Too big to fail becomes too big to regulate
By Larry Doyle
Excerpt is from In Bed with Wall Street by Larry Doyle. Copyright © 2014 by the author and reprinted by permission of Palgrave Macmillan, a division of Macmillan Publishers Ltd.
Dodd Frank also gives regulators a variety of mechanisms they can use to channel political policy through the dominant institutions. The partnership works in both directions: special treatment for the Wall Street giants, new political policy levers for the government.
—David Skeel, S. Samuel Arsht Professor of Corporate Law, University of Pennsylvania Law School, The New Financial Deal: Understanding the Dodd-Frank Act and Its (Unintended) Consequences.
After 2008, the number of brokerage houses on Wall Street significantly diminished. No longer did the names Bear Stearns, Lehman Brothers, Wachovia, Countrywide, Washington Mutual, and Merrill Lynch represent single- standing entities. While most of these houses were taken over by other firms at the behest of Uncle Sam, the fire that engulfed the house of Lehman threatened all the other financial houses and the world economy were it not for the liquidity of Uncle Sam’s bailout.
The Wall Street landscape was greatly changed. In order to appreciate how business operates among the remaining houses, we need to understand the dynamics of a sparsely populated neighborhood.
Not long ago, Wall Street had far more houses than just those that fell in the crisis. The truth is, there have been
an extraordinary amount of takeovers and consolidations on Wall Street over the last few decades. In the process, many legendary houses have been relegated to little more than footnotes in Wall Street lore: A.G. Becker; Alex Brown; A.G. Edwards; Bankers Trust; Dillon Read; Dean Witter; Donaldson, Lufkin & Jenrette; Drexel Burnham; E.F. Hutton; First Boston; First Union; Greenwich Capital; Hambrecht & Quist; Kidder Peabody & Co.; Kuhn, Loeb & Co.; Irving Trust; Montgomery; Nations Bank; Paine Webber; Prudential Securities; Robertson Stephens; Salomon Brothers; Shearson; Swiss Bank; Warburg; Wertheim; and more.
If you walk down Wall Street now, what do you see? For an industry that once boasted a wide array of large, medium, and small houses, Wall Street now is dominated by a handful of megabanks, including Goldman Sachs, JPMorgan Chase, Citigroup, Bank of America, Morgan Stanley, and Wells Fargo. Foreign houses include Barclays, Deutsche Bank, Credit Suisse, Royal Bank of Scotland, HSBC, and Union Bank of Switzerland. Although there are plenty of other houses that operate within the financial markets, these sprawling firms can flex their muscles and exert uncommon, if not unhealthy, influence.
If Wall Street was once the embodiment of free market capitalism, the new neighborhood is nothing short of an oligopoly—that is, a system in which markets are dominated by a small number of firms. Typical behaviors often witnessed within an oligopoly include:
- Price controls, periodic bouts of collusion, and market manipulation.
- Barriers to entry are kept very high.
- Firms can retain abnormally high profits long term.
- Firms can and will hoard and withhold information and knowledge.
- Those individuals and institutions outside the system do not have access to the information and knowledge and pay the price literally and figuratively in the process.
- A high degree of interdependence among the firms.
- Conflicts of interest are accentuated as opportunities arise to deal in a proprietary manner as opposed to engaging in customer-related business.
Not exactly a healthy system for anyone outside of the inner circle. An oligopoly is also not ideal for investors and consumers. Away from Wall Street, we also see oligopolies at work within aircraft manufacturing, media, wireless communications, film and television production, oil and gas, and the mining of selected metals. While Wall Street certainly had oligopolistic tendencies well before the recent crisis, the trend has sharply accelerated in the last few years. In fact, as the government has looked to help the banking system recapitalize itself, there is no doubt that the megabanks have taken advantage of the less competitive marketplace. Just consider the following evidence:
- Numerous quarterly reporting periods in which the large banks have literally generated profits each and every day. These perfect scores, so to speak, were unheard of under normal market conditions.
- Exceptional collateral demands made by the banks of their customers engaging in derivatives transactions. As highlighted by Bloomberg: “Goldman Sachs Group Inc. and JPMorgan Chase & Co., two of the biggest traders of over-the-counter derivatives, are exploiting their growing clout in that market to secure cheap funding in addition to billions in revenue from the business. . . . ‘If you’re seen as a major player and you have a product that people can’t get elsewhere, you have the negotiating power,’ said Richard Lindsey, a former director of market regulation at the U.S. Securities and Exchange Commission who ran the prime brokerage unit at Bear Stearns Cos. from 1999 to 2006.”
- Investment banking fees for underwriting activities, mergers and acquisitions, and advisory work are high, and often the work presents conflicts of interest for firms that maintain both proprietary investment and trading operations.
- The disingenuous manner in which the large banks engaged homeowners attempting to modify their mortgages. The mortgage servicing arms of these large banks are supposed to work on behalf of homeowners and investors. Illicit practices by servicers across the industry, including the robo-signing of mortgage documents within foreclosure proceedings, gave the appearance of collusive racketeering and led to multi- billion dollar settlements.
- The ability for the megabanks to utilize their competitive advantage from the implied government- subsidized “too big to fail” funding of operations allows them to squeeze other firms right out. This lessened competition yields higher transaction costs across a wide array of products for investors and consumers alike. Across virtually every line of business on Wall Street, from trading to consumer lending, we are seeing profiteering from collusive type pricing. In certain circumstances, such as the manipulation of overnight interest rates (e.g., Libor) that was widely exposed in 2012, the collusion was clearly illegal. In other instances, such as the ongoing exorbitant interest rates on credit cards, the practices were technically legal, but the end results (outsized profits and little competition) were very much the same.
After the bailout, the once “too big to fail” banks sitting high atop the hill on Wall Street have now only gotten that much bigger:
- The four largest mortgage originators (Wells Fargo, JP Morgan Chase, U.S. Bancorp, and Bank of America) now write approximately 50 percent of the home mortgages in our country. The largest originator, Wells Fargo, has approximately 30 percent of the market.
- The four largest banks issue close to 70 percent of the credit cards.
- The six largest banks by assets (JPMorgan Chase, Bank of America, Citigroup, Wells Fargo, Goldman Sachs, and Morgan Stanley) hold assets valued at close to two- thirds of our nation’s GDP. In 1995 the six largest banks held assets equal to 17 percent of our nation’s GDP.
- The four largest banks hold close to 40 percent of our nation’s bank deposits, up from 32 percent pre-crisis. If there was ever a doubt that our megabanks were “too big to fail,” then this final piece of data, the granddaddy of them all, will defy those who might believe otherwise:
- The five largest banks hold 95 percent of the exposure within the quadrillion-dollar (that is a thousand trillion) derivatives market. That figure represents approximately $3.2 million for every man, woman, and child in the United States of America. The banks dominating this market sector are JPMorgan Chase, Bank of America, Citigroup, Wells Fargo, and Goldman Sachs.
And of course, under the “too big to fail” business model, these banks have also become “too big to regulate.” Many Wall Street executives, especially J.P. Morgan’s Jamie Dimon, would deny this assertion.
However, J.P. Morgan’s $6 billion loss due to derivatives trading activity within its chief investment office in 2012 says otherwise. Not to allow their advantages to go to waste, the banks and their executives have been able to position themselves as “too big to prosecute” as well. Against the backdrop of populist rage directed at Wall Street, Washington knew that it needed to bring some form of renewed regulatory oversight to an industry that had lost its moral compass—if not its way entirely. The legislation undertaken was designated the Dodd-Frank Wall Street Reform and Consumer Protection Act, given that it was led by Senator Christopher Dodd (D-CT) and Representative Barney Frank (D-MA). Dodd chaired the Senate Banking Committee and Frank led the House Financial Services Committee. Given those positions, it was not a surprise that they would have led the legislative effort to reform Wall Street; however, for those who watched closely, it seemed all too surreal that two individuals who had long fed sumptuously at the Wall Street (and related) troughs were now charged with cleaning up the mess.
The stated goals of the Dodd-Frank legislation were “to promote the financial stability of the United States by improving accountability and transparency in the financial system, to end ‘too big to fail,’ to protect the American taxpayer by ending bailouts, to protect consumers from abusive financial services practices, and for other purposes.” Certainly an all-encompassing canvas, but goals and aims are one thing; the delivery and impact of the law rest in the details and implementation.
As with any sweeping piece of legislation, political pressures and heavy lobbying are to be expected from groups not looking to cede previously hard-won turf battles. Few groups knew how to play that game better than the Wall Street lobby that had funneled billions of dollars into the campaign war chests of Washington legislators. A year’s worth of debate, political maneuvering, and assorted machinations from a wide array of constituencies ultimately yielded a Dodd-Frank bill that ran more than 2,300 pages. Many in Washington heralded the legislation as bringing the requisite reforms to an industry that had developed and launched financial weapons of mass destruction. Truth be told, the act was more an architectural blueprint subject to further review, analysis, and revision than a finished product ready to return our markets and economy to healthy footing.
Aside from the thousands of pages of actual text, Dodd- Frank directed no less than 22 separate regulators to undertake work on over 400 separate rules. These regulators encompassed not only existing agencies but also newly formed entities such as the Financial Stability Oversight Council and the Consumer Financial Protection Bureau. The former was charged with identifying and managing systemic risk in the financial system. The latter was directed to make markets for consumer financial products and services work for Americans. Existing institutions deeply affected by the new legislation are the Commodity Futures Trading Commission (CFTC), Department of Treasury, Federal Deposit Insurance Corporation, Federal Housing Finance Agency, Federal Reserve, Federal Energy Regulatory Commission, Federal Trade Commission, National Credit Union Administration, Office of the Comptroller of the Currency, Office of Thrift Supervision, State Insurance Regulator, and the Securities and Exchange Commission.
Not many folks seemed to notice that there was no meaningful mention of the Wall Street-funded police known as the Financial Industry Regulatory Authority included in this legislation, despite its ostensible mission of bringing financial regulatory reform to Wall Street. Conspicuously absent was substantial discussion of the political leaders and regulators who manned our ship while it crashed on the rocks, and were now peddling reform from the pulpit. The United States Chamber of Commerce brought attention to this pathetic reality. “The Dodd-Frank Act left nearly every pre-crisis regulator intact and failed to address longstanding, fundamental weaknesses in the system. While increasing the workloads of the existing agencies, the Act did not introduce the critical infrastructural and process changes within agencies needed to restore regulatory efficiency and effectiveness.
The enormous symbolic tarpaulin presented by Dodd-Frank promised unknown yet widespread new regulations and serious hurdles for chief financial officers and other executives involved in business planning. Many of these executives felt they were paying the price for bad practices that were centered on Wall Street, even if their business was far removed, literally and figuratively, from our nation’s financial hub. Regulatory uncertainty is not conducive to economic growth, but that is what we got when legislators, bank executives, and lobbyists came together. In the process, the ties that bind Wall Street and Washington have grown even tighter.
Accountability and transparency in the financial system? Nice buzzwords for politicians and regulators pandering to the public, but not when the all-powerful Federal Reserve is holding court behind closed doors to finesse the finer points raised by Dodd-Frank.
Washington continues to extol Dodd-Frank as the means by which our financial industry is being cleaned up, but this is largely a bill of goods. The legislation is the architectural outline, but the engineers working on the opaque operation are largely based within the Federal Reserve. As the Wall Street Journal highlighted in early 2012, “While many Americans may not realize it, the Fed has taken on a much larger regulatory role than at any time in history.”
During the critical first few years after the passage of Dodd-Frank, when much of the research and analysis for proposed reforms was being undertaken, the calendars of Fed, Treasury, and CFTC officials were overwhelmingly filled by meetings with representatives of the major Wall Street banks. No surprise there. These lobbyists certainly knew their way around Washington. Why bother forming an oligopoly unless one takes advantage of the perks?
Those meetings, often led by Federal Reserve Chairman Ben Bernanke himself, have spawned wide-ranging legal and practical changes to the financial industry with little to no public input. In so many words, investors and consumers are being told by the Fed, “Trust us on this.” Imagine the nerve—the very entity that was at the wheel of the nation’s economy as it lurched into the ditch continues not only to hold the keys but to steer in the most favorable direction for its banking brethren. The rest of the American populace is simply carried along as excess baggage.
Did Dodd-Frank succeed in addressing its key goal, that is, did this massive piece of regulatory reform categorically end “too big to fail”? In print or theory perhaps, but in practice Dodd-Frank has set a course that tries to establish a price tag, underwritten by the large systemically important financial institutions, for the “too big to fail” subsidy provided by Uncle Sam. This price, in terms of increased capital ratios, may or may not ultimately lessen the risk or costs of future bailouts, but it certainly does not eliminate the possibility of them.
Most individuals in Washington and elsewhere have acknowledged that while we might hope to work our way back toward true capitalism and allow major banks to fail, we are still a long way from that reality. To state otherwise, regulators and public officials would open themselves up to ridicule. “Not even the Secretary of the Treasury, Timothy Geithner, believes that the Dodd-Frank Act ended ‘too big to fail.’ When asked . . . Secretary Geithner said out loud what everyone already knows to be the truth: ‘In the future we may have to do exceptional things again if we face a shock that large.’”
Understand risk to protect your company
Larry Doyle had a long (23 years) and successful career on Wall Street, which included working as national sales manager for securitized products for J.P. Morgan. During the global financial crisis, he started the blog, www.senseoncents.com, to help explain what was happening.
One of his conclusions: The global financial crisis has created an enduring sense of uncertainty. The 2008-09 bailout, the subsequent ineffectual reform, lack of accountability, and opacity has created a widespread perception that Wall Street is rigged. This is bad for capital markets. He’s reluctant to point political fingers, saying that every administration since 1970s is implicated.
But until there’s structural change, what do you do if you’re running a business right now?
“If I’m running a business, it’s all about information,” Doyle says. “It’s the type of thing –people may not like what they see, but they have to understand it. They have to understand who the players are, and the rules of the road, or even the lack thereof, so they can position themselves accordingly, and understand where the risks are.”
Business owners have to do extra work to find out some key questions. “I think any entity now, whether it’s a financial entity or a corporate entity, needs to understand how Wall Street regulation operates, so they don’t presume there’s meaningful protection,” says Doyle.
Doyle recommends asking the following: “Do you have the proper personnel on board in order to understand the risks? What are those risks—whether it’s credit risk, whether it’s structured risk, and/or whether it’s liquidity risk?”
And keep in mind: “The people who are supposed to be providing the investor protection—I would maintain— don’t.”