Here’s an odd prediction forthe coming year: 2013 will be a watershed for financial reform. True, while theglobal financial crisis erupted more than four years ago, and the Dodd-Frankfinancial reforms were adopted in the United States back in 2010, not much haschanged about how Wall Street operates – except that the large firms havebecome bigger and more powerful. Yet there are reasons to expect real progressin the new year.
The US Federal Reserve is finally shifting its thinking. Ina series of major speeches this fall, Governor Dan Tarullo made the case thatthe problem of “too big to fail” financial institutions remains with us. Weneed to take additional measures to reduce the level of systemic risk –including limiting the size of our largest banks. News reports indicate thatthe Fed has already started saying no to some bank mergers.
At the same time, the US Federal Deposit InsuranceCorporation has become a bastion of sensiblethinking on financial-sector issues. In part, this is because the FDIC isresponsible for cleaning up the mess whenfinancial-sector firms fail, so its senior officials have a strong incentive toprotect its insurance fund by preventing risks from getting out of control. TheFDIC is showing intellectual leadership as well as organizational capabilities– Vice Chairman Tom Hoenig’s speeches are a must-read.
Wall Street is pushing back,of course. But the rolling series of scandals surrounding global megabanksmakes it difficult for anyone to keep a straight facewhen executives insist that our largest banks must maintain their current scaleand scope. Do we need HSBC to facilitate global money laundering?Do we need Barclays and UBS to manipulate Libor(a key benchmark for interest rates around the world)? Do we need still morelosses at poorly run trading operations for JP Morgan Chase?
The pro-bank lobby groups are positioning themselves toargue that the new resolution powers under Dodd-Frank have ended thetoo-big-to-fail problem, and we can expect a public-relations drive in thisdirection early in the new year. But the consensus view at the most recent meeting of the FDIC’s Systemic ResolutionAdvisory Committee (of which I am a member) was that this claim should not be takenseriously. Under Dodd-Frank, it is arguably easier for the FDIC to handle thefailure of a single large financial institution than it was in pre-Dodd-Frankdays. But what if two or three or seven firms are all in trouble at the sametime?
The answer, as former Fed Chairman Paul Volcker implied atthe meeting, is that we would be right back where we started – in the panic andfrozen credit markets that followed the collapse of Lehman Brothers inSeptember 2008. Indeed, the idea that substantial shocks could soon hit the USfinancial system is not far-fetched. TheEuropean debt crisis, for example, remains far frombeing resolved. A significant sovereign-debt restructuring there would bring down European banks and potentially damage USbanks – as well as financial institutions around the world.
Meanwhile, the continuing problems at European banks are a stark reminder that operating highly leveraged, thinlycapitalized firms is incredibly risky. And the regulatory failures in Europe –consider the German Landesbanks, for example – will become only more obvious inthe coming months. Creating a common supervisory authority will mean nothingunless it can clean up the mess created by the existing supervisors. And that cleanup will expose more of the rot in banks’ current operations.
The need for banks to finance themselves with more equityand relatively less debt will be the focus of one of the main publishing eventsin economics in 2013. Anat Admati and Martin Hellwig’s The Bankers’ NewClothes: What’s Wrong with Banking and What to Do About it? will appearofficially in March, but advance copies are already being closely read inleading central banks. Bankers everywhere will rush to read it before theirregulators do.
The road to the ongoing financial and economic crisis wasbuilt on a foundation of intellectual capture: not only regulators, butacademics, too, became captivated by modernfinance and its methods. Admati and Hellwig are at the vanguardof the counterrevolution, challenging the great myths of banking head-on.
Do we need financial institutions to be so highly leveraged(that is, carrying so much debt relative to equity)? No, they argue. If banksof all kinds were financed with more equity, they would have stronger buffersto absorb losses. Both the equity and the debt issued by well-capitalized bankswould be safer – and therefore cheaper.
Bankers want to be so highly leveragedfor a simple reason: implicit government guarantees mean that they get the upside when things go well, while the downsideis someone else’s problem. Contrary to bankers’ claims, this is not a goodarrangement for society.
Admati and Hellwig are confronting the bankers and theirallies in no uncertain terms, grounding their argument in deep financialthinking, yet writing for a broad audience. Whatever else happens in 2013, wecan be sure that they will not win the Goldman Sachs Business Book of the Yearaward.