Five years after being bailed out by the federal government, the U.S. banking system hasn’t merely recovered from the financial crisis that brought it to the brink of collapse. It is generating record profits—the sorts of figures usually associated with oil giants like ExxonMobil and Royal Dutch Shell. During the past twelve months, for example, JPMorgan, the country’s biggest bank, has earned $24.4 billion in net income.
From one important perspective, that is good news. To some extent, the financial success of the banks reflects the continuing recovery in the economy at large. With the rate of loan defaults falling, the housing market recovering, and businesses expanding, the banks’ traditional lending and mortgage businesses have been doing very well—at least until the recent increase in interest rates, which has put a bit of a damper on applications for mortgage refinancing.
But the remarkable rebound in the financial sector isn’t quite what it appears. Despite all that has happened since 2008, banking remains a very peculiar business—peculiarly cosseted, peculiarly financed, and peculiarly risky. Indeed, its current prosperity reflects not just the over-all economic recovery but the persistence of many of the factors that got us into the financial crisis in the first place: an emphasis on trading rather than lending, a high degree of leverage, and implicit subsidies from the taxpayer.
Let’s begin with trading. In the aftermath of 2008, there was much talk of banks getting back to basics, which meant concentrating on lending to businesses and households, and jettisoning many of their investment bankers, whose generously remunerated antics had helped to bring on the financial crisis. Some big banks have done this. Mostly, though, they have been overseas institutions, such as Union Bank of Switzerland and Lloyds TSB. Here in the U.S., setting aside Wells Fargo, which has always been a special and estimable case, the megabanks have continued to rely on trading and investing in securities for much of their income. In the latest quarter, Citigroup’s investment-banking arm generated more than sixty per cent of the bank’s net profits, and JPMorgan’s investment bank generated more than forty per cent of the firm’s net profits.
A second common theme in the aftermath of the crisis was that banks, in order to be able to withstand future shocks, needed to build up their capital buffers and borrow less money. (It often surprises people who don’t know much about banking to hear that banks, whose primary role is to lend, also borrow vast sums of money and build up huge debts, but they do. In 2008, it was the difficulty banks encountered rolling over their debts that almost caused them to collapse.) Timothy Geithner, the former Treasury Secretary, was one of the main proponents of raising capital levels and reducing leverage ratios. Rather than breaking up the banks or curtailing their more perilous activities, Geithner argued, the key was to make them more resilient. More capital was the answer, I recall him saying on numerous occasions.
In the past few years, the big U.S. banks have certainly improved their capital positions, largely by retaining some of the vast profits they have been making. But even now they don’t have nearly enough capital to rule out a repeat of 2008, a point acknowledged last week by the big-bank regulators—the Federal Reserve, the Federal Deposit Insurance Corporation, and the Office of the Comptroller of the Currency—who are belatedly urging the megabanks to keep their leverage ratios to a maximum of twenty to one. (Under this standard, for every hundred dollars that a bank lends out or invests in securities, it would need to have five dollars in capital or equity.)
If you think that figure still sounds high, you are right. Most big nonfinancial companies maintain a leverage ratio of about one to one: their liabilities are half equity and half debt. Some of the most successful corporations, such as Google and Apple, hold hardly any debt at all. Banks have always argued that they are different, and to some extent this is true. One of the things they do is take out short-term loans from other financial institutions and use the proceeds to extend long-term loans to their customers, or purchase long-term bonds—a process known as “maturity transformation,” which helps finance industrial and residential investment. But in recent decades, the banks have taken lending and leverage to extremes, leaving them acutely vulnerable to shocks.*
The reason for this isn’t hard to find. Banks, in limiting the amount of capital they hold and financing most of their activities by accumulating debts, are able to ramp up the rate of returns that they earn on capital (or equity). This trick tends to boost their stock prices, as well as the value of their executives’ stock options. But, as the economists Anat Admati and Martin Hellwig point out in their important book, “The Bankers’ New Clothes: What’s Wrong with Banking and What to Do About It,” it also makes banks more likely to get into trouble and need bailing out again. “Whatever else might be done, significantly reducing the reliance of large banks on borrowing is the most straightforward and cost-effective approach to crisis prevention,” Admati and Hellwig write. “Current and proposed regulations go in the right direction, but they are far from sufficient and have serious flaws. This situation represents the success of bank lobbying and the prevalence of flawed arguments … in the debate.”
Officially, of course, there is no prospect of another big bank bailout. As part of the reforms enacted after 2008, the federal government was given the power to wind down any large financial institution, even a non-bank, that gets into trouble, without calling upon the taxpayer. But the official position isn’t the reality. If a bank such as JPMorgan, which has more than $2.4 trillion in assets and transacts with tens of thousands of other firms, was on the verge of collapse, it is virtually inconceivable that the government would allow it to go under. The same goes for Goldman Sachs and Morgan Stanley, the two remaining big independent Wall Street investment banks.
One of the many ironies of government’s response to the crisis is that it accentuated rather than resolved the too-big-to-fail problem. By encouraging further consolidation in the financial industry—at Washington’s behest, Wells Fargo acquired Wachovia, Bank of America took on Countrywide and Merrill Lynch, and JPMorgan bought the remains of Bear Stearns—and issuing commercial-banking licenses to Goldman and Morgan Stanley, which guaranteed them access to the Fed’s emergency-lending facilities, the government created an élite group of banks that can raise money cheaply, because everybody knows they are backstopped by the taxpayer.
And this isn’t the only way that recent policy actions are helping boost bank profits. In holding short-term interest at close to zero per cent for years on end, the Fed has effectively handed the banks a license to print money, and that license is being partly financed by bank depositors. Through borrowing on a short-term basis and investing the proceeds in long-term Treasuries or mortgage bonds, the banks can pocket a generous “spread,” which is precisely what they have been doing. And because the Fed has explicitly stated that it won’t raise interest rates until the unemployment rate comes down to 6.5 per cent, and perhaps not even then, the trade carries little immediate risk.
Helping the banks isn’t the Fed’s primary aim, of course. Ben Bernanke’s monetary policy was designed to stimulate the over-all economy, and it’s had some success, particularly in the housing market. But one of its side effects has been that some of the very institutions that brought about the financial crisis have received an implicit subsidy. In this way, as in many others, the old rule for banks still applies. Heads they win; tails we lose.
* Leverage ratios are tricky things. According to the banks’ own numbers, which reflect their choices of what is counted as capital and something called “risk weighting,” their leverage ratios are already pretty low—in some cases, under ten. But these numbers are unreliable. Using definitions agreed upon in the international Basel agreement for regulating banks, the research firm Keefe, Bruyette, & Woods figured that Citigroup, JPMorgan Chase, Goldman Sachs, and Morgan Stanley all have leverage ratios of more than twenty, which is the U.S. government’s new target. (The study was reported in the Wall Street Journal.) Only Wells Fargo (13.7) and Bank of America (19.6) meet the target. To be sure, the American banks are less leveraged than many of their European counterparts, something they frequently point out. But that’s hardly reassuring. It was largely because many European countries allowed their banks to get so big and undercapitalized that they are in such serious trouble.
Original Article
Source: newyorker.com
Author: John Cassidy
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