Risk & Compliance

Are There Good Banks and Bad Banks?

No, there are simply big banks that get federal subsidies and small banks and nonbanks that don't, thanks to regulatory favoritism: Opinion.
Christopher WhalenMay 10, 2017
Are There Good Banks and Bad Banks?

In an October 1925 speech in Birmingham, Mich., Senator James Couzens, the business partner of Henry Ford, sketched out a vision of “good” businessmen, who are ethical, and “bad” businessmen, who are unscrupulous in their dealings with the public, the ultimate consumer.

OpinionIf you protect the markets from fraud, Couzens argued, you ultimately protect the consumer. The optimistic assumption in the 1920s was that industries could be exhorted and led to ethical behavior by the example and standard-setting of their own business leaders.

Today we have given up on people doing the right thing without coercion. Instead we rely on regulators and experts of varying flavors to moderate and oversee commercial behavior. Thus there is a bias in favor of regulated industries and a negative view of the private sector.

For example, there is a constant refrain from the regulatory community when it comes to commercial banks vs. nonbank financial firms. Simply stated, the latter are seen as embodiments of evil that are inferior to regulated institutions.

Leonid Bershidsky, writing for Bloomberg View in March, embodied this perspective, chiding “shadow banks” for engaging in “regulatory arbitrage” vis-à-vis the blessed world of regulation. But nothing could be further from reality.

Nonbanks represent the private sector, the baseline for economic activity. Banks are government-sponsored entities with implicit sovereign support. Most of the major rating agencies, for example, assume a degree of “lift” for the credit ratings of the largest U.S. banks because of the presumption of support for their depositors in times of crisis.

We should remember that the regulators that supposedly make commercial banks safer than nonbanks have an appalling track record, having failed to predict or avoid financial crises in 2008 and 2001, for example. Our beloved regulators pander endlessly to consumers but routinely ignore acts of fraud in the world of securities and institutional investors. A false narrative says that the abuse of consumers caused the 2008 financial crisis. It was, in fact widespread securities fraud by the largest banks that caused the crisis.

Nonbank lending institutions actually must play by the same rules as banks, except they have no balance sheet and no cheap backup funding from the Federal Reserve Bank or federal home loan banks. Nonbank mortgage firms, for example, are forced to affirm their credit every day, because they often fund their business via short-term bank loans.

Nonbanks with investment-grade ratings typically run at leverage ratios of 5:1 or less, but some asset classes such as aircraft, rail cars, and other types of transportation assets can and do support greater leverage.

Regulated banks, by comparison, can run at 15:1 leverage on the balance sheet, and more if they use off-balance-sheet (OBS) financing, the core systemic risk issue behind the 2008 financial crisis. Just as large corporations use OBS transactions to hide taxable income offshore, commercial banks have long used special-purpose entities to hide leverage.

Think about that for a minute. Regulated banks have huge advantages over nonbanks in the form of public subsidies such as the discount window and federal deposit insurance that support higher leverage rates. Yet they banks still feel the need to cheat in terms of disclosure of risk exposures squirreled away in a special purpose vehicle somewhere offshore.

The general behavior of regulators and journalists toward nonbank companies illustrates the statist drift toward a largely regulated environment in the financial system. In this fantastic world of “macroprudential” policy, regulators soar like starship pilots who guide the economy and oversee financial institutions simultaneously. European Central Bank governor Mario Draghi typifies this “superman” syndrome.

But central bankers do not see all banks as being created equal. For macroeconomists-turned-central bankers, a few large banks are preferred to a myriad of smaller banks and nonbanks, all seen as too troublesome (to regulators) to have any economic utility. Regulators are openly contemptuous of smaller banks and nonbanks alike, which is one reason why the research community treats nonbanks firms with such slight regard.

Just to illustrate the enormous skew in the thinking inside the Federal Reserve System, an April 10, 2017 blog post by the Federal Reserve Bank of New York actually advances an explicit justification for subsidizing large banks in times of market stress. The blog states.

“We use the model to consider a subsidy on bank equity issuance. That is, for example, for every $1.00 in equity raised, the government would contribute an additional $0.10 in equity. The goal of this regulatory scheme is to induce banks to raise more equity, thereby contributing to strengthening their balance sheets.”

The first thing to notice is that the folks at the FRBNY are worried about absolute levels of capital rather than bank behavior. In times of market stress, whether a bank is raising capital generally does not matter. The reserve of confidence with the bank’s counterparties does matter.

The confidence of financial counterparties is a reflection of consistency and character, not capital. Focusing on good governance and the presence of dubious OBS financial transactions is more important for crisis avoidance than the level of capital. Only the fact that the government is the buyer of large bank equity, in the FRBNY proposal, would provide additional credit support to the issuer.

Thankfully, the article does note that, above a certain level, a subsidy for large banks is “a cost to society with little or no benefit.” But the article never asks if, as a general matter, it as a good idea to support large, zombie banks with public funds.

Like large auto manufacturers, the largest banks generally don’t even earn their nominal cost of capital. Is it really good public policy to support these regulated monopolies at any time? Maybe President Trump is right when he considers breaking up the top four money-center banks.

What would the breakup of a major bank entail? It might be easier than you imagine.

If we disassembled the four largest banks and ended up with six to eight specialized consumer and wholesale banks with $500 billion to $1 trillion in assets, the U.S. markets would function far better.

Add to that another eight to ten large nonbank broker-dealers, led by the likes of Goldman Sachs and Morgan Stanley and focused on capital markets and wealth management, and you have an extremely competitive and dynamic capital finance marketplace. (Hint: There are several new, emerging broker-dealers that are owned by buy-side firms.)

For good measure, let’s consolidate the top 20 to 30 nonbank mortgage seller/servicers down to about four or five large platforms, each with hundreds of thousands of loans in their servicing portfolio. These larger mortgage platforms would be more stable in terms of liquidity, perhaps profitable, and possibly able to invest in technology.

We might even introduce these large nonbank mortgage firms to some large community banks. Hey, you never know. Suddenly the “risks” of nonbanks may start to take on a new complexion for members of the public research, journalistic, and regulatory communities.

The point of this tirade is that nonbanks are not bad banks. They just don’t have the fat subsidies that federally insured and regulated commercial banks take for granted. If we focused on important issues — namely, preventing systemic crises via regulation of deceitful — OBS transactions and broadly enforcing rules against securities fraud, the entire concern about capital for banks and nonbanks alike would assume a far smaller part of the public narrative.

You can tell a good bank or nonbank from a bad apple by whether it (or its clients) cheat on disclosure of risk and/or taxes in their off-balance-sheet transactions, the ultimate source of systemic risk.

For example, if a bank or nonbank has a whole department that specializes in constructing innovative tax and/or investment strategies for clients using offshore financing vehicles, then beware.