Regular readers know that the solution is to require these banks to provide ultra transparency and disclose on an ongoing basis their global asset, liability and off-blance sheet exposure details.
Why ultra transparency?
Sunlight is the best disinfectant and most of the problems posed by these banks can be cured by sunlight.
Here are some of the problems sunlight solves.
Problem 1: Financial contagion.
With access as a result of ultra transparency to all the information needed to independently assess these banks, unsecured bank debt and equity investors become responsible for the losses on their investments.
Being responsible for losses on their investments gives investors an incentive to not having a greater exposure to an investment that the investor can afford to lose.
As a result, each bank limits its exposure to the other banks to an amount where any bank can fail without dragging down the other banks with it.
Problem 2: Too much risk.
With ultra transparency and the responsibility for absorbing losses, investors subject the banks to market discipline for the first time since the 1930s. Investors subject the banks to market discipline by linking the return they require on their investment in the bank to the risk being taken by the bank.
This market discipline provides an incentive for management to reduce business complexity (1,000s of subsidiaries involved in arbitraging regulations and taxes are subject to closure) and reduce the risk of their exposures (proprietary trading is out as it has an unfavorable risk/return profile when all market participants can see what bank is doing and trade against it).
Problem 3: Governments are obligated to bailout TBTF
Ultra transparency ends the bailouts that result from the moral hazard of governments recommending investment (see: stress tests that purport to show banks are solvent under extreme economic circumstances) in the banks. Investors can now do their own stress tests.
Problem 4: Excessive banker pay
Subjecting the banks to market discipline results in banks becoming much more like utilities that exist to provide the real economy with access to credit and payment processing that it needs.
While the banks will still make money, it will be done with a much more conservative risk profile and banker pay will reflect this.
While your humble blogger could go on about the problems that ultra transparency solves, US Attorney General Eric Holder's admission that some banks are Too Big to Jail creates a new problem.
While ultra transparency eliminates a bank's ability to manipulate a benchmark interest rate like Libor (the rate can be based off of actual transactions), it does not address a bank that wants to engage in money laundering for the drug cartels or terrorists.
What ultra transparency does do to help make banks prosecutable for these crimes is make it so the banks can fail as a result of being prosecuted for these crimes without bringing down the financial system or the economy.
Too big to fail.” .... it’s also the question that is proving hardest to resolve, as post-crisis efforts to prevent the financial system from another near-catastrophe continue.
Eric Holder, the country’s Attorney General, raised eyebrows nationwide as well as the blood pressure on Wall Street when he testified to the Senate Judiciary Committee Wednesday that he believes the size of the biggest global banks “made it difficult” to prosecute them for any misdeeds.
What happens, he asked, if levying criminal charges means jeopardizing the national or even the global economy?Ultra transparency ends this issue (see discussion of financial contagion above).
Even more alarming, perhaps, is his suggestion that the size – and thus the influence – of the big banks is so immense that Wall Street can ensure investigations never bear any fruit.
Too-big-to-fail banks, he said, may have “an inhibiting impact on our ability to bring resolutions” to situations that the government has investigated....Regular readers know that Jeff Connaughton wrote a terrific book on how Wall Street uses this influence to always win when it comes to legislation and regulation.
Ultra transparency works to counter-balance Wall Street's influence when it comes to bringing resolution for criminal matters.
Recall that under ultra transparency, investors are responsible for all losses on their exposures to the banks. This gives prosecutors tremendous leverage over Wall Street. Wall Street has to toe the line because investors know that they can be wiped out by criminal conduct.
Comments like Holder’s may add to the pressure to break up the big banks, but the authors of a new report published by the Milken Institute, a think tank, come down against such a move, in large part because there is no evidence that it would make the system safer or more manageable. There is, on the other hand, a risk that it would be a destabilizing process, they write in the report, entitled Breaking (Banks) Up Is Hard to Do.
Who decides what is too big? Or how a bank should be broken up?...That is one of the reasons that I like requiring the banks to provide ultra transparency. It is no longer a debate over questions like what is too big or how a bank should be broken up.
What limits the size and complexity of these banks is the risk that investors are willing to accept knowing that they are going to lose their investment if the bank fails. It is this limitation on risk that investors convey through how much they require to be compensated for taking on the risk of loss.
It is up to bank management to figure out how what is the best combination of size and complexity within the risk restraints applied by investors.
Of course, as the Milken Institute report points out, there is no way to determine in advance which kind of Wall Street institution will become a systemic threat.
The most serious threats to the financial markets previously had come from fraudulent accounting, or from flawed risk management at hedge funds such as Long-Term Capital Management.
The size of the institutions themselves was no determinant of how serious the threat became to the stability of the financial markets. Even in the case of Long-Term Capital, the fund itself was tiny compared to the banks.
What mattered was the leverage and counterparties involved.This is why transparency is the solution. Transparency forces each bank counter-party to limit its exposure to what it can afford to lose.
If it doesn't limit its exposure to what it can afford to lose, a bank can expect to be perceived as very risky and as a result have to pay a very high return to attract investors.
To the extent that a Wall Street institution is not only big but involved in every kind of financial transaction, the odds increase that it will be caught up in whatever kind of crisis erupts next....Again, ultra transparency puts a premium on banks limiting their exposures to what they can afford to lose. And it puts in place market discipline to enforce this.
It is the behavior of banks, not their size, that we should be focused on, and to that extent Holder hit the nail on his head in his testimony.
If the size of banks gives them the ability to fend off regulators or investigators, that’s far more of a threat to the system than anything else. Just look at the way that banks influenced policymaking in the years that led up to the financial crisis.
The goal here shouldn’t be for Washington’s policymakers to declare that any bank whose deposits top a certain percentage of the country’s GDP should be broken up.
Rather, they should be looking at whether the regulation is capable of reining in excesses and bad behavior, and holding bankers and other Wall Street participants – regardless of the size of their institution – responsible for their misdeeds. The purpose must be to ensure the stability of the system, not enshrine some hypothetical perfect size.