13 Bankers Review

Simon Johnson and James Kwak make the case in 13 Bankers that we have allowed our largest banks to grow too big to the point where their collapse (Lehman Brothers ) threatens the stability of our entire financial system. Using empirical evidence, this Sloan School Economist and McKinsey Consultant make a strong case not only for increased banking regulation, but even hard-capped size limitations. In this article, I will try to summarize some of their most salient points.

They argue that once a bank becomes too big to fail (TBTF), they can skirt regulations by shifting risk into their less regulated, more complex lines of business, such as derivatives, CDO’s and Structured Investment Vehicles (SIVs). They continue to increase risk to speed growth knowing that ultimately the US Federal Government will have no choice but to come to their rescue (a.k.a. Moral Hazard – AIG, Bear Stearns, Merril Lynch in 2008) in the unlikely event of a catastrophic financial melt-down.

Ronald Reagan is generally credited with ushering in the modern deregulation movement in the US drawing from the ideas of noted University of Chicago Economist Milton Friedman. Reagan’s first Treasury Secretary was Donald Regan, the Merrill Lynch CEO who led the deregulation of brokerage commissions, as he sought to transform Merrill Lynch into a diversified financial services company.

Congress under Reagan passed the Garn-St. Germain Depository Institutions Act in 1982, which removed many regulations from the Savings & Loan (S&L) industry, allowing them to expand into commercial lending, corporate bonds, and other higher risk investments. Reagan praised the Act as “the first step in our administration’s comprehensive program of financial deregulation.” Between 1985 and 1992, over 2000 banks failed, and over one thousand people were indicted. Thrifts suspected of fraud cost the government $54B.

Even after the S&L crises, Washington was dominated by Alan Greenspan at the Federal Reserve, an Ayn Rand disciple himself, and Robert Rubin, and Lawrence Summers at the Treasury, who were both strong advocates of banking deregulation. The Bush Administration continued to promote the financial de-regulatory environment right up to the 2008 collapse.

The Gramm-Leach-Bliley Act of 1999, and the Commodity Futures Modernization Act of 2000 not only repealed the Glass-Steagall separation of commercial and investment banking, but also restricted the regulation of over-the-counter derivatives. Both these bills were widely seen as responsible for the financial crises of 2008.

Johnson & Kwak also point out how Wall Street began to attract the top talent from the most prestigious business schools. “While only 5% of men in classes around 1970 were in finance fifteen years after graduation, that figure tripled to 15% for classes around 1990.” The banking sector, with its lure of great wealth, were attracting some of our brightest students out of the math and science PHd programs.

In the 1990s, asset-backed financial products such as Mortgage-backed securities (MBSs), and later, Collateralized Debt Obligations (CDOs), became increasingly important to Wall Street. In 1997, JP Morgan pioneered the use of Credit Default Swaps (CDS) as well, which were leveraged as a strategy to shift the risk of default on the underlying loans from the bank (JP Morgan) to the CDS issuer (often AIG). This enabled the bank to avoid having to maintain capital reserves for these loans.

Banks used securitization (CDOs & MBSs) to pass on default risk to their investor clients. However, some banks believed strongly in the soundness of the more senior tranches, which were less riskier than the junior tranches, but paid out a smaller rate of return. They also often had more investment interest in the higher yielding, but consequently, riskier tranches, even though most of the senior tranches received AAA ratings from the credit bureau agencies.

Banks created Structured Investment Vehicles (SIVs) to raise money by issuing commercial paper and investing it in longer-term, higher-yielding assets. “Citigroup, for example, used SIVs to buy over $80B in assets by July 2007. These vehicles allowed banks to invest in their own structured securities without having to hold capital against them.” SIVs allowed banks to take on more risks without increasing capital requirements.

Fannie Mae and Freddie Mac were Government Sponsored Enterprises (GSEs) with a mandate to not only provide liquidity to the housing market, but to lend to people with low to moderate incomes. “In 2002, as part of the Bush Administration’s Blueprint for the American Dream, they committed to finance $1.1 trillion in loans to minority borrowers.” Many in Congress have blamed these mandates and increasing loan targets set by HUD as the main contributor to the housing bust, but Johnson & Kwak would argue otherwise. The riskiest mortgages, they claim, which fueled the bubble would never meet the strict conforming loan guidelines used to regulate Fannie & Freddie lending.

“As profit-maximizing private corporations, Fannie and Freddie tried to relax their underwriting standards in order to get into the party, reducing documentation requirements and lowering credit standards. But ultimately, regulatory constraints prevented them from plunging too far into subprime lending. Housing expert Doris Dungey wrote “The immovable objects of the conforming loan limits and the charter limitation of taking only loans with a maximum loan-to-value ratio of 80%…plus all their other regulatory strictures, managed fairly well against the irresistible force of innovation.”

Elizabeth Warren, the Harvard Law Professor, Assistant to the President, and Special Advisor to the Treasury Secretary, called for the creation of a consumer protection agency which would have the authority to regulate “unfair, deceptive or abusive acts or practices for all credit, savings and payment products.” The Obama Administration backed her idea and proposed the creation of the Consumer Financial Protection Agency (CFPA). Although the banking lobby mobilized against it, the agency was created with the passage of the Dodd-Frank Wall Street Reform & Consumer Protection Act, signed into law by President Obama on July 21, 2010.

Johnson & Kwak argue there are at least six banks that are TBTF – Bank of America, Citigroup, Goldman Sachs, JP Morgan Chase, Morgan Stanley and Wells Fargo. The $180B taxpayer funded bailout of AIG was in effect a response to the colossal impact an AIG collapse would have had not only on these banks, but on our entire financial system.

Additionally, Alan Greenspan, the Chairman of the Federal Reserve from 1987 to 2006 diverged from his de-regulatory rhetoric after the financial crises of 2008. More excerpts from his comments are in the book, but some notable quotes include: “If they’re too big to fail, they’re too big…At a minimum, you’ve got to take care of the competitive advantage…I don’t think merely raising the fees or capital on large institutions or taxing them is enough…I mean radical things, as you know, break them up…In 1911, we broke up Standard Oil. So what happened? The individual parts became more valuable than the whole.” Ironically, once one of the loudest advocates of financial de-regulation, Greenspan, was now suggesting some of the harshest regulation. He wanted to break up the TBTF institutions.

Opponents often argue that big banks provide financial services that large corporations require, and that the only way US banks can compete for these services on a global scale is to be allowed to grow as large as their global competitors. Another common argument against regulation is that larger financial institutions are more efficient than smaller one’s due to economies of scale.

Johnson & Kwak state there is no empirical evidence to support these claims. To the contrary, large, multi-national corporations instead rely on a conglomerate of different banks for major offerings of debt or equity. When Johnson & Johnson needed to raise debt in 2008, they used 11 different banks, and in 2007, 13 different banks. Johnson & Kwak not only promote asset cap limits, but feel these limits must be adjusted and regulated based on the asset risk.

Johnson & Kwak also point out studies that show economies of scale vanish at some point below $10B in assets. They cite the 2007 Geneva Report, “International Financial Stability,” co-authored by Roger Ferguson, a former Federal Reserve Vice Chairman, that found consolidation in the financial sector over the previous decade did not lead to economies of scale beyond a low threshold. Rather, large banks are actually less efficient than mid-sized banks without the TBTF subsidy (ability to take higher risk due to TBTF stature). Another study showed larger banks gained productivity not through acquisition & consolidation, but rather through investments in Information Technology.

In summary, 13 Bankers demonstrates how TBTF institutions can not only threaten the stability of the entire financial system as they seek to speed growth through financial innovation and risk-taking, but they are also less competitive & less efficient than their midsized counterparts once you remove the TBTF subsidy. Kwak & Johnson show how de-regulation caused the S&L crises of the early 1990s, and similarly how that same de-regulation fervor in the 2000s lead to the 2008 crises, just as today the calls for less financial regulation have already begun. How quickly we forget, and how influential the power brokers of Wall Street are in shaping public policy. Financial innovation, and a general over-emphasis of the financial sector from the lure of great wealth in the longer term creates destructive bubble environments unless they are carefully watched, regulated and broken up when their size becomes a TBTF threat.


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