I try to believe that any glimmer of illumination I can occasionally shed on the structure, function, and operation of global financial markets has a positive effect on the net stock of knowledge about my business out there in the world. Not only with you, my direct and regular audience, but also hopefully with unconnected and more distant intelligences like regulators, executives, and legislators who might collectively have the will and ability to change conditions for the better. Or at least not fuck them up so regularly.
But then I stumble on unmitigated codswallop like this, from industry lobbying group The Financial Services Forum, in response to President Obama's announcement today of new proposed regulations governing the banking sector:
The problem of ’too-big-to-fail’ isn’t that some institutions are large, it’s that there is currently no statutory authority to wind down a financial conglomerate in the way that the FDIC is currently authorized to unwind banks. More effective supervision, coupled with the authority to seize and wind down large firms, is the appropriate remedy ‘to too-big-to-fail’.
Large institutions provide significant value to customers – in the sheer size of credits they can deliver, in the array of products and services they can provide, and by their geographic reach – that smaller institutions simply cannot provide. This unique economic value is particularly important to large, globally active clients and contributes directly to economic growth and job creation. Large institutions are also far more diversified in their business mix as compared to smaller institutions, which tend to be engaged in fewer businesses and regions and, therefore, are exposed to greater concentration risk. In this regard, larger institutions are more stable than smaller institutions. Rather than being a source of risk, size can mitigate risk.
No, no, no. A thousand times no.
Well, okay, I do agree that some regulatory agency needs both statutory authority and the institutional capability (and cojones) to liquidate large financial conglomerates the next time one or more of them trip over their own dicks, which I guarantee will happen sooner than any of us expect. It would also be a pleasant surprise if someone in authority actually decided to supervise these mongrel idiots, instead of going on golf outings with them every six weeks and approving their regulatory fitness reports over cocktails.
But the assertion that large, multi-line financial conglomerates provide customers with services no smaller institutions can deliver is pure poppycock. The mid-1990s concept of globe-striding financial supermarkets has been completely discredited, most notably by their sad-sack poster child, Citigroup. Wholesale institutional clients make a point of using more than one investment or commercial bank for virtually all their financial transactions, no matter what they are. In fact, the bigger the deal, the more banks the customer usually uses. This is because banking clients want to 1) spread transaction financing and execution risk across multiple service providers and 2) make sure none of these oligopolist bastards has an exclusive right to grab the client by the short and curlies. Just look at securities underwriting data, for chrissakes: as the number of independent investment banks has shrunk (and their product lines, geographic reach, and balance sheets have swollen) over the past 20 years, the average number of book running underwriters per transaction has risen. This is not the result one should expect if one believes customers prefer to use giant universal banks as one-stop shops.
And the last argument—that larger size and greater diversity lead to lower risk concentration and greater systemic stability—is flatly untrue. In fact, the truth is quite the opposite, as these prescient words of wisdom from August 2007 demonstrate (emphasis added):
Now, to be fair, ... hedge funds did not invent the use of leverage in investment management, and they are not the only market participants who use it. Nevertheless, I think few would argue that hedge funds, in aggregate, deploy a great deal of leverage, ... in pursuit of higher returns. Much of this is direct leverage, in the form of margin loans borrowed from their prime brokers, the investment banks. But another substantial chunk consists of embedded leverage, which takes the form of structural leverage embedded in tradeable securities and derivatives. Often, hedge funds use margin loans to purchase and hold structurally levered derivatives, thereby compounding leverage upon leverage. This, as I am sure you will agree, can be a combustible mix.
Complicating the picture is another transformation in the market from previous practice, concerning the distribution of risk. Risk—fundamentally in the form of risky securities and derivatives—is widely believed to have become far more broadly distributed among investors, hedge fund and otherwise, than it used to be. A common example is the new paradigm for corporate loans. Where before commercial banks originated and held such obligations on their balance sheets for the duration of the loan, now commercial and investment banks originate, package, and distribute the lion's share of such loans to a broad universe of investors, thereby diffusing these risks throughout the system.
Some market pundits argue that this development (and analogous developments in other securities markets) has not only made the financial markets more efficient—by directing specific risks to those investors with particular appetites for them—but also safer, since the consequence of any one particular security or issuer blowing up should be more broadly and diffusely distributed across the universe of investors. Should Chrysler go belly up, the argument goes, a great many investors will feel a fair amount of pain, but no one investor or lending institution should blow up with it. Furthermore, the proliferation of hedge funds with different investment strategies means that there are plenty more investors out there to take the other side of losing trades. Shocks to the system should get dampened pretty quickly. Intuitively, these concepts make a lot of sense.
But if this is true, why does the recent meltdown in the subprime mortgage market seem to be spilling over into other, apparently unrelated securities markets, like those for corporate and high yield debt? Do investors really believe that subprime mortgage defaults in Florida and Las Vegas are going to affect Cerberus Capital's ability to repay the loans it wants to use to buy out Chrysler? Why has the blow up of Bear Stearns' subprime hedge funds put the kibosh on KKR's ability to issue debt to buy British pharmacy operator Alliance Boots? Whence this fabled "contagion" whereof everyone speaks? Wherefore the "flight to quality?"
Well, consider this. A fund with a highly levered balance sheet, and its investment fingers in many pies, is hit with losses in one of its sub-portfolios. Due to the nasty two-edged bite of leverage, its equity drops significantly, and the only way it can restore its risk profile is to raise more equity or liquidate some of its investments. Given the poor market conditions in the affected sub-portfolio, it is often more prudent to liquidate securities in other sub-portfolios. But this, as you can imagine, puts downward price pressure on securities in those previously unrelated markets. Presto, contagion. This is the "common holder" problem which some believe is the primary culprit.
Consider further. What if a substantial portion of our hedge fund's holdings consisted of loans to other investors—hedge funds, perhaps—whose own portfolios were experiencing losses? Well, then, "liquidating" those positions and reducing its risk exposure would look an awful lot like calling the loans, or reducing their outstanding balances. Finally, add this to the mix. What if our fund had another side to its business, which generated revenues from the origination, market-making, and placement of securities, which revenues were negatively affected by turmoil in some or all of the markets where it also had investments? Well, that would be a triple whammy, and our little hedge fund would look an awful lot like a prime broker investment bank.
Market-making investment banks are usually net long in many securities markets at any one time, so they are directly affected by declining liquidity and declining prices. Prime broker investment banks are also by definition long credit exposure to hedge funds and other levered investors, and when the portfolio values of those investors come under pressure, the risk and value of those margin loans goes up and down, respectively, forcing the prime brokers to deliver margin calls. (Unlike most hedge funds, clearing banks and securities firms are subject to intense regulatory oversight on their own creditworthiness, so they do not normally have the luxury of sweeping problems under the carpet, as some might suggest.) And finally, investment banks earn substantial fees from activities like M&A, securities underwriting, and securities placement, which all come under pressure in times of market turmoil.
Investment and commercial banks remain the primary transmitters of contagion in times of market stress, because they remain the central nodes through which the lifeblood of credit flows, and because they are exposed so strongly to both direct and indirect effects of market swoons. They remain the lenders of last resort—at least in the short term—as the gently swaying spans of tens of billions of dollars of hung equity and debt bridges can attest. And they are the quickest and fiercest enforcers of the risk reduction and delevering responses to market disruptions, because their own highly levered balance sheets keep them regularly poised on the edge of the abyss themselves.
So you can see, Dear Reader, what was already pretty obvious to me, mere months into what would turn out to be the greatest financial panic in generations: large, integrated investment and commercial banks concentrate contagion and risk in the marketplace. Sadly, even I was too naïve to realize our crack corps of financial regulators were missing in action, and the executive managements of these financial institutions were off smoking crack in the boardroom instead of minding the store.
But the point of my previous tirade stands: large, integrated, multi-line commercial and investment banks with fingers in almost every financial pie around the globe do not reduce systemic risk in the slightest. Instead, they comprise both the source and the pathway of contagion for systemic risk and potential breakdown.
Too big to fail banks are not the solution to our problems: they are the source of them. And no amount of PR bullshit will ever change this irrefutable fact.
Put that in your pipe and smoke it, Mr. Volcker.
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