Mike Shedlock

Dallas Fed president Richard Fisher blasted too-big-to-fail banks, CEO compensation, bank risk-taking, inadequacies in Dodd–Frank regulation, and unintended consequences of poor legislation in a speech in New York on Monday.

Please consider excerpts from Containing (or Restraining) Systemic Risk: The Need to Not Fail on 'Too Big to Fail:'

I confess that in matters of monetary policy and regulation, I am often in the minority. This does not make me the least bit uncomfortable. The majority opinion is not always right; indeed, my experience as an investor has biased me to conclude that more often than not, the consensus view is the wrong view, even among the most erudite.

For example, some of you may recall the public letter written by 364 eminent economists predicting disastrous consequences that would result from Thatcher’s policy initiatives. That letter was published in the Times of London on March 30, 1981. The British economy began a recovery almost immediately afterward.

Most regulatory reform initiatives applied since the Banking Act of 1864 have missed the mark. They looked good on paper and appeared to solve the problems of the day but later proved not up to the task. This is especially true with efforts to solve the “too big to fail” problem, in which an unwillingness to follow through on prior policy commitments to actually close down large failures and impose losses on their uninsured creditors has led to what economists call “time inconsistency” in policy.

While there is much to criticize about Dodd–Frank, I cotton to those blunt statements on ending too big to fail. For, if after the myriad rules and regulations are written and implemented we have not eradicated too big to fail from our financial infrastructure, reform will have failed yet again.

In looking at regulatory reform and implementing Dodd–Frank, I think a key point worth repeating is that the distinction between “commercial banks” and “the shadow banking system” is a false one. The two became intertwined beginning with the bypassing of Glass–Steagall strictures by Sandy Weill and Citicorp and the deregulatory initiative of Gramm–Leach–Bliley. The fact is that the largest commercial banks played a major role in many of the more problematic phenomena of the recent credit boom and ensuing crisis, including the spread of what I have previously referred to as financial STDs, or securitization transmitted diseases.

In the aftermath of the Panic, these viruses linger. Last week, the New York Times printed an interesting article by Joe Nocera, who drew upon the observations of a highly regarded regional banker from Buffalo, Robert Wilmers of M&T Bank. Wilmers claimed that of the $75 billion made by the six largest bank-holding companies last year, $56 billion derived from trading revenues.

Nocera noted that "in 2007, the chief executives of the Too Big to Fail Banks made, on average, $26 million … more than double the compensation of the top nonbank Fortune 500 executives."

These recent numbers buttress Nocera’s reasonable conclusion that bank CEOs “were being compensated in no small part on their trading profits—which gave them every incentive to keep taking those excessive risks.”

I am sympathetic to these concerns. There is no logic to having the public underwrite through deposit insurance or subsidize through protective regulation the risk-taking ventures of large financial institutions and their executives. There is a substantial case to be made for separating the “public utility”?or traditional core function of banking?from the risk-taking function.

To be sure, financial problems are not limited to large institutions and their complex, opaque and conflicted operations. Regional and community institutions that have, for the most part, stuck to the public utility function have faced their own difficulties, especially in the context of construction lending. But while over 300 banks failed during the crisis, another 7,000 did not. Community and regional banks that are not too big to fail appear to have succumbed less to the herdlike mentality and promiscuous financial behavior that affected their megabank peers.

Moreover, when smaller banks got into deep trouble, regulators generally took them over and resolved them. In the treatment of big banks, regulators, for the most part, tiptoed around them. Failing big banks were allowed to lumber on, with government support, despite the extensive damage they wrought. Big banks that gambled and generated unsustainable losses received a huge public benefit: too-big-to-fail support.

Post-crisis, the large institutions are even larger: The top 10 now account for 64 percent of assets, up from 58 percent before the crisis and substantially higher than the 25 percent they accounted for in 1990. In effect, more prudent and better-managed banks have been denied the market share that would have been theirs if mismanaged big banks had been allowed to go out of business. This strikes me as counter to the very essence of competition that is the hallmark of American capitalism: Prudently managed banks are being victimized by publicly subsidized competition from less-prudent institutions.

In solving the crisis at hand during the Panic, it appears that the most imprudent of lenders and investors were protected from the consequences of their decisions; the sinners were rescued and the virtuous penalized. In crafting regulations in response to Dodd–Frank, we need to restore market discipline in banking and let the market mete out its own brand of justice for excessive risk-taking rather than prolong the injustice of too big to fail.

It is not difficult to see where this dynamic, if uncorrected, will lead—to more pronounced financial cycles and recurring crises. I would argue that the failure to reform the banking system in Japan was one of the principal reasons for that country’s “Lost Decade(s).” We must not let that pathology take hold here.

Making Matters Worse

Here, I think it wise to draw upon the insight of the classical liberal Frédéric Bastiat in his take on unintended consequences.

To the extent that a large scale becomes necessary to absorb the regulatory cost associated with reform, Dodd–Frank could intensify the tendency toward bank consolidation, resulting in a more concentrated industry, with the largest institutions predominating even more than in the past. Such an outcome would appear to me contrary to the stated spirit and goal of the act. A more consolidated industry would only magnify the challenge of dealing with systemically important institutions and offsetting their historically elevated too-big-to-fail status.

My concerns over regulation-induced economies of scale and the implications for industry consolidation apply to all the size classes of banks, given the extensive list of new or enhanced requirements created by Dodd–Frank and their associated compliance costs.

The act indicates that all banking organizations with more than $50 billion in assets should be subject to enhanced supervision. Yet, few really believe a $50 billion bank poses a systemic threat to our $17 trillion banking system. Nor is a $50 billion bank qualitatively similar along risk dimensions to the very largest ones that exceed $2 trillion in size. The top 10 banking organizations have a cutoff point of $300 billion. I posit that this group should constitute the primary target for enhanced supervision. Interestingly, despite its large share of industry assets, this group holds only about 20 percent of the small-business loans on bank books. Clearly, these institutions are engaged in substantial activities outside the traditional banking role. It is within these very largest banks, and perhaps a few slightly smaller yet highly complex or interconnected ones, that systemic risk is concentrated.

If the enhanced-supervision requirements are not highly graduated and imposed primarily on the very largest banks, it is not difficult to imagine how the costs associated with such supervision could lead mid-tier banks that exceed the $50 billion threshold—yet fall well short of megabank status—to seek merger partners in order to achieve sufficient scale by which to help cover the cost of regulation. This would compound the problem rather than alleviate it.

However, when it comes to the top 10 or so, I would apply Dodd–Frank extensively and vigorously. I would apply all the elements of heightened supervision—from enhanced standards for capital and liquidity requirements, leverage limits and risk management to the additional measures of living wills and credit-exposure reports, concentration limits, extra public disclosures and short-term debt limits—with full force.

I quoted Bastiat’s criterion for a good economist as one who accounts for “effects that must be foreseen.” Economists did not do a good job of foreseeing the financial crisis. Neither did regulators. Moreover, previous measures directed at containing too big to fail proved ineffective, with no one too surprised that when crisis came, many large-bank counterparties were protected under implicit guarantees.

Let’s hope that going forward, regulators can do better, avoiding both unintended consequences and time inconsistencies. For if they don’t, and they are unable to solve the too-big-to-fail issue in a timely manner, we will ultimately have to take more draconian measures and simply break up the largest banking organizations to eliminate the threat they pose to financial stability and economic growth.

That is my contrarian view, and I’m sticking with it.

Thank you.

Fisher Hits the Bulls-Eye.

It is exceptionally rare for me to endorse a lengthy speech by a Fed governor. However, Fisher hits the bulls-eye on many points.

Fisher blasted Sandy Weill and Citicorp, plus:

  • Fisher blasted too-big-to-fail
  • Fisher blasted Dodd-Frank
  • Fisher blasted CEO pay
  • Fisher blasted the "herdlike mentality and promiscuous financial behavior" of large banks
  • Fisher blasted the removal of Glass–Steagall
  • Fisher cited trading profits and promotion of risk taking
  • Fisher cited Frédéric Bastiat on unintended consequences and the seen vs. unseen

What's not to like?

I suspect this is one of the few lengthy speeches by anyone on bank regulation that would have Barry Ritholtz, Calculated Risk, Yves Smith, and myself in major agreement. It would be interesting to see them chime in.

Alas, I suspect Fisher wasted his breath. Bernanke is not behind those ideas, and getting Congress to completely revamp Dodd-Frank would be difficult at best, even with a major push by Bernanke.

Reflections on Another Lost Decade

Fisher said "I would argue that the failure to reform the banking system in Japan was one of the principal reasons for that country’s Lost Decade(s). We must not let that pathology take hold here."

Unfortunately that very pathology has already taken hold.

Greenspan and Bernanke both criticized Japan for not forcing banks to take losses and write down assets. When given the same opportunity, the Fed and ECB opted to kick the can at taxpayer expense while embarking on a misguided QE policy, just as Japan did.


Mean time, European banks have $188 Billion at risk from Greece, Ireland, Portugal, and Spain. Excluding default risk, those banks are still woefully short of capital according to a study coming out tomorrow.

Please consider European Banks’ Capital Shortfall Means Greece Debt Default Not an Option

The “fragilities” of Europe’s banking industry mean a Greek default isn’t an option, European Union Economic and Monetary Affairs Commissioner Olli Rehn said in New York last week. By delaying a decision some investors consider inevitable, policy makers risk increasing the cost to European taxpayers and prolonging Greece’s economic pain.

“European officials are trying to buy time for the troubled economies to get their house in order and the banks to be strengthened,” said Guy de Blonay, who helps manage about $41 billion at Jupiter Asset Management Ltd. in London.

While estimates of the capital shortfall vary, the vulnerability of European banks to a sovereign shock isn’t disputed. Independent Credit View, a Swiss rating company that predicted Ireland’s banks would need another bailout last year, found in a study to be published tomorrow that 33 of Europe’s biggest banks would need $347 billion of additional capital by the end of 2012 to boost their tangible common equity to 10 percent, even before any sovereign default.

European banks had $188 billion at risk from the government debt of Greece, Ireland, Portugal and Spain at the end of 2010, according to a report this week from the Bank for International Settlements. European lenders held $52.3 billion in Greek sovereign debt, with German banks owning the biggest share, the BIS data showed.

European banks are trading at 0.83 times book value, according to the banks index, almost the widest discount since the end of 2008 to their U.S. counterparts, which trade at 0.94 times book, based on the 24-member KBW Bank Index. (BKX) The five-year average price-to-book ratio of the 51 European lenders is 1.34, data compiled by Bloomberg show.

That banks in both regions are trading below book value indicates investors don’t believe their assets are worth as much as the companies say.

Low market valuations make any potential capital-raising more dilutive for shareholders, said Simon Maughan, head of sales and distribution at MF Global Ltd. in London. Questions about regulatory requirements are adding pressure on bank stocks, making a quick recovery unlikely, he said.

“The big issue behind why price-to-book ratios are well below averages is that the market is saying banks can’t make a proper return and certainly not a return anything like they’ve been used to getting,” said Maughan.

EU regulators are seeking to assuage investors’ concerns about capital with a second round of stress tests on 90 lenders. The European Banking Authority is promising tougher tests this year after failing seven of 91 banks last year and finding a capital shortfall totaling 3.5 billion euros, or about a 10th of the smallest estimate from analysts. Ireland’s biggest banks needed a rescue four months after passing the test.

Tests carried out in the U.S. in 2009 found 10 lenders including Bank of America Corp. (BAC) and Citigroup Inc. needed to raise $74.6 billion of capital. The banks were required to raise the funds from private investors or accept government aid.
Mark-to-Fantasy Asset Valuations

Bank stocks have been in the gutter because of mark-to-fantasy accounting. No one believes asset valuations, and no one believes results of existing stress tests.

Few will believe the results of the next one.

Only 22% of Respondents Expect Next Stress Test will be Credible 

The Wall Street Journal reports Spanish, German, Greek Banks Seen Failing Stress Tests -Survey
Banks from Spain, Germany and Greece are expected to have to raise the most new capital following the next round of European stress tests, according to a survey of investors by Goldman Sachs published Monday.

But the survey of 113 fund managers, mostly from hedge funds and long-only investors, also found that only 22% of respondents expect the test to be a "credible reflection of bank resilience," highlighting the lack of credibility of the stress test.

Last year's test rubber-stamped the balance sheets on several banks that later fell on hard times, including Irish banks that a few months after the tests were published had to be bailed out.

According to the Goldman survey, investors expect the stress tests to show that banks will need another EUR29 billion in fresh capital. It expects 90% of the banks included in the test to pass. Investors on average expected nine out of the 91 banks that will take the test to fail, down from 10 institutions that failed last year's stress tests.
The stress test should include default because default is the epitome of stress. Default is also highly likely.

The expected result of the stress test is a mere EUR29 billion in fresh capital ($42.5 billion US) for 91 banks. Compare that to Credit View's analysis that shows 33 banks, need $347 billion in capital, not counting a risk of default.

Mike "Mish" Shedlock
http://globaleconomicanalysis.blogspot.com


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Mike Shedlock

Mike Shedlock is a registered investment advisor representative for Sitka Pacific Capital Management.