Cap This!

Lest we forget that the recent financial crisis has imposed real costs on the real economy, Simon Johnson of The Baseline Scenario reminds us, at length.

He claims that bailing out financial institutions considered too big or too connected to fail was the principal vector in the recent contagion, and he asserts we will have fixed nothing if we do not fix this:

9) At the heart of every crisis is a political problem – powerful people, and the firms they control, have gotten out of hand. Unless this is dealt with as part of the stabilization program, all the government has done is provide an unconditional bailout. That may be consistent with a short-term recovery, but it creates major problems for the sustainability of the recovery and for the medium-term. Again, this is the problem in the U.S. looking forward.

And in Europe, too, a point which Mr. Johnson makes as well.

His solution? Explicitly limit the size of financial institutions through the imposition of hard caps:

2) There is a strong precedent for capping the size of an individual bank: The United States already has a long-standing rule that no bank can have more than 10 percent of total national retail deposits. This limitation is not for antitrust reasons, as 10 percent is too low to have pricing power. Rather, its origins lie in early worries about what is now called “macroprudential regulation” or, more bluntly, “don’t put too many eggs in one basket.”

3) This cap was set at an arbitrary level — as part of the deal that relaxed most of the rules on interstate banking — and it worked well (until Bank of America received a waiver).

4) Probably the best way forward is to set a hard cap on bank liabilities as a percent of gross domestic product; this is the appropriate scale for thinking about potential bank failures and the cost they can impose on the economy. Of course, there are technical details to work out — including how the new risk-adjustment rules will be enacted and the precise way that derivatives positions will be regarded in terms of affecting size. But such a hard cap would the benchmark around which all the specifics can be worked out.

5) What is the right number: 1 percent, 2 percent, or 5 percent of G.D.P.? No one can say for sure, but it needs to be a number so small that we all agree any politician who cares about our future would have no qualm letting it fail, and when doing so have confidence that our entire financial system is not at risk as it fails.

6) A hard cap at 4 percent of G.D.P. seems about right for a bank with the most conservative possible portfolio. This would mean no bank in our country would have no more than about $500 billion of liabilities, even with a relatively low risk portfolio. On a risk-adjusted basis, most investment banks would face a cap around 2 percent of GDP.

This seems to be a sensible goal. Other commentators, including the likes of Felix Salmon, have argued in the past for a hard cap of $500 billion on the largest financial institutions. Certainly the number itself can be argued about, and as usual the devil will hide in the details of exactly how one counts the liabilities of a financial institution in an age of securitization, off balance sheet liabilities, and over the counter derivatives. Nevertheless, it seems like a sensible starting point.

However, Mr. Johnson fails to mention what I consider to be an equally if not more important point: what financial leverage we will allow these institutions to maintain. It will do us no good whatsoever to have a bunch of globally interconnected $500 billion financial intermediaries if they are all levered 15-, 20-, or 30-to-1. At least in the subsector known as investment banking, one can make a strong argument that it was leverage which killed Bear Stearns and Lehman Brothers, not simply their sheer size.

Equity, or permanent capital, is the one shock absorber and resource available to a financial institution which allows it to weather the storm of a financial panic or run on the bank. After that, the only ones left to pick up the pieces are the failed banks' creditors and, as we have been so sadly reminded recently, ourselves.


Sources: Measuring The Fiscal Costs Of Not Fixing The Financial System by Simon Johnson of The Baseline Scenario.