Monday, September 21, 2009

Let a Hundred Investment Banks Bloom

Clive Crook nails it this morning in the FT:
At the recent G20 finance ministers’ meeting in London, Tim Geithner, the US Treasury secretary, won tentative, sometimes grudging agreement to his main ideas for stronger regulation. The single most important change, he believes, is requiring banks and shadow banks to hold more capital. He proposed higher capital ratios—higher still for systemically important firms, with new counter-cyclical components—and a cap on total leverage. To supplement these more demanding capital requirements, he also called for minimum levels of liquidity, and for “living wills” to allow the orderly winding up of failing financial firms.

All this makes excellent sense. If Mr Geithner’s proposals are acted on, the global financial system will be far better protected in future. ...

The global finance industry is in no position, yet, to mount a vigorous campaign against changes which, if they are adequate, will implicitly tax its growth. That is what higher capital requirements would do, and is precisely why they are needed. Checking the industry’s expansion must be seen as an aim of policy, not an unintended consequence.

The financial sector is, by wide agreement, too large in relation to the general economy. It must shrink in relative terms—not grow—as the economy recovers from recession.

More to the point, our biggest financial institutions are far too big. Of course, it will do us no good simply to force existing too-big-to-fail banks to shrink, since that will mean even less lending and credit provision on their part. Given ongoing asset bubble deflation and the fragility of the economic recovery, the last thing we need is for credit intermediaries to tighten the lending spigot further.

Instead, what we need is a period of deconsolidation in the financial industry to mirror what now appears to have been a risky and eventually ruinous period of consolidation and aggregation over the past three decades. I have pointed out before in these pages that financial intermediaries at every scale—individual banker, individual bank, and industry as a whole—comprise a dense and dynamic network for the connection of sources of capital to the users of capital. It just makes sense that this network would be more robust and less prone to catastrophic failure the more independent nodes there are in the system and the less network "traffic" (i.e., capital) flows through any one node or pathway. Such a network should be less costly to monitor and regulate than a more concentrated one, as well, since we would care less about the fate of any one bank within it.

Redistributing and rebalancing the nodes of distribution in the global financial system is job number one. Designing, imposing, and carefully monitoring relatively simple, risk-adjusted leverage limits based on the type of activity a financial intermediary conducts1 is the best way to do it. While financial innovation seems to have played a significant role in the recent bustup, I am less worried than some about its inherent riskiness to the stability of the financial system. It was contagion across market sectors, accelerated by huge leverage at critical investment and commercial bank nodes of the system, which helped the looming collapse in real estate securities spill over into the broader economy, not the particular intricacies or flaws of CDOs, credit default swaps, or mortgage-backed securities.

If I had to pick one decision which played the pivotal role in the financial crisis, it would have to be the SEC's agreement to waive leverage limits at the biggest investment banks in 2004. From traditional levels in the low teens the high teens to high twenties, leverage ratios at banks like Lehman Brothers and Bear Stearns skyrocketed to the mid thirties and higher. I don't care how good a risk manager you are, if you only have three dollars in equity supporting $100 in assets, the merest market move or collapse in trading liquidity can kill you. If you fail with a balance sheet of $10 or $20 billion, a bunch of shareholders, employees, and counterparties will wipe away a tear and mourn your passing. If you're holding half a trillion to a trillion dollars, however, the collateral damage from your ruin will have everybody licking their wounds—and writing outraged letters to the Times—for years, if not decades.

* * *

The global banking industry is huge, and quite diverse. It will take time to bleed the air out of that bubble and reallocate people and capital to more productive pursuits. In the meantime, however, perhaps all the populist demagoguery and officious government interference is providing an important and unrecognized service in the industry's long-term transformation. After all, the more bankers and traders leave floundering giants like Citigroup and Bank of America for regional investment banks and independent advisory boutiques, and the more they divest high-risk proprietary trading operations like Phibro, the closer we will be to a system where the failure of either or both of those firms won't merit more than a shrug of the shoulders on Wall Street or Main.

Based on recent developments, many commentators contend we have become proto-socialists in this country (or worse). Given that, we could do worse than follow the sage advice on social transformation offered by one of last century's most successful proto-capitalists:

Letting a hundred flowers blossom and a hundred schools of thought contend is the policy for promoting progress in the arts and the sciences and a flourishing socialist culture in our land.

— Mao Zedong

Forward, Comrades! Let a hundred small- to mid-sized investment banks bloom!

UPDATE: A correspondent gently reminds me that I was a complete knucklehead when I asserted that historical leverage ratios in the industry were in "the low teens." I have done the research, corrected the error above, and managed to generate another War and Peace-sized chunk of prose in the process. Sigh. The gods of brevity are not pleased with me.

1 Naturally, a firm which originates consumer loans and mortgages with the intention to hold them and funds its business with a large dollop of low interest-bearing consumer deposits should merit a higher leverage limit than a firm which conducts riskier activities funded solely by volatile wholesale funding markets. With leverage ratios, there is no reason to default to "one size fits all."

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