Thomas M. Hoenig, President, Federal Reserve Bank of Kansas City has some interesting things to say today about Paul Volcker, risk taking, and especially about bank capitalization.

Please consider The Financial Foundation for Main Street.

History tells us that for a country to succeed and endure economically it must adhere to a simple set of principles. No matter the market’s complexity, these principles anchor both its financial system and overall economy. And the most fundamental of these principles is a commitment to maintaining the integrity of the institutions within the system. This commitment provides a culture of sound business ethics, a confidence in the rule of law, the reliability of contracts, and a culture of fair play on a level field.

If we stray from our core principles of fairness or ignore the rule of law, we distort the playing field and inevitably cultivate a crisis. When the markets are no longer competitive, firms become a monopoly or an oligopoly and it matters more who you know than what you know. Then, the economy loses its ability to innovate and succeed. When the market perceives an unfair advantage of some over others, the very foundation of the economic system is compromised.

As a nation, we have violated the central tenants of any successful system. We have seen the formation of a powerful group of financial firms. We have inadvertently granted them implied guarantees and favors, and we have suffered the consequences. We must correct these violations. We must reinvigorate fair competition within our system in a culture of business ethics that operates under the rule of law. When we do this, we will not eliminate the small businesses’ need for capital, but we will make access to capital once again earned, as it should be.

In a 1999 speech on financial megamergers, I concluded that “To the extent these institutions become ‘too big to fail,’ and … uninsured depositors and other creditors are protected by implicit government guarantees, the consequences can be quite serious. Indeed, the result may be a less stable and a less efficient financial system.”

More than a decade later, the only thing I can change about this statement is that the government guarantees are no longer just implicit. Actions during the financial crisis have made this protection quite explicit.

The results

TBTF status provides a direct cost advantage to these firms. Without the fear of loss to creditors, these large firms can use higher leverage, which allows them to fund more assets with lower cost debt instead of more expensive equity. As of year-end, the top 20 banking firms held Tier 1 common equity equal to only 5.1 percent of their assets. In contrast, other banking institutions held 6.7 percent equity.

If the top 20 firms held the same equity capital levels as other smaller banking institutions, they would require $210 billion in new equity or reduced assets of over $3 trillion, or some combination of both.

Furthermore, TBTF reduces the cost of the debt that these firms issue. Due to their implied government support, ratings agencies explicitly increase the debt ratings of the largest banking organizations above the intrinsic rating that would be assigned based on the bank’s condition and the amount of leverage. Not only do these firms get to use more debt, but the debt is cheaper.

This framework has failed to serve us well. During the recent financial crisis, losses quickly depleted the capital of these large, over-leveraged companies. As expected, these firms were rescued using government funds from the Troubled Asset Relief Program (TARP). The result was an immediate reduction in lending to Main Street, as the financial institutions tried to rebuild their capital. Although these institutions have raised substantial amounts of new capital, much of it has been used to repay the TARP funds instead of supporting new lending.

Policy changes

Changes must be made so that the largest firms no longer have the incentive to take too much risk and gain a competitive funding advantage over smaller ones. Credit must be allocated efficiently and equitably based on prospective economic value. Without these changes, this crisis will be remembered only in textbooks and then we will go through it all again.

First, we must enable capitalism to work and reduce the incentive of our largest financial institutions to take on too much risk by allowing them to fail in an orderly manner.

Second, we must strengthen our supervision of financial firms by returning to simple, well-established rules, such as maximum leverage and loan-to-value ratios.

Third, we must improve the regulatory framework, which may involve reversing some of the deregulation that occurred in the 1990s. Specifically, adopting a version of the proposed Volcker rule would be healthy for long-term stability. It should (1) focus on banning financial holding companies from proprietary trading and investing in or sponsoring hedge funds, and (2) require trading and private equity investment to be housed in separately capitalized subsidiaries subject to strict leverage and concentration limitations. In addition, I strongly support increasing the transparency in financial markets by requiring standardized derivative transactions to be cleared through centralized counterparties, and to the extent feasible, traded on exchanges.

Tier 1 Ratios

click on chart for sharper image

click on chart for sharper image

Check it out. The top 20 banks have over $3 trillion in excess leverage. And that assumes that tier 1 capital of 6.7% is reasonable.

How long do you think it will take to unwind that leverage? Moreover, given that assets are not marked to market, the situation is much worse than it looks. Bear in mind that unwinding that leverage will be deflationary.

While I do not think Glass Steagall would have prevented this crisis I agree with Hoenig on these points “(1)banning financial holding companies from proprietary trading and investing in or sponsoring hedge funds, and (2) require trading and private equity investment to be housed in separately capitalized subsidiaries subject to strict leverage and concentration limitations.”

The reason which I have explained before is the legitimate use of regulation is to provide a level playing field and to reduce fraud. I consider front-running trades and trading against clients to be fraud.

Goldman Sachs is nothing but a giant hedge fund, yet Bernanke has made it a bank holding company able to borrow money from the Fed at ridiculously low rates and do whatever it wants with the money.

This is patently absurd and needs to be fixed. Likewise, Fannie Mae and Freddie Mac should not exist at all. Yet they do, and at great systemic risk.

Of course we must realize something that Hoenig did not say: The great enabler in this mess is not the lack of regulation, but rather regulation that created the Fed, regulation that blessed the big three rating agencies – Moody’s, Fitch and the S&P;, the regulation that created Fannie Mae, and regulation that created FDIC.

FDIC allowed hopeless institutions to attract cash by offering above market rates on CDs and deposits. That in turn fueled absurdly risky condo projects in Florida, California, and Las Vegas, all of which went bust. Ultimately, FDIC served to concentrate bank failures so they would happen en masse rather than spreading bank failures out over time.

Regulation should not sponsor rating agencies, promote housing, or any other such nonsense. Regulation should protect property rights, civil rights, and level the playing field so everyone has an equal chance under the law. Look how far we have strayed. Regulation has done everything but what it should have done.

Mike “Mish” Shedlock
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