Regulation & the Roosevelts

We highlight JP Morgan Chase & Co. (JPM - Analyst Report), Morgan Stanley (MS - Analyst Report), Citigroup, Inc. (C - Analyst Report) and Bank of America Corp. (BAC - Analyst Report).

Some of the most far-reaching reforms of the New Deal were the financial regulations that FDR put into place. Conceptually, one can think of them as a three-legged stool.

The first regulation effectively said that investors have to have good (and fair) access to information. This is the essence of what the SEC is all about. Firms need to publish annual and quarterly reports (10-K's and 10-Q's) so investors can see the balance sheets and income statements. People with special access to information should not be allowed to profit from it at the expense of other market participants (i.e. no insider trading or front-running). Conflicts of interest need to be disclosed.

There is much more that the SEC does (or is supposed to do), but most of these fall in the general category of making sure that accurate information is available to investors. As the market has changed, the sorts of information that investors need changed. Unfortunately, the SEC was not able (or willing) to keep up. This is particularly true with respect to derivatives.

The second leg of the stool was that if you put your money in the bank, it is safe. That is why the FDIC was created. This meant that bank runs would be minimized. The Federal Reserve also plays a role in this regard, and its authority to lend to illiquid banks predated the Depression -- but it was not aggressive enough in using its authority in the early 1930's. The Fed can lend to illiquid institutions and thus provide the cash needed to pay out depositors during a run without the bank having to shut down, but it is much better to prevent bank runs in the first place.

If people know their money is safe in a bank, they will not rush to take it out at the first rumor of trouble. The FDIC is funded by insurance premiums the banks pay based on the amount of insured deposits they have. If a bank got into trouble, the FDIC would come in and usually find another bank to take over the deposits (which are bank liabilities) and most of the assets, and sell off the rest -- doing so in the "least costly" manner possible.

The final leg of the stool was that if the money in the bank was insured, the bank would not be able to run off to Vegas with it. Banking would be a very conservative -- boring, almost -- public utility-type business. Banks would not be allowed to take major risks with depositors money. This meant that for a half a century we had what was referred to as 3-6-3 banking. Bankers would take in deposits at 3%, lend them out at 6%, and be on the first tee by 3 PM.

Yes, risk-taking is a very important part of the economy. However, those risk-taking activities needed to be kept separate from that boring conservative world of commercial banking. As a result, Congress passed the Glass-Steagall Act. This required for example, for the "House of Morgan" to be broken up into a Commercial Bank, J.P. Morgan (JPM - Analyst Report) and a separate Investment Bank, Morgan Stanley (MS - Analyst Report).

Starting in the mid-1990's, all three of these pillars started to be eroded. The SEC was specifically prohibited from regulating many derivatives by the Commodity Futures Modernization Act of 2000. It looked the other way when banks and investment companies created Special Purpose Vehicles (SPVs) which distorted the true nature of the balance sheets of many large financial institutions.

It came to believe that markets tended to be self-regulating, and thus it could spend much of its time looking for minor paperwork infractions. Occasionally it was prodded into action by more aggressive oversight by State Attorneys General (i.e. Eliot Spitzer in the wake of the Dot.com bust), but generally it took a hands-off approach, particularly during the first eight years of this century.

Under pressure from the bank lobbies, Congress decided to limit the size of the insurance fund at 1.25% of insured deposits. This meant that for several years, banks did not have to contribute much to the fund. Clearly this was a mistake. Last year, 25 banks failed, which drove the insurance fund down to 0.40% of insured assets at the end of 2008 from 1.22% at the end of 2007.

So far this year 32 more banks have failed. We do not yet know how big the fund was relative to insured deposits at the end of the first quarter, but it is safe to say that it is well below 0.40%. Normally the low level of reserves in the fund would lead them to charge higher premiums to banks to replenish the fund, but that would mean sucking money out of the banks at a time when we are trying to recapitalize them. The FDIC did suggest a special assessment of $27 billion on the banks to shore up the fund but it got shot down by the bank lobby and the bankers' friends in Congress. Instead, the FDIC has asked that its line of credit at the Treasury go to $500 billion from the current limit of $30 billion.

Glass-Steagall was pretty much a dead item by the time it was formally repealed in 1999. The biggest exemption from the rules that was granted was allowing Citibank to buy Travelers Insurance creating Citigroup (C - Analyst Report). The Secretary of the Treasury at the time, Robert Rubin, ended up as Vice Chairman of Citigroup. Clearly he benefited from that exemption and the subsequent repeal of the Depression Era law that kept the system stable for so long. The rest of the country, not so much.

As the financial crisis hit, the response was mostly ad-hoc. The only port in the storm resulted in the country moving even further away from the idea behind Glass-Steagall. J.P. Morgan took over Bear Stearns and Bank of America (BAC - Analyst Report) bought Merrill Lynch. In the process, the "too big to fail" institutions became even bigger.

This brings us to the other Roosevelt, Teddy. He recognized that if companies got too big, they could act in ways that hurt consumers. Also that concentrations of that much wealth in one place are dangerous to Democracy. U.S. antitrust laws came about due to late-nineteenth-century hostility toward large corporations. However, enforcement has been focused less on size than on specific anti-competitive practices.

The Sherman Act of 1890 prohibited collusion among companies to constrain freedom of trade, for example price fixing. The Clayton Act of 1914 went further in specifying anti-competitive practices, such as bundling or mergers that create excessive concentration in an industry (you don't need to collude to fix prices if you simply buy out all your competition).

Starting with the Reagan Revolution, but continuing even under the Clinton Administration, antitrust enforcement by the Department of Justice has become very tolerant of size and concentration. At times it has focused instead on whether mergers will benefit or harm consumers. During the last eight years it has been almost non-existent, since almost by definition an anti-trust action is interfering with the markets.

Under the last administration in particular, but generally since 1980, there was a strong presumption that the market was always right and could not make a mistake (or if one were made it would be self-correcting). The feeling was that economies of scale would lead to greater efficiencies and thus benefit consumers, as much or more than concentration would hurt consumers by limiting competition, allowing firms to jack up prices. It seems clear that there are limits to economies of scale, and at some point firms, particularly financial firms, simply become too large and complicated to manage effectively.

Lost in this was the idea that excessive concentrations of wealth will lead to excessive concentrations of power, particularly political power. With the defeat of the mortgage cram-down legislation last week, can anyone doubt the political clout that the banks have, even after they have been bailed out by the taxpayers to the tune of hundreds of billions?

One of the highest return-on-capital investments out there is spending money to get the rules changed in your favor. While we have thousands of banks, we really have only a handful that are really significant. The top 19 banks that are going through the "stress tests" are the ones that really count, and not even all of them are really that important.

Still, the level of concentration among the banks is not big enough to trigger the rules under the Clayton Act. Financial institutions should be treated as a special case, but there is probably a need for new anti-trust legislation to do so. We cannot afford to let any of the big banks fail, particularly any of the Big Six. If they cannot be allowed to fail, they are very difficult to control. They can take on excessive risks knowing that if the bet pays off, they win, but if the bet goes bad, the taxpayer will pay.

Financial institutions that are too big to fail need to be broken up into smaller firms, each large enough to benefit from economies of scale, but none large enough to threaten the entire world economy if they were to fail. If we don't do something then we will face the same problems again, perhaps not tomorrow or next year, but in a decade or so. Never again can we let banks grow to the point that they are too big to fail.

We need to make banking boring again. Separate out the casino from the public utility-type functions of a bank. Make each of the banks much smaller. The world will be much safer if, once again, bankers can get in a full 18 holes before dinner.