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Last updated: April 30, 2013 7:24 pm

Finance: Out to break the banks

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US regulators and lawmakers fear large institutions are still too big to fail
Bank icons

A staunch conservative from Louisiana known for being pro-gun and opposed to gay marriage (and for a prostitution scandal) teams up with a liberal from Ohio who opposed the Iraq war and once had to apologise after comparing anti-union politicians to Hitler.

In the bitterly divided US Congress of 2013, such alliances are supposed to be impossible. But David Vitter, a Republican senator, and Sherrod Brown, a Democrat, have found common ground on an issue that allies left and right: attacking the country’s biggest banks.

Under a banner of “ending ‘too big to fail’”, the odd couple have tapped into an undercurrent of popular anger, rattling the likes of Bank of America, JPMorgan Chase and Citigroup.

The problem the senators identify is one that has troubled policy makers for decades and continues to do so. Confronted by a teetering Lehman Brothers, Northern Rock or Bank of Cyprus, they have had the same dilemma: instigate a taxpayer-funded bailout or risk contagious panic.

In the US, the 2010 overhaul of financial regulation known as the Dodd-Frank Act was supposed to have dealt with the problem. A financial group’s failure has been made less likely by limiting risky trading and requiring more loss-absorbent equity capital. Failures have been made easier to handle by allowing the government to wipe out shareholders and forcibly convert debt to equity. International efforts to come up with a global plan to deal with large bank failures are well under way. Higher international capital requirements in a deal known as Basel III are being phased in for banks around the world.

But there is a new-found zeal among members of Congress from both parties and from some senior regulators to go further. They want to eradicate the possibility of new bailouts or disastrous collapses and to end the phenomenon of too big to fail.

Barney Frank, the former Democratic congressman who co-authored Dodd-Frank, says the renewed debate is unnecessary. “There is a strange view that if a large institution fails, even though the law doesn’t allow for bailouts, there will be overwhelming public pressure to keep them alive,” he says. “The notion that there will be an overwhelming demand to keep these firms alive – I just don’t know what planet these people have been living on.”

But Mr Frank has left the stage, along with Sheila Bair, the chairman of the Federal Deposit Insurance Corporation, and Tim Geithner, Treasury secretary. As architects of the post-crisis response, all were invested in the idea that too big to fail had been dealt with. Their departure gives proponents of going further a greater chance of success.

Last week Mr Brown and Mr Vitter unveiled their latest draft legislation on the topic, which would sharply increase the capital requirements on the largest banks with assets of more than $500bn, forcing them to hold 15 per cent equity against their assets.

Analysts at Goldman Sachs calculate the increased capital is worth about $1.2tn, which would equate to the largest banks forgoing dividends and share buybacks for up to 15 years. If shareholders accepted that, they would also have to accept a permanently lower return on equity. Many in the industry believe the economics would not work: the biggest banks might have to break up to escape the tougher regime. Mr Vitter and Mr Brown could live with that – and believe others can, too.

“If we took that vote today, we’d get upwards of 40 senators,” Mr Brown says, adding that he is working with 10 Republican senators to drum up additional support. A majority of the Senate is within reach, he says, though industry lobbyists dispute that count.

What appeals to the members of Congress who might eventually back such legislation is the wave of enthusiasm across the country, particularly in rural districts served by small community banks struggling to compete with their biggest rivals.

Camden Fine, who heads Independent Community Bankers of America, the association for the country’s 7,000 small banks, says he will expend “every ounce of influence we have in this town” to get legislation passed.

There have been several catalysts for action, including JPMorgan’s $6bn trading losses last year, which led many to question whether any large institution was truly safe if one of the world’s best-managed banks could inflict such damage on itself.

Unlikely cheerleaders for breaking up the banks have emerged, including Sandy Weill and John Reed, who in the 1990s assembled Citigroup, the archetypal financial supermarket. Both have disowned the model, with Mr Weill calling for splits that would leave banks in businesses that are “not going to risk the taxpayer dollars, that [are] not too big to fail”.

But the moment that crystallised the sentiment was the admission by the country’s top legal official that some banks were “too big to jail”. Eric Holder, the US attorney-general, has come under stinging criticism for not prosecuting banks or top bank executives in the wake of the financial crisis.

Asked at a March hearing whether some banks had escaped prosecution because of their size, Mr Holder surprised the room by conceding the point. “I am concerned that the size of some of these institutions becomes so large that it does become difficult for us to prosecute them when we are hit with indications that if you do prosecute, if you do bring a criminal charge, it will have a negative impact on the national economy, perhaps even the world economy,” he said.

Mr Holder’s statements are considered to be the most explicit admission of concern by a senior Obama administration official regarding the risks posed by big financial groups.

“That’s what you’d expect to hear from some little tinhorn republic, where certain families that have done wrong escape prosecutions because of their connections,” says Mr Fine. “You don’t expect to hear something like that in the US.”

The more profound unfairness, critics say, is that the biggest banks can borrow more cheaply, feeding a vicious cycle of ever-greater dominance. “I can’t find anybody who argues that Dodd-Frank solves too big to fail, other than the big banks who would have to adjust [to a new regime],” says Richard Fisher, president of the Federal Reserve Bank of Dallas.

The concern is that banks such as JPMorgan enjoy implicit government guarantees: creditors believe that, as with Bank of New England in 1991 and Citigroup in 2008, the government will find a way to rescue them rather than take the risk that the new tools created by Dodd-Frank could fail, leading to credit freezes and a breakdown in payment networks.

. . .

For years this held true. In the past three years credit rating agencies have started to downgrade banks on the assumption that the possibility of a bailout is lower and the funding differential has narrowed. Some analyses find it has disappeared. But even respected figures in the middle, such as Ben Bernanke, chairman of the US Federal Reserve, say it is still apparent.

“Clearly there are grounds for continuing concerns about subsidies associated with too big to fail,” says Larry Summers, the former Treasury secretary and economics adviser to President Barack Obama and now a professor at Harvard University. “The steps contained in Dodd-Frank are clearly constructive. But I think we have a long way to go with respect to issues associated with international resolution, with respect to assuring sufficient capital levels, and with respect to appropriate risk systems. Market evidence does provide some grounds for concern about too-big-to-fail subsidies.”

The renewed debate over the size and power of the big banks has alarmed Wall Street lobbyists, who are spending heavily to fight back.

“It is of the highest risk and concern,” says one top industry lobbyist. Groups are spending millions of dollars to combat the perception that they are protected by the government. The Clearing House, Financial Services Forum and Financial Services Roundtable, three of the biggest trade associations, are all engaged.

Tony Fratto, White House spokesman under the George W. Bush administration, is involved in a daily dogfight on the issue from his perch at Hamilton Place, a Washington lobby group hired by banks including Citi. Prominent academics such as Simon Johnson at Massachusetts Institute of Technology and Anat Admati at Stanford University debate fiercely in speeches, newspaper columns and on Twitter.

While both sides have been fighting over the facts, there is also much faith-based rhetoric.

“The too-big-to-fail issue has become theological,” says Paul Saltzman, head of the Clearing House, which represents the biggest banks. “That is my biggest worry – a debate where facts don’t matter. In order to conclusively prove your point, we have to have a crisis, a large bank has to fail and the shareholders, creditors and culpable management need to suffer the consequences without any taxpayer-funded support. No one wants that counterfactual event to occur.”

The concern for the banks is that opponents on this issue are not just Democrats such as Mr Summers but also Republicans, including Kevin Warsh, a former Fed governor. Mr Warsh argues that by trying to force the banks into safer activities and branding them systemically important, the problem is getting worse. “If the government chooses select firms to be public utilities atop the business of banking, it is very difficult for the other 7,000 banking institutions to lend and compete,” he says. “That is an obstacle to economic growth.”

Banks might favour less regulation but they would not favour Mr Warsh’s alternative: far more capital and simple leverage ratios that do not allow banks to put less capital against safer assets.

Another concern is that the actors are not just former officials or lawmakers but active regulators who have power to force changes. Among them is Tom Hoenig, vice-chairman of the FDIC, who has also called for significantly higher and simpler capital requirements on large banks.

What is new, and what is most worrying for the banks, is that the most powerful regulators at the Fed show little desire to quell the calls from their more feisty colleagues.

Bill Dudley, Federal Reserve Bank of New York president, recently quizzed prominent investors, including Alan Howard, co-founder of Brevan Howard, and David Tepper, co-founder of Appaloosa Management, about whether they viewed “some large financial institutions as too big to fail” and what risks they posed. He has said in speeches that Dodd-Frank and the new higher Basel III capital requirements should be given a chance to prove their worth but that officials might have to go further. Daniel Tarullo, the Fed governor in charge of regulation in Washington, has made similar comments.

. . .

Fed officials are considering higher capital requirements, according to people familiar with the discussion, which they could impose without any input from Congress. The FDIC is also considering using its new powers under Dodd-Frank to force divestitures if banks deliver “living wills”, designed to show how they could be liquidated, that are deemed inadequate. “The living wills are the thin end of the wedge,” says a banker who fears they might be the start of regulators demanding more sweeping changes.

In Europe, politicians such as Angela Merkel, the German chancellor, and Michel Barnier, the European commissioner in charge of financial services, warn against going too far, too fast on reform, afraid that the economic recovery will be derailed.

Perhaps, ultimately, Republican leaders in the House of Representatives, Mr Obama or Mr Bernanke will step in and block attempts to hobble the biggest banks, fearing wider repercussions.

Members of Congress might be swayed by the grassroots lobbying of small bankers in their districts. But they also like the donations of the biggest groups and are susceptible to the argument that breaking up banks such as JPMorgan would push their business to foreign groups, such as Deutsche Bank or Barclays, that can offer a full suite of products.

“I think it’s dangerous,” says Bill Demchak, chief executive of PNC Financial Services, a bank that, with $300bn in assets, is not large enough to qualify for most of the proposed curbs. “As a selfish competitor does it help us if the bigger banks get hurt more than we do? Yes. But I think it harms our economy.”

For now the upper hand is with the reformers. It might be that they have too much momentum to fail.

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