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Too Big To Trust: Banking Reform and Financial Instability

Jamie Dimon, JP Morgan Chase’s high profile CEO has performed a public service. His firm’s well publicized Three billion --and counting-- loss puts to rest, at least for the time being, the notion that we can count on deregulated financial markets and self-interested bankers to reach socially optimal outcomes. That Dimon’s loss matters to more than his stockholders has been clear from the attention given to this story. Even our limp corporate media recognize that should this bank fail, it will become a further burden for taxpayers. The more frightening thought, however, lies in the complex web of relations between Dimon’s gamble and other mega banks whose viability may depend on Chase’s ability to meet its financial obligations.JP Morgan Chase CEO Jamie Dimon. Heralded as one of the "best on Wall Street," Dimon proves that the best just isn't that great and that big banks shouldn't be run like casinos.

Classical market theory, on which Dimon and much of the corporate media so frequently rely, pictures a world in which economic actors are independent of each other and none controls enough of the market to set or manipulate prices. They are price takers rather than price makers.

That world is long dead in fiancé. A few firms control large portions of the market and have leveraged their market shares into political power, further distorting and destabilizing markets. Their apologists have failed not merely to predict this crisis but have no theory as to how economic crisis is even possible. They are thus utterly unqualified to lead us out of this crisis. And their inadequacies are especially consequential. Oligopoly and instability in particular product markets can affect long term economic growth, but distortions and instability in the market for credit and money, the life blood of a capitalist economy, potentially threatens the entire system.

Dimon’s colossal misstep has led to renewed interest in the Volcker rule, which would prohibit depository institutions from using client money to speculate in financial markets. The risks to the entire financial system when the banks that hold our deposits can speculate in financial markets are widely recognized. Positive as such a step it, it nonetheless has several inadequacies. Under the versions of the rule now being discussed banks would still be allowed to engage in speculative trade on behalf of their clients, a loophole big enough to encompass many complex and dangerous trades. And if the modern full service banks refuse to engage in such trades, will they not lose at least some of their depositors to more lightly regulated hedge funds?

Progressives have quite properly praised New Dealers and the 1933 Glass-Steagall Act for its separation of garden-variety commercial banking from the more speculative investment banking. Glass-Steagall ushered in a generation of stable prosperity. Yet as Hyman Minsky, perhaps the twentieth century’s most profound progressive student of finance pointed out, Glass-Steagall had lost its effectiveness long before its formal demise. Commercial banks were prohibited from engaging in security trades, but investment banks were allowed to perform many of the usual depository functions. In addition, the environment in which banks operated changed as a consequence of the very success of Glass-Steagall and post World War II capitalism. Wealth, both in the form of personal assets and pension funds, was being accumulated in large amounts. (I draw my analysis of Minsky from an excellent monograph prepared by the Levy Economics Institute of Bard College, Beyond the Minsky Moment.)

And paradoxically, even the post Vietnam and OPEC decline of US capitalism benefited finance. The large and growing balance of trade deficits were compensated by large capital transfers to US bond, stock, and real estate markets, widely regarded by our trading partners as the deepest, most speculatively lucrative in the world. (See Yanis Varoufakis, Modern Political Economy, Ch. 11 “From Global Plan to Global Minotaur.) These beliefs became in fact self-fulfilling prophecies. This was an age of what Minsky called money manager capitalism, and increasingly economic growth was dependent on speculatively driven increases in asset prices.

Size matters. Smaller banks are less likely to drag the whole system down. Economies of scale in banking are achieved at levels far smaller than today’s largest banks, five of which control about 50% of all banking business.

Enter such innovations as the money market mutual fund. And just as they were losing some of their depository business, conventional banks were also under siege on the loan side. A commercial paper market through which large pools of capital were used to finance short-term loans to big corporations emerged. These largely unregulated funds were able to offer big corporate borrowers better deals for both loans and deposits and naturally eroded a large part of conventional banks’ business.

With governments generally choosing not to regulate these new financial innovations, conventional banks had to change to survive. And conventional banking changed in ways that lie at the heart of our contemporary crisis. Administrative rulings allowed them to create special subsidiaries so as to take some of their assets off their books and in turn securitize these assets, turn them into combinations of loans that were marketed at a higher price than single—and presumably more risky—loans commanded. And in order supposedly to reduce risk further, a whole new world of derivatives was created, especially the credit default swap. These presumably insured banks against declines in the value of the synthetic securities. These swaps generated fee returns for banks and because they were unregulated they proliferated like wild fire. They added to confidence in the game, thereby adding systemic risk.

In the process the whole model of banking changed from what Minsky called originate and hold to originate to distribute banking. Further in order to compete, banks were allowed to merge and become bigger. In many industries, size enables economies of scale, but for banks the principal gain was cheaper access to capital. That access was based largely on the market’s perception—remarkably prescient in this case—that governments would not let big money center banks go under.

As I examine this brief thumbnail sketch of financial history, I draw several tentative conclusions. Size matters. Smaller banks are less likely to drag the whole system down. Economies of scale in banking are achieved at levels far smaller than today’s largest banks, five of which control about 50% of all banking business. Nonetheless, even smaller banks, especially given the herd mentality that often prevails in financial markets, could precipitate a crisis. Securitization thus demands a closer look. Minsky suggested that banks be organized as holding companies with subsidiaries that would provide deposit services, home and small business loans, insurance, advice on long term estate and pension planning. Each subsidiary would be regulated and would have appropriate capital requirements. Individual bank can fail because of its small size without bring others down—unless they are engaged in copy-cat techniques. And within each bank, restrictions on size and subsidiary function allow examiners a better chance to understand and supervise activities and to see where possible problems may be emerging. Furthermore, the failure of small relatively small banks is salutary. Problems can be spotted and nipped before they threaten the system. When banks are too big to fail, their inadequacies are often papered over and each crisis tends to be larger and more threatening than its predecessors. Furthermore, too-big-to-fail banks are both a consequence and a cause of oligarchic politics, with politicians and bankers locked in a socially destructive alliance.

Following logic similar to Mansky, University of Massachusetts economist Gerald Epstein has suggested: “There is increasing recognition by economists and public officials that the too big to fail banks need to be cut down to size. Senator Sherrod Brown has introduced the SAFE banking act which, like his proposal with Senator Ted Kaufman in 2008, is designed to limit the size of banks and put on hard leverage limits and size restrictions.”

Smaller banks structured in these terms would be more inclined to build the kind of relationship banking that Misnky advocated, where loans are held and the banks have a long term interest in the development of their clients.

Perhaps Minsky’s greatest insight was the recognition that any financial regulations regime may be susceptible to problems and must develop in conjunction with the evolution of the economy. His suggestions for institutional reform were hardly the final word but did suggest a framework that might spur more stable growth in the foreseeable future and foster attentiveness to new problems.

Minsky’s alternative banking model is a long way off, but short of that we can surely take steps to reduce bank size. In addition states can create their own public banks, as North Dakota has done. (See for instance Ellen Brown’s recent piece on this.) State banks need not and should not get into the business of evaluating individual home and business loans. Nonetheless, they can serve important system-sustaining purposes. They provide depository services for state taxes and other fees. Why should private banks reap profit from holding and recycling these funds? They can address social priorities by making loans to community banks engaged in small business and housing lending. Such steps would be positive in their own right and would open further discussion of just what banking is for.

Finally, unlike many of our bankers and political leaders today, Minsky realized that just as the productive economy’s health depended on a healthy financial sector, the financial sector required a stable economy. Minsky continually emphasized that “the success of Glass-Steagall was due as much to the existence of Big Government as a complement to the lend of last resort function of the central bank as it was to the restrictions placed on the assets that deposit-taking institutions could hold.” Minsky would undoubtedly follow Epstein and Brown political economist Mark Blyth in denouncing the austerity agenda that so grips both US and European politics today. Financial deregulation corporate power and shredded safety nets are a toxic brew: As Epstein puts it,“austerity [is] making all of these solutions more difficult. With few attractive options to lend to businesses, which have little incentive to invest in plant and equipment in a stagnating economy, excess liquidity piles up on the balance sheets of banks and corporations. With lax regulation bankers have more and more incentive to undertake the dangerous gambles like those at JP Morgan. People must demand and politicians must enact an end to the policies of the austerity buzzards who are squashing jobs and economic growth, and preventing investments in people and in the transition to a green economy. As Keynes understood, unless the government takes a lead in job creation, a stagnating economy with massive liquidity will only encourage more speculation and more financial instability.”