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Sunday, October 21, 2012

Should Citi Be Broken Up or “Prodded”?

In 2011, the office of the special inspector general for the Troubled Asset Relief Program published a report on the aid provided to Citigroup by the U.S. Government during the financial crisis of 2008. “Unless and until an institution such as Citigroup is either broken up,” the report concludes, “so that it is no longer a threat to the financial system, or a structure is put in place to assure that it will be left to suffer the full consequences of its own folly, the prospect of more bailouts will potentially fuel more bad behavior with potentially disastrous results.” The Dodd-Frank Act of 2010 was an attempt to provide such a structure, with the federal government’s role being oriented to upping reserve requirements for the biggest banks and ordering the liquidation of big banks in bankruptcy, rather than to break up the banks too big to fail. That is to say, rather than add systemic risk to the restraint-of-trade criterion of anti-trust law, Congress and the U.S. president decided in 2010 to allow the banks with $1 to $2 trillion in assets to decide whether to downsize of their own volition or continue to face the raised reserve requirements.
 
Philosophically, the American body-politic in very general terms tends to view the proper role of government as tinkering with the contours of markets to affect business incentives rather than intervening directly in a company, as in breaking those up that have grown too big (and powerful) for the public good. Making it more costly for a big bank to retain all its lines of business (i.e., its size) instead of breaking it up is believed on a rather subtle level by the society at large give due regard to property rights (i.e., economic liberty). The public tends to view such an approach as balancing property rights with the public good. More nefariously, the approach can also be viewed as a manifestation of the political power of corporations on K Street in Washington, D.C. over Congress and the White House. Actually, adjusting market incentives via regulation can be said to prioritize property rights and private wealth over the public good where the threat to the market mechanism itself and the financial system (not to mention the republic!) is particularly grave. The American orientation to the market mechanism in preference to "big government" tends to disregard this scenerio wherein an improbable systemic collapse is part of the equation.
 
The fear that the fall of Lehman Brothers would trigger the collapse of the American financial system “by Monday” led Congress to put hundreds of millions of TARP money up for a vote on a “fast-track” that is astonishing by Congressional standards, not to mention democracy itself. The American "approach" itself had to be temporarily put on hold, and by a Republican administration! Not to be outdone, the free market orientation held on in the form of no-strings on the bailout money.

It can be argued that TARP itself was not only insufficient, but also that it actually enabled the marginally-run banks that were too big to fail to endure and thus continue to inflect the system with systemic risk. In terms of the ensuing reform law on financial regulation in 2010, it can be argued that to enable a mammoth bank that is regarded as too big to manage to continue to exist by rejecting the break-up approach (or reinstating the Glass-Steagal Act) in favor of relying only on setting up differential reserve requirements (i.e., regulatory costs) based on total assets and otherwise helping to order the liquidation process of an already-defunct bank may be too detrimental to the public interest. In other words, the tremendous size of the banks and the associated systemic risk may make the market-oriented American approach too property-rights oriented for the public good.

                                                                                          Is Citibank so tall that its fall would wreck the financial system?    Washington Post.

In terms of unmanageable banks, I have in mind Citigroup in particular, which I will turn to below, though Bank of America could easily be added to this list, given Ken Lewis's "empire-building" moves to acquire Countrywide and Merrill Lynch. He might as well have hung a sign outside of headquarters in Charlotte, "Dump Your Crap With Us! We'll Buy It!" Being the biggest bank, as though a Walmart in the financial world, is not necessarily a good thing both on the firm level and in terms of systemic risk in the economy.
 
Referring to Citi, Gary H. Stern, former president of the Federal Reserve Bank of Minneapolis, said, “I ask myself, ‘Could I manage one of these places with lots of capable senior officers?’ and I think the answer is no.” That is to say, the bank had become too large to manage. Like blindfolding a car driver or putting a confused drunk driver behind the wheel, having a heavy piece of machinery running not fully under control can be to invite an accident. It is very risky, even self-destructive, merely to allow such a thing to go on. Relying on the CEO to “pull over” and by analogy reduce obstructions by reducing the vehicle’s size (maybe unhooking a trailer) can be viewed as a luxury that the public interest cannot afford.
 
Gretchen Morgenson of the New York Times writes that “(g)iven Citi’s close ties to Washington, we can only hope that the change of command [of CEO] also reflects a regulatory prodding to overhaul the company. And if that involves cutting this behemoth down to a manageable size, then taxpayers should definitely cheer.” Regulatory “prodding” can be viewed as woefully insufficient if we are to rely on an empire-building CEO to voluntarily bring his “behemoth down to a manageable size.” That is, the fact that Pandit had felt perfectly fine with Citi being beyond a manageable size does not bode well for taxpayers cheering any time soon on hopes that Mike Corbat might suddenly see the light as he entered the corner office on his first day as CEO. He was more likely to see the power of his new office over such an expansive empire than to reflect on how he could have less under him. The motivation of a CEO is crucial to the question of whether the American market-oriented approach is sufficient to deal with something on the order of systemic risk.
 
The “regulatory prodding” approach that tends to sway the American electorate as a whole, even if subtly, may be fatally flawed in that economic efficiency and even profit-seeking itself are presumed in the approach to be the exclusive or primary motivators of CEOs and even boards. In actuality, the empire-building motive of power may eclipse even greater profitability, and therefore be oblivious to the prodding of additional reserve requirements. That is to say, the "market-prodding" approach may fall short by treating non-financial motives as extrinsic to the business calculus. Such motives may ignore or even trump "new and improved" regulations designed to channel financial motives in business. A bank's CEO might say, "I'll put up the additional reserves! I don't want to cut off product-lines that otherwise tie into my overall strategy synergistically."  Translation: I want to expand my empire even if it costs more proportionately because I like the pleasure that comes from the additional sense of power. Nietzsche could hardly have put it better.

For our purposes, the following axiom can be set forth for business as a phenomenon as well as at the managerial level:

Business is not only economic or financial in nature; it is also political in the sense that power is in the mix.

Managers are motivated not just by financial considerations such as efficiency, cost-containment, and revenue maximization, but also by the desire to control, which is an application of power.

The market-oriented approach to regulation may not sufficiently take into account this axiom. Structuring the market mechanism itself may need to be supplemented by a more direct intervention in private companies so systemic risk is lowered to a level that does not present taxpayers with a "high risk, low probability" collapse of the financial system itself. The sheer continued existence of Citibank (and even Bank of America) may point to the inadequacy of the Dodd-Frank Act as “reform” adequate to the purpose, given what we learned, or should have learned, from living through the financial crisis in September 2008.
 

Source:

Gretchen Morgenson, “Citi’s Torch Has Passed. Now Find a Knife,” The New York Times, October 20, 2012.