Fed's Proposal on Merchant Banking

We at Better Banking Law have enjoyed the columns of Steven Davidoff Solomon, law professor at Cal-Berkeley, which have appeared periodically in the New York Times. For example, a fine piece was published just two days ago: "Public Companies See Gold in California".

However, the column published in the Times on September 13th, titled "Fed Proposes Ban on Merchant Banking, a Practice With Little Risk", was not well thought out and surprisingly one sided. It chided the Fed’s proposal and was written mostly from the perspective of the Too Big To Fail commercial banks, their lobbyists and law firms. He states that the Fed’s proposed ban is another step back to the Glass-Steagall Act, but neglects to mention that the Banking Act of 1933 (Glass-Steagall) created Federal Deposit Insurance in addition to separating commercial banking from investment banking. And that is why only Federally Insured commercial banks (not investment banks) were prohibited from engaging in merchant banking.

A couple of paragraphs later he states that these merchant banking limitations ended in 1999 with the Gramm-Leach-Bliley Act which ended Glass-Steagall, but neglected to note that the other section of Glass-Steagall, which created Federal Deposit Insurance, remains very much intact. He further states that the removal of this merchant banking stricture was uncontroversial at the time. The question is why would permitting Federally Insured bank holding companies to combine banking and commerce, an obvious conflict, not be controversial?

He follows these statements by quoting a trade group for bank holding companies and a law firm that represents commercial banks as being opposed to the Fed’s proposal. Their positions are predictable, but why not also quote sources that are concerned about future taxpayer bailouts of Too Big To Fail Banks, and thus supportive of the Fed’s proposal?

He then states the following:

"The reason for the industry’s exasperation is easy to see. Merchant banking is simply the practice of buying operating companies. The risk to a bank holding company is twofold. First, the bank could lose its money — as with any investment. Or second, it could be held liable for the debts of that company."

However, there is a third risk and that is potential conflicts. Does the bank holding company, which owns an operating company, favor it by extending loans on more beneficial terms over other companies it does not own? Furthermore, won't objective lending standards sometime be compromised in support of the bank's own investment?

The professor also shows concern that, under the Fed's proposal, an operating company may not benefit because a Federally Insured bank would not be an eligible investor. However, the Federal Reserve must certainly have weighed that issue in reaching its decision and one must wonder how in the world so much merchant bank financing was accomplished from 1933-1999, when Federally Insured banks were prohibited from making such investments. The nation did fine without them and there are many more eligible investors today, both individual and institutional, without resorting to funds from taxpayer supported Federally Insured banks.

The foregoing are some of Better Banking Law’s observations regarding Mr. Solomon’s September 13th column. The following is another response to his piece by Saule T. Omarova, a Cornell law professor, which appeared on the New York Times Dealbook website on September 19th, titled "Real Risks in Big Banks’ ‘Merchant Banking’ Activities". We at Better Banking Law find it compelling:

The Perfect is the Enemy of the Good - the article appears below as well.

Glass-Steagall has returned to contemporary debate, brought on by the platforms of both Democrats and Republicans calling for its re-enactment. While it seems more and more U.S. Citizens now realize the importance of Glass-Steagall, it unfortunately remains misunderstood and misrepresented by many. This includes, not surprisingly, the banks, their lobbyists, law firms, and sadly, much of the press, which has often naively parroted the opinions of the conflicted banks and their lobbyists. For this reason, though in a perfect world I would whole-heartedly support its re-enactment, in the actual world it may well be “a bridge too far.” Based on my experience and involvement with the Glass-Steagall controversy over the past 35 years, I must conclude that "the perfect is the enemy of the good".

My involvement began in the 1980's and continued in 1990, when I served as Chairman of the Securities Industry Association (SIA), whose membership at that time consisted overwhelmingly of investment banking firms, and only a handful of commercial banks. Following the financial crisis, I returned to my bank reform efforts by founding Better Banking Law - the purpose of which is to help enact meaningful Federal legislation, which would eliminate future taxpayer bailouts of banks or any other financial institutions.

As Chairman of the SIA some 25 years ago, I saw the handwriting on the wall when large, Federally Insured commercial banks were relentless in their desire to engage in the risk-taking that non-insured investment banks were permitted under Part II of Glass-Steagall. Part I of course was the creation of Federal Deposit Insurance, which necessitated the separation required under part II. Nevertheless, over the years commercial banks convinced their banking regulators to reinterpret the Glass-Steagall statute to permit them to engage in investment banking. In 1990, under my leadership, the SIA proposed Federal legislation which would have permitted separately capitalized investment banking subsidiaries of bank holding companies to compete with traditional investment banks, but only with very strong firewalls to prevent such subsidiaries access to Federal Deposit Insurance. It was called the SIA Plan. Though not providing as strong a separation as Glass-Steagall, it was another way to protect taxpayers, while maintaining a fair, safe and resilient financial system. An interview, published in 1990 in Investment Dealer’s Digest, articulates the plan put forward by the SIA, as well as my views on healthy bank reform.

One of the most encouraging bank reform developments is Sir John Vickers' ringfencing plan, which is now law in the UK. More on The Vickers Plan can be found on the Better Banking Law website. In the SIA Plan, where we used the term “firewalls” to segregate the riskier businesses from government insured deposit taking, they use the term “ring fencing” and they ring fence the retail bank rather than the investment bank, but the concept is the same.

We at Better Banking Law believe strongly that in the U.S., a similar, bipartisan solution is achievable.

It is one that avoids:

• Complex and costly regulation

• The moral hazard of To Big To Fail banks engaging in excessive risk-taking with an implicit government guarantee, which encourages privatizing profits and socializing losses

It is one that enables:

• Competition and innovation

• Failure as well as success (without a need for taxpayer bailouts)

• A balance of opinion on Capitol Hill from all types/sizes of financial institutions, including banks, investment banks, insurance companies and money managers

Further to this last point, why should these distinctly different businesses all continue to sing from the same hymnal? That was never the case when Glass-Steagall was the law of the land.

Finally, I make a strong case on the Better Banking Law website as to why our nation needs bank reform legislation and I welcome comments on how we can make a fair, safe and resilient financial system a reality.

Better Banking Law responds to "Are Big Banks Necessary?" by John Heltman on March 8th in American Banker

Neel Kashkari, the new President of the Federal Reserve Bank of Minneapolis, recently publicly expressed a view that big banks should perhaps be broken up to prevent a recurrence of the taxpayer bailout of 2008. In reaction, Mr. Heltman interviewed six big bank advocates and two supporters of Mr. Kashkari’s position. The big bank advocates Mr. Heltman quoted are as follows:

1. GREG BAER, president of the Clearinghouse Association and former executive of JP Morgan Chase and Bank of America;

2. KAREN SHAW PETROU, managing partner at Federal Financial Analytics;

3. TONY FRATTO, partner at Hamilton Place Strategies and former Treasury official in the Bush Administration;

4. DAVID HIRSCHMANN, president and chief executive of the Center for Capital Market’s Competitiveness at the US Chamber of Commerce; 

5. H. RODGIN COHEN, senior chairman at the Sullivan & Cromwell law firm; and

6. JOHN DEARIE, acting chief executive of the Financial Services Forum. 

The following supporters of Mr. Kashkari’s position quoted in the article are:

1. MARCUS STANLEY, policy director for Americans for Financial Reform; and

2. DENNIS KELLEHER, president of the public advocacy group Better Markets. 

Inasmuch as this reporting was published in the American Banker, perhaps it is not surprising that the 6 - 2 pro-big bank advocates vs. financial reform advocates ratio would be considered a fair fight. Nevertheless, a careful reading of the article demonstrates that Mssrs. Stanley and Kelleher more than held their own in the discussion. That is, they were given chances to respond to the stated pro-big bank positions until the very end of the article. However, at that point the reporter chose to end the article by quoting Mr. Fratto at length, giving him the last word with no opportunity for either Mr. Stanley or Mr. Kelleher to respond. The following comprise the final two paragraphs of the article:

Had the reporter permitted either Mr. Marcus or Mr. Kelleher to respond to Mr. Fratto, I imagine this is how they might have done so:

Mr. Fratto considers it unfair and problematic that the banking industry should require a formal cap on size inasmuch as no one is asking for similar caps on large firms engaged in aerospace, telecommunications or technology. But those businesses do not enjoy the benefit of either Federal Deposit Insurance or access to the Federal Reserve window in times of financial upheaval. Mr. Fratto must know that banks are vastly different from all other businesses in that respect.

Moreover, banks are far more heavily leveraged than the businesses of aerospace, telecommunications or technology. Banks have only 6-9% of their assets in the form of equity; the rest is all borrowed. Conversely, the other businesses mentioned are more likely to have at least 75% of their assets in equity with 25% or less in borrowed funds. Obviously Federally insured banks are very different from other businesses in this respect as well and, more fundamentally, banking and commerce have always been separate in America.

In Mr. Fratto’s second paragraph, he employs a colorful analogy, stating that after the Titanic hit the iceberg (it would have been wrong) to decide that there should be no more big boats. Obviously true. However, a better analogy was employed several years ago by John Reed, the former Citigroup CEO who, after many years of advocating for the repeal of Glass-Steagall, discovered how damaging that repeal was to the nation’s economy and changed his view entirely. Mr. Reed was quoted several years ago as follows: “I would compartmentalize the industry for the same reason you compartmentalize ships. If you have a leak, the leak doesn’t spread and sink the whole vessel.”

Additionally, here’s a quote from Mr. Reed’s recently released 2010 interview with the Financial Crisis Inquiry Commission, where he questioned the structure of combining retail and investment banking - basically, Citigroup’s entire model:

Finally, while Mssrs. Stanley and Kelleher have indeed provided excellent counter arguments to those of the big bank advocates, we at Better Banking Law have additional strong arguments which refute many of the assertions made by such big bank advocates and welcome your inquiries.

Better Banking Law responds to PIMCO's misguided assertions

In a recent FT article, PIMCO responded to Neel Kashkari's statement that the largest banks may need to be broken up, by stating that they think it is a bad idea. They make the following five assertions:

1. REGULATIONS ARE ALREADY HELPING. Better Banking Law does not disagree; however PIMCO goes on to state that several large banks have shrunk their balance sheets in recent years. But they neglect to say that, while one or two banks may well have done so, the fact remains that the four largest banks, as reported recently in the Wall Street Journal, in 2015 held $8.01 Trillion in total assets, which comprised 51% of all bank assets. Whereas in 2006, those same four banks held $5.18 Trillion of total assets, representing a mere 44% of the total. Some shrinkage!

2. A BREAK UP COULD PROMPT ANOTHER CREDIT CRUNCH. This is surely an odd argument, since it was the large universal banks that contributed in a major way to the financial crisis in '08 through their foolish underwriting of bonds backed by toxic mortgage assets and derivative securities thereof.

3. SMALLER BANKS ARE NOT NECESSARILY LESS RISKY. Better Banking Law has never asserted that small banks are not without risk. But when small banks have failed, the FDIC has very effectively dealt with those failures. However, when gigantic banks fail, FDIC funds become woefully inadequate and require, as in 2008, the bailout of such universal banks, to protect the nations economy. Furthermore, the smaller banks seldom deal in derivatives or other exotic financial instruments, which can lead and have lead to disaster.

4. BOND HOLDERS WOULD BE WARY OF NEW ENTITIES. At present, holders of the bonds of large US bank holding companies are unsure, due to BHCs complexity, just what the source of payment for their bonds may be. However, since all BHC bond holders were bailed out in 2008, such holders likely assume that the bank debt owed them will ultimately be paid by Uncle Sam. This moral hazard must surely end. BHC bond holders get significantly more yield than they earn on US treasuries, so why should such holders be bailed out again by the government?

5. THERE COULD BE A POTENTIAL INCREASE IN COUNTERPARTY RISK. After a breakup, a counterparty would be much more assured that a specific entity, which can be far better analyzed than the entire BHC, is responsible for its payment of its obligation.

PIMCO's final statement is as follows: "While further measures to encourage simpler and smaller balance sheets and operations may be needed, policymakers need to keep a close eye on their unintended consequences, no matter how politically appealing the measures may seem." Had this sentence not included the word "politically", it would have been fine. Sadly, with that word, the statement becomes a cheap shot. This issue is not political: it has to do with protecting taxpayers from a situation where, if things work out for the banks, their bondholders, stockholders and executives get the benefit. Whereas, if they fail, taxpayers are on the hook - as happened in 2008. Furthermore, to the extent politics is involved, the lobbyists and lawyers for the banks have far more access to Congress through their and the banks' own gigantic campaign contributions. Thus, the taxpayers become the only party without political representation in Congress.

Neel Kaskari's full speech "Lessons from the Crisis: Ending Too Big to Fail" can be viewed here.