Monday, October 22, 2012

Representative Brad Miller: 'the right way to break up the big banks'

In a Bloomberg column, Representative Brad Miller argues that the right way to break up the big banks is to make each of its subsidiaries a stand alone entity with, among other items on the list, its own board of directors, assets and capital.

He asserts that this would help the market exert discipline on the big banks.

Unspoken, but underlying his argument, is the idea of bringing ultra transparency to each of the bank's subsidiaries.

The only way the market can know what the assets and liabilities of a subsidiary are is if the banks are required to disclose them.  Specifically, if the banks are required to disclose on an ongoing basis for each of their subsidiaries their current global asset, liability and off-balance sheet exposure details.

As your humble blogger has said repeatedly, it is only when the market knows what the assets and liabilities of a subsidiary are that market participants become responsible for all gains and losses on their exposures to the banks and their subsidiaries.

Market participants become responsible because they have access to all the useful, relevant information in an appropriate, timely manner for making a fully informed investment decision.  As a result, under the principle of caveat emptor in the FDR Framework, market participants have an incentive to use this information to assess the risk of the banks and their subsidiaries.

Since the market participants are responsible for absorbing any losses, they have an incentive to adjust their exposure to reflect the risk of the banks and their subsidiaries and the market participant's ability to absorb any losses given the risk.

Regulators already have the power to cure many ills of too-big-to-fail banks....
Requiring the banks to provide ultra transparency is at the top of the list of unused power.
The nine biggest bank holding companies together have almost 20,000 subsidiariesJPMorgan Chase & Co. (JPM) has 3,391 subsidiaries;Goldman Sachs Group Inc. (GS) has 3,115; Morgan Stanley (MS) has 2,884; Bank of America Corp. has 2,019; and so forth. Each of the seven biggest bank holding companies has units in at least 40 countries. Goldman Sachs has 1,670 subsidiaries abroad. 
Lehman Brothers Holdings Inc., with about 8,000 units, left them all in the shade. 
More subsidiaries are apparently not an indicator of better management.....
Regular readers know that there are two primary reasons for all these subsidiaries:  create opacity and arbitrage rules and regulations.
Bank holding companies create subsidiaries for tax or regulatory purposes, but rarely to limit liability, the usual reason for creating corporations. 
The liability of a corporation is limited to the assets of the corporation where the corporation meets certain legal requirements. .... The assets of the corporation must be kept separate, rather than commingled with those of others. The capital of the corporation must be reasonably adequate for its business. 
Most important, the corporation must present itself as a separate entity, so any business partners know its obligations will only be satisfied by that corporation’s assets.
In practice, bank holding companies’ subsidiaries do little of that. The holding companies operate as a single enterprise with consolidated management and a common pool of capital and liquidity. 
In short, each of the megabanks is just one big sloppy mess of an enterprise, with every subsidiary on the hook for the liability of the parent corporation and all of the siblings. The megabanks regard that as a virtue....
Imagine how much opacity it created that makes it impossible for regulators or market participants to figure out exactly how much risk the banks are taking.
That is a nightmare for bank supervision. 
A regulator has no realistic way to assess the risk posed in thousands of subsidiaries engaged in all manner of businesses with unlimited liquidity, and the experience of American International Group Inc. teaches that the liability of one relatively small subsidiary can matter.... 
It is for this reason that I have been recommending ultra transparency.

Market participants have the resources and capabilities to assess the risk hiding in each of these subsidiaries.

More importantly, because they are on the hook for any losses, market participants have an incentive to exert discipline on the banks to reduce their risk and the number of subsidiaries.
Market participants cannot realistically assess the assets and liabilities of a megabank any more than a regulator can.
Market participants cannot realistically assess the assets and liabilities of a megabank because of a lack of ultra transparency, not a lack of resources, expertise and incentive to do the job if they had the data.

Even though regulators have access to the necessary data, they fail to realistically assess the assets and liabilities of a megabank.  This is a reflection of regulatory capture as well as the structure of the regulators (need to speak with one voice even when there is dissenting opinion) and the monitoring of regulators by politicians.
They assume that megabanks are still too big to fail, so they will get paid one way or another. If market participants knew they could be paid only from the assets of the specific subsidiary with which they did business, they would consider that subsidiary’s assets and potential liabilities. 
The reason that market participants 'assume' they will get paid one way or another is because they are not provided with all the useful, relevant information they need in an appropriate, timely manner through ultra transparency so they can make a fully informed investment decision.
That diligence is part of “market discipline,” a drastic change from the unlimited liquidity for every line of business. Governor Tarullo really should consider requiring stand-alone subsidiaries under existing law, just in case Senator Brown’s and my bill hits a snag.
Governor Tarullo, Senator Brown and Representative Miller should focus on making sure the banks provide ultra transparency.

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