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Wednesday, May 16, 2012

Market and/or Government: Reducing Systemic Risk in Banking

If the five largest banks—JP Morgan, Bank of America, Citigroup, Goldman Sachs, and Morgan Stanley—are too big to fail and yet substandard operationally on account of their respective complexities (e.g., investment banking added to commercial banking), might it be that the market-based decisions of investors will relegate the giants, which by the way had price-to-book value ratios of between .37 to .77 in May 2012, thereby solving the problem of systemic risk?

Smaller banks may be favored by investors because such banks do not “suffer a conglomerate discount,” according to the Wall Street Journal. “They also don’t have big investment-banking or trading arms.” These “arms” are relatively volatile and opaque businesses, and they may be more susceptible to the E.U. debt crisis due to the trades in derivatives. Finally, being less complex means being easier to value, and this can give investors added confidence, particularly as risk management has not exactly been done well at the largest U.S. bank by assets (i.e., JP Morgan)—though Goldman did well in hedging against the bear housing market (and its derivatives).

Therefore, investors could swing the balance away from the biggest banks, though such a shift would take time—barring a herd-like mentality. Regardless of their numbers, the biggest banks can run on the sheer solidity of a well-known name. The shock at the $2 billion loss demonstrates just how much reputational capital had been in the name, “JP Morgan Chase.” Indeed, Jamie Dimon, chairman and CEO of that bank when the huge loss took place, has argued nonetheless that being big allows the bank to compete globally, make large investments in technology and provide broad services to multinational companies. Even though his self-serving pitch omits the problem of risk (e.g., losing $2 billion trying to reduce risk), discounting the inefficiencies and risks that go with greater complexity can take a while, at least in terms of the market as a whole, because the big guys are not exactly going to lay down and give it up to the smaller guys without some pushback. Indeed, the big guys have considerable market and political power that can translate into hidden advantages written into regulations.

Even if the object is merely apparent, given the power of the big banks, it makes sense then that the U.S. Government sought to help at least “level the field” between the large and small by instituting capital surcharges for systemically important (i.e., large) banks. “We are creating incentives right now for institutions to get simpler, less complex and less volatile, and the market is going to be pushing people in that direction,” says William Isaac, FDIC chair during the 1980s thrift crisis and now head of Fifth Third. The question before us here is how much the market’s push can be relied on to get us to a place where systemic risk can be tolerated.

Even with a level playing-field, will investors favor smaller banks with higher price-to-book values sufficiently to cause the biggest banks to lose some lift and float closer to the ground? Even with the capital surcharges, is the playing-field level? Finally, is “level” enough for investors to favor smaller banks, which represent less systemic risk?

In the 1980s, the market-based approach to regulation, such as in the arrangement in which pollution permits could be bought and sold, sought to fuse public policy objectives with the efficiency of the market. I remember well having been steeped in that ideology in business school. Any objection to the approach in class quickly got a sarcastic, “Ok, Ted”—short for Ted Kennedy (or “you socialist!”). As an MBA student, I volunteered to assist a professor on a paper singing the praises of the efficiencies possible in self-regulation applied to securities dealers (NASD). In retrospect, I view my approach and that of the broader ideology as incredibly naïve, even if the efficiency aspect was well-intentioned. A solution allowing for efficiency “automatically” had a certain intellectual beauty to it, which I suspect some advocates experienced as akin to an unexpected good orgasm at a French whorehouse.

Rather than police bad boys, an industry will naturally seek the lowest common denominator if the government allows the industry to be regulated by self-regulation. The industry itself can then benefit by everyone cutting corners. In other words, short-term profit outweighs the long-term reputational capital to the industry itself from policing bad apples rather than joining them. Government is uniquely situated with regard to the common weal, or public good, to guard and protect it from short-sighted encroachments by aggrandizing players and even entire industries.

Therefore, it would be a mistake to think that systemic risk could be reduced by the biggest banks regulating themselves and their industry. It would be a case of wolves guarding the hen house. The question thus boils down to whether government regulation (uncaptured by the regulatees) or the market mechanism should be relied on to reduce systemic risk, or whether some combination of the two (i.e., government regulation "encouraging" the market) is optimal. If regulations unimpaired by bank lobbying are even possible in the U.S., it might be that the market has the final word anyway. The question then would be whether the market naturally seeks to reduce systemic risk, or is such risk an externality to the market and thus within the reach only of government.


David Reilly, “Bank Investors Bail onToo-Big-To-Fail,” The Wall Street Journal, May 16, 2012.