Monday, August 4, 2014

Wall Street Subsidies Silently Magnifying Systemic Risk

At a U.S. Senate hearing on a GAO report on the costs of expectations of government support for banks should they go under, “discussion went far beyond the report and delved into the current state of banking, the limits of the Dodd-Frank Act and what should be done about banks that are simply too big to manage,” according to The New York Times.[1] Six years after the massive credit freeze, a major question hinged on whether some financial institutions were still too large, complex, and interconnected to be liquidated in an orderly and containable manner should they head under water. 

To the extent that the Dodd-Frank Act of 2010 confers subsidies on such banks, that benefit may explain in part why the largest banks had increased in assets by 25 percent, according to Fed Chair Janet Yellen in July of 2014. Being larger, and thus more significant in the functioning in the financial system in the U.S. and even globally, these banks had more rather than less systemic risk under the Dodd-Frank Act. “Today’s report confirms that in times of crisis, the largest megabanks receive an advantage over Main Street financial institutions,” Sens. Sherrod Brown and David Vitter concluded in a statement. “Wall Street lobbyists may try to spin that the advantage has lessened. But if the Army Corps of Engineers came out with a study that said a levee system works pretty well when it’s sunny — but couldn’t be trusted in a hurricane — we would take that as evidence we need to act.” In other words, introducing systemic advantages to the biggest banks had increased their systemic risk.

Anat Admati, a professor at Stanford said at the hearing, “The subsidies are real and they are very large. The main problem with the guarantees is they reinforce and create perverse incentives and intensify the conflicts of interest between the banks and the rest of society.” As The New York Times points out, "there is an enormous value in a bank’s ability to tap the taxpayer for a bailout rather than being forced to go through bankruptcy.” This value is doubtlessly not lost on people in choosing a bank; hence the biggest of the banks gain market share and get larger.

Accordingly, Sen. Brown drew the following conclusion: “This report has underscored that if there is a real crisis, investors will move their money to the banks that are too big to fail. That was significant and is really troubling. The system continues to reward risky behavior.” It is as if society itself, through its government, was unknowingly pressing down on its most vulnerable part of the financial system—the mammoth, even bloated, megabanks on Wall Street—hence putting additional, albeit subterranean strain on the financial system.

To be sure, Mary J. Miller, undersecretary for domestic finance at the United States Treasury, wrote in a letter prior to the hearing on the GAO report, “We believe these results reflect increased market recognition of what should now be evident — Dodd-Frank ended ‘too big to fail’ as a matter of law.” The operating assumption here is that the increased capital reserves tied to size will temper the systemic risk of the big banks, even if the financial disincentive to get bigger had not worked. As the water-levy analogy suggests, the reserves may work fine if an individual bank is in trouble, but fail should the financial system itself be flirting with collapse. It is highly unlikely, for example, that higher reserves would have saved Citigroup and Morgan Stanley as speculators shorting bank stocks were beginning to go from bank to bank, as if huge financial institutions were dispensable dominoes on a game board, in the wake of Lehman’s closure in September of 2008.

It seems likely that the subsidy inherent in being likely to get taxpayer-funded help from the U.S. Government is at least one of the factors playing into why the big banks have gotten even bigger. Among the lessons to be learned is the utility in drafting financial reform legislation of assessing how the financial incentives and disincentives that are woven into the fabric of the system itself (i.e., its design) would be altered. From such a systemic analysis, policy makers could gain a better sense of whether a given reform would be compromised from within, with the financial system itself working against the law's aims. Put another way, the sheer existence of the subtle, subterranean dynamics of any social/religious, economic, or political system means that we ought not be so sure of ourselves as a society that we have in fact solved a problem merely by legislating it away.  

1. This and all quotes in this essay are from Gretchen Morgenson, “Big Banks Still a Risk,” The New York Times, August 3, 2014.