If Big Banks fail again, will Uncle Sam come to the rescue? You bet

(The following is an excerpt from E****asy Money—The Greatest Ponzi Scheme Ever and How It Is Set to Destroy the Global Financial System). A large number of firms like AIG, Citigroup, Fannie Mae, Freddie Mac, etc., were rescued in the aftermath of the financial crisis because they were deemed to be too big to fail_._ There were similar examples in Europe as well. What does the term too big to fail really mean? It essentially means that the firm is too interconnected with other firms to be liquidated quickly and, hence, it needs to be bailed out. [caption id=“attachment_2169845” align=“alignleft” width=“380”] Money story. Reuters[/caption] Some of these firms had become big by buying a spate of other financial firms and in the end had become simply unmanageable. The British economist John Kay calls this the new Peter Principle. The original Peter Principle essentially states that every person rises to his or her level of incompetence in a hierarchy. Simply put, as a person keeps getting promoted, he is bound to be appointed to a job that he is not good at. The same is the case with banks and financial institutions, which keep buying and diversifying into different businesses, until they land up in a business they do not really understand. At the same time, they become bigger and bigger. AIG is a very good example of this. It was an insurance company which started selling credit default swaps (CDSs) through its financial products unit based in London. The business raked in the profits for a while and became one of the most important divisions in the firm. But then things started to go wrong. A unit of 120 people, which formed the financial products division and which sold CDSs, brought down a company of 120,000 people, until it was rescued by the US government. Barclays is another good example. The bank had and still has very strong retail operations, but it ran into a crisis because of its investment banking operations. A firm like Citigroup, which is present in a large number of financial service businesses as well as investment banking businesses, was extremely unwieldy to manage. But, at the same time, the firm was so big and into so many different businesses that letting it go would have led to a lot of job losses and other firms going bust as well. Alan H Meltzer, writing in a research paper titled Reflections on the Financial Crisis says, “The Fed … must get rid of ’too-big-to-fail.’ If a bank is too-big-to-fail, it’s too big.” To his credit, Alan Greenspan had pointed out the risk of big banks as far back as October 1999. He had said in a speech that “megabanks being formed by growth and consolidation are increasingly complex entities that create the potential for unusually large systemic risks in the national and international economy should they fail.” Hence, it is important to make sure that there are no institutions which are too big to fail. As Bob Swarup puts it in Money Mania: “If the vanishing of an institution will destroy the network of our economy, it is too large to survive. Citigroup will one day go bust. Probability and evolution tell us that. Therefore, we can either keep trying to postpone the inevitable or remove that anomaly. This can be done over time by shrinking the institution through incentive or breaking up the institution.” Interestingly, research carried out by the Federal Reserve has been unable to find any economies of scale of operation beyond a certain size. As Greenspan asks in The Map and the Territory: “I often wondered, as the banks increased in size throughout the globe prior to the crash and since: Had bankers discovered economies of scale that Fed research had missed?” In fact, there is little to suggest that banks benefit from any economies of scale, when they grow beyond $100 billion in assets. In an April 2000 speech, Greenspan had said that “[h]undred-year floods come only once every 100 years. Financial institutions should expect to look to the central bank only in extremely rare situations.” But that, as we know, did not turn out to be the case. In the years to come it will be very difficult for central banks around the world to let go of a financial institution in trouble. In fact, Greenspan feels that “most of the American financial system would be guaranteed by the US government”, in the event of the next crisis. This, despite the fact that the Dodd–Frank Act, which was passed in the aftermath of the financial crisis, prohibits government bailouts and the form of support that the Fed used to bailout AIG. In fact, when he signed the bill into law, Barack Obama, the President of the United States, said: “The American people will never again be asked to foot the bill for Wall Street’s mistakes.” He went on to add that in the time to come, there would be “no more taxpayer-funded bailouts.” The problem is that the government of the United States bailed out a large part of its financial system in 2008 and, hence, it is believed that it will have to do the same thing all over again, whenever the next crisis occurs. The financial markets know this and discount this possibility while lending to big financial firms. Hence, big financial firms, which are deemed to be too big to fail, are able to borrow money at lower rates of interest than they would have been able to if there was a possibility of them being allowed to fail. And this will lead to the inefficient allocation of capital. The government of the United States understands that there is a possibility of it ending up guaranteeing most of the American financial system whenever the next crisis occurs. This can be gauged from the following fact. On May 10, 2012, JP Morgan, the largest bank in the United States, reported a loss of $2 billion from a failed hedging operation. The loss barely reduced the bank’s net worth. And more than that, the shareholders of the bank suffered the loss and not its depositors. Nevertheless, the loss was considered to be a threat to American taxpayers and Jamie Dimon, JP Morgan’s CEO, was called to testify before the Senate Banking Committee. Why did this happen? The only explanation for this lies in the fact that JP Morgan is now viewed as a de facto government-sponsored enterprise, which may have to be bailed out as and when the next crisis occurs. ******* (Former Fed Chairman) Alan Greenspan feels that the biggest threat that has emerged from the crisis is the phenomenon of too big to fail. He believes that it has rapidly spawned an American form of crony capitalism. Hence, he sees “no alternative to forcing banks to slim down below a certain size,” to ensure that “if they fail, they will no longer pose a threat to the stability of American finance.” But breaking down companies is easier said than done. Attempts by the US Justice Department to break down the software major Microsoft did not get anywhere. Hence, any attempt to break down the likes of Citigroup into smaller companies will be met with a lot of resistance. The risk of several financial firms being too big to fail is likely to continue in the days and years to come. At the Senate Banking Committee hearing in June 2012, JP Morgan’s Dimon said that the government should not prop up banks which get too reckless. They should allow banks to fail (even his own) and investors who hold the shares in the bank should lose their money. He went on to say that reckless institutions should be “dismantled,” and their “name should be buried in disgrace.” This can only work if financial institutions are a lot less complex than they currently are. The German banking system is a very good example of this. Retail banking in Germany is dominated by small banks which are active only locally. These banks were hardly affected by the financial crisis and the recession that followed it. An argument that is often made while trying to justify the existence of big financial firms is that the United States has gigantic firms in almost every industry, so why should finance be any different? The answer is straightforward. If a big financial firm fails, it threatens to bring down the entire financial system with itself. That is not the case with other firms. (Excerpted from Easy Money—The Greatest Ponzi Scheme Ever and How It Is Set to Destroy the Global Financial System, by Vivek kaul. Published by Sage Response** 2015 / 384 pages / paperback/price Rs 395 (9788132113447).**