Dr. Talat Ulussever*
It is a well-known fact that financial markets, especially banks, are subject to more developed regulatory mechanisms than other sectors of the economy in order to safeguard the public’s savings, bring stability to the financial system, and prevent abuse of financial service customers. In fact, banks lie at the heart of the world’s financial system and have indispensable functions in business life. In addition, banks play crucial role in the economic life of the nations. The economic performance of the nations, thus, is strongly related to the soundness of their banking systems. Although banks create no new wealth, but their borrowing, lending, and related activities facilitate the process of production, distribution, exchange, and consumption of wealth. Consequently, banks are considered as one of the building blocks of the nations’ economic development.
No need to mention that the size, variety, and characteristics of financial transactions may produce awfully harmful effects on the entire economic system, which justify the more developed regulatory and supervisory regime of the banks and financial institutions, with the explicit objective of ensuring the soundness and stability of the system. There are countless examples of how weak or incomplete regulatory mechanism of banks and financial institutions has created dramatic financial, economic, and social problems.
However, regulation is still an unpleasant word on many people’s eye, especially on managers and stockholders, who often see the rules imposed upon them by the governments as costly, burdensome, and unreasonably damaging to innovation and efficiency. This state of mind with help of some popular concepts of economics and finance, like freedom, efficiency, international competition and economies of scale, gained momentum in 1980’s, and the rules of the game in financial arena rather changed in 1990’s; more and more financial service regulations were set aside or weakened, and free market place, not government dictation, was relied upon to shape and restrain what financial firms could do. A well-known example is the 1999 Gramm-Leach-Bliley Act, also known as Financial Services Modernization Act. This act removed the regulatory walls of the Glass- Steagall Act, which is an important legislation from the Great Depression-era that imposed a number of regulations on financial institutions like separating banking from security trading, underwriting and insurance industry.
Citibank’s merge with Travelers Group in 1998 had been seen as a violation of the Bank Holding Company Act (BHCA), and Citibank had thus been given two-year forbearance. Following the GLB act, however, not Citigroup/Traveler Group merger just became legal but several new mergers also took place.
This is an undeniable fact that the repeal of important portions of the Glass-Steagall Act made banks seek high returns by investing money from checking and savings accounts into “creative” and “innovative” financial instruments such as collateralized debt obligations (CDOs), mortgage-backed securities (MBSs) and credit default swaps (CDSs). These risky investments have been blamed to be caused to the collapse of the financial markets in 2008 and the resulting global financial crisis. The original idea of freeing up the banks or justification of the GLB act was to allow the US banks to compete at the national and international scale especially with European banks. However, many US banks engaged in very aggressive and riskier investments seeking higher returns following the GLB act. These aggressive behaviors were amplified as banking companies grew more complicated, drawing funding from more sources and investing in a wider range of activities. Increasingly, some investments were made to profit the firms’ employees and shareholders, which are unrelated to the needs of customers. Those banks had been making increasingly massive profits until the bubble burst in 2008. Although the impetus for the climb in profitability primarily came from the investment banking activities, the key area of growth was in securities with especially mortgage assets. Furthermore, the banks’ activities had been increasingly funded from the wholesale market by lending between banks on narrow margins and not the traditional depositor base in the commercial part of the banks’ business.
The problem was not truly recognized before 2008. When the bubble burst, it became not just obvious how risky these activities had been but the enormous scale of securitization combined with high leverage also almost led to a collapse of the whole financial system. In fact, being derivative products there were many third parties that had significant exposure to asset-backed securities (ABS). Consequently, the investment activities of those banks, aggressively seeking higher profits and market share regardless of the risk, pervaded the whole economy.
Another bill, known as the Commodity Futures Modernization (CFM) Act, had been passed just a year after the GLB Act. I do not think it is false that those two acts together undoubtedly contributed to the 2008 crisis. The (CFM) act unleashed the derivatives market and paved the way for banks to become more aggressive about investing in mortgages. This is basically how it ended up with the largest banks filled with toxic assets, off-balance sheet commitments, and in-house hedge funds among other “investments.”
Nobel Prize winner Paul Krugman prescribed a four-step view of the recent financial crisis as follows1;
- The bursting of the housing bubble has led to a surge in defaults and foreclosures, which in turn has led to a plunge in the prices of mortgage-backed securities — assets whose value ultimately comes from mortgage payments.
- These financial losses have left many financial institutions with too little capital — too few assets compared with their debt. This problem is especially severe because everyone took on so much debt during the bubble years.
- Because financial institutions have too little capital relative to their debt, they have not been able or willing to provide the credit the economy needs.
- Financial institutions have been trying to pay down their debt by selling assets, including those mortgage-backed securities, but this drives asset prices down and makes their financial position even worse. This vicious circle is what some call the “paradox of deleveraging.”
In consequence of the 2008 financial crisis, several giant financial firms failed and, as expected, they claimed the government bailout. Even though there was a strong public opposition to the failed firms’ bailout call, the US government bailed them out with little exception. As a result, taxpayers have had to foot a huge bill to save the nation’s debt-ridden banks because the government and pro-bailout people claimed that if those failed financial institutions were not saved, then the economy could collapse. They, furthermore, have argued that if there are losses to be covered and it is a matter of saving the financial system from collapse, then taxpayers do have to pay and always have done. They implicitly send message to the taxpayers by saying that if you want the financial system to collapse, you do not bailout anybody. If the system collapses, everybody will suffer and the economy will face a serious depression, which definitely creates more catastrophes then the bailout.
Nearly two year has passed since Congress and former President Bush gave the Treasury Department the authority to distribute hundreds of billions of taxpayer dollars to failed banks, a u t o m a k e r s , and AIG. Treasury gave money to more than 700 companies, but a handful of firms received Troubled Asset Relief Program (TARP) money in especially massive amounts. On the other hand, Congress neither specified how the money must be spent, nor dictated how the money must be used by aided institutions (e.g., not to pay CEO bonuses), nor imposed any system of checks and balances. As some people predict, banks may be using the bailout money to advance their own self-interest (they are, after all, for profit entities) rather than to thaw the credit freeze since there is no any system of checks and balances as mentioned above.
Under what conditions would multi-billion-dollar bailouts of private businesses be acceptable? What are the criteria that would be used for deciding when it is prudent to use public money to save private business? It is possible to ask more questions like those. They are obviously terrific questions with no obvious common answers. Different group of people can answer the above questions, however they possibly cannot satisfy others. Even the other people can claim that the answers and/or justifications are biased and cannot help the economy at all especially in the long term.
While researchers, academics as well as practitioners were still discussing the recent financial crisis and bailout issues, the big banks in the US announced that they made large profits and handed out huge bonuses only a year after one of the biggest banking crises and bailouts in the history. Thus, thousands of top traders and bankers on Wall Street were awarded huge bonuses and pay packages, even as their employers were battered by the financial crisis. This has unavoidably attracted much criticism given how instrumental the banks were causing the crisis.
Table 1: The major bailouts in 2008 and 2009
|2008||JP Morgan Chase and the federal government bailed out Bear Stearns when the financial giant neared collapse. JP Morgan purchased Bear Stearns for $236 million; the Federal Reserve provided a $30 billion credit line to ensure the sale could move forward.||$30 billion|
|2008||On Sep. 7, 2008, Fannie and Freddie were essentially nationalized: placed under the conservatorship of the Federal Housing Finance Agency. Under the terms of the rescue, the Treasury has invested billions to cover the companies’ losses. Initially, Treasury Secretary Hank Paulson put a ceiling of $100 billion for investments in each company. In February, Tim Geithner raised it to $200 billion. The money was authorized by the Housing and Economic Recovery Act of 2008.||$400 billion|
|(A.I.G.)||2008||On four separate occasions, the government has offered aid to AIG to keep it from collapsing, rising from an initial $85 billion credit line from the Federal Reserve to a combined $180 billion effort between the Treasury ($70 billion) and Fed ($110 billion). ($40 billion of the Treasury’s commitment is also included in the TARP total.)||$180 billion|
|Auto Industry||2008||In late September 2008, Congress approved a more than $630 billion spending bill, which included a measure for $25 billion in loans to the auto industry. These low-interest loans are intended to aid the industry in its push to build more fuel-efficient, environmentally-friendly vehicles. The Detroit 3 — General Motors, Ford, and Chrysler — will be the primary beneficiaries.||$25 billion|
|2008||In October 2008, Congress passed the Emergency Economic Stabilization Act, which authorized the Treasury Department to spend $700 billion to combat the financial crisis. Treasury has been doling out the money via an alphabet soup of different programs. Here’s our running tally of companies getting TARP funds.||$700 billion|
|Citigroup||2008||Citigroup received a $25 billion investment through the TARP in October and another $20 billion in November. (That $45 billion is also included in the TARP total.) Additional aid has come in the form of government guarantees to limit losses from a $301 billion pool of toxic assets. In addition to the Treasury’s $5 billion commitment, the FDIC has committed $10 billion and the Federal Reserve up to about $220 billion.||$280 billion|
|2009||Bank of America has received $45 billion through the TARP, which includes $10 billion originally meant for Merrill Lynch. (That $45 billion is also included in the TARP total.) In addition, the government has made guarantees to limit losses from a $118 billion pool of troubled assets. In addition to the Treasury’s $7.5 billion commitment, the FDIC has committed $2.5 billion and the Federal Reserve up to $87.2 billion.||$142.2 billion|
It is obviously immoral and insincere: If they win, they walk away with the profits; if they lose, the taxpayer picks up the tab. Consequently, this picture beyond doubt created widespread public anger against Wall Street bankers.
A report2, released by Andrew M. Cuomo, the New York attorney general, provides a little more details about the bailouts. The report confirms that nine of the financial firms that were among the largest recipients of federal bailout money paid about 5,000 of their traders and bankers bonuses of more than $1 million apiece for 2008. For instance, bonuses of more than $1 million went to 953 traders and bankers at Goldman Sachs, while Morgan Stanley awarded seven-figure bonuses to 428 employees. Even though they are weaker banks, Citigroup and Bank of America distributed million-dollar bonuses to hundreds of their workers. Thus, many people raised their voice by saying, “risk is being socialized, yet profits are privatized.” That means the rich elite makes money at the expense of the taxpayers. That is completely unfair and not what it should be.
It is morally revolting that the architects of the crisis had huge bonuses only a year after being bailed out by the taxpayer. With large profits made by the banking industry allowing the payment of the massive bonuses, it not just created widespread public anger as mentioned above, but also justified the argument that the new regulation for the banking industry is a must. Thus, it has become obviously necessary to regulate the banking industry in such a way that excessive risk-taking becomes not possible. In response to the distress and turmoil created by the financial firms and banks, the Obama administration proposed a two-part plan regulation, suggesting the comprehensive changes to the financial sector regulation.
President Obama first proposed a new tax or fee on the 50 largest U.S. financial institutions related to the costs of the government bailout of the financial industry. The idea is to discourage excessive risk-taking, to re-balance a tilted playing field, and to generate needed revenue. The fee is expected to raise $90 billion over the next 10 years and $117 billion over about 12 years. Although the tax would be imposed on 50 largest banks, insurance companies, and large broker-dealers, roughly 60% of the revenue is expected to come from the 10 largest financial firms. If approved by lawmakers, the fee would go into effect on June 30, 2010, and last at least 10 years. It would amount to 0.15% of total assets minus high-quality capital, such as common stock, and disclosed and retained earnings.
Yet even if Congress goes along with this fee proposal, it will practically not be enough. Because the executives who run these institutions are likely to force shareholders to bear the burden of the tax, while they just keep on much as before. In fact, shareholders have already suffered as the executives undertook mergers, paid out bonuses, and took other actions that have diminished shareholder value. Moreover, a new tax would probably give the bankers one more excuse not to restart lending. Mr. Obama made a second and more direct proposal by adopting the ideas of Paul Volcker, the former Fed chairman, on the 22nd of January, 2010. This regulation restricts banks from making investments that are not intended to benefit customers, which is known as proprietary trading. Mr. Obama’s new proposal put new limits mainly on the size and activities of the largest banks by intending to toughen existing limits on the size of financial firms and force them to choose between the protection of the government’s safety net and the often-lucrative business of trading for their own accounts or owning hedge funds or private-equity funds. Mr. Obama highlighted this point by saying, “Never again will the American taxpayer be held hostage by a bank that is too big to fail.” The second proposal focused on two points. The first concerns restrictions on the scope of activities. In the case of having insured deposits, and hence accessing to emergency funds from the central bank, the banks would not be allowed to own or invest in private equity or hedge funds nor would they be able to engage in “proprietary” trading though they could continue to offer investment banking for clients, such as underwriting securities, making markets and advising on mergers.
The second focuses on size. Banks already face a 10% cap on the national market share of deposits. This would be updated to include other liabilities, namely wholesale funding. The aim is to limit concentration, which has increased greatly over the past 20 years, accelerating during the crisis as healthy banks bought sick ones. The four largest banks now hold more than half of the industry’s assets. This second proposal is easily considered as, at least, seeking to return the “spirit of Glass-Steagall Act” and will for sure impede the growth of the largest banks and bar them from making what Mr. Obama called “reckless” investments.
Logically and honestly speaking, it is hard to claim that the new plan is intended to punish the big banks instead it is intended to create a sound and more reliable financial system. Although some researchers, academics as well as practitioners either totally or partially disagree with the plan, and do not believe that it will help avoid the new financial crises, a significant support has come from different types of people with all level. The latter definitely believe that Mr. Obama’s plan to separate core commercial banking from some higher risk activities in financial conglomerates and to place a moratorium on further consolidation could help to avoid the new financial crises by resolving some major risks inherent to the current financial system.
As it is known, commercial banks function as intermediary between depositor and borrower and provide the loans and services to households and companies that are the life-blood of business activity and job creation. Investment banks, by contrast, have often engaged in activities that are more intensive use of complex instruments subject to highrisk volatility, and invested bank capital in hedge funds and private equity firms, which are in high return-high risk category. Nobody has problem with hedge funds and other speculative clubs, so long as they are not risking taxpayer money, whether directly like Fannie and Freddie or indirectly by threatening to bring down the system.
The recent financial crisis has provided a clear lesson against allowing excess leverage and risk-taking through financial innovations that do not correspond to corporate and retail customers’ banking needs. In retrospect, one can trace the origins of the crisis to a shift over time away from the ‘credit culture’ of commercial banking towards an ‘equity culture’ focused on generating profits for shareholders and management by exploiting new financial innovations and leveraging them while taking advantage of regulatory and tax loopholes. Therefore, as proposed in Mr. Obama’s plan, separating these from mainstream activities like deposit-taking and lending, as well as some investment banking activities that correspond to customer needs, such as underwriting, market-making, broking and some derivatives services, could definitely bring important benefits for commercial banking. The separation could notably decrease contagion and counterparty risks, and help sustainable growth by focusing management attention on the core needs of bank clients without major distractions and disruptions.
As Acharya (2009)3 claims, the goal of bank regulation is to restrain systemic risk rather than the individual risk of institutions. Accordingly, imposing a fee especially on the largest financial institutions, both for their expected losses when individual institution’s failure and for expected losses when whole market’s failure in the case of the financial system as a whole becomes undercapitalized, minimizes the systemic risk, thus suggest a solution, possibly good and efficient solution. As a consequence, even though it may have some possible flaws, given this framework for regulating systemic risk, Mr. Obama’s proposal of imposing a fee against systemic risk of institutions is not just fair on the eye of public but also makes true economic sense.
Moreover, again even though there are some concerns, separating commercial banking and other forms of financial intermediation from proprietary trading definitely limit systemic risk without affecting the financial sector’s ability to function its core activities. Obviously, one can easily count several points that need to be fixed and raise some concerns with Mr. Obama’s new bank plan. On balance, however, both, a fee against systemic risk and scope restrictions, deserve serious consideration and seem to be right steps in the right direction.
* Assistant Professor, King Fahd University of Petroleum & Minerals, Dhahran, Saudi Arabia
1 http://www.nytimes.com/2008/09/22/ opinion/22krugman.html
2 http://www.nytimes.com/2009/07/31/ business/31pay.html
3 Acharya, Viral V (2009), “A Theory of Systemic Risk and Design of Prudential Bank Regulation”, Journal of Financial Stability,5(3), 224-255.