“$2 trillion is far too big in terms of the social costs.” - Simon Johnson, MIT economist
See our too big to fail page for more.
Here’s the problem: Wall Street banks can borrow money for less than other financial institutions largely because creditors see them as “too big to fail.” Specifically, according to scholars at the IMF, the biggest banks get an implicit subsidy of around 0.8 percentage points.
Now, 0.8 percentage points doesn’t sound like much, and it’s not for typical Americans. But for banks that have trillions in assets, 0.8 percentage points can add up to billions.
Bloomberg, in their image above, shows that without these implicit multi-billion-dollar subsidies Bank of America and Citigroup would be bleeding. In short, too big has failed.
“The fundamental problem with banks,” writes James Surowiecki in The New Yorker, “is what it’s always been: they’re in the business of banking, and banking, whether plain vanilla or incredibly sophisticated, is inherently risky.”
On the surface, Surowiecki’s assertion makes sense. Banking has always been risky and always will be. Bankers lend money, and lending money always carries the possibility of default.
Then again, lots of activities are risky. For instance, we could say that the fundamental problem of driving is that whether you’re in a Hummer or a Mini Cooper, driving is inherently risky. You could die doing it.
So, yes, okay, banking is inherently risky.
But questions remain: Why did we have a banking meltdown in 2007-08 unlike any since the Great Depression, and what can we do to prevent it from happening again?
Surowiecki argues that the financial crisis “was not the product of too much trading or too little disclosure.” Instead, he says, the financial crisis was the product of too much credit, egged on by the activities of all banks, big or small.
The solution, then, is to require banks to have a greater percentage of ownership when they borrow money from other banks, the same way a homeowner should be required to put down a portion (say, 20%) of the cost before getting a home loan. This is something we strongly agree with. Equity, or holding an ownership stake in a loan, should be part of all lending practices, and we need more of it to better safeguard against default.
The problem with Surowiecki’s argument is that he unnecessarily draws up false choices. Again, he says the financial crisis was caused by banks with too little equity and not because of too much trading or opacity, even though he admits that, yes, trading and opacity have increased in recent decades.
Surowiecki fails to see that what he calls the “orgy of irresponsible lending” happened not only because of too little equity but also, to a similar extent, because there was too much trading and opacity in the market. The saturation of derivatives trades paved the way for more subprime lending, and the saturation of opacity meant that Wall Street firms could hide their risk in off-balance sheet entities which allowed them to borrow more and more. All three of these factors (and more) exacerbated the crisis, the same way an insanely bad pileup at an intersection general has many factors, including inattention, bad brakes, reckless driving, heavy traffic, bad weather, poorly designed roads, faulty traffic lights, etc.
In short, we agree that we should implement better equity requirements and we even admit that doing so may prove to be the very best solution for safeguarding against a future financial crisis. So to that extent, no, The New Yorker isn’t wrong about what makes a bank risky. We’re just wary that people will assume that improving equity requirements is the silver bullet to our problems. In reality, there is no silver bullet.
In addition to implementing better equity requirements we need to:
- better regulate exotic derivatives
- limit or end Wall Street bonuses
- restructure incentives within Fannie Mae and Freddie Mac
- implement more transparent accounting practices
- break up the Wall Street firms that have enormous lobbying power and concentrated risk.
The failure to implement each of these reforms (and others, including reforms related to global markets) inflated the housing bubble that led to the financial crisis of 2007-08. Likewise, the failure to enact these reforms now will exacerbate future financial crises.
Of course, each of those solutions require the action of legislators, who often can’t be relied on. This is why we urge people to boycott the Wall Street banks and switch to a local lender, in part as an act of protest against the status quo.
See why else you should switch.