Return of Glass-Steagall?

The Obama administration's proposals (as part of the comprehensive financial market reform Bill currently in the Congress) to impose stricter limits on the size and scope of trading activities of big banks to prevent excessive risk taking marks atleast a partial return to the era of Glass-Steagall and is a clear acknowledgment of the fact that the decision to repeal the Chinese wall between commercial and investment banking activities of financial institutions did contribute to the sub-prime crisis.

Last week the administration had announced plans to recover atleast a part of the costs incurred in the TARP bailout with something similar to a bank tax. This renewed vigor on fighting the big banks comes as President Obama said,

"My resolve to reform the system is only strengthened when I see a return to old practices at some of the very firms fighting reform; and when I see record profits at some of the very firms claiming that they cannot lend more to small business, cannot keep credit card rates low, and cannot refund taxpayers for the bailout. It is exactly this kind of irresponsibility that makes clear reform is necessary."

The Obama administration proposals include

1. Limit the Scope - No bank or financial institution that contains a bank (taking federally insured deposits) should 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.

2. Limit the Size - Limit the consolidation of financial sector by placing broader limits on the excessive growth of the market share of liabilities at the largest financial firms, and to supplement existing caps on the market share of deposits. Since 1994, the share of insured deposits that can be held by any one bank has been capped at 10% and it is now proposed to expand that cap to include all liabilities, so as to limit the concentration of too much risk in any single bank.

Despite small concessions like payment of bonuses by deferred stock instead of cash, the remaining Wall Street majors have all announced record bonuses on the back of a resurgent equity markets and a market depleted of competition. Despite its less-than-stellar year (in fact, the first annual loss in its 74 year history in 2009), Morgan Stanley earmarked 62 cents of every dollar of revenue for compensation ($14.4 billion for salaries and bonuses), an astonishing figure, even by the gilded standards of Wall Street. Goldman, which made record profit of $13.4 billion for 2009 on revenue of $45.2 billion, has set aside $16.2 billion (or 35.8% of its revenues, lower than previous years) to reward its employees (or an average of $498,000 for its 32,500 employees). However, there remain doubts about later and backdoor payments that would boost the share of bonuses.

What has also raised popular outrage comes from the fact that most of the profits of these large firms have come from obscure and largely socially not-beneficial (some would say socially costly, given the excessive risk taking and inevitable bailouts) trading activities and not retail or commercial lending that directly contributes to economic growth. In fact, it is clear that these institutions cornered most of the benefits from the unprecedented quantitative easing measures, blanket debt guarantees and low interest rate policies of the Fed and the Treasury, which were originally meant to restore confidence in the financial markets and get banks to re-open their credit taps for cash-strapped businesses and individuals. However lending remains constrained with banks keeping their credit taps dry, under the excuse of counter-party risks, and are instead using the cheap money to play and drive the equity markets and their bottom-lines.

In this context, Simon Johnson (echoing Krishna Guha in the FT and the famous Pecora investigations into the causes of the Wall Street crash of 1929) has called for broad anti-trust investigations into some of the big firms. He sees "definite elements of oligopoly in wholesale markets, underwriting new issues, and mergers and acquisitions both in the United States and around the world", which has contributed to the very high profits in big banks over the past decade. He asks the question

"Is there evidence that our leading banks have used their pricing power or other aspects of their market muscle to keep out competition or otherwise distort behavior in very profitable arenas, like over-the-counter derivatives?"

Prof. Johnson also raises concerns about the dramatic increase in the share of assets in the largest six US banks that now stand around 60% of GDP, up from around 20% in the early 1990s, a level of concentration that increased during the crisis and bailout of the past two years. Among the regulatory steps proposed to address the problems generated by this concentration includes "raising capital requirements steeply, as well as a size cap on biggest banks to rein them in".

Apart from these, as Goldman Sachs CEO Lloyd Blankfein himself acknowledged in his recent Congressional testimony, there is an immediate need to bring the shadow banking system, consisting mainly of the unregulated over-the-counter (OTC) derivative products, under stricter supervision. Paul Krugman too has argued about the need to rein in the shadow banking system.

Update 1
Nice Economix post places the new plan, described the "Volcker Rule" by Obama himself, in historical perspective with respect to the Glass-Steagall Act.

Update 2
Viral Acharya and Matthew Richarson have this article commenting on Obama administration's bank reform - financial crisis responsibility fee and limit on the size and scope of trading activities - proposals. They write, "President Obama’s plans – a fee against systemic risk and scope restrictions - seem to be a step in the right direction from the standpoint of addressing systemic risk, if their implementation is taken to logical conclusions."

Update 3
Bank of England Governor Mervyn King argues "that big banks must separate their higher-risk trading and investment banking businesses from their core deposit-taking functions". He said, "After you ring-fence retail deposits, the statement that no one else gets bailed out becomes credible".

Unlike the US with its Glass-Steagall Act which was repealed in 1999, there have been no legla separation of investment banking functions for deposit taking bank holding companies.

Update 4
Simon Johnson has an incisive critique of the "Volcker Rule" on two grounds - the limit on scope rule can be overcome by banks that will immediately shed all their banking activities in the firm belief that they will be bailed out irrespective of anything; the limit on size rule applies only to future growth of bank and therefore ignores the problem of size among the incumbents.

He proposes some cap on the size of banks at some low level related to the real economy. He favors a cap on bank assets and liabilities as not more than a small percentage of Gross Domestic Product, and set that percentage so the banks go back to the size they were in the early 1990s, when the banking system worked fine and we didn’t have anything like our current levels of systemic risk.

Update 4
Daniel Gross has an excellent article that explores why the big five investment banks got too big, too greedy, too risky, and too powerful.

Update 5
Paul Volcker makes the case for financial market overhaul.

Update 6
Hank Paulson and Alan Blinder call for creation of a single systemic risk regulator (both prefer the Fed for this role because the responsibility for identifying and limiting potential problems is a natural complement to its role in monetary policy) and a resolution authority to impose an orderly liquidation on any failing financial institution so as to minimize its impact on the rest of the system.

Prof Blinder also advocates setting up a Consumer Financial Protection Agency (CFPA) to help unwary consumers from being duped into investments in risky financial products and restrictions between proprietary trading and trading, hedging, and market-making on behalf of clients, though he feels that the latter is very difficult to structure.

Update 7
Wall Street elders too call for more effective regulation of financial markets, with some going beyond the Volcker Rule and advocating banning any deposit taking commercial bank from indulging in any trading activity (not just proprietary), even for its clients - questioning whether trading operation should even exist under the same roof as a standard commercial bank.

Update 8 (22/5/2010)
The US Senate passes its version of the financial market regulation bill. See details of the comparison with the House version here and here.

Financial market regulatory reforms - still-born?

Forget, health care reforms in the US, the much trumpeted makeover of the global financial markets appears set to die the "mother of all deaths"! How things have changed in the global financial market landscape over the past few weeks! From virtually begging for bailouts and accepting, albeit grudgingly, unprecedented conditions on among other things, executive compensation practices, Wall Street and their counterpart firms across the world, are now pulling out all the stops to prevent ceding ground on anything but cosmetic regulatory reforms. Lehman, AIG, Merrill Lynch and the rest appear to have been mere blips in the remorseless march of the financial markets.

After the tumultuous events of the past year, it was only natural to expect a radical restructuring of the global financial market architecture and tighter and more intrusive financial market regulations to prevent the recurrence of similar crises. But a year on, with green shoots sprouting in the economy and equity markets rising steeply, regulatory reforms are slipping to the backstage and business as usual appears to have set in. With the worst of the crisis blowing over (or so it appears), a golden opportunity to have in place an effective financial market regulatory architecture appears to have been missed.

As the Times reports, despite being "backstopped by huge federal guarantees, the biggest banks have restructured only around the edges". In the meantime, job losses have stopped, pay increases are back, executive compensation is set to reach greater heights, profits have been rising, and equity markets are soaring. As the Times writes, "For now, banks still sell and trade unregulated derivatives, despite their role in last fall’s chaos. Radical changes like pay caps or restrictions on bank size face overwhelming resistance. Even minor changes, like requiring banks to disclose more about the derivatives they own, are far from certain... legislation to force derivatives trading onto exchanges has stalled, and banks are still writing contracts with limited regulatory oversight."



As many people have argued, any failure to press ahead with reforms or settling for a weak and diluted set of reforms will unleash uncontrollable moral hazard concerns and invariably set the stage for an even bigger calamity in the years ahead. If major banks are allowed to keep making bets that are ultimately backed by taxpayer guarantees, they will return to the practices that led them to underwrite trillions of dollars in bad loans. All the recent cut backs on risky positions, reduction in leverage, and allocation of larger cushion against losses by Wall Street firms will be swept away in the inevitable wave of "irrational exuberance" that surrounds the next bubble. Further, as the Times quotes Nassim Nicholas Taleb who says that the extensive government support that began after Lehman collapsed will lead investors to assume that governments will always prevent major banks from collapsing.

In an excellent article Alan Blinder had traced the lack of much headway with financial reforms to - the feeling that it is "yesterday's problem", has been lost in the overcrowded legislative agenda, has been lobbied to death, and caught in bureaucratic infighting and turf wars. He prioritizes on atleast three sets of reforms - creation of a systemic risk regulator (which not only just watches risks develop and issues warnings, but is also empowered to take action), a new mechanism to euthanize or rehabilitate giant financial institutions whose failure could threaten the whole system, regulate and make transparent derivatives trading (by standardizing them and pushing their trades into clearinghouses or organized exchanges, where more capital would be required and collateral would have to be posted often).

Jeffry Frieden traces the resistance to change in financial markets to special-interest politics (regulatory agencies are often sympathetic to the industries they regulate, or "regulatory capture"), technical complexity (modern finance and its instruments are arcane and complex, and therefore beyond the comprehension of most consumers, lawmakers, bureaucrats and even regulators, all of whom depend on the financial institutions themselves to get information), fragmentation (separate regulations and regulators for each variety of bank - commercial banks, savings and loans, credit unions - and other financial institutions, enables them to "jurisdiction-shop" for the most favorable regulatory environment and also leads regulators to guard their turf), and uncertainty (new instruments are typically not well understood — indeed, they may have been devised precisely to avoid easy control by the regulators). He writes,

"For financial regulation to be reformed in line with the true public interest, then, requires an almost magical combination. Policymakers and regulators must be generally immune to political pressure from the financial services industries. Reformers have to have a broad and deep understanding of the great complexity of modern finance. Central policymakers need to be willing and able to override the opposition of existing, turf-protecting, state and federal regulators. And enough people have to care, and to be paying attention, to get politicians to focus on the topic and push it to a conclusion."

The Times also points to the work of Edward J Kane, who while arguing that tax payers must guard against the corrupting influence of bureaucratic self-interest among regulators and the political clout wielded by the large institutions they are supposed to police, calls for holding regulators accountable when they perform as poorly as they did in recent years.

The NYT has excellent graphics on how the Wall Street institutions first shrunk as the crisis deepened and are now growing back (market capitalization of the 29 biggest Wall Street firms fell from $1.87 trillion on October 9, 2007 to just $290 bn on March 9, 2009, and have risen to $947 bn on Sept 11, 2009); the status of the major players during the financial crisis; and the financial market crisis timeline over the past year. The Times also has this debate about why financial market reforms are getting stalled.

Update 1
See also this op-ed on the regulatory reform agenda. And President Obama's speech on financial market reforms, and responses here, here, here, here, here, and here.

Update 2
Economist Roundtable on financial market rgulation proposals here.

Normalcy restored in Wall Street!

A few months back Wall Street was on its knees, literally, out with a bowl pleading for bailouts. After a series of capital and liquidity injections, access to cheapest credit, credit expansions (by lowering collateral scope and standards), blanket deposit guarantees, and plain bailout assistance, the Wall Street landscape is now dominated with a handful behemoth financial conglomerates. The shakeouts, consolidations and mergers, bankruptcies, and bailouts of the past few months have led to an unprecedented concentration of financial power among these remaining giant "too-big-to-fail" institutions. Ironically, this and the precedents set and signals conveyed, over this period may have left the financial system even more amenable to moral hazard and systemically vulnerable to increased instability and risks.

Amidst all the talk of green shoots and glimmers of hope, the recent announcements of unexpectedly good second quarter results by Goldman Sachs, JP Morgan, Bank of America, and Citigroup stand out for its audacity.



All these institutions have taken large slices of direct (both cash and debt guarantee support) and indirect (implicit guarantees like "too-big-to-fail" support) tax-payer financed government assistance and favorable regulatory changes (like permission to investment banks to indulge in depositary activities).

It has therefore, rightfully and very obviously to anyone, been claimed that the American tax payers deserve a large chunk of the profits of these institutions. Further, all these remaining institutions stand to gain spectacularly by capitalizing on the turmoil in financial markets and their rivals’ weakness to pull in billions in trading profits.

Goldman’s profit was lifted by record quarterly revenue of $6.8 billion in its fixed-income, currency and commodities unit, where mortgage and other credit instruments are traded, and a unit where Goldman has embraced bolder risk-taking. Goldman has already returned the $10 bn it received under the TARP as equity injection, in return for preferred shares, with the dividend on them.



Goldman Sachshas been raking in money in large part because government assistance through debt guarantees, money it received from the AIG bailout and access to cheap loans from the Federal Reserve. It was paid 100 cents on the dollar for its $13 billion counterparty exposure to the insurer, and it has $28 billion in outstanding debt issued cheaply with the backing of the Federal Deposit Insurance Corporation.

As the Times writes, "Goldman’s trading revenues have been helped by the fact that several of its rivals have gone out of business following the credit crisis, a fact that has added to its market share. It has also been able to increase it fees." Its equity underwriting business also generated record net revenues, worth $736 billion in the second quarter, as it benefited among other things from a rush by other troubled banks to issue shares and raise their capital levels.

These spectacular profits have been accompanied by a return to the flawed short-term profits driven executive compensation regime, marked by the usual massive payments to executives and traders.



The fact that all these firms recevied massive amounts in bailout assistance and other aforementioned support, makes these payouts appear plain indecent. Goldman, which posted the richest quarterly profit in its 140-year history and announced that it had earmarked $11.4 billion so far this year to compensate its workers, is expected to payout on average, roughly $770,000 to its employees this year, almost the same as what they received at the height of the boom.

However, these results may actually be concealing more than what they reveal and may have been boosted by one-time windfalls, inflows of bailout monies, and most importantly the access to cheap credit to leverage for big gains. In fact, the bulk of profits of Citigroup and Bank of America come from one time asset sales - the former from a joint venture with Morgan Stanley for its Smith Barney division, and the latter from the sale of shares in the China Construction Bank. Credit losses, from credit cards to home loans, continue to mount across most of these banks, the toxic assets remain, and the fundamentals remain shaky on most parameters.

In any case, these profits and the massive payouts being made to top executives and traders is only the latest example of the now well established feature of Capitalism 2.0 - privatization of gains and socialization of losses!

Update 1
Even as Goldman is luxuriating in its tax payer sponsored profits, another bank holding company, CIT, is not so fortunate as it battles for survival - bankruptcy or bailout! But CIT's smaller size, $80 bn in liabilities as opposed Goldman's $800 bn, may make CIT "too-small-to-be bailed out". More on this here and here.

Update 2
Times reports that the generous bonuses to employees announced by the big banks for 2009 may be at the expense of shareholders. Roughly 90 cents out of every dollar that these struggling big banks earned in 2009 — and sometimes more — is going toward employee salaries, bonuses and benefits.

Citigroup paid its employees so much in 2009 — $24.9 billion — that the company more than wiped out every penny of profit, and after paying its employees and returning billions of bailout dollars, Citigroup posted a $1.6 billion annual loss.

Citigroup is, in effect, paying its employees $1.45 for every dollar the company took in (payout ratio) last year. Bank of America is spending 88 cents of every dollar it made in 2009 to compensate its workers. At Morgan Stanley, that figure is 94 cents. JPMorgan Chase, which has fared better than those three, paid out 63 cents of every dollar. Though Goldman is paying only 45 cents per dollar made, on average in absolute terms each of its 36,200 employees would take home a record $447,000. Until recently, the ratio for most Wall Street banks hovered around 60 cents of every dollar, in line with other labor- and talent-intensive industries like retailing and health care.

The five largest banks on Wall Street — Bank of America, Citigroup, Goldman Sachs, JPMorgan Chase and Morgan Stanley — earned a combined $147.4 billion before paying compensation and taxes in 2009. They plowed back a combined $31.2 billion into their companies and returned a total of $2.1 billion to shareholders in the form of dividends. They paid $114.1 billion to their employees.

Update 3 (2/4/2010)
Hedge fund salaries were back to their ususal highs in 2009, with Daiv Tepper leading the pack by earning $4 bn and whose fund yielded 130% return for investors in his Appaloosa Investment Fund I, according to survey by the AR magazine. Second came George Soros's Quantum Endowment where he earned $3.3 bn and investors 29%. The earnings of the top 25 fund managers tumbled 50% in 2008.

In an indication of how richly compensated top hedge fund managers have remained despite public outrage over the pay packages at big banks and brokerage firms, the top hedge fund managers rode the 2009 stock market rally to record gains, with the highest-paid 25 earning a collective $25.3 billion, beating the old 2007 high by a wide margin. The minimum individual payout on the list was $350 million in 2009. For many of the top 25, the big personal gains in 2009 came after steep losses in 2008. Mr. Tepper's flagship fund, dropped 27% in 2008.