Saturday, July 20, 2013

The Volcker Legacy: Too Big to Fail

Most people associate Paul Volcker with his role as the chairman of the Federal Reserve when inflation was defeated in the early 1980s.  For that, he deserves all the kudos he receives.

Few people associate Paul Volcker with his role as the chairman of the Federal Reserve and through his leadership of bank supervision and regulation creating the concept of Too Big to Fail banks.

However, it is the creation of Too Big to Fail banks that our current financial crisis has shown is his most important, lasting legacy.

In a very interesting American Banker article, Francine McKenna discusses how Continental Illinois was the first Too Big to Fail bank.  The collapse of Continental Illinois was the result of opacity that hid from the market what a combination of irresponsible lending, self-interest, hot money and lack of restraint by the Fed was allowing to be done to a bank that faced no market discipline.

In a related article, Ms. McKenna lays out the lack of regulatory restraint on banks and the adoption of the Too Big to Fail policy.

“The Congressional testimony of the OCC’s Conover in September 1984 also mentioned that the OCC had considered earlier whether it should have taken action much sooner to stop Continental from growing so quickly and, in hindsight, so recklessly.  
Conover testified that he believed such action would have been inappropriate but that the OCC could have placed “more emphasis on . . . evaluation and criticism of Continental’s overall management processes.” 
Federal Reserve Board Governor Charles Partee is quoted in William Grieder’s 1987 book “Secrets of The Temple” saying: “To impose prudential restraints is meddlesome and it restricts profits. If the banking system is expanding rapidly, if they can show they’re making good money by the new business, for us to try to be too tough with them, to hold them back, is just not going to be acceptable.” 
If that’s not enough foreshadowing of the policy prescription the Federal Reserve would deliver during the 2008 financial crisis, here’s Conover again during his testimony explaining to Congress why everyone but shareholders was made whole in the Continental Bank bailout: 
“…had Continental failed and been treated in a way in which depositors and creditors were not made whole, we could very well have seen a national, if not an international, financial crisis, the dimensions of which were difficult to imagine. None of us wanted to find out…” 
The day after Conover’s testimony, the Wall Street Journal published an article by Tim Carrington, “U.S. Won’t Let 11 Biggest Banks in Nation Fail—Testimony by Comptroller at House Hearing Is First Policy Acknowledgement”.
By the mid-1980s, Too Big to Fail had become the policy of the Federal Reserve and other bank regulators.

Regular readers know that I have written extensively about the Loans to Less Developed Countries crisis as it was the next step on the evolution of the concept of Too Big to Fail banks.  This crisis was very important for two reasons:

  1. It cemented into the regulatory culture the notion that if the regulators and the Too Big to Fail banks "hid" the true extent of the losses at these banks, the market would go on as if the losses did not exist.
  2. It drove monetary policy as the Fed, after informing the banks, chose to cut interest rates in an effort to generate earnings that could be used to recapitalize these institutions.
A little background is necessary to understand these conclusions.

Walter Wriston, a former chairman and CEO of Citicorp, said that "people go bankrupt, but countries don't".  Based on this observation, the large US banks plunged into lending to Less Developed Countries.

Of course, Mr. Wriston was wrong.  Countries do go bankrupt and this point had become obvious by the mid-1980s.  

Unfortunately, by the time this point was obvious, the exposure of the large US banks to the Less Developed Countries was multiples of their book capital levels.  A fact that was well known to market participants as banks disclosed the level of their exposures to the Less Developed Countries.

In fact, the general magnitude of the losses on these loans was also known to the market as predecessors to Bloomberg reported the prices at which the Loans to Less Developed Countries traded. When a Less Developed Country's loans trade at fifty cents on the dollar, it was a pretty safe bet that the value of the loans held by the banks reflected this pricing.

So the question that the Fed as the lead regulator for the Too Big to Fail banks faced was do we require the banks to write down their loans to Less Developed Countries upfront to reflect current market valuations or do we engage in regulatory forbearance and let the banks engage in extend and pretend and bring the losses slowly through their income statement as they generate earnings?

The Fed chose regulatory forbearance and the idea of "hiding" the actual magnitude of the losses from the market.

Please note, the market had a very good idea of the size of the losses, it just did not know the exact amount of the losses.

When John Reed at Citicorp eventually recognized the losses on the Less Developed Country loans, the market responded by bidding up Citicorp's price.  The write-off confirmed the market's conclusion about the size of the losses.

The Fed mistakenly believed that the fact the market had not collapsed when it became obvious the banks were insolvent and the subsequent positive reaction by the market was an endorsement of its policy choice.

The market didn't collapse because there was sufficient transparency into each of the Too Big to Fail banks to determine a) the general magnitude of loss and b) whether the bank's net interest income was greater than its ongoing operating expense after adjusting for the income actually generated by the loans to Less Developed Countries.

The Fed's policy response set another precedent.

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