Wednesday, May 30, 2012

How Political Clout Made Banks Too Big to Fail

How Political Clout Made Banks Too Big to Fail

Political Clout Made Banks Too Big to Fail
Illustration by Jordan Awan
The U.S. has historically kept the financial sector in check through a combination of sound principles and serendipitous decisions. But as the financial system gained strength in recent years, it also gained political influence. In the last decade, it has become too concentrated and too powerful, which has damaged not only the economy but the financial sector itself.

How did it happen? In 1933, the Glass-Steagall Act erected a wall between two ways that banks could help customers borrow money. The idea was to keep commercial banks from exploiting their depositors, who might get saddled with the bonds of firms that could not repay the money they owed. One beneficial side effect of the Glass-Steagall Act was to fragment the banking sector and reduce the financial industry’s political power. Another was to foster healthy competition between commercial banks and investment banks.

Bank Concentration

Starting in the 1970s, these limits were progressively removed. The deregulation unquestionably increased the efficiency of the banking sector and fostered economic growth. But with this growth came concentration. In 1980, there were 14,434 banks in the U.S., about the same number as in 1934. By 1990, this number had dropped to 12,347; and by 2000, to 8,315. In 2009, the number was less than 7,100.
Most important was that the concentration of deposits and lending increased significantly. In 1984, the top five U.S. banks controlled only 9 percent of the total deposits in the banking sector. By 2001, that figure had increased to 21 percent and, by the end of 2008, to almost 40 percent.
This process of deregulation and consolidation culminated in 1999 with the passage of the Gramm-Leach-Bliley Act, which completely removed the separation between commercial banks and investment banks. The real effect was political, not economic, at least directly. Under the old regime, commercial banks, investment banks and insurance companies had different agendas, so their lobbying efforts tended to offset one another. But after the restrictions ended, the interests of all the major players aligned. This gave the industry disproportionate power in shaping the political agenda.
The concentration of the banking industry amplified this power. Consider the example of the 2005 bankruptcy reform: After more than 10 years of discussions in Congress, on April 20, 2005, President George W. Bush signed into law the Bankruptcy Abuse Prevention and Consumer Protection Act, which overhauled bankruptcy, especially personal bankruptcy.
Historically, the U.S. has been a pro-debtor country. This bias has made defaulting on credit-card debt relatively painless, and the percentage of Americans filing for personal bankruptcy has been high even during economic expansions. In 2003, for example, the percentage of adults filing for bankruptcy in the U.S. was 10 times higher than that in the U.K.
The 2005 reform was intended to discourage opportunistic filings by debtors who used bankruptcy to wipe out their debt even when they could afford to repay at least part of it. A reduction in opportunistic filings, it was thought, would lower the cost of credit for all Americans.
But a reduction in strategic defaults that is achieved by making all defaults (including nonstrategic ones) more painful might have negative implications by inhibiting risk taking by entrepreneurs, which would depress economic growth.

Strengthened Lobbying

Prior to the repeal of the Glass-Steagall Act, creditors seldom joined forces to lobby because they often had distinct interests. In the past, different kinds of lending were often carried out by different types of institutions. After the major consolidation that took place in the banking sector, though, a smaller number of entities performed all of these functions -- and for them, consensus was easier. The 2005 reform was dominated by the credit lobby and the National Consumer Bankruptcy Coalition. The result was a law that was entirely in favor of creditors.
The consequences were rapidly felt. Only eight months after the law was signed, house prices plateaued and then started to drop, straining the financial situation of many homeowners. In the pre-bankruptcy-reform world, distressed homeowners would have filed for personal bankruptcy, which would have allowed them to discharge their credit-card debt, making it easier to hold on to their houses. Under the new law, this option was no longer open. According to calculations based on a recent study, the 2005 reform increased the number of people defaulting on their mortgages by almost 500,000; and when a mortgage holder defaults and the house is auctioned off, on average it loses 27 percent in value. If we apply this loss to the average price of a house sold in 2005 ($290,000), we can estimate that the financial industry lost $39 billion as a result of bankruptcy reform.
Yet the reform’s strongest negative effect on the financial industry resulted from an arcane section of the bill that was little noticed at the time and that strengthened the rights of derivatives owners in bankruptcy cases.
The 2005 law, rather than requiring a derivatives holder to be paid back as much as possible with a bankrupt company’s assets, allowed the derivatives holder to pretend that nothing had happened at all. That means the derivatives holder got the right to receive a contract identical to the one it had signed before, but now with a different counterparty. The previous counterparty would shoulder the transaction cost of the new contract, which typically ranges from 0.1 percent to 0.2 percent of the contract’s face value.

Lehman Collapse

If this cost seems insignificant, just look at what happened with Lehman Brothers Holdings Inc. At the time it went bankrupt, the bank had derivatives contracts with a notional value (face value) of $35 trillion. At an average transaction cost of 0.15 percent, reintegrating those contracts amounted to $52.5 billion of extra cost. In other words, in addition to repaying its debt to derivatives holders before anybody else was paid, the Lehman bankruptcy estate had to spend an additional $52.5 billion on new contracts, reducing the payoff of all the other creditors by that amount.
Another reason that large banks are politically influential is that their demise can create a catastrophic disruption in the economy -- or so policy makers believe. Whether they are right is irrelevant.
Suppose a large asteroid is hurtling toward Earth and has a 5 percent chance of hitting us, creating $10 trillion worth of physical damage to the U.S. Should the president authorize a $700 billion mission to destroy the asteroid and stave off disaster? If you reason in purely statistical terms, the expected cost of failing to act (0.05 × $10,000 billion = $500 billion) is much less than the cost of acting.
But if the president spends the money to stop the asteroid, nobody will know whether it would indeed have hit the Earth, had he neglected to act. By contrast, if he does nothing, he has a 5 percent chance of going down in history as the president who knowingly failed to avoid catastrophe. Doesn’t the operation to destroy the asteroid suddenly look much more appealing? And, after all, the aerospace industry would be delighted to be paid to work on the mission. Perhaps because all of the experts would, directly or indirectly, benefit from the proposed mission, the public would start hearing that the chances of disaster are really 10 percent to 20 percent. With those odds, the $700 billion mission would make sense, both politically and statistically.
The circumstances that make policy makers succumb to the “too big to fail” doctrine are similar. An important difference, however, is that a Federal Reserve chairman’s resolve to bail out banks actually increases the likelihood of disaster, since the implicit promise to intervene has a perverse influence on the banks’ willingness to take risk.

Self-Fulfilling Prophecy

Worse, “too big to fail” creates a self-fulfilling prophecy: Shortsighted policy makers will always prefer the cost of a bailout to the cost of upsetting the market. As a consequence, the problem continues and expands. Anticipating government bailouts in case of emergency, lenders are willing to lend to large financial institutions very cheaply and without restrictions. The managers of these financial institutions find it attractive to borrow a lot and to take wildly risky gambles, because they can maximize their profits by doing so.
Unfortunately, the risky bets also maximize the probability that the government will have to intervene, as well as the cost to the government when it does. The value of this implicit government subsidy is estimated to be half of a percentage point of interest. Multiplied by the debt of the top 18 bank holding companies, it corresponds to a $34.1 billion subsidy per year.
By reducing the cost of credit for large banks deemed “too big to fail,” this subsidy also distorts competition, hampering small banks’ ability to compete. The result, naturally, is an increase in the number of big banks -- banks that may need to be rescued in the future.
(Luigi Zingales is a professor of entrepreneurship and finance at the University of Chicago Booth School of Business, a contributor to Business Class and a contributing editor of City Journal. This is the first of three excerpts from his new book, “A Capitalism for the People: Recapturing the Lost Genius of American Prosperity,” which will be published in June by Basic Books, a member of the Perseus Books Group. The opinions expressed are his own.)

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