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Federalist Society Event: October 2nd: How Risky Are the Banks Now? What Regulatory Reforms Make Sense?
Hosted by the Federalist Society. RSVP to attend virtually.
October 2, 2023 at 1:00 PM ET
Six months ago, we experienced bank runs and three of the four largest bank failures in U.S. history. Regulators declared there was “systemic risk” and provided bailouts for large, uninsured depositors. What is the current situation? While things seem calmer now, what are the continuing risks in the banking sector? Banks face huge mark-to-market losses on their fixed-rate assets, and serious looming problems in commercial real estate. How might banks fare in an environment of higher interest rates over an extended period, or in a recession? Reform ideas include a 1,000-page “Basel Endgame” capital regulation proposal. Which reforms make the most sense and which proposals don’t? Our expert and deeply experienced panel will take up these questions and provide their own recommendations in their signature lively manner.
PANELISTS
William M. Isaac - Chairman, Secura/Isaac Group
Keith Noreika - Executive VP & Chairman, Banking Supervision & Regulation Group, Patomak Global Partners
Lawrence J. White - Robert Kavesh Professorship in Economics, Leonard N. Stern School of Business, New York University
MODERATOR
Alex J. Pollock - Senior Fellow, Mises Institute
June 16 event: The 2023 Bank Runs and Failures: What Do They Mean Going Forward?
Hosted by the Federalist Society.
William M. Isaac - Chairman - Secura/Isaac Group
Keith Noreika - Executive VP & Chairman, Banking Supervision & Regulation Group - Patomak Global Partners
Lawrence J. White - Robert Kavesh Professorship in Economics - Leonard N. Stern School of Business, New York University
MODERATOR
Alex J. Pollock - Senior Fellow - Mises Institute
This year’s sudden collapse of First Republic, Silicon Valley, and Signature banks were the second, third, and fourth largest bank failures in US history, bringing perceived systemic risk and bailouts of wealthy depositors. In addition, the global Credit Suisse bank collapsed and commercial real estate losses threatened. Politicians, regulators, and bankers are debating why the massive regulatory expansion following the last crisis didn’t prevent the renewed failures. Some emphasize repetition of the classic financial blunder of buying long and borrowing short. Others question the 2018 reforms to the Dodd-Frank Act, or cite the monetary actions of the Federal Reserve. Various proposals include more deposit insurance, mark-to-market accounting, higher capital requirements, more stress tests, or bigger regulatory budgets.
Our expert panel discusses the issues and risks going forward, the outlook for new legislation and regulation, and what, if anything, should be done.
Letter: Bagehot had much to say on the caution of bankers
Published in the Financial Times.
The run on Credit Suisse “has got every thoughtful banker and regulator in the world looking over their shoulder”, writes Robin Harding (Opinion, May 31).
Congratulations to them! They have understood the fundamental nature of the business they’re in. Walter Bagehot, the great 19th-century economist and journalist, had already explained this in Lombard Street in 1873: “A banker, dealing with the money of others, and money payable on demand, must be always, as it were, looking behind him and seeing that he has reserve enough in store if payment should be asked for.” Bagehot adds: “Adventure is the life of commerce, but caution is the life of banking.”
Alex J Pollock
Senior Fellow, Mises Institute, Auburn, AL, US
AEI May 9: Addressing the Underlying Causes of the Banking Crisis of 2023
View Alex’s address:
AEI, Auditorium
1789 Massachusetts Avenue NW
Washington, DC 20036
In June 2017, then–Federal Reserve Chairwomen Janet Yellen said that because of enhanced Dodd-Frank Act regulations, she did not believe there would be a new financial crisis in her lifetime. Unfortunately, like many Federal Reserve forecasts, this turned out too optimistic as regulators were forced to invoke emergency systemic risk powers to contain contagious bank runs. What went wrong? Was it a failure of monetary policy? Supervision? Regulation? What changes, if any, are needed?
Join AEI as a panel of experts discusses the causes of the recent banking crisis and the federal agencies’ forensic reports and policy prescriptions and shares their own views on what policies, regulations, and supervision practices need to be reformed.
Submit questions to Catriona.Fee@AEI.org.
If you are unable to attend, we welcome you to watch the event live on this page. After the event concludes, a full video will be posted within 24 hours.
Agenda
10:00 a.m.
Introduction:
Paul H. Kupiec, Senior Fellow, AEI
10:15 a.m.
Panel Discussion
Panelists:
Charles Calomiris, Henry Kaufman Professor of Financial Institutions, Columbia University
Andrew Levin, Professor, Dartmouth College
Bill Nelson, Executive Vice President, Bank Policy Institute
Alex J. Pollock, Senior Fellow, Mises Institute
Moderator:
Paul H. Kupiec, Senior Fellow, AEI
12:00 p.m.
Q&A
12:30 p.m.
Adjournment
JPMorgan Chase, FDIC put an end to First Republic's slow bleed
Published in the American Banker:
"There's a lesson in that for all finance that what seems like a darling and a wonderful winner at one moment seems like the opposite only a little while later," said Alex Pollock, a former Treasury Department official.
…
"Obviously there's a very generalized problem of people making the most classic financial mistake, which is investing in long-term fixed-rate assets and funding them with floating-rate money," Pollock said. "They were lulled into it by the actions of the central banks — by keeping interest rates both long and short-term very low for very long periods of time, and convincing people that it was going to continue."
The Silicon Valley Bailout
Published in Law & Liberty.
In spite of the financial market losses and crashes of 2022, government agencies kept assuring us that the banking system was in good shape. Until it wasn’t. Then they were citing “systemic risk” as the reason for a bailout. Surprised again!
The Silicon Valley Bank (SVB) failed on March 10 with great fanfare, as befitted the second largest bank failure in U.S. history. It failed, it turns out, with the balance sheet mistake of borrowing very short and investing very long, a mistake so elementary as to display remarkable financial incompetence.
SVB’s failure was preceded by the collapse of Silvergate Bank, and followed by the failure of Signature Bank (the third largest bank failure), by lines of customers making withdrawals from First Republic Bank, and pressure on banks known to have large unrealized losses on their investments. As always happens in a banking crisis, the government intervened. In this case, it guaranteed the uninsured deposits at the failed banks—and presumably all banks—and created a special Federal Reserve loan facility backed by the U.S. Treasury that will lend on an under-collateralized basis to banks which have large market value losses on their bonds and mortgage-backed securities.
After SVB failed, wealthy depositors, including venture capitalists and cryptocurrency barons, presumably sophisticated financial actors, whose money was caught in the failure, immediately began begging the government for a bailout. (It is reasonable to assume that those among the begging parties who are large Silicon Valley Democratic contributors could get their calls to Washington answered.)
The SVB situation reminds us that deposits are in fact unsecured loans to the bank by another name. As everybody knows, for up to $250,000 per depositor per bank, they are guaranteed by the government. For any amount beyond that, as a lender, you are at risk, or supposed to be. If the banks fails, you become an unsecured creditor of the insolvent estate. Every big depositor in SVB knew this perfectly well. They nonetheless chose to make unsecured loans of huge amounts, in one case of $3.3 billion to one poorly managed bank. Thinking of them correctly as lenders, should sophisticated lenders who make bad loans suffer losses accordingly? Of course.
The perpetual wisdom of managing a bank was expressed by Walter Bagehot, the great financial thinker and partner in a successful private bank himself, 150 years ago. It has been re-learned to their sorrow by the banks, both failed and threatened, in recent days. Wrote Bagehot in 1873:
A banker, dealing with the money of others, and money payable on demand, must be always, as it were, looking behind him and seeing that he has reserve enough in store if payment should be asked for…. Adventure is the life of commerce, but caution… is the life of banking.
Bagehot added that what is required is “a wise apprehensiveness, and this every trained banker is taught by the habits of his trade, and the atmosphere of his life.” But the management of SVB and other failures, perhaps too caught up in a speculative environment and too focused on public relations, did not develop sufficient apprehensiveness.
Bagehot’s insight reflects the inherent logic of bank runs. Once a bank has lost its credibility and a widespread withdrawal of deposits and other credit has begun, the holder of a non-government guaranteed deposit (an unsecured loan to the bank, as we have said) is faced with a compelling logic. To hold on and keep the deposit in the now-risky bank has zero upside. The best you can ever get is your money back. But it has a huge downside: you may suffer a big loss on funds that you supposed had minimal risk, you may have even the money you do eventually get back tied up in a receivership, you will have made yourself a first class sucker, and if you are a professional short-term money manager, you may well lose your job. In sum: zero upside, huge downside. So you take the money now. Everyone else is making the same totally rational calculation, and good-bye bank.
All the desperate statements from the bank’s management, as long as they last in their jobs, that really everything is OK, will only convince you that things must be really bad—and every plea from the government to stay calm and have confidence will confirm that your fear is justified. As Bagehot also said, “Every banker knows that if he has to prove he is worthy of credit… in fact his credit is gone.” This is now being demonstrated once again.
Every bailout means taking some people’s money and giving it to others.
“Yellen dismisses bailout” began the page one headline of the Financial Times for March 13, the Monday after the Friday closure of SVB. But by the time that issue of the paper landed in my driveway, a huge bailout had been announced.
The FT article related that “Treasury Secretary Janet Yellen…dismissed calls from some of those with money caught up in SVB to launch a full-scale bailout.” “But,” it continued, “US authorities were facing mounting calls from investors, entrepreneurs and some lawmakers to step in more forcefully to ensure all depositors were made whole.”
Of course, that “all” only meant that big depositors were to made whole, since those with claims up to the quite respectable amount of $250,000 were guaranteed already. The $250,000 obviously covered all the widows and orphans and anybody of modest means. These are the people who proponents of government deposit guarantees always argue are unsophisticated and cannot understand how a bank works, so need to be unconditionally protected. But they already were. So the actual issue was bailing out very sophisticated venture capitalists, cryptocurrency promoters, and various billionaires, all of whom were quite capable of understanding the nature and risks of banking in the SVB fashion.
Should such sophisticated lenders to banks be bailed out from their own financial mistakes?
One partner of a Silicon Valley venture capital firm wrote in this context, “I’m sure many will look upon [SVB’s] demise…and chuckle gleefully about how the technology industry just got a spanking. So be it. We are not seeking special treatment or handouts.”
But they were seeking very special treatment and a very big handout: the government giving them in immediate cash 100% of their uninsured claims on a failed bank receivership. And they got the handout. Whether one was surprised or not by this is perhaps a measure on one’s cynicism.
It is easy for cynics to imagine the calls from the wealthy uninsured depositors and their agents with the U.S. Treasury, the Federal Reserve and the White House. Naturally, internet posts were soon talking of political favors to Silicon Valley Democratic contributors.
As my colleague, Benjamin Zycher, considered the matter:
Now that the bailout of the SVB depositors at 100 percent rather than the nominal $250,000 limit has been announced, it is difficult to discern whether the primary motivation is avoidance of future bank runs… or an old-fashioned effort to reward the wealthy friends of the Democratic Party in Silicon Valley.
As Ben suggests, it is probably both.
Every bailout means taking some people’s money and giving it to others. President Biden has claimed that this bailout does not involve taxpayer money. To the contrary, it makes the U.S. Treasury, in other words the taxpayers, first in line to take losses on the under-collateralized loans the Federal Reserve will make to banks under the bailout plan. Every such bailout tends to encourage risk taking and a lack of wise apprehensiveness in the next cycle.
Meanwhile, losses to the Federal Deposit Insurance Corporation from the bailout of the SVB’s wealthy depositors will be assessed on all other banks. That still means taking money from other people to give to the big SVB depositors. So a small, sound, careful bank in, say, small town Wisconsin, will have money taken from it to give to the California venture capitalists, crypto barons, and billionaires, to cover their losses from the incompetence of the Silicon Valley Bank. That is the idea. How do you like it?
The Mystery of Banking
The bank has ten billion this year,
But the money is surely not here—
It’s been quite lent away,
Pending some future day,
So it’s only a promise , that’s clear.
Is it borrowers then with their share
Who have the bank’s money to spare?
Nope! They’ve spent it all,
To get profits next fall,
So the money is clearly not there.
One may begin wondering where
Is this something not here and not there—
There’s a ten billion list,
But does money exist?
Such thoughts only lead to despair.
Alex J. Pollock, c. 1970
Financial pain in the behemoth assets
Published in The Australian:
“Are banks too big to fail? Of course they are, as much as ever and probably even more so,” says Alex Pollock, who was deputy director of financial research at the US Treasury until February.
...
The US Federal Reserve banks have become the biggest player in the commercial banking system. “They are now huge home lenders; their $US2.2 trillion of mortgage loans is bigger on an inflation-adjusted basis than the entire savings and loans industry before its collapse in the 1980s,” Pollock says.
Governments and regulators quite like a big, concentrated financial system, which explains why little real reform was achieved in the wake of the financial crisis. What did happen was a huge increase in complexity that benefits large incumbents and regulators themselves. Regulators can “manage the system” more easily and treasurers can enjoy lower interest rates. And activist central banks can ensure governments enjoy much lower borrowing costs than otherwise.
“Banking everywhere has been, is and will be a deal between bankers and politicians,” Pollock says.
Government policies reshape the banking industry: Changes, consequences, and policy issues
Hosted by the American Enterprise Institute.
On April 12, AEI’s Paul H. Kupiec hosted a panel discussion on recent changes in the banking industry and their consequences for the wider economy. He reviewed how the industry has consolidated, is lending less to the private sector, and is relying more on federal guarantees.
Richard E. Sylla of New York University summarized the history of the banking industry. Aside from a 50-year period of stability, US banking has trended toward a system characterized by a few large banks with extensive branch systems, branch systems that are now in decline themselves.
Charles Calomiris of Columbia University summarized more recent trends in the banking industry as a “three-legged stool”: extreme consolidation, extreme dependency on government support, and reliance on real estate lending. Alex J. Pollock of the R Street Institute added that the greater “banking credit system” is increasingly influenced by the Federal Reserve and government-sponsored enterprises.
Bert Ely of Ely & Company enumerated the industry risks. Depository institutions are intermediating deposits into government debt. Low interest rates have also squeezed bank margins and reduced the cushion to absorb losses that may arise from the pandemic.
— John Kearns
Event Description
The federal government response to the 2008 financial crisis, including new laws, prudential regulations, and Federal Reserve monetary policies, has left a lasting impact on the banking industry. Not only has the number of independent depository institutions almost halved since 2000, but the industry has also become much more concentrated in a few large “systemically important” institutions. Moreover, the characteristics of the largest banks have changed dramatically according to incentives established by heightened prudential regulatory requirements and the Federal Reserve’s long-lived zero interest rate environment.
Join AEI as a panel of banking experts discusses postcrisis changes in the banking industry and their consequences for the wider economy.
Event Materials
Paul H. Kupiec: “20 years of banking history in 67 charts and tables”
Richard Sylla: “From exceptional to normal: Changes in the structure of US banking since 1920”
Alex J. Pollock, Hashim Hamandi, and Ruth Leung: “Banking credit system, 1970–2020”
Charles W. Calomiris: “Introduction: Assessing banking regulation during the Obama era”
Agenda
10:00 AM
Introduction and opening remarks:
Paul H. Kupiec, Resident Scholar, AEI
10:15 AM
Panel discussion
Panelists:
Charles Calomiris, Henry Kaufman Professor of Financial Institutions, Columbia University
Bert Ely, Principal, Ely & Company
Alex J. Pollock, Distinguished Senior Fellow, R Street Institute
Richard E. Sylla, Professor Emeritus of Economics, New York University
Moderator:
Paul H. Kupiec, Resident Scholar, AEI
11:30 AM
Q&A
12:00 PM
Adjournment
What Drove Five Decades of Big Changes in Banking?
Published by the Office of the Comptroller of the Currency.
A new post authored by Alex J. Pollock, Hashim Hamandi, and Ruth Leung (2021) on the Office of Financial Research (OFR) website helps answer that question, and it focuses specifically on the changes in U.S. banking that occurred from 1970 to 2020. The analysis includes chartered state and national banks, other depository institutions, and some specialized banking intermediaries, such as the 12 Federal Reserve Banks, and what the authors label the government mortgage complex, which consists of Fannie Mae, Freddie Mac, and Ginnie Mae. It also considers subgroups of banks—in particular, the ten largest commercial banking enterprises.
…
Much of this is well known. What is less understood is how the expansion in the generosity of deposit insurance has fueled real estate lending by deposit-financed intermediaries. A typical U.S. bank today has about three-quarters of its lending devoted to real estate loans of some kind. As observed by Pollock (2019), “We still use the term ‘commercial banks,’ but a more accurate title for their current business would be ‘real estate banks.’” This is a far cry from the prohibition on real estate lending for national banks prior to 1913. How does increased deposit insurance generosity affect banks’ mortgage lending?
…
Alex J. Pollock (2019), “Bigger, Fewer, Riskier: The Evolution of U.S. Banking since 1950,” The American Interest , February 25.
Alex J. Pollock. Hashim Hamandi, Ruth Leung (2021). “Fifty-Year Changes in the Banking Credit System, 1970-2020.” Post, Office of Financial Research.
Banking Credit System, 1970-2020
Published by the Office of Financial Research, U.S. Department of Treasury.
BY Alex J. Pollock, Hashim Hamandi, Ruth Leung, OFR*
This essay puts the depository institutions industry into broad historical perspective, looking at the fifty year changes from 1970 to 2020.
For this analysis, we aggregate the Banking Credit System, defined as the government-chartered depositories and their principal chartered support entities. We define the relevant components as:
The largest ten bank holding companies (BHCs)
All other insured depository institutions
The Government Mortgage Complex (Fannie Mae + Freddie Mac + Ginnie Mae)
The Federal Reserve Banks.
As the following five tables demonstrate, the changes in this system and its components over this period with respect to asset size, relative size, share, size relative to nominal GDP, and long-term growth rates are dramatic.
As shown in Tables 1 and 2, there has been dramatic expansion in the scale of the institutions involved. Table 1 measures this in nominal dollars. Table 2 adjusts these numbers for inflation, using constant 2020 dollars. The increase in size in both nominal and real terms is remarkable.
Over the same period, the number of insured depositories has dropped dramatically: from over 19,800 in 1970 to about 5,000 in 2020—a reduction of 75% since one co-author (Alex Pollock) was a bank management trainee.
Meanwhile, the huge residential mortgage sector has become dominated by the Government Mortgage Complex, which was in 1970 relatively small, almost a rounding error, but has grown very big indeed. In nominal terms, it is now almost 260 times as big as it was in 1970, compared to the depository institutions asset growth of 28 times.
Table 1.
(1)Our goal is to understand the banking sector. If we expanded to non-bank companies, the size and growth would be even larger. Some of these companies’ activity is reflected in the Government Mortgage Complex, where they have a dominant share of mortgage servicing, and also in auto loans, credit cards and other consumer lending.
(2)1971
Of course, a lot of the growth when expressed in nominal dollars represents the endemic inflation of the post-1970 monetary regime. Table 2 shows the system’s still remarkable growth after adjusting for inflation.
Table 2.
(1)Values for 1970 are expressed in constant 2020 dollars using CPI values for June 2020 and December 1970.
Equally remarkable is the shift in the composition of the system, as shown in Table 3.
The ten largest BHCs in 1970 together equaled only 16% of the Banking Credit System, equal to about one-quarter of the aggregate size of all the other insured depositories. By 2020, the top ten have become 34% of the total system and have 1.3 times the assets of all the rest of the banks put together. Alternately stated, over these decades the consolidation of the historically highly fragmented American banking business has proceeded very far.
The big winners of share of the system over 50 years are the largest ten banks, the Government Mortgage Complex, and the Fed. The big losers of share are all the other depository institutions.
Table 3.
(1)Totals may not sum exactly due to rounding.
As shown in Table 4, the Banking Credit System over 50 years grew enormously relative to the economy as a whole—from 89% to 182% of GDP.
Table 4.
(1)Totals may not sum exactly due to rounding.
The assets of the biggest ten banks grew much faster than the other banks, increasing from 14% to 62% of GDP. All the other banks put together, now numbering about 5,000, fell from 63% to 47% of GDP.
The Government Mortgage Complex hugely inflated from 3% of GDP to 40%, by far the biggest change.
Table 5 shows the 50-year compound average rates of growth, both nominal and real, for the Banking Credit System, and GDP growth rates as a baseline comparison.
Table 5.
The Banking Credit System as a whole grew substantially faster than GDP over 50 years.
The Federal Reserve, now by far the biggest bank of all, grew much faster than GDP.
The Government Mortgage Complex grew fastest of all by far, at 11.8% per year in nominal terms, almost double the 6.1% for nominal GDP.
In Sum
Over the last 50 years, the Banking Credit System grew vastly bigger relative to the economy, much more consolidated, and much more dependent on both the government mortgage complex and the government’s central bank, greatly increasing its dependence on explicit and implicit government guarantees. This history exemplifies the maxim of Charles Calomiris and Stephen Haber (1) that every banking system is a deal between the bankers and the politicians.
(1)Fragile by Design (2014)
*Views and opinions expressed are those of the authors and do not necessarily represent official positions or policy of the OFR or Treasury. All the data used in this paper are from public sources, including the Board of Governors of the Federal Reserve System, Congressional Budget Office, Federal Deposit Insurance Corp., Department of Housing and Urban Development, Office of Federal Housing Enterprise Oversight and U.S. Bureau of Labor Statistics.
In Memoriam: George Kaufman, PhD
Published in Loyola University Chicago.
At a retirement dinner held following the conference, banking leader Alex J. Pollock gave a speech about Kaufman and his contributions to the field entitled “57 Years of Banking Changes and Ideas.” He ended his remarks: “Let us raise our glasses to George Kaufman and 57 years of achievement, acute insights, scholarly contributions, policy guidance and professional leadership, all accompanied by a lively wit. To George!” Read Pollock’s entire speech→
Comment Letter To OCC, Board of Governors of the Federal Reserve System, and FDIC
Published by the R Street Institute.
Via e-mail to:
Office of the Comptroller of the Currency
Board of Governors of the Federal Reserve System
Federal Deposit Insurance Corporation
Re.: Comments on the Proposed Joint Rule on “Regulatory Capital Treatment for Investments in Certain Unsecured Debt Instruments of Global Systemically Important U.S. Bank Holding Companies, Certain Intermediate Holding Companies, and Global Systemically Important Foreign Banking Organizations”
OCC: Docket ID OCC-2018-0019; RIN 1557-AE38
Board: Docket No. R-1655; RIN 7100-AF43
FDIC: RIN 3064-AE79
Dear Sirs and Mesdames:
Thank you for the opportunity to comment on this proposed joint rule.
In my view, the logic of the proposal is impeccable. Because it is, it should be applied to another, parallel situation, as discussed below. The proposal’s objective, “to reduce interconnectedness and contagion risk among banks by discouraging banking organizations from investing in the regulatory capital of another financial institution,” makes sense, but might be improved by adding, “or if such investments are made, to ensure that they are adequately capitalized.”
I believe another rule with exactly the same logic and exactly the same objective is required to address a key vulnerability of the U.S. banking system. That is to apply the logic of the proposed rule to any investments made by U.S. banks in the equity securities of Fannie Mae and Freddie Mac, two of the very largest and most systemically risky of American financial institutions. As you know, hundreds of American banks took steep losses on their investments in the preferred stock of Fannie and Freddie when those institutions collapsed, and such investments caused a number of banks to fail. That banks were able to make these investments on a highly leveraged basis was, in my judgment, a serious regulatory, as well as management, mistake. On top of this, U.S. regulations allowed banks to own Fannie and Freddie securities without limit.
Banks were thus encouraged by regulation to invest in the equity of Fannie and Freddie on a hyper-leveraged basis, using insured deposits to fund the equity securities. Hundreds of banks owned about $8 billion of Fannie and Freddie’s preferred stock. For this disastrous investment, national banks had a risk-based capital requirement of a mere 1.6%, since changed to a still inadequate 8%. In other words, they owned Fannie and Freddie preferred stock on margin, with 98.4%, later 92%, debt. (With due respect, your broker’s margin desk wouldn’t letyou do that.)
In short, the banking system was used to double leverage Fannie and Freddie, just as the investments in TLAC debt addressed by the proposal would otherwise double-leverage big banks. To analogously correct the systemic risk, when banks own Fannie and Freddie equities, they should have a dollar-for-dollar capital requirement, so that it really would be equity from a consolidated system point of view.
I respectfully recommend, true to the principle and the logic of the proposed joint rule, that any investments by a bank in the preferred or common stock of Fannie and Freddie should be deducted from its Tier 1 regulatory capital. I believe this should apply to banks of all sizes.
These are my personal views. It would be a pleasure to provide any further information or comments which might be helpful.
Thank you for your consideration.
Respectfully,
Alex J. Pollock
Do you believe central bank assurances?
Published by the R Street Institute.
To reassure savers worried about the safety of their deposits, the Reserve Bank of India (India’s central bank) recently announced it “would like to assure the general public that Indian banking is safe and stable and there is no need to panic.”
The problem is that when government officials issue such assurances, do you believe them?
Governments confronted by the risk of a banking crisis have to say the same thing regardless how severe the risk really is. They must say that the system is safe and you should not panic, because they are afraid that, by sharing any doubts, they would themselves set off the panic they fear. Therefore, their statements of assurance have no informational substance.
“When it becomes serious, you have to lie,” Jean-Claude Juncker, then head of the eurozone finance ministers, with admirable candor said of the European financial crisis of the 2000s.
“We have no plans to insert money into either of those two institutions,” Treasury Secretary Henry Paulson said of Fannie Mae and Freddie Mac in the summer of 2008. One month later, he began inserting into both of them what became $187 billion of bailout money.
Governments and banks in stressed situations are up against Walter Bagehot’s insight into the fragility of credit. “Every banker knows that if he has to prove he is worthy of credit,” Bagehot wrote in 1873, “in fact his credit is gone.” I imagine that will always be true.
The term “credit” comes from credo = “I believe.” In a threatened crisis, you suddenly realize that you have not much ground, if any, for believing in a bank’s soundness or believing the government’s assurances that things are fine.
Echoes of the US savings and loan industry’s collapse
Published in the Financial Times.
Metro Bank has the problem so pointedly observed by the great Walter Bagehot in 1873: “Every banker knows that if he has to prove he is worthy of credit . . . in fact his credit is gone.”
Your editorial “Metro panic shows need for proactive regulation” (May 14) says “Metro’s loan book . . . is fully covered by customer deposits.” Of course, customer deposits are not inherently stable — they are inherently unstable. Their stability, as you suggest, is solely due to the guarantee provided by the government.
This fact, so humbling for bankers, has powerful effects, most strikingly shown by the collapse of the US savings and loan industry in the 1980s. Savings institutions that were irredeemably insolvent were nonetheless able to keep their deposits because they were guaranteed by a government deposit insurance fund. However, this fund, the Federal Savings and Loan Insurance Corporation, was publicly admitted to be itself broke! But the depositors correctly believed that behind it all the time was the US Treasury, as in fact it was. This allowed many insolvent S&Ls to keep funding disastrous speculations, which made the ultimate cost to the Treasury far bigger.
Bigger, Fewer, Riskier: The Evolution of U.S. Banking Since 1950
Published in The American Interest.
The total assets of JPMorgan Chase, the biggest U.S. bank, are now about $2.6 trillion. The total assets of the entire American commercial banking system in 1950 were $167 billion. In nominal dollar terms, Morgan by itself is more than 15 times as big as all the banks in the country together were in 1950, when Harry Truman was President and the United States was enjoying an economic boom after the cataclysms of the Depression and the Second World War. The fourth largest bank today, Wells Fargo, with $1.9 trillion in assets, is 11 times as big as the whole banking system was then.
Of course, there has been a vast price inflation and depreciation of the dollar over that time, so that a dollar today is worth about what a dime was in 1950. Adjusting the 1950s number for total banking assets to 2018 dollars brings it to $1.7 trillion. Thus in inflation-adjusted terms Morgan alone is still about 1.5 times as big—and Wells Fargo 1.1 times as big—as the whole banking system in the 1950s. Are these banks “too big to fail”? Of course they are. But so were the biggest banks in 1950.
On average over the past seven decades, banking assets and loans have grown more rapidly than the U.S. economy. In 1950, total banking assets were 56 percent of a GDP of $300 billion. Now at about $16.5 trillion, they are more than 80 percent of a GDP topping $20 trillion. Total bank loans relative to GDP grew even faster than banking assets did, from 18 percent of GDP in 1950 to 45 percent today.
Thus banking both in absolute terms and relative to the economy has gotten much bigger over the decades, but there are many fewer banks than there used to be.
“Ours is a country predominantly of independent local banks,” approvingly said Thomas McCabe, then Chairman of the Federal Reserve, in a commencement address in 1950. As McCabe observed, banking was then mostly a local business. There were at that point 13,446 commercial banks. The U.S. population was 153 million. Now there are 4,774 commercial banks for a population of 329 million. So as the American population has more than doubled, the number of commercial banks dropped by 64 percent.
In 1950, there were also 5,992 savings and loan institutions. Today there are 703, so the total of insured depositories fell from 19,438 in 1950 to 5,477 today, or by 72 percent. The previous multitude of banks was the result of unique American politics in which agrarian interests protected small, local institutions. The reduced numbers have moved closer to what a market outcome would ordain. We can expect the consolidation to continue.
As to risk, in the entire decade of the 1950s, there were a mere 28 commercial bank failures—only 0.2 percent of the average number of banks. But banking got a lot riskier as time went on, particularly in the financially disastrous 1980s. In that decade, 1,127 commercial banks failed—40 times the failure rate of the 1950s. Maybe the bankers hadn’t gotten smarter, although they certainly employed more MBAs. State and Federal regulators didn’t appear any smarter either.
In addition to the bank failures, 909 savings and loans failed in the 1980s, bringing the total depository failures for the decade to 2,036—about four per week over ten years. Tough times! When the savings and loan industry collapsed, its government deposit insurer, the Federal Savings and Loan Insurance Corporation, also went broke, triggering a $150 billion taxpayer bailout.
The 1990s were not as bad as the 1980s, but 442 commercial banks (16 times as many as in the 1950s) and 483 savings and loans failed, for a total of 925.
The Federal Reserve optimistically announced that the 21st century heralded a new, stable era—“The Great Moderation.” Soon after that, however, came financial crisis and panic, showing once again that bankers and regulators have not gotten smarter, despite the addition of many PhDs in mathematics and science to the ranks of the MBAs in the finance industry. Ben Bernanke, then Chairman of the Federal Reserve, judged in 2006 that “banking organizations of all sizes have made substantial strides over the past two decades in their ability to measure and manage risks.” That was just before the 2007-09 financial crisis. Apparently they hadn’t made such big strides after all.
Since 2000, 573 depository institutions have failed, of which 486 have been commercial banks. There would have been more failures without the government’s emergency TARP investments in banks, improvised government guarantees, and other forms of bailouts. These include the bailouts of the insolvent Fannie Mae and Freddie Mac, much of whose debt was held by banks, as was encouraged by regulation.
Should we want a banking system with no failures, as was virtually the case in the 1950s? Of course not. As the distinguished economist Alan Meltzer put it, “Capitalism without failure is like religion without sin.” Economic growth requires risk-taking and hence the failures that go with it. But we don’t want too much systemic risk, or for the banking system to collapse from time to time. Since 1950, the United States has experienced both extremes. No one knows how to achieve the golden mean.
We can see how much American banking has changed in the course of one lifetime. But one thing did not change: the tight connection between banking and the government. As banking scholar Charles Calomiris has convincingly summed it up, all banking systems are a deal between the politicians and the bankers.
Of course, the details of the deal shift over the decades. Congress frequently legislates about banking (as detailed further below). One watershed banking enactment was the Federal Reserve Act of 1913, which created the U.S. central bank, the proper role of which was still being debated in 1950. At the time of its origin, it was thought that the Federal Reserve would end financial crises and panics: obviously it didn’t and relative to this hope the act was a failure. But the act was a definite success at creating what it called an “elastic currency”—the ability of the Federal Reserve to create more money and allow banks to expand. This ability in its original form was subject to the gold standard, which meant keeping dollars freely convertible to gold. We today can hardly imagine then-prevailing idea that you could go to your bank any time and turn in your paper dollars for gold coins minted by the United States at a fixed parity rate. This idea was only a memory by 1950, but under the 1944 Bretton-Woods agreement, the U.S. government was still promising to foreign governments that they could redeem dollars for gold.
In 1971, after various dollar crises, the government reneged on this commitment, which was the last vestige of the gold standard. With that, the dollar became far more elastic than the authors of the Federal Reserve Act could ever have imagined. The Federal Reserve became able to expand the currency and the credit base of banking by as much as it wanted. It could either print up more paper dollars, or more directly, simply credit the deposit accounts banks have with it to expand the supply of money. This can be done without limit except for the Federal Reserve’s own judgment and the extent of political controversy it is willing to endure.
Since 1950, an essential banking system development is that the Federal Reserve has grown ever more prominent, more prestigious and more powerful. Whether a republic should trust such immense money power to the judgment (which is actually the guessing) of its central bank is a fundamental political question to which the answer is uncertain.
But it is certain that the banking system, including the central bank as a key component, is highly useful to governments, especially to finance wars. A well-developed banking system that can lend large sums of money to the government is a key military advantage. This is a classic element in banking. The deal between politicians and bankers that created the Bank of England in 1694 was that the new bank would lend the government money to finance King William’s wars, in exchange for monopoly currency issuing privileges. U.S. national banks were created in 1863 to finance the Union armies in the Civil War; they bought government bonds and in exchange got to issue a national currency. The Federal Reserve first established its importance by lending money for the purchase of government bonds to finance American participation in the First World War. The young Fed “proved in war conditions an extremely useful innovation,” as a 1948 study of American banking observed.
The banks of 1950 were stuffed with Treasury securities as a result of their having helped finance the Second World War. At that time, the Federal Reserve was buying as many Treasury bonds it took to keep the interest rate on long bonds at 2.5 percent, to keep down the interest cost to the government. This was also meant to keep the market price of the banking system’s huge bond portfolio steady.
At that point, the banks in total owned more Treasury securities than they had in loans. Treasuries were 37 percent of their total assets—an unimaginably high proportion now. Total loans were only 31 percent of assets—now unimaginably low. These proportions made the balance sheet of the banking system very safe. In remarkable contrast, banks today have merely 3 percent of their assets in Treasury securities (see graph 3).
In the banking system of 1950, reflecting the experience of the 1930s, the government was intent on protecting the banks by reducing competition for and among them. Arthur Burns, who was Chairman of the Federal Reserve 1970-78, looked back from 1988 in The Ongoing Revolution in American Banking to explain the 1950s banking regime:
The legislation suppressed competition not only among banks but also between banks and other financial institutions. The ability of banks to compete with one another geographically was limited by rules on chartering and branching. No new bank could set up business without acquiring a national or state charter, and the authorities were disinclined to grant a charter if existing banks would suffer. . . . The ability of banks to compete with one another for demand deposits was limited by a prohibition against payment of interest on such deposits. . . . Banks could offer interest on time and savings deposits . . . but the amount they could pay was limited by a regulation known as Reg Q. . . . Competition between banks and other financial institutions was limited by restrictions on the kind of services each could offer.
In short, the government restricted competitive entry and limited price and product competition. The design was to promote safety by effectively having a banking cartel, with the government as the cartel manager.
This cartel idea was removed step by step in succeeding decades. The Regulation Q price controls, a big political deal in their day, proved a painful problem in the severe “credit crunches” of 1966 and 1969. They were obviously outdated by the time interest rates went into double digits in the 1970s and 1980s, and were belatedly removed. As the 1960s became the 1970s, U.S. banking had become more competitive, innovative, international and interesting, but also riskier. Banking scholars could discuss “the heightened entrepreneurial spirit of the banking industry” in 1975. Of course, there cannot be a competitive market without failures, in banking as in everything else, and we have observed the failures of the 1980s, 1990s and 2000s. But the tight link between banking and the government continued.
By the 1950s, banks had become accustomed to depending on having a lot of their funding guaranteed by the government in the form of deposit insurance. Although many banks had originally opposed the idea as promoting weak and unsound banking, they became and remain today absolutely hooked on it. It has come to seem part of the natural financial order.
But government guarantees of deposits, as is known to all financial economists, tend to make banks riskier, although it simultaneously protects them against bank runs. This combination of effects is because their depositor creditors no longer have to worry about the soundness of the bank itself. Consequently, unsound banking ventures can still attract plenty of funding: This is called “moral hazard,” and its importance in every financial crisis of recent decades can hardly be overstated. To try to control the risk to itself generated by moral hazard, the government must regulate more and more—but its attempt to control risk in this fashion has often failed.
Nonetheless, the extent of deposit insurance has been increased over time. The year 1950 saw a doubling in the amount of deposit insurance per depositor from $5,000 to $10,000. Since then, it has grown 25 times larger in nominal terms, to $250,000, and three times bigger in real terms. These increases are shown below.
As Arthur Burns observed, banks were formerly forbidden to pay interest on demand deposits (checking accounts). In 1950, these deposits comprised the great majority of the banks’ funding—75 percent of the total liabilities of the banking system. That meant that by law 75 percent of the funding had zero interest cost. I well remember as a bank trainee in 1970 having an old banker explain to me: “Remember that banks succeed or fail according to this one number—demand deposits.”
Those days are gone. Demand deposits now are only 11 percent of bank liabilities, and banks can pay interest on them. The graph below shows the historical decline of demand deposits in bank balance sheets.
One of the riskiest classes of credit are real estate loans, which are central to most banking crises. In 1950, real estate loans were only 26 percent of the total loans of the banks. But since then, having accelerated in the 1980s, they have grown to be the predominant form of bank credit, reaching 57 percent of all loans in 2006, just before the real estate collapse. They are now 47 percent of all bank loans, and in the majority of banks, those under $10 billion in total assets, are 72 percent of loans.
We still use the term “commercial banks,” but a more accurate title for their current business would be “real estate banks.”
We may consider together the trends of reduction in the lowest-risk assets, the decline of demand deposit funding, and the shift to riskier real estate credit by combining graphs 3, 4 and 5 into graph 6. The balance sheet of the banking system from 1950 to now has utterly changed.
During these seven interesting banking decades, Congress has been busy legislating away. This is natural: As long as the close connection of the government and banks continues, so will their dynamic interaction through politics, and so will congressional attempts to direct or improve the banking system, or to fix it after the busts that recur in spite of repeated attempted fixes.
Below is a list of the remarkable amount banking legislation since 1950. The mind boggles at the vast volume of congressional hearings, lobbyist meetings, and political speeches all this legislation entailed.
Federal Deposit Insurance Act of 1950
Bank Holding Company Act of 1956
Bank Merger Act of 1960
Bank Merger Act of 1966
Bank Holding Company Act Amendments of 1966
Interest Rate Adjustment Act (1966)
Financial Institutions Supervisory Act of 1966
Fair Housing Act (1968)
Truth in Lending Act of 1968
Emergency Home Finance Act of 1970
Fair Credit Reporting Act (1970)
Bank Holding Company Act Amendments of 1970
Equal Credit Opportunity Act (1974)
Real Estate Settlement Procedures Act of 1974
Home Mortgage Disclosure Act of 1975
Fair Debt Collection Practices Act (1977)
Community Reinvestment Act (1977)
Federal Reserve Reform Act of 1977
International Banking Act of 1978
Financial Institutions Regulatory and Interest Rate Control Act of 1978
Depository Institutions Deregulation and Monetary Control Act of 1980
Garn-St Germain Depository Institutions Act of 1982
Competitive Equality Banking Act of 1987
Financial Institutions Reform, Recovery, and Enforcement Act of 1989
Federal Deposit Insurance Corporation Improvement Act of 1991
Housing and Community Development Act of 1992
Riegle Community Development and Regulatory Improvement Act of 1994
Riegle-Neal Interstate Banking and Branching Efficiency Act of 1994
Economic Growth and Regulatory Paperwork Reduction Act of 1996
Gramm-Leach-Bliley Act of 1999
International Money Laundering Abatement and Financial Anti-Terrorism Act of 2001
Sarbanes-Oxley Act of 2002
Check Clearing for the 21st Century Act (2003)
Fair and Accurate Credit Transactions Act of 2003
Federal Deposit Insurance Reform Act of 2005
Financial Services Regulatory Relief Act of 2006
Housing and Economic Recovery Act of 2008
Emergency Economic Stabilization Act of 2008
Helping Families Save Their Homes Act of 2009
Credit CARD Act of 2009
Dodd-Frank Wall Street Reform and Consumer Protection Act (2010)
an Act to instruct the Inspector General of the Federal Deposit Insurance Corporation to study the impact of insured depository institution failures (2012)
Reverse Mortgage Stabilization Act of 2013
Money Remittances Improvement Act of 2014
Credit Union Share Insurance Fund Parity Act (2014)
an act to enhance the ability of community financial institutions to foster economic growth and serve their communities, boost small businesses, increase individual savings, and for other purposes (2014)
American Savings Promotion Act (2014)
FAST Act (this cut Federal Reserve dividends to large banks) (2015)
Economic Growth, Regulatory Relief and Consumer Protection Act (2018)
In conclusion, we may consider three different perspectives on long-term banking change.
In the 1980s an old employee was retiring after 45 years with the Bank of America, so the story goes. The chairman of the bank came to make appropriate remarks at the retirement party, and thinking of all the financial developments during those years, asked this long-serving employee, “What is the biggest change you have seen in your 45 years with the bank?” His reply: “Air conditioning.” Arthur Burns summed up 1950s banking in this way: “This was a simple system, operating in a simple financial world.” But that is not how it seemed at the time, or at any time. As William McChesney Martin, Chairman of the Federal Reserve 1951-70, said in a 1951 speech to the American Bankers Association: “We are all painfully aware today of the manifold and overpowering complexities of our modern life.”
That feeling characterizes all the years from then to now.
A Most Enjoyable History of a Most Remarkable Bank
Published in Real Clear Markets.
This is a colorful book, full of great stories and forceful (if not always admirable) personalities, who deserve to be remembered. It gives us repeated lessons of how banking is a business always intertwined with the government, demonstrated in the long history of Citibank, a very important, very big, often quite creative, and sometimes very troubled bank. It reminds us of the theory of Charles Calomiris that every banking system should be thought of as a deal between the bankers and the politicians.
According to then-Treasury Secretary Henry Paulson’s instructive memoir of our most recent financial crisis, on November 19, 2008:
“Just one week after I had delivered a speech meant to reassure the markets, I headed to the Oval Office to tell the president that yet another major U.S. financial institution, Citigroup, was teetering on the brink of failure.
‘I thought the programs we put in place had stabilized the banks,’ he said, visibly shocked.
‘I did, too, Mr. President.’”
This exchange led to the instructions from the President which appear on page 1 of Borrowed Time:
“Don’t let Citi fail.”
At this point, as the book tells us, “The Office of the Comptroller of the Currency and Citigroup guessed that Citibank would be unable to pay obligations or meet expected deposit outflows over the ensuing week. Citigroup’s own internal analysis projected that ‘the firm will be insolvent by Wednesday, November 26.’”
“As ever,” the authors add, “the latest crisis in the banking sector caught many regulators by surprise.”
Now, if Citibank had failed and defaulted on its obligations, what would have happened? Nobody wanted to find out. Then-New York Federal Reserve President Tim Geithner forecast that it would be a “catastrophe,” the book relates, and quotes the then-head of the Federal Deposit Insurance Corporation (FDIC), Sheila Bair: “We were all fearful.”
In their place would you, ladies and gentlemen, have been fearful, too?
Yes, you would have been.
Would you have decided on a bailout of Citibank, as they did?
Yes, you would have.
The FDIC had a special and very pointed reason to be fearful: a failure of Citibank would have busted the FDIC, too—this government insurance fund would itself have needed a taxpayer bailout. As we learn from the book:
“The FDIC staff did a seat-of-the-pants calculation and estimated the agency’s potential exposure to Citibank to be in the range of $60 billion to $120 billion. Even at the low end of that estimated range, losses would ‘exhaust the $34 billion or so in the [Deposit Insurance Fund].’”
So the FDIC would have been broke—just like the Federal Savings and Loan Insurance Corporation was twenty years before. In short, the bailout of Citibank was an indirect bailout of the FDIC. This insightful lesson is not made explicit in the book, but is a clear conclusion to draw from its account.
Going back in history to 147 years before these events of 2008, we find the situation interestingly reversed. In 1861, at the beginning of the Civil War, City Bank—at that point spelled with a sensible “y” and not the marketing “i” of much later times—was helping save the government, as the U.S. Treasury scrambled to raise money for the army.
We learn from the book that Moses Taylor, then the head of City Bank, “played a leading role in gathering private and municipal funds to equip and sustain Union troops and also in managing the issuance of federal debt to pay for the war.”
In the summer of 1861, “Secretary of the Treasury Salmon Chase visited a group of New York bankers and told them he needed $50 million ‘at once.’ The bankers huddled, and the Tylor, speaking for the group, announced, ‘Mr. Secretary, we have decided to subscribe for fifty millions of the United States government’s securities that you offer, and to place the amount at your disposal immediately.’”
We can imagine how relieved and happy that must have made the Treasury Secretary.
As the Civil War dragged on and became vastly more expensive, one of the ways to finance it was the creation of the national banking system to monetize the government debt. City Bank then became a national bank, as it still is.
However, the limitations of the national bank charter made it hard to be in the securities business. How City Bank got around this in the boom of the 1920s makes interesting reading, including how it actively financed the stock market bubble of the decade.
Then came, of course, the collapse and the disaster of the 1930s, and that brought government investment in the preferred stock of City Bank by the Reconstruction Finance Corporation. “The debate is over whether City really needed Washington’s money,” the book tells us, “or was persuaded to participate in a broader program intended to show that the government was shoring up the nation’s banking system.” It continues, “Just as in 2008”—note how financial ideas as well as events repeat themselves—“federal officials in the 1930s wanted healthy banks to accept government investment so that the weak banks that really needed it would not be stigmatized.” But which category was City Bank in?
The authors conclude that “it seems likely that City really did need the money.”
Citibank was and is a very international bank. This has its advantages, but also its problems. In the 1930s, City was in trouble from its international loans to, as the book relates, Chile, Cuba, Hungary, Greece and most importantly, Germany.
Germany had boomed in the 1920s and was the second largest economy in the world. It had financed its boom with heavy international borrowing, especially from the United States. By the 1930s, it was obvious that this had not been a good idea from the lenders’ point of view.
In the natural course of events, the costly 1930s experience became “ancient history,” and in the 1970s, Citi (now spelled with an “i”) was the vanguard of a great charge into international lending, in which a lot of other banks followed.
The leader and chief proponent of the charge was Walter Wriston, Citi’s CEO and the most innovative and best known banker of his day. Says the book:
“Wriston’s most remarkable achievement at Citibank was persuading Washington that lending money to governments in developing countries was nearly risk-free.”
But the government was already cheering for these loans. “There had for years been a tendency among many government officials to look with favor on loans to less-developed countries [LDCs].”
About these loans, Wriston notoriously said, “They’re the best loans I have. Sovereign nations don’t do bankrupt.”
No, they don’t. But they do default on their loans—and quite often, historically speaking. And default many foreign governments did, starting in 1982.
At that point, the Chairman of the Federal Reserve was the famous Paul Volcker. As the book discusses, his solution to the possibility the U.S. banking system had become insolvent was to mandate that the LDC loans not be called the bad loans they were, that no loan losses would be booked against them, and that the banks would indeed have to make new loans to keep the Ponzi scheme going. In other words, the solution was to cook the books.
With this big gamble, as it turned out, things did keep going. When LDC loans were finally charged off in the late 1980s, there was a new boom on: financing commercial real estate. This boom in turn collapsed in the early 1990s. We might say there is a theme and variations involved.
In 1981, just before the Wriston-led charge into LDC debt went over the cliff, the biggest ten banks in the United States, in order, were:
Bank of America (the one in San Francisco, long since sold)
Citibank
Chase Manhattan
Manufacturers Hanover
Morgan Guaranty
Chemical Bank
Bankers Trust
Continental Illinois
First National Bank of Chicago
Security Pacific
Consider this: of the ten, only two still exist as independent companies. Eight of the ten are gone. To people not in the financial trade, or even to younger ones in it, these once-important names are probably unknown. As a song written by one of my old banking friends goes:
“You were a big bank, Blink and now you’re gone!”
But Citibank, the subject of the eventful history related by Borrowed Time, is not gone—it is still here.
Which is the only other survivor of the former top ten? Maybe you would like to guess?*
In short, if you have a taste for the adventures and evolving ideas, the ups and downs, the growth and reverses, and the innovations and blunders of banking over the years, you will enjoy this history of a most remarkable institution.
*The answer is Chemical Bank, although it has changed its name to JPMorgan.
Minneapolis Fed’s TBTF plan has some GSE-sized holes
Published in American Banker.
The Federal Reserve Bank of Minneapolis this winter finalized its “Minneapolis Plan to End Too Big to Fail” — that is, a plan intended to end the problem of “too big to fail” financial institutions, including both banks and nonbank financial companies.
But here is something remarkable: Fannie Mae and Freddie Mac, among the most egregious cases of “too big to fail,” appear nowhere at all in the plan.
Have the Federal Reserve Bank of Minneapolis authors forgotten how Fannie and Freddie blew masses of hot air into the housing bubble, then crashed, then got a $187 billion bailout from the U.S. Treasury? Have they not noticed that Fannie and Freddie remain utterly dependent on the credit guaranty of the Treasury, remaining TBTF to the core?
Since the plan focuses on excessive leverage as the fundamental cause of “too big to fail” risk, have they not considered that Fannie and Freddie each had capital of less than zero at the end of last year, so they had infinite leverage along with their $5.4 trillion in liabilities?
Defenders of Fannie and Freddie will cry that they can’t build capital when the Treasury takes all their profits every quarter. But whoever may be to blame does not change the overwhelming fact: the government-sponsored enterprises are “too big to fail.”
The Minneapolis plan notes that, under the current regime, firms “can continue to operate under their explicit or implicit status as TBTF institutions potentially indefinitely.” This is true — and it is especially true of Fannie and Freddie. So the plan should say instead: “Under the current regime, banks and nonbank financial firms, including notably Fannie Mae and Freddie Mac with their $5 trillion in risk exposure, can continue as TBTF institutions potentially indefinitely.”
What should be done about the TBTF nonbank companies? According to the Minneapolis Fed, the answer is for the Congress to impose a “tax on leverage” that offsets the advantages of running at high leverage and low capital. This tax on leverage will apply to any company with more than $50 billion in total assets. Since Fannie has over $3 trillion of assets and Freddie over $2 trillion, it is safe to say they would qualify.
If the secretary of the Treasury certifies that the company in question does not pose systemic risk, the tax would be 1.2 percent of liabilities under the plan. It is certainly hard or impossible to imagine that any Treasury secretary could certify that Fannie and Freddie pose no systemic risk. So in their case the tax on leverage would be 2.2 percent of total liabilities — 2.2 percent of “anything other than high quality common equity.”
Among the types of firms that the plan would consider for the leverage tax are “funding corporations, real estate investment trusts, trust companies, money market mutual funds, finance companies, structured finance vehicles, broker/dealers, investment funds and hedge funds.” Again, and amazingly, Fannie and Freddie are not on the list.
But if this proposal applies to any these entities, or indeed to anybody at all, it certainly applies to Fannie and Freddie. That is especially true since the market arbitrages across capital requirements of different financial institutions. It sends mortgages to Fannie and Freddie, not because they are most skilled at managing risk, but rather because they have the highest leverage. This was true even before they crashed, since Fannie and Freddie had charters granting them far greater leverage than any other financial institutions.
We’ve calculated how much the proposed Minneapolis tax on leverage would cost these financial behemoths. For Fannie, total liabilities are $ 3.35 trillion, so the annual tax would be 2.2 percent times that, or $74 billion. Fannie’s profit before tax for the year 2017 was $18.4 billion, so the tax in the size proposed by the Minneapolis Plan would be four times Fannie’s total pretax profit.
For Freddie, the corresponding numbers are liabilities of $2.05 trillion and a leverage tax of $45 billion, which would be 2.7 times its 2017 pretax profit.
In short, instead of paying about 100 percent of their profits to the Treasury, Fannie and Freddie together would pay Treasury well over 300 percent of their profits. This would obviously cause them to operate at a huge pro forma loss.
As a first step, we make the much more modest proposal that Fannie and Freddie should be required to pay the Treasury for its credit support, which makes their existence possible, an annual fee of 0.15 percent to 0.20 percent. Such a fee would be consistent with what undercapitalized banks must pay for a government guarantee from the Federal Deposit Insurance Corp., which is also assessed on their total liabilities. Fannie and Freddie’s effective, though not explicit, guarantee from the Treasury is extremely valuable and should be paid for, without question. As is the intent of the Minneapolis plan, charging a fair price for it would significantly reduce the capital arbitrage the GSEs exploit, reduce the distortions and vulnerabilities they introduce into the mortgage market and reduce the massive taxpayer subsidies they have heretofore enjoyed.
As the foremost “too big to fail” institutions in the country — indeed, in the world — Fannie and Freddie must be included in any TBTF reform plan that is to be taken seriously.