So my timing was pretty good. Following a column yesterday on how Australia’s hubris is unwittingly laying the foundations for the next GFC, which I posited would likely originate out of Asia, and the growing unity between intellectuals on both the left and right around the need to embrace a ‘narrow banking’ approach to regulating too-big-to-fail financial ‘utilities’, President Obama has taken the first tentative, although possibly flawed, steps along this road.
In brief, he has announced two new policy initiatives: (1) no bank or financial institution that contains a bank will be allowed to own, invest in or sponsor a hedge fund or a private equity fund, or proprietary trading operations unrelated to serving customers for its own profit; and (2) further restrictions will be placed on growth in the market share of liabilities (read deposits and deposit-like instruments) at the largest financial firms, to supplement existing caps on deposits, which have been set at 10% since 1994.
And there are direct ramifications here for Australia. The President’s team has stated that they expect their peers to follow suit:
“We want to do this in coordination with our allies. You've seen England moving in some of these similar directions, as very small number of firms that this would apply to. And these rules would be applied to foreign subsidiaries in the U.S.”
The first measure is straight out of the narrow banking playbook. It very much accords with what I wrote about yesterday regarding the need to separate the supposedly safe, and taxpayer-backed, deposit-taking activities from the riskier, casino-style operations (mainly proprietary trading). It is also exactly what neoclassical economist and Chicago-school pinup boy, Professor John Cochrane, has proposed.
Yet the Administration made clear that this is also not a second coming of ‘Glass-Steagall’, which once enacted the division between commercial and investment banking activities. In a briefing to media, one of the President’s senior economic advisors, Austan Goolsbee, commented:
“It's not returning to Glass-Steagall. This is about reining in…investments with the backing support or other types of guarantees given by the American taxpayer... It's clearly not nearly as far as Glass-Steagall; it's something quite different from that…
The spirit of this, which is separating risky activities from banks, which is trying to eliminate some conflicts of interest, and which is about trying to limit the amount of subsidy or backing from the American taxpayer that's getting translated into their bottom-line profits, those are themes that people were trying to address back in the Depression when they passed Glass-Steagall.
But the specifics of Glass-Steagall, which were created in 1934, underwriting securities and trading in securities are no longer in the current financial system the things that pose the greatest risk. I do think that if you re-impose Glass-Steagall in its entirety, you would put some very severe restrictions on U.S. financial institutions that would put them in a difficult spot.
The point is… we want to eliminate conflicts of interest…these cross-subsidies or "heads I win, tails the taxpayer loses". But we -- we're not going back to the 1934 rule because on a technical level I think that's not really central on that.”
This new policy will presumably pose the biggest problems for the US investment banks that generate a lot of their profits from black-box principal trading. My former alma mater, Goldman Sachs, is the prime candidate here: in notable contrast to, for example, Australia’s largest investment bank, which focuses on managing third-party money and does little-to-no on-balance-sheet trading (and has a well-known aversion to hedge funds), Goldman is like a matryoshka doll chock-a-block full of them.
Unsurprisingly, Goldman has just announced that it will sacrifice all of its fourth quarter bonuses and donate US$500 million to charity, which will bring its total philanthropic contributions in 2009 to more than US$1 billion.
It is Obama’s second initiative that I have a problem with. Enacted in Australia it would likely force the break up of at least CBA and Westpac. But this makes little sense as there are natural scale economies in utility banking. Rather than clamping down on these efficiencies, Obama would be better served by constraining what activities too-big-to-fail institutions can undertake (ie, sterilise those risks that expose the institutions to failure).
Obama’s new proposal actually exacerbates the core problem I identified in 2009 as one of the critical causes of the US cataclysm: the absence of a nationally integrated deposit-taking sector and the resultant disintermediation of traditional ‘balance-sheet’ lending by the two Frankensteinian Government Sponsored Enterprises (GSEs), Fannie Mae and Freddie Mac (this thesis was published in several forums, including by Professor Nouriel Roubini’s RGE Economics and the private journal, Strategic Economic Decisions).
More specifically, I argued that the deeply ingrained cultural opposition in the US to nationally operated and regulated banks, which can be traced all the way back to the Founding Fathers and the battle waged between George Washington’s Treasury Secretary, Alexander Hamilton, and Thomas Jefferson and his Virginians over the creation of the First Bank of the United States, had led to the world’s most decentralised and, crucially, prone-to-fail banking system. According to the FDIC, there are currently over 8,400 banks and savings institutions in the US, around half of which have less than $100 million in assets—a remarkable 2,698 of these institutions failed between 1984 and 2003 with many more collapses since the onset of the GFC.
This has meant that the vast bulk of all home loans in the US (around 70 per cent) are funded not using the balance-sheets of large transnational banks, and in turn the regionally diversified retail deposits of their customers, but via the far more complex, unstable and, in its unique US incarnation, conflicted process of “securitisation.”
In contrast to the rest of the world—where securitisation, if it exists at all, has been a small yet important part of the housing finance mix (cf. Australia and Canada)—this process completely dominates home loan funding in the US. The concern is with the deleterious consequences of a financing system that initially evolved from the parochial designs of competing States within the highly fragmented US federation, and which was distorted further by the US Government’s policy responses to the spate of banking failures during the Great Depression. Of course, such failures were themselves an artifact of the vulnerabilities borne from the incredibly decentralised financing system that was the product of the desire of individual states to regulate and control the banks (and, incidentally, any insurance companies) operating within their domains.
The outcome of these State and Federal Government decisions, and the continued missteps of US policymakers ever since (including the “partial” privatisation of Fannie Mae—in the sense that it retained “public” privileges—by LBJ in 1968 to remove its debts from the government’s balance-sheet, and the misplaced creation of the second major GSE, Freddie Mac, in 1970 purely to compete with Fannie), has been to supplant deposit-taking organisations as the primary source of housing finance in the US in favor of the nebulous mission of the GSEs and, crucially, the process of securitisation that they pioneered.
It is my belief that the two GSEs became a synthetic surrogate for the nationally-integrated banking systems that serve as the foundation for housing finance in most other countries (like Australia, Canada, and New Zealand) that have avoided virtually all of the extreme dysfunctions that emerged in the US (but, of course, were nevertheless casualties of the ensuing crisis). In doing so, the dominance of the artificial GSE-based financing infrastructure also attenuated pressure on State and Federal Governments to pro-actively facilitate the wholesale consolidation of the geographically fractured and prone-to-fail US banking system that should have organically occurred over the 20th century.
The ineluctable result of this taxpayer subsidised “fire-and-forget” funding foundation was the destructive crisis that first emerged in the summer of 2007, and which has been quickly transmitted around the world by closely integrated wholesale capital markets. Notwithstanding the relative integrity and health of many international debt securities, the liquidity of credit markets in countries that are far removed from the US, and which share none of its problems, has been eviscerated with savage real economy consequences.
If the US is to have any hope of cauterising these problems and preventing similar cataclysms from reemerging in the future, the Administration and key thought-leaders have to start by acknowledging the structural system flaws that brought about these issues in the first place. Applying myopic bandages in a desperate bid to avoid a cathartic recession without concomitant reforms is emphatically not the long-term answer. In fact, the Administration’s policies are just going to increase the likelihood of the same issues inevitably occurring again (although no doubt on another President’s watch).
In short, the US’s entire credit creation system must be transformed back to a hold-to-maturity, balance-sheet based focus. At some point, the GSEs should be fully nationalised and, alongside other public housing finance agencies, phased out of the day-to-day housing finance infrastructure. Governments have a role to play supplying the public goods of liquidity and price discovery when markets fail—but only when markets fail.
In the medium to long term, the Administration needs to create something that has been beyond previous governments since the days of the Founding Father: a robust and nationally-integrated private banking infrastructure, which is underwritten principally through retail deposits, in order to firmly reposition balance-sheets as the main repository of credit in the US. To achieve this, the Administration must establish singular banking and insurance regulators rather than the kaleidoscope of agencies they currently have, and remove all of the legal and regulatory obstacles to enable the private banking system to expand to eventually replace the GSEs.
While there are undeniable diversification benefits to be garnered from securitisation, as can be seen in countries like Australia and Canada, there is no evidence that the off balance-sheet capital available through this medium should completely disintermediate the deposit-taking system.
