The modest worth of big banks
What can we afford to do about the financial industry?
Jamie Dimon of JPMorgan Chase would have us believe that regulators’ attempts to clip the wings of financial companies are about as misguided as trying to curb spam by shutting down the Internet. To most Americans, a financial crisis that lopped $19.2 trillion off household wealth and produced the deepest recession since the 1930s may be reason enough to limit what financial institutions can do. Andrew G. Haldane, executive director for financial stability at the Bank of England, estimates that the crisis wiped out one to 3.5 years’ worth of the world’s economic output, in present value.
Bankers, however, still hold dear to the argument that financial innovation has driven prosperity over the last 50 years. In their view, new techniques — including the credit-default swaps and mortgage-backed securities at the center of the financial crisis — improved the industry’s ability to understand risk and distribute it among a more diverse group of investors, making credit more widely available. Tying the hands of finance in the name of risk reduction would, they contend, impose incalculable costs on society as a whole.
This view may seem out of place a couple of weeks after JPMorgan admitted it lost $2 billion, maybe $3 billion, on a bad bet on the price of corporate debt. Still, it deserves investigation: how much economic damage would be inflicted by limiting what financial leviathans can do? Put differently, what has our high-tech financial industry really done for the rest of us of late?
It appears that the answer is less than Mr. Dimon would have us believe.
Part of the problem is measuring what the financial industry does. It manages our savings, runs the payment system, offers financial advice, and lends to businesses and consumers. This is valuable. Effective credit allocation increases productivity. Performing these services requires banks to bear risk. For instance, banks use deposits that we can withdraw at a moment’s notice to finance long-term loans.
It is easy, however, to overstate what this is worth. Value added by the financial industry, its direct contribution to the economy, topped $1.2 trillion in 2011, according to government statistics. That’s 8.3 percent of gross domestic product, double its share of three decades ago. To paraphrase Goldman Sachs’s Lloyd C. Blankfein, this looks like God’s work on steroids.
But the measure is hopelessly flawed. Because banks’ output is measured by the interest they charge for credit, their contribution to the economy appears to increase when they take bigger risks at higher yields. By this measure, your Uncle Fred’s session at the slots in Vegas should count as G.D.P. Banks’ fast-growing contribution to the economy is an illusion, the mechanical result of a huge expansion in the risks they decided to take.
Banks borrowed hand over fist to finance their lending, juicing it with high-tech products and parking much of it in subsidiaries like special-purpose vehicles to evade legal limits on leverage. According to Mr. Haldane, at the peak of the financial bubble in 2008 large complex financial institutions in the United States (a group that includes JPMorgan) held assets amounting to 50 times their capital, on average. This means that for every $50 dollars in investment, they borrowed $49.
All this credit was great for big banks — whose return on equity rose in tandem with their leverage. In 1989, the chief executives of the seven biggest banks in the country made about 100 times the income of the typical American household, on average. On the eve of the crisis in 2007, they made more than 500 times the median.
But the lending was of dubious value to the rest of us. Economists know there is a point after which more lending stops helping and starts hurting growth. One study puts it at about 110 percent of gross domestic product. On the eve of the crisis, credit to the private sector in the United States reached 213 percent of G.D.P., up from 96 percent in 1982. And all we got was a mass of busted residential mortgages.
Banks didn’t just overdo the credit. A lot of high-tech finance just moves money around without increasing the size of the pie. High-speed trading may increase bankers’ fees, but its economic benefits are dubious. Financial technology allows banks to operate with less capital than regulators think prudent. And it helps firms avoid taxes. Rather than increase transparency and understanding, financial innovations like mortgage-backed securities and credit-default swaps cloud where the real risks are.
This is not to say that finance is useless. But there is no evidence that we need a financial industry of the huge size and complexity we have.
The economics suggest that big banks are less efficient at credit creation than smaller ones. And there is no evidence that the simpler financial system we had from the 1940s through the 1970s restrained growth. In fact, for all its innovation, the financial industry of today is less efficient than it was in the age of the railway, according to research by Thomas Philippon at New York University. That is, it charges the rest of society more for financial intermediation than it did 130 years ago.
Considering the evidence, regulators could at the very least remove the taxpayer subsidy that has paved the road for banks to become so big.
The knowledge that no government would ever allow a Citigroup or a JPMorgan to fail amounts to an enormous subsidy. It reduces the cost of capital of the biggest banks and gives them an edge over smaller rivals whose bankruptcy would not convulse the economy.
The subsidy to the world’s top 22 banks topped $1.2 trillion a year between 2007 and 2010, according to one study. It adds nothing to economic well being. But it provides an incentive for banks to bulk up: in 2008 three banks held some 40 percent of all the assets in the banking system, up from 10 percent in the early 1990s. And the system has become more concentrated since then.
Regulators are proposing two broad ways of curbing our megabanks. One is the Dodd-Frank financial reform’s attempt to forbid financial institutions from doing certain risky things. The Volcker Rule portion of the reform, for instance, would bar commercial banks, which take deposits from the public and are formally insured by taxpayers, from trading securities for their own account. Dodd-Frank forbids big commercial banks from investing more than 3 percent of their assets in hedge funds.
The other is to require banks and some other big financial institutions to raise a lot of capital to ensure they can endure severe shocks. If a bank borrows $9 to invest $10, it can lose at most $1 before going bust. If it only borrows $5 to make the $10 investment, it obviously can lose more. Banks with more capital will be more careful, because they have more skin in the game. They will have less incentive to grow to raise profitability.
Other options could be considered. Some people want to restore limits imposed in the 1930s and removed in the 1980s and 1990s, which barred commercial banks from engaging in investment banking activities. A more direct way to end the taxpayer subsidy would be to put a cap on the size of financial institutions, so we could afford to let them go bankrupt without risking the world. As the Bank of England head Mervyn King once said: ”If banks are thought to be too big to fail, then they are too big.” JPMorgan today has about four times the assets of Lehman Brothers when it failed.
Bankers have lobbied furiously against these restrictions. Mr. Dimon said new global capital requirements negotiated in Basel, Switzerland, are ”anti-American.” The Institute for International Finance — a lobby group for banks — said the restrictions would destroy 7.5 million jobs by 2015.
But what would really hurt the economy would be to let the restrictions be lobbied away. The capital requirements have been heavily diluted from what regulators first proposed, and banks still oppose them. Banks also demand enormous loopholes in the yet-to-be-completed Volcker Rule, proposed limits on derivatives trading and other restrictions.
Big banks’ steadfast opposition to the rules is understandable. If executed properly, the rules could cost them billions in foregone profit. For the rest of society, the benefits appear to outweigh the costs.
PHOTOS: A JPMorgan Chase bank in Manhattan. The institution has resisted attempts to impose more regulations on the industry. (PHOTOGRAPH BY EDUARDO MUNOZ/REUTERS); Andrew G. Haldane, a director at the Bank of England. (PHOTOGRAPH BY CHRIS RATCLIFFE/BLOOMBERG NEWS) (B4)
Late Edition – Final
By EDUARDO PORTER