Are Banks Too Big To Tolerate?

I was one of three panelists invited to speak at an American Institute seminar last week. The question we were asked to address was an intriguing one: not are banks “too big to fail,” which has become so common a term that most people recognize its TBTF acronym, but are banks “too big to tolerate.”

The speakers and those who participated in the question-and-answer session that followed disagreed on a number of issues. But as the Daily Caller reported the next day, “While the mix of conservative and liberal speakers differed sharply on how to restore the country’s rigid financial industry, all agreed on one point: The 2010 law—commonly known as ‘Dodd-Frank’…has utterly failed in its purpose of reducing the systematic risk posed by enormous financial institutions.”

I have vivid memories of the very contentious and partisan Senate debates before the passage of Dodd-Frank, formally known as the Wall Street Reform Act. You may remember that it passed with just three Republican votes. But you can re-read every speech made on the Senate floor and find we all agreed on one issue. Every Republican, every Democrat agreed that the American taxpayer should never again have to bail out a bank because it was too big to fail.

Dodd Frank’s main solution was a new resolution authority, which would somehow allow an orderly liquidation of a failing bank. At the time, a number of senators agreed that it simply wasn’t realistic to believe that, at a time of financial crisis, these gigantic banks could be resolved. How, we asked, given their thousands of international connections, could they be resolved in any acceptable time frame when there was no provision for resolution authority across international borders? That was nearly three years ago.

Earlier this month the Financial Stability Board said that international regulators still lack the power to impose losses on creditors and resolve banks without taxpayer bailouts. The Board said, “Few jurisdictions have equipped administrative authorities with the full set of powers to resolve banks”. The board pointed out that the comparatively simple Lehman Brothers bankruptcy took over three years.

It was comparatively easy to close Merrill Lynch on Friday and reopen it asBank of America BAC +0.16% Merrill Lynch on Monday. But if Citibank goes bust, exactly who do you think is going to take it over? And how long will it take? What is equally obvious—if Citibank is in that kind of trouble, what are the odds of Bank of America and Chase not being affected? Resolutionauthority, all three panelists agreed, is a paper tiger that will fall apart the minute it is tested in a real-life financial crisis.

No one can argue with the fact that our biggest banks have grown even larger and more complex since the financial meltdown. That is in part a result of a number of forced mergers including the Merrill Lynch one cited above. According to the Federal Reserve, in 2011 our five largest banks’ assets accounted for 56 percent of GDP, up from only 43 percent in 2006. That’s some “only.” The number was just 18 percent of GDP in 1995, before the repeal of Glass Steagall. The alarming concentration of assets in our megabanks is a major reason there has been movement across the political spectrum to agree that they are in fact TBTF.

In addition, since the passage of Dodd Frank, we have identified problems caused by the size of some of our banks we didn’t see three years ago. First is the difficulty in holding large banks to the same legal standards that apply to everyone else. Last year the head of the Department of Justice’s Criminal Division, Lanny Breuer, gave a speech where for the first time, he informed us that his decisions on whether to prosecute a bank or company could depend on the bank’s possible financial failure. This was a novel prosecutorial approach. He had never mentioned it before and it was certainly missing from his testimony at two hearings of the Senate Judiciary Committee on prosecutions of fraud by major banks during the financial meltdown.

His position became official Department of Justice policy last month when Attorney General Holder told the Senate Judiciary Committee, “I am concerned that the size of some of these institutions becomes so large that it does become difficult for us to prosecute them when we are hit with indications that if we do prosecute — if we do bring a criminal charge — it will have a negative impact on the national economy, perhaps even the world economy. I think that is a function of the fact that some of these institutions have become too large.”

The official Department of Justice policy is that executives of Too Big To Fail banks have a get out of jail free card.

Another thing we have learned since the passage of Dodd Frank is that the size and power of banks can make them very difficult to regulate. In the wake of the flood of Dodd Frank rules, regulators have had difficulty in issuing on time the meaningful rules required by the act.

The one sided power of the big banks to slow down or stop regulators from writing rules can be seen in a study by Kim Krawiec, a colleague of mine at the Duke Law School. She looked at lobbying activity involving the four regulators that would have responsibility of writing the Volcker Rule. She found that firms and individuals representing financial institutions made 92 percent of the lobbying contacts on Volcker to the agencies. Only 8 percent were by public interest groups and members of the Senate. Is it any surprise then that there is no Volcker Rule almost three years after passage of Dodd Frank? You nearly have to conclude that some banks are too big to regulate.

Finally, we have seen examples of how incredibly difficult it is to manage these huge, complicated financial institutions. According to SNL Financial, our largest six banks have paid $62.6 billion in fines to settle lawsuits in the past three years. To make matters worse, Compass Point has estimated that it will take another $24.7 billion to settle pending suits, most of them involving the mortgage junk banks sold to investors. If you or I were running companies that heavily fined, would we have to admit to ourselves that we were having real trouble managing them?

How can anyone who followed the recent hearing of the Senate Permanent Subcommittee on Investigations into the JPMorgan Chase JPM +1.99% $6.3 billion scandal not be worried about how big banks are managed? You know the story of the London Whale debacle. A trading position in JPMorgan Chase’s London Office began to spiral out of control. Rather than cutting loses, risk standards were changed again and again. Losses increased, news of those losses got out, management mislabeled synthetic credit trades as “hedges,” and Jamie Dimon called the whole thing a tempest in a teapot. John McCain had it right: “Let me be clear: JPMorgan completely disregarded risk limits and stonewalled federal regulators.”

In a recent letter to stockholders, Dimon said the whole thing was the stupidest and most embarrassing situation he had ever been a part of. Great. But it wasn’t just an embarrassment. It was a clear indication that even a competent manager like Jamie Dimon has trouble managing a modern mega bank.

The LIBOR story is even worse. There is evidence that, as early as 2005, some banks began manipulating the LIBOR rates. Derivative traders convinced the people in the bank responsible for reporting interest rates to lie about them, thereby maximizing their profits. It boggles the mind to think of how many bank executives over the following years had to sign off on this behavior, and how many internal controls did not exist or were bypassed.

My answer to the seminar question was easy to reach. If our biggest banks are Too Big To Fail, Too Big To Prosecute, Too Big to Regulate and Too Big To Manage, they are definitely Too Big To Tolerate.

I’ll write about some solutions to the problem next week.

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