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Riding the bank capital merry-go-round

by Robert Teitelman | Published September 13, 2011 at 1:24 PM

Again, the banks. What is a big bank? Public or private; a business or a utility? Or is it a kind of hybrid? How essential are big banks to the economy? These are actually moss-backed questions that have recurred at least since the '30s, but increasingly since 2008. But the explosive growth of the biggest banks since the '80s -- and, of course, their difficulties in the financial crisis -- have given them a real edge today.

On one hand, there is a widespread acceptance that the biggest banks do receive a market subsidy for their too-big-to-fail status; this hard-to-eradicate belief that the government would never allow a J.P. Morgan Chase & Co. or a Goldman, Sachs & Co. to fail -- no matter the resolution authority written into Dodd-Frank -- gives them a funding advantage over smaller competitors, not to say a stimulative injection of moral hazard. But it also nudges them into the ranks of government-sponsored enterprises, like Freddie Mac and Fannie Mae, now wards of the state. (This creates weirdly incoherent politics: Republicans were most opposed to the GSEs, but today attack "over-regulation" in GSE-like banks. This only works if you ignore the subsidy and TBTF, but you still quickly get mired in the populist narrative of bank bailouts.) On the other hand, the big banks defend their prerogatives using, ironically, a similar type of argument: that they are so large that they are essentially identical to the national interest. When J.P. Morgan's Jamie Dimon complains that the Basel III capital rules are "anti-American," he is essentially arguing a kind of Bush doctrine for international banking: Since the big banks are so important for economic growth, the government should do everything it can to make them more competitive against overseas rivals.

Dimon also takes another position, articulated a few months ago, that comes in the form of a question but taps a similar talking point: What proof does the Federal Reserve have that raising capital levels on American banks won't have a devastating impact on the real economy? Well, there's no empirical proof, as Ben Bernanke admitted, which makes the Fed look like it is putting the economy at risk over a mere theory. The fact that there's also no proof that the big banks are necessarily good for the economy doesn't come up, which suits Dimon's purposes. If J.P. Morgan's effect is negligible, then why doesn't the government leave it alone? And so around and around we go.

This intellectual shell game between banks as private and public entities has been occurring not only in the U.S., but in Europe and the U.K. Many of the same arguments were made in the U.K. in the months preceding the final Vickers Report, just released, which calls for higher capital levies for British banks and a ring-fencing of the consumer from wholesale businesses -- a sort of Glass-Steagall-lite. The British banks argued, exactly like their U.S. brethren, that you can't raise capital and drive through reforms while the economy is so fragile. (Why is the economy so weak? In part because the Cameron austerity budget, which had the unintended consequence of giving the banks an anti-reform argument. Around we go again.) That's just one the things that makes Dimon's "anti-American" comment so delicious. After all, some of his biggest rivals in Britain and the Continent are facing even more onerous capital levies than U.S. banks, and complaining about the exact same thing. This is regulatory arbitrage in action and an explanation for inaction: As long as there's one exception (Dimon points to Asia) that seems to escape the burden, the entire effort becomes suspect. Collective regulatory action then appears infinitely difficult, particularly in hard times. Basel III in this regard is not just anti-American, it's anti-Western.

Beneath all this is another confusion. The popular talking point on capital is the argument that higher capital will reduce profitability at the big banks, which will force them to reduce lending. Well, no -- not necessarily. Yes, profitability, defined as return on capital, will undoubtedly fall, but as Philip Stephens in today's Financial Times says, that's probably good, or at least safer. Banks that generate returns of 20% or 30% appear historically to be reckless banks. If we want a safer banking system, we're probably better off with somewhere around 10%. Will that reduce lending? Well, that depends. Falling returns will reduce share prices, which may (or may not) affect compensation within the bank. Lower share prices and smaller multiples will also give the banks a little less currency for expansion, via M&A, or for innovation. Is this good or bad systemically? Well, this could swing a variety of ways. The bank could try to use that capital effectively by lending more; or it could take on all kinds of other risks to try to boost returns. Some of this will depend on individual bankers and their boards; but whether big banks as a whole take a race to the bottom or to the top will depend upon the vigilance of outside monitors: shareholders and regulators. Scary.

The problem for bankers like Dimon or Barclays' Bob Diamond is that both are walking narrow tightropes. Their banks came out of the crisis larger and more diversified than before; neither was engaged in the strategies that almost sank the global financial economy. But to defend themselves, they have to quickly shuffle between their national importance as a class of institutions (big universal banks) and their individual rectitude and skill (look how well we at least have done). Eventually, they find themselves making almost the exact same argument as their critics: that they are essential to the economy and the nation. Dimon and Diamond -- separated at birth? -- both make competitiveness arguments; both claim regulators are threatening the recovery; both point to their records. But for all their success, both of them also cannot escape the fact that their big-bank peers, from Bank of America and Citigroup to Royal Bank of Scotland and Northern Rock, not only ran into serious trouble requiring state aid (or in RBS' case a state takeover), but are now talking, as Brian Moynihan at BofA is, of significantly downsizing. All of which raises the ultimate question: Should any big bank remain exceptional? Now I'm dizzy. - Robert Teitelman

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