Why Wall Street Should Oppose Too Big to Fail

The too-big-to-fail doctrine, now at the heart of the administration's proposal to reform financial regulation, might seem the best of all possible worlds to the big banks on Wall Street. They can take all variety of risks, speculating in this and dabbling in that, yet their obligations are guaranteed 100% by the U.S. government. Anyone and everyone will trade with them--and indeed at favorable prices--because they cannot default. Their borrowing costs will be barely above comparable Treasuries, but their profits have no upper limits. Although the administration and the federal banking authorities rumble about pay limits, that's why you have lawyers. There's never been a lawyer who didn't see a loophole or five in the law, and the highly compensated counsellors who serve the carriage trade will burn the midnight oil so that they can find every tiny crack in the regulatory structure, figure out how to drive a tractor trailer of compensation through it, and bill their clients handsomely in the process. And should there be a scarcity of loopholes, the canine-toothed lobbyists on K Street will whip out their checkbooks, already preprinted to be payable to (blank) Re-election Campaign, and make Swiss cheese of previously solid law.

But sometimes, something that looks almost too good to be true is too good to be true. The too-big-to-fail policy, already implemented by the Federal Reserve and Treasury Dept. on a de facto basis, has created a cartel of financial oligarchs. These megabanks derive significant market advantages from their favored status, and have reported commensurate profits. But the backlash has already begun. Their compensation policies are under severe scrutiny. Counter-intuitively, Citigroup had to sell what was perhaps its most profitable unit, the commodities trading operation that was supposed to pay its head trader $100 million this year. Those banks with credit card operations are losing significant revenue streams as new legislation increasing consumer protections restrain the gouging of struggling customers. Leverage is being limited to a debt-to-equity ratio of something around 10 to 1, compared to 30 or 40 to 1 during the halcyon days before Lehman collapsed. Leverage limits will slow profit growth, which will eventually affect employee compensation. The employees that enabled banks to act like hedge funds will gradually migrate to real hedge funds, because the big bucks for MBAs aren't in opening passbook savings accounts. Personnel are the only true assets of any bank that wants to be an investment bank, and this migration will drain away the people who provide the sparkle to bank profits.

The future only promises more government presence among the big banks. The soon to be created federal agency/council/czar/doyen or whatever (hereinafter, the "uber-regulator") that will manage systemic risk may turn out to be much more intrusive than the big banks think. To do the job of systemic risk management properly, the uber-regulator will need shiploads of data, much more information than bank regulators now collect. The federal bank regulators were blind-sided by Bear Stearns, Lehman and AIG--they didn't know how massively these firms were inter-connected and intertwined with everyone else in the world of finance. In order to avoid replaying these really scary videos, the uber-regulator will have to know how deeply intertwined and inter-connected the big banks are. But that won't be enough. One would have to dig into the next layer of counterparties, find out who they are, and how vulnerable they would be if one or more of the big banks went down for the count. The counterparties might not like this, but the uber-regulator would have no choice. The reason AIG got its blank check bailout was that the Fed and Treasury belatedly learned, post-the Lehman bankruptcy, that AIG was deep in a vat of liabilities owed to everyone that mattered in finance. This is information the uber-regulator would need on a regular basis--you can't wait until the toilet is flushing to get the information. You need it now, before the crisis, in order to prevent system-threatening conduct. And going to the first layer of counterparties may not be enough. One might have to look into the counterparties of the first level counterparties, and then their counterparties, and so on, to find out how much liabilities loop back to the big banks and other interesting things. The financial services industry has turned itself into a dense thicket of inter-connectedness that beats Facebook, My Space and the rest of the world of social networking by an exponential factor of 100. The uber-regulator will have to dive into granular details in order to do its job properly. Numerous lightly regulated financial players might soon find themselves receiving routine visits from skeptical federal examiners. That might put a damper on their exuberance.

And if the dicier--and potentially more profitable--stuff moves off shore and away from federal jurisdiction, guess what will happen? The uber-regulator and probably other federal regulators will tell the financial oligarchs to stay away from it. Passbook savings, CDs and credit cards will have to suffice as product lines.

GM might eventually get out from underneath the federal thumb by repaying the money it's borrowed from the government. We taxpayers all hope it does. But the financial oligarchs can never escape the federal grip, because they'll always be too-big-to-fail. Unless they make themselves not so big, such as through strategic divestitures and spin-offs. Or by opposing a federal policy that could easily make them more regulated than they ever thought possible.

The free enterprise system doesn't exist without the possibility of failure. If failure is abolished, we end up somewhere between Socialism and Communism. The federal government should allow major financial institutions to fail but try to limit the collateral damage. Given that AIG's creditors received 100 cents on the dollar, it would have been no more expensive to allow AIG to go down the drain and write checks to its creditors for everything AIG owed them. AIG's senior management would have been out of jobs, and deservedly so. Many and perhaps most of its employees would probably have kept their jobs since the operating insurance subsidiaries of AIG are mostly sound and could have been sold off or established as free-standing businesses. The end result would have been a better outcome, and we would perhaps be having less of a handwringing experience in formulating reforms for federal financial regulation.