Simon Johnson is the Ronald A. Kurtz Professor of Entrepreneurship at the M.I.T. Sloan School of Management and co-author of “White House Burning: The Founding Fathers, Our National Debt, and Why It Matters to You.â€
Proponents of the status quo in the financial sector just cannot catch a break. Early August is supposed to be a time when regulators and markets slow down, or perhaps even take a vacation. But this year news of mismanagement or worse continues to emerge from complex financial institutions.
It's time for a new approach to bank capital. A proposal by two United States senators is not a panacea, but it would have a significant effect on big banks and how they operate.
Earlier this week, Standard Chartered, a large global bank (about $600 billion in total assets) based in Britain was accused of breaking American law in its dealings with Iran and other countries under financial sanctions imposed by th e United States.
The complaint, lodged by New York State's Department of Financial Services, suggests that the bank's executives deliberately deceived regulators. The complaint says in part:
For almost 10 years, SCB schemed with the Government of Iran and hid from regulators roughly 60,000 secret transactions, involving at least $250 billion and reaping SCB hundreds of millions of dollars in fees. SCB's actions left the U.S. financial system vulnerable to terrorists, weapons dealers, drug kingpins and corrupt regimes, and deprived law enforcement investigators of crucial information used to track all manner of criminal activity.
If these accusations are correct, someone was taking huge risks with the bank's reputation by breaking the law.
StanChart, as the bank is sometimes known, is pushing back hard against these accusations. This reminds me of Robert E. Diamond Jr., the chief executive at Barc lays, who came under pressure and responded by trying to take on the Bank of England - until he was forced out.
Bankers benefit from a great deal of state protection and subsidies. It is unwise for them to break the rules and then turn on the people seeking to enforce the law. Standard Chartered's banking license in the United States could easily be revoked - and it should be revoked if the charges are accurate.
At the same time, the near failure in recent days of Knight Capital further illustrates the risks inherent in running a complex securities trading operation. Some sort of programming error resulted in the company's buying stocks it did not want and quickly suffering large losses of about $440 million. The Securities and Exchange Commission understandably declined to let the company have a “do over,†i.e., withdraw the trades.
Brad Hintz, a banking analyst at Sanford C. Bernstein & Company, drew one lesson:
Knight Capital should remind investors how the investment banks became bank holding companies four years ago; markets froze, confidence was lost, funding dried up and a reluctant central bank was forced to step in to save the U.S. capital markets.
Mr. Hintz is right that “as investors learned in 2008-2009, the most significant risk to any major broker-dealer is a loss of confidence.†But he then draws the policy conclusion that securities trading operations should remain inside megabanks, where they can be backed by essentially unlimited credit from the Federal Reserve.
It's precisely the prospect of unlimited and typically unconditional support from central banks that encourages moral hazard - meaning that bank management is not sufficiently careful. If we increase the government backing and implicit subsidies for megabanks, will they take bigger or smaller reckless risks? What would you do?
A much better approach would be to force large financial institution s to increase their equity funding relative to how much they borrow. When the business is riskier and when its failure would have more dire consequences for the economy, we want any potential bankruptcy to become much less likely.
Senators Sherrod Brown, Democrat of Ohio, and David Vitter, Republican of Louisiana, made this point in a powerful letter this week to Ben Bernanke, the Federal Reserve chairman. With regard to the Fed's proposed rules for how large banks fund themselves, the senators write:
We urge you to revisit your proposed rule and modify it so that megabanks fund themselves with proportionately more loss-absorbing capital per dollar of assets than smaller regional or community banks. The surcharge on the megabanks should be high enough that it will either incent them to become smaller or will help to ensure they can weather the next crisis without another taxpayer bailout.
The letter is well argued and should be requ ired reading for everyone concerned about financial sector stability. “More capital†is sometimes used as a rhetorical smokescreen by people who actually do not want any reform; in contrast, Senators Brown and Vitter are pressing the Fed on the right specifics - and for amounts of equity funding that would really make a difference.
Highly leveraged financial institutions do not have the incentive to be careful; their executives get the upside when things go well, and the downside is someone else's problem. Executives and traders in megabanks are paid based on their return on equity unadjusted for risk.
As Anat Admati and her colleagues have been asserting, these executives want to have less equity and more debt, and they don't care about how this affects the rest of the financial system.
Bigger banks are more dangerous. They should either have to fund themselves with much more equity or break themselves up. Their executives can choose.
The financi al sector should take up this issue because megabank behavior has become so bad that it damages everyone's business. Investor confidence has taken a beating precisely because highly leveraged financial institutions get into so much trouble. As Dennis Kelleher of Better Markets put it on his blog:
It's not the fundamentals or computer trading or Wall Street misconduct or one scandal after another. It is the fundamentals and computer trading and Wall Street scandals and lots more. To ignore or deny the effect of the daily drumbeat of Wall Street mishaps and misconduct like the Knight Capital implosion, JPMorgan's London Whale losses, the metastasizing Libor Scandal, HSBC and Standard Chartered criminal conduct, plus the Facebook and BATS listings debacles and high-frequency trading incidents like the Flash Crash (not to mention the rot revealed by the 2008 financial crisis like no-accountability bailouts and Goldman's Abacus deal) is to deny reality, how inv estors think and how markets work.
Fair or unfair, all of those incidents plus the lousy fundamentals combine to give people the impression or belief that the markets are a bad investment, that they are rigged, that the professional insiders have an advantage, that whoever has the fastest computer wins and that individuals and ordinary investors just don't stand a chance.
As Senators Brown and Vitter suggest, we should increase the required equity funding for megabanks to make them safer, to improve their behavior, and to help restore investor confidence. More equity funding for megabanks is not sufficient; we need more taxpayer safeguards, including regulatory fail-safes. But it is essential if these banks are ever to become better run.
