Cleansing and Reforming our Financial System

Why don’t we just admit that the current financial and regulatory system is dysfunctional?

We face two fundamental problems.

First, we need to clean the financial system — close weak banks more aggressively, encourage bankruptcies/foreclosures, and free good assets held by poorly financed owners. Small and medium sized businesses with quality projects are not getting loans. This problem will not be solved by tax breaks or targeting some incentives. We need structural change.

Second, the current regulatory system failed us. It needs to change. Our system is comprised of three federal agencies: the Office of the Comptroller of the Currency, the Federal Deposit Insurance Corporation, the Federal Reserve, as well as 50 state banking departments! I am not even including the Office of Thrift Supervision and all of the Savings and Loan Institutions nor the National Credit Union Administration which supervises all the credit unions.

There are state chartered banks as well as national chartered banks. As a result of the historical maze of changing regulations, we have over 7,000 banks. There is no economic reason for 7,000 banks. It is inefficient both for the bank in providing the lowest cost and highest quality services to their customers. It is a nightmare to regulate.

What is most alarming is that none of our leaders have stepped up with bold proposals to revamp our financial and regulatory system.

To analyze these issues, let’s go back to the President’s speech of January 21, 2010 proposing two regulatory ideas.

The January 21, 2010 Speech

The President’s first proposal had to do with banks running speculative operations:

First, we should no longer allow banks to stray too far from their central mission of serving their customers. In recent years, too many financial firms have put taxpayer money at risk by operating hedge funds and private equity funds and making riskier investments to reap a quick reward.

I agree with the President on this one. I made this exact point in Davos in 2005. Indeed, I made the point directly to Senator Richard Shelby who, at the time, was the Chairman of the Senate Banking Committee.

Essentially, this means the partial repeal of the repeal of Glass-Steagall. It is partial because banks would still be able to trade risky assets for customers – but they would be prohibited from running their own proprietary trading operations. More on this later.

This proposal is now known as the Volcker rule (former Chairman of the Federal Reserve). The president said:
It’s for these reasons that I’m proposing a simple and common-sense reform, which we’re calling the Volcker Rule, after this tall guy behind me. Banks will no longer be allowed to own, invest or sponsor hedge funds, private equity funds or proprietary trading operations for their own profit unrelated to serving their customers.

The second proposal was directed at non-banks:

There has long been a deposit cap in place to guard against too much risk being concentrated in a single bank. The same principle should apply to wider forms of funding employed by large financial institutions in today’s economy.

This one I do not like. Again, I will elaborate below.

It is worrisome that it took one year to come forward with such bare bones reforms. We need to push deeper.

U.S. Banking History 101

The Glass-Steagall Act of 1933 separated prohibited commercial banks from doing investment banking.

There was plenty of motivation. The U.S. economy had crashed into a Great Depression. Before the Act, many banks had practices that we would consider unethical today. For example, if the Investment Bank division held stock in a troubled company, the troubled company might get a cheap loan from the Commercial Bank division. In addition, stock that the Investment Bank held was often promoted to customers of the Commercial Bank.

All of this ended with Glass-Steagall.

By the way, the official name of the bill was The Banking Act of 1933 — and it did other important things, like establish the Federal Deposit Insurance Corporation.

In 1999, the key provisions of the Act (the separation of commercial and investment banking) were repealed by the Gramm-Leach-Bliley Act. A major proponent of the repeal was then Treasury Secretary Larry Summers. The repeal had broad bi-partisan support. The final bill passed the House (362-57) and Senate (90-8) and was signed by President Clinton.

The repeal opened aggressive expansion of commercial banks into much riskier investment strategies.

In some ways it put us back to pre-1933. Remember one of the complaints was that banks were making cheap loans to support companies that they were investing in. Fast forward to 2008. Banks were using customers’ deposits (cheap capital, and government guaranteed) to invest in their own highly speculative investments.

It is clear that we are not going back to pre-1999. Deputy Treasury Secretary Neal Wolin made said on January 25, 2009, that the new regulations are directed at the banks own prop desks. That is, banks will still be allowed to trade in risk securities for their own customers.

All FDIC-insured banks are quasi-government institutions. It does not make sense for banks to be making highly risky bets with capital that is made cheap courtesy of the U.S. taxpayer. In addition, it does not make sense for massive bonuses to be paid out when these institutions win their bets but when the bets go sour to rely on government subsidization (zero interest rates, guarantees) and bailouts.

However, it is but one piece of the problem.

Scope of Operations

The other issue is the “too big to fail”. The President proposed putting a cap on the size of financial institutions (non-banks). The idea being that no one firm should be so large to put the system at risk.

I don’t like this idea (at least applied to the current U.S. situation). Let me elaborate.

  • If we measure a particular financial institution’s assets (or liabilities) relative to GDP, we really don’t have a size problem. In countries like the U.K., Beligium, Switzerland, you have individual banks that have liabilities that greatly exceed the country’s GDP. We don’t have anything like that.
  • If you like the idea, where do you draw the line?
  • Even if the idea is implemented, the problem is not one particular institution – the problem is with contagion. There is no difference between one big financial institution failing and a contagious reaction of many smaller banks failing. A cap on size does nothing to mitigate a systemic event.
  • It will likely constrain the ability of our financial industry to compete globally.

The main problem is that it does not address the underlying issues. Lehman’s failure would not have been avoided with such a measure (Lehman was an investment bank). It wasn’t the size of Lehman that caused the problem.

Lehman failed because it took big risk. They were betting on heads and it turned out tails. Big risk means potentially huge rewards but also commensurate losses. They lost.

Lehman’s demise and the near demise of many other financial institutions might have been avoided if there was a different approach to regulation.

The immediate mess of the aftermath of Lehman was largely a result of the Chapter 11 procedures being ill-suited for financial institutions. That can be changed.


  1. Transfer all jurisdiction over banking to a single central authority. That is, only national banks should be chartered. This is the way banks operate in other developed countries. Currently, we have the OCC supervising about 3,000 banks and state banking departments responsible for over 5,000 banks.
  2. OCC and FDIC should be consolidated. The Federal Reserve should remain independent.
  3. Encourage consolidation of the many small banks (this is easy to do because many of them are insolvent but allowed by the FDIC to keep operating). There are many natural economies of scale that both reduce costs to customers, improve service and provide a natural hedging of risk for the bank (you do not want all your customers concentrated in one area of the country).
  4. Make banks fess up to the real value of their troubled loans. There are reports that FDIC staff have instructed many banks to restructure troubled loans into short-term interest-only loans. This is a terrible strategy. It assumes a robust recovery. However, the very fact that financial institutions are housing these assets that have little value – decreases the chances that they can make loans to quality borrowers. To be clear, these actions reduce the chance of a robust recovery. It simply delays the pain. Surely, we learned something from Japan’s disasterous strategy in the 1990s.
  5. Set up a Resolution Trust entity to house the troubled assets of failed financial institutions. I estimate that there are at least 1,000 institutions that should be closed. The financial system is not healthy until we greatly reduce the troubled loans on the balance sheets of our financial institutions. Again, we cannot continue to follow the Japanese playbook of the 1990s.
  6. Reserve requirements must be strongly procyclical. That is, in good times, banks must greatly add to their reserves. This provides a cushion in bad times. Our current system does not recognize this simple intuition.
  7. Investigate another layer of insurance called by Flannery “reverse convertible debentures” and Kashyap and Stein as “capital forbearance certificates”. Read about it here.
  8. Any financial institution that benefits from the explicit or implicit support of the U.S. taxpayer should be regulated. For example, AIG. The AIG disaster lead to a $162 billion bailout that cost each working American approximately $1,000.
  9. A new system of regulation should be streamlined (not redundant) and designed to achieve the objectives (reduce and control risk) and the lowest possible cost to the financial institution. The regulator should provide an atmosphere that encourages rather than stiffles innovation on the part of financial firms.So, I am not calling for more regulation — I am calling for less regulation but more effective regulation. It is reasonable that part of this regulation should include steps to protect consumers with common sense items such as no liar loans, no ninja loans, no prepayment penalties, transparent interest rate/fees for loans/cards, etc.
  10. Much of our problems are due to an explicit subsidization of the housing sector. This comes in many forms. Most Americans are so used to the deductability of mortgage interest that they don’t realize, in almost all other countries, there is no deduction. In addition, more than 90% of new mortgages are being underwritten by Federal agencies. Finally, the government has been active in the mortgage market in buying mortgage securities, thereby pushing interest rates lower. We need to re-examine all of these subsidies. The highest priority questions: (i) Should we abandon mortgage interest deductability? and (ii) Should the government be the insurer of almost all new mortgages issued?

Crisis and Leadership

A financial crisis and a recession exact a terrible human toll. It is not just about 10% of the labor force being out of a job. Millions more are not counted in the official numbers because they have given up looking for a job. Additional millions are living in fear they will soon lose their job.

I don’t think anyone doubts that a well functioning financial system is critical to the future growth prospects of our economy.

Right now, the system is broken.

In summary, we need a two pronged strategy. First, we need to cleanse the financial system. Given the current regulatory system, we need a new strategy that swiftly purges the weak financial institutions. Our current strategy of keeping zombie banks going damages the economy’s future growth and employment prospects. We need to send the message that the government is not the lender of last resort for too big to fail organizations. Second, we need a bold change in the way that we regulate our financial institutions.

Regulatory reform alone is not sufficient.  The moral-hazard effects of government explicit and implicit bailouts will overwhelm the good effects of improved regulation. We need both cleansing and a fresh approach to regulation.

While a crisis has many downsides, it also provides an opportunity. It is one of the few times that bold, system-wide, changes can be implemented. The Banking Act of 1933 is a good example of bold legislation.

Am I naive?

Perhaps. However, someone needs to step up. We need more than cosmetic changes.

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2 Responses to Cleansing and Reforming our Financial System

  1. Mr. Smith says:

    I do not think you are naive, but perhaps working with incomplete information. My conclusions are somewhat similar to yours. However, from my vantage point, I see first hand why it is not so simple – but first, a disclosure and disclaimer:

    I am an employee of the FDIC. The following represents my personal view only and is in no way endorsed, approved, or otherwise supported by the FDIC, the U.S. Government or any other affiliated agency.

    I agree the financial system needs to be cleansed. However, the dirtiest parts are not the banks, it is the “non-banks” that promulgated the chicanery which led to the demise of the system and should be put down. I believe the regulatory system is acting swiftly to deal with weak banks and weak borrowers. Closing a bank has far-reaching ramifications; regulators do not take the idea lightly with good reason. The topic itself warrants its own discussion, but for the sake of expediency, I’ll present two reasons why bank closings may appear to occur slowly: protection of depositors and respect for private industry. The U.S. Government, through the FDIC, guarantees the deposits of the American people (up to a limit). First, a bank must be dismantled with care so as to protect deposits, or at least minimize the cost to the Deposit Insurance Fund. Second, it is a big deal for the government to take over any business, especially a bank. The regulatory system is set up to support a private industry and free market. As with the spirit of due process throughout our legal system, banking regulation is designed to give private companies every opportunity to right the ship before government intervenes.

    On your point of good assets…again this is worth an entire separate post…what makes an asset “good”? It has value or generates cash. Ideally it has value because it produces cash. I don’t see loans with good assets as the problem. I do see loans with assets that have lost value or stopped generating cash causing major problems. If the underlying asset is good (and by asset I mean real assets, not that Imagineering crap they do on Wall Street), there many options to ameliorate the situation.

    We are in a bit of a catch 22 regarding lending to small businesses. Many of the healthy banks attribute their success to conservative underwriting and investing. These are the banks that turned down business that eventually caused problems for those that did take the risk. In a recessionary environment there are even fewer borrowers that will qualify under these conservative underwriting guidelines. The thinking is that the conservative management practices kept them out of trouble, therefore, stay the course, don’t abandon the strategy now. Many of the weak banks are under regulatory action that effectively constrains the banks’ ability to lend until the banks are rehabilitated. I understand the immediate economic pain, but like any rehabilitation program, it must be followed methodically to minimize the risk of another injury that would surely be game-ending. Regulators appreciate this dilemma, as evidence I will refer you to the “Interagency Statement on Meeting the Credit Needs of Creditworthy Small Business Borrowers” released jointly by the FDIC, Federal Reserve, OCC, OTS and NCUA on Feb. 5, 2010.

    Parts of the regulatory system didn’t perform as well as they could have. Other parts responded well. The recent crises even revealed areas missing altogether from the regulatory framework. To understand what works well and doesn’t requires a little more detail about the regulatory patchwork than you described. All banks have some form of federal oversight; each of the federal agencies has primary supervision authority for a segment of banks as dictated by law. OCC supervises all nationally chartered banks. The FDIC, who actually employees the largest number of examiners, supervises state-chartered banks who are not members of the Federal Reserve. The Fed explicitly supervises state-chartered banks who are members of the Federal Reserve and bank holding companies; it has also ill-defined responsibilities for what we’ll just call “everyone else”. Of course the OTS gets all the thrifts. Additionally, the FDIC has back-up supervisory authority for any insured institution, since it does have skin in the game regardless of the primary federal regulator. State-chartered banks are additionally supervised by their respective state regulator who works with their federal counterparts. Looking at where the fires broke out in the crisis, one can see where the weakness lies. Surprisingly, bank examination and regulation are managed rather consistently across the agencies. Through the FFIEC (Google it), the agencies synchronize their respective codes of regulation and share best practices.

    Actually it is not a nightmare to regulate 7,000 banks. There is no simpler, more transparent business than a community bank. No, we don’t need that many, but the sheer numbers do not create the inefficiencies one might expect. It is a nightmare to regulate the Leviathan financial institutions (not going to name names, but this audience is smart enough to figure it out). The complexity of these organizations makes it easier to elude regulators – although, I’m not saying that they do.

    As for what is best for the customers, I disagree that the large number of banks leads to high cost and low quality service for customers. Let’s first look at the pure economic forces. A market with many banks approaches pure competition which will be the most efficient in the long run. Having only a few banks, like Canada which has five, creates an oligopoly, which puts pricing power in the hands of the banks and risks collusion at the expense of consumers. One might assume that a large enterprise should enjoy operational efficiencies of scale and have an advantage over smaller banks. In theory, they should. However, having worked for a large multi-national bank and witnessing small community banks, I can tell you the promised efficiencies never materialize. Large banks are actually less efficient as evidenced by standard metrics available in their regulatory reporting. Large banks manage anonymous data and talk about customer relationship management while small banks have actual relationships with their customers. So while I understand the potential benefits with fewer banks, I don’t see it playing out that way in the market.

    I think you oversimplify the similarity between one large bank and several small banks failing. The point is made easier with a few metaphors.

    Let’s say I wanted to ship a Ming Vase from New York to Chicago. I have several options for packing. I could encase it in concrete or surround it with Styrofoam peanuts. Weight-induced cost prohibitions aside, a concrete encasement will protect against bullets, radiation, fire, brimstone, but offers little protection when the package falls eight feet off the back of the truck. When the concrete falls, a few things can happen. The concrete could absorb the force of the fall causing the concrete to crack thereby compromising the integrity of the entire structure; and/or the force could be conducted through to the vase causing it to crack. Not a good option. Consider why Styrofoam peanuts are the packing material of choice. While Styrofoam doesn’t have near the raw strength of the concrete, several pieces working together create a more desirable system. Whereas the concrete absorbs, focuses and in some cases amplifies the energy of the fall, the peanuts disperse the energy. Several individual pieces near the point of impact could “fail”; however the collective system continues to perform its duty. Similarly, a banking system with a multitude of small institutions can more effectively disperse and diffuse systemic events.

    Alternatively, what if I were some nefarious force of evil that wanted to make the banking system fail? What types of systems would be easier targets? Military strategy offers some insight for this example. Suppose we have two potential enemies and both having fighting forces of 1,000. Equating a large bank with several small banks that have an equal amount of aggregate assets or deposits is much like equating two enemy forces based on the total number of combatants. The organization of the enemy tells me their strengths and weaknesses and the type of strategy I will need to prevail. I cannot use the same plan of attack for both an enemy that fights as a single phalanx and an enemy that operates as a network of terror cells. For the enemy that behaves as single force, I can take them down with systemic events – i.e. cut off their supply line (think funding and liquidity) or drop a nuke in the middle of the formation (think over-weighted exposure to homogenous asset classes). The organization as a large force invites the greater amount of force required to bring about defeat. The terror network has no similar systemic exposure; the weaknesses are diversified – multiple supply lines, dispersed location, varied fighting styles and weaponry. There is nowhere one can, even if one wanted to, drop a nuclear weapon that would bring down all the cells at once. The network can be brought down, but not by a few large systemic events. A system comprised of many small banks collectively has diversified exposures that in aggregate provide a much better defense against systemic shocks.

    The Styrofoam peanuts and network of terrorist cells work because survival of the system is not predicated on all components of the system surviving. Even after the recent systemic crises where over 100 banks have failed, several thousand banks representing a majority of deposits weathered the storm with no government help. All the money center banks had to be bailed out. All the investment banks would be gone but for political intervention.

    I agree consolidating regulatory authority makes sense. However, I don’t see the current segmentation of authority as a major problem. The problems were agencies not taking proactive responsibility for their jurisdiction and the participation of players with no designated supervision period. It’s like the old legislative argument, we don’t need more laws, we just need to enforce the ones we have. If I were to restructure, I would dissolve the OCC or dilute it back into Treasury (the OCC has long outlived its original purpose) and consolidate financial supervision to the FDIC, which like the Fed is also independent. The FDIC has the most comprehensive force to supervise banks and, because it writes the check to cover deposit losses, has duly aligned incentives. The Fed would become more of a traditional central bank focusing on monetary policy.

    Getting banks to fess up to the real value of troubled loans is exactly what regulators are doing. I would not characterize your anecdotal information about restructuring loans as any sort of strategy. Banks are required to test for and recognize impairment and separately report to what extent they are restructuring troubled debts. Regulators examine primary data in banks to ensure this is occurring. Regulators do not look kindly upon management that is not duly recognizing impairment. That said, let’s consider why a restructuring might occur and why it might be advantageous to do so. Suppose a developer wants to buy a piece of raw land to turn into a housing development. The cost of the project consists of land purchase, costs to get the land builder-ready (this means putting in all the infrastructure so a builder can come in and put up a house), and interest carry during the development period. The loans are customarily structured as interest only for a term that will allow ample time to make the improvements and sell the developed lots to builders. If the project began in 2006 and came online 2008, what happened to the developer? Consumers quit buying houses, builders quit building, demand disappears. The developer is left holding a pipe farm with freshly paved roads. Even the most respected developers have exhausted their personal assets trying to keep these projects afloat. What should the bank do? They can foreclosure and take over the property – that doesn’t fix the demand problem. They can sell it for $1, but the “good” asset isn’t going back into circulation – still no demand. Furthermore, taking the loss doesn’t free up capital for more lending, by definition it eliminates capital. Keeping a loan on interest only can be the best option among no good alternatives. I do not believe bankers have any rosy expectations for a robust recovery. The small banks have a front row seat to the hardships of their small business customers. At any rate, regulators do not simply accept that restructured loans remain viable earning assets. Irrespective of the merits of restructurings, the regulatory requirements for managing debt restructurings are clear, troubled debt restructurings must be duly impaired and reported.

    The Resolution Trust Corporation is so 1990’s. That was the course of action following the S&L crisis. RTC did have immediate benefit as it allowed banks to quickly offload problem assets. However, running RTC was actually very expensive – so expensive that the government doesn’t want to do it again. That’s why you see what look like sweet loss sharing deals for those who acquire the assets of failed institutions. The FDIC knows it will be very expensive to take the asset on balance sheet so they have instead structured the loss exposure to equal the expected cost to carry the problems assets with the opportunity for upside.

    I totally agree on the cyclicality of reserves, for everyone, not just banks, insurance companies too.

    I agree on extending the long arm of the law to touch anyone benefitting from government bailout. And don’t even get me started on executive compensation.

    I agree on the principle of more effective legislation. In general, I’m a big fan of innovation – it allows us to be the “civilized” people we are today and enjoy the benefits of modern society. However, one thousand years of history prove that no good ever comes from financial innovation. Inevitably, financial innovation always leads to total disregard for the very common sense you suggest.

    The problem with housing policy is that we experienced too much of good thing. Yes, home ownership benefits society. No, not everyone is capable of being a homeowner and we should stop kidding ourselves that home ownership is an unalienable right. Any short-term issues with the Fed supporting the mortgage market will be evident soon enough. Long term, I would rearrange the current system. As currently designed, Fannie and Freddie subsidize the mortgage market and private mortgage insurers get to make a profit for insuring the residual risk not mitigated by underlying collateral. We should get rid of Fannie and Freddie, give the mortgage market back to the banks, get rid of private mortgage insurers and set up a national fund to insure catastrophic risk for mortgages. The best enforcement for prudent lending is to make the lender liable for losses. When actions and consequences are aligned, the monkey business goes away. This is long overdue.

    In summary, I would like nothing better than to see Messrs Glass, Steagall, and Volcker come roaring back with a vengeance. Now, back to the banks.

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