a thrift with $125 billion in assets which included plenty of bad mortgage loans. As those bad loans sank Wachovia, the government tried to merge it with Citibank. (This would have given a financial disaster, Citibank, a national branch network. The broke would be merged with the broke, but would create an excuse to funnel money to politically connected Citibank.) However, Wells Fargo, with $575 billion in assets in 2007, purchased Wachovia instead. Wells Fargo, now including Wachovia (and Gold West,) is a nationally branched commercial bank,with $1.8 trillion in assets.

And what of the investment "banks" that, along with money center commercial bank, Citibank, were at the center of the crisis? Goldman Sachs and Morgan Stanley are now bank holding companies. They are now like JP Morgan Chase. Bear Stearns is owned by JP Morgan Chase. Merrill Lynch is owned by Bank of America. And the broker-dealer operations of Lehman Brothers is now owned by Barclays North America, which is owned by Barclays, a British bank holding company.

Are these institutions too big? Are they too big to fail? Wachovia failed. While it wasn't the biggest, it was of the same order of magnitude as these institutions. Citibank undertook what was borderline criminal activity. Was it too big to fail? Perhaps it is too late now, but I don't see why FDIC couldn't have taken it over, maybe even clawed back some of the SIV funds, guaranteed whatever brokered deposits it wanted, and then reorganized the bank.

The investment banks didn't fail because of underwriting losses or bad trades. They operated what amounted to commercial banks--borrowing with short term commercial paper and funding large portfolios of mortgage backed securities. They simply made what amounted to bad loans. Nothing in this experience suggests that the merger of J P Morgan and Chase Manhattan creates some kind of danger to Chase Manhattan. The actual lesson would be that if Chase Manhattan made too many bad loans and fails, this might make it impossible for traders at JP Morgan to transact stocks and bonds because counter-parties would worry about deliveries of funds and securities at the clearinghouse!

The nationally (or at least, regionally) branched commercial bank that failed, Wachovia, didn't fail because it was too big, or took losses on underwriting loans, or had trading losses. It failed because of bad loans, though bad loans from a recently purchased subsidiary.

My view is that nothing in the current crisis shows that large nationally-branched universal banks that accept deposits, make loans, underwrite securities, and trade securities are a danger. There really weren't any universal banks in the U.S. going into the crisis. Today, Bank of America fits that model. Rather than breaking Bank of America up or shrinking it, the best solution is for there to be more such institutions, and that perhaps they will grow more quickly than Bank of America, resulting in less concentrated banking system--about 20 universal banks with roughly 5 percent market shares.

The trivial lesson from the crisis is that banks shouldn't make bad loans. Don't lend into a speculative bubble! Since so many banks and thrifts (including the shadow bank operations of the investment banks,) did make similar mistakes, the key lesson I take from the crisis is that the possibility of a large portion of the banking system simultaneously becoming bankrupt must be considered.

In my view, a special bankruptcy process for banks is appropriate. The FDIC's approach of over-the-weekend reorganization is appropriate. I think that Kevin Dowd's notion of immediate write-downs of deposits and other bank debt, with no interruption of operation, is the least bad option. (see page 5 of the linked paper.)

And, of course, making sure that the quantity of money (however defined) always adjusts enough so that cash expenditure is expected to return to an unchanged 3 percent growth path within the next year will greatly reduce any real disruption created by the failures of banks, whether investment, commercial, money center, community, or nationally-branched or universal.


  1. "[T]he key lesson I take from the crisis is that the possibility of a large portion of the banking system simultaneously becoming bankrupt must be considered." Of course, in part it should be considered how to prevent that from happening. But suppose it did happen; what then should the government do (beyond bailing out depositors, assuming deposit insurance still existed)? Your recommendations: expedited bankruptcy for banks, and "making sure that the quantity of money (however defined) always adjusts enough so that cash expenditure is expected to return to an unchanged 3 percent growth path within the next year . . . ." This ". . . will greatly reduce any real disruption created by the failures of banks"; but is it enough, or are there other measures the government should also take? (And in increasing the money supply, might other means beyond traditional open market operations [buying government securities] have to be used? If so, what are they, and what are the drawbacks of using them?)

    You sometimes give the impression that you regard manipulating the money supply as a panacea for financial panics such as the recent one. Is that pretty much accurate?

  2. I think keeping nominal expenditure on a stable growth path provides tremendous benefits and it can be obtained by adjusting the quantity of money to equal the demand to hold money.

    What this prevents is problems that are associated with an generalized inability to sell goods. There could be disruptions in production because of lack of credit. Funds may not flow between and among households and firms in ways that generate the greatest returns. And if excessive resources had been devoted to a particular sector (like housing,) it still remains necessary to reallocate resources. These will tend to result in shortages of output. There may be surpluses in some sectors, but these are more than offset my shortages in other sectors.

    And so, a stable growth path of nominal expenditure implies that an disruption of credit markets will be resolved in an environment where at least some sectors of the economy are profitable. And further, shortages of credit will be associated with profits for newly organized or reorganized banks.

  3. I think that means: Yes, it's accurate.

  4. Bill:

    Great post. Did you see Arnold Kling's NR article on this issue?