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Too Big to Fail: Déjà vu All Over

Joshua Rosner
American Bar Association
Banking Law
Mark Hopkins Hotel
August 9, 2013


How Big is Big?

•  The 12 largest banks (assets of $250 billion to $2.3 trillion) are 0.2 percent of all banks but hold 69 percent of industry assets.
•  The Big Five today are about twice as large, relative to the economy, as they were a decade ago;
–  2006 – Big 5 bank assets represented 43 percent of US GDP;
–  2012 – Big 5 bank assets represented 58 percent of GDP.


TBTF – A Viable Business?

•  Earnings growth is not from core banking activities
–  Cost cutting driving income. Last quarter:
•  Wells revenue growth was flat, income up 20%;
•  Bank of America revenue growth 3%, income up 70%;
•  Citi revenue growth 8%, income up 26%;
•  JPMorgan revenue growth 14%, income up 32%.
–  Trading
–  Investment Banking
–  Last year our largest firm’s ROA was less than 1%


Banks are Safer Today?

•  Really? Consider our most esteemed SIFI.
–  Excluding private litigation and most mortgage related actions (other than the national settlements), we estimate that between 2009-2012, our “best” managed TBTF bank:
•  Spent in excess of 12 percent of net income on regulatory and legal settlements;
•  Spent in excess of 20 percent of net income on litigation expense.


Examples of Problems Settled

•  Anti-Money Laundering and Bank Secrecy Act:
–  The Reporting, Procedures, and Penalties Regulations ("RPPR”);
–  Cuban Assets Control Regulations;
–  Weapons of Mass Destruction Proliferators Sanctions Regulations ("WMDPSR");
–  Executive Order 13382, "Blocking Property of Weapons of Mass Destruction Proliferators and Their Supporters;"
–  The Global Terrorism Sanctions Regulations;
–  The Iranian Transactions Regulations;
–  The Sudanese Sanctions Regulations ("SSR");
–  The Former Liberian Regime of Charles Taylor Sanctions Regulations ("FLRCTSR”);
–  Beyond these “egregious” violations, transferred 32,000 ounces of gold bullion to the benefit of a bank in Iran.


More Examples

•  Segregation of client funds:
–  September 2009 settled with CFTC for failing to segregate $725 million of their own monies from segregated accounts of $9.6 billion.
•  “under segregation of customer funds”, “untimely computation of segregation”, “untimely notification of the Commission of under segregation” and “failures to supervise”.
–  June 2010 settled with British FSA
•  Failure to “adequately protect between $1.9 billion and $23 billion of client money”;

•  Failure to “segregate client money held by its futures and options business... The error remained undetected for nearly seven years”.
–  April 2012 settled with the CFTC
•  Failure to “implement undertakings to ensure the proper handling of customer segregated funds in the future and to release customer funds upon notice and instruction from the CFTC”


Yet More Examples

•  •  •  •  •  Commodities Violations
Fictitious Trade/Wash Sale transactions
Libor manipulation?
Metals market manipulation?
Municipal Bond Market:
–  November 2009 – Settled Jefferson County bond scandal allegations that employees directed more than $8 million to close friends of Jefferson County commissioners in an effort to secure business;
–  July 2011 – Settled over antitrust provisions of the Sherman Act relating to bid rigging and payments associated with seeing competitors bids in 93 municipal bond deals in 31 states;
–  December 2012 – Settled for “unfairly obtaining the reimbursement of fees they paid to the California Public Securities Association (Cal PSA) from the proceeds of municipal and state bond offerings” and violating ”fair dealing and supervisory rules of the Municipal Securities Rulemaking Board by obtaining reimbursement for these voluntary payments to pay the lobbying group”.


Even More Examples

•  Consumer Abuses:
–  In 2010:
•  Settled allegations it harmed 49,000 customers for illegal practices in flood insurance;
•  Settled allegations it violated longstanding laws in its sale of unregistered securities to Florida’s Local Government Investment Pool.
–  In 2011:
•  Settled for overcharging 6,000 soldiers and wrongfully foreclosing on other soldiers;
•  Settled for materially false, deceptive or otherwise misleading in violation of the Federal Trade Commission Act in auto finance.
–  In 2012:
•  Settled over abusive practice of processing customers’ checks from the largest transaction to the smallest in an effort to increase the number of checks subject to overdraft penalties;
•  Settled alleged violations of NY State and Employee Retirement Income Security Act (ERISA) laws;
•  Settled allegations of illegally boosting the minimum payments due on customers credit cards. By increasing these payments on borrowers who were unable to make these payments, the firm was also alleged of benefitting from increased late fees.


Yes, Even More Examples

•  Energy Market Manipulations:
–  In 2013
•  Settled with FERC for “engaging in 12 bidding strategies in wholesale energy markets from September 2010 to November 2012, resulting in tens of millions of dollars in overpayments from the grid operators”;
•  FERC action over attempts at preventing the implementation of state-requested changes to two California power plants. Seemingly attempted to prevent new capacity from reducing energy prices.


How will they Survive?

•  With growth a problem how will they grow and compete?
•  Oligopoly:
–  OECD definition: “An oligopoly is a market characterized by a small number of firms who realize they are interdependent in their pricing and output policies. The number of firms is small enough to give each firm some market power.”
•  Where will growth come from?
–  New business exposures?


New Exposures

–  As a result of benefits granted by GLB, and a lack of core growth, TBTF banks now seek control of non-financial assets.
•  A stated goal of controlling “monopolistic” and “quasimonopolistic” assets;
•  Ability to “support more debt / leverage without incurring more risk than real estate”;
•  “attractive inflation protection characteristics”.
–  Creates further systemic interconnectedness
–  Increases unmanageable regulatory burdens


So Far, No Pushback

•  Our largest banks now control numerous:
–  Ports;
–  Airports;
–  Electric utilities;
–  Gas utilities;
–  Water utilities;
–  Sewer utilities;
–  Wind power farms;
–  Solar power generation;
–  Parking garages;
–  Rail leasing;
–  Parking meters;
–  Charter schools.
More regulators in more jurisdictions? How will that oversight and coordination fare?



New Risks

•  •  Often retain the operational risk in these non-financial transactions
Always retain the reputational risk:
–  Chicago Parking Meters;
–  Failed toll roads;
–  Price fixing in metals;
–  Manipulation in regulated energy markets.
Where potential liability costs exceed asset value, risk is systemic and reverts to taxpayer regardless of DFA.
•  If bank controlled Valdez, Bhopal facility, Fukushima:
•  Counterparties would demand more collateral against positions;
•  Bank liquidity would be strained;
•  Counterparty concerns would become contagious;
•  Fed would have to step in to stabilize system.
–  Could this ever happen? THIS IS NOT HYPOTHETICAL, IT HAS.



Only One Risk Really Matters

•  4 Risks
–  Operational;
–  Credit;
–  Liquidity/Interest Rate;
–  Reputational.
•  Reputational risk is the only risk that wipes out the value of a firm.


Dodd Frank

•  Leaves TBTF institutions intact until they become troubled.
•  Subject them to greater oversight by the same Federal Reserve that mismanaged prudential oversight of precisely those largest financial holding companies at the center of the crisis.
•  Ignores need for new coordination among regulators of other controlled businesses.


What is a “Troubled” Institution?

•  A bank with a CAMEL rating of ‘4’ or ‘5’.
•  Post Dodd Frank it includes a bank with over $50 billion in assets that is rated ‘3’.
•  Keep in mind that, during the crisis, on the 1-5, best to worst, secret CAMELS rating scale regulators use to define troubled institutions:
–  BofA was only a 3; and
–  Speculated that Citi was only a 2 (even as they were begging the government for support).
•  Should we wait until an institution is really even worse then they were?
•  You don’t employ a bomb squad to sit around and wait for a bomb to explode; you engage them to dismantle it as soon as one is identified.


What Has Congress Done

•  Title I
–  Intended as proactive attempt to ensure banks could be resolved through a bankruptcy regime.
•  Title II
–  Intended as backstop resolution for a failing firm.
•  Still, Standard & Poor’s and Moody’s (MCO) aren’t convinced. They assert that the government would rescue megabanks in a future crisis.


Title I - Ignored

•  Title I, specifically mandates firms designated as “systemically important” create, and submit to the Federal Reserve, “living wills” that detail how they can be resolved through the Bankruptcy Code.
•  If regulators ensured that these firms could be resolved under the Bankruptcy Code, as intended by law, then liquidation authority under Title II would be entirely unnecessary.
•  Still, no legal method to deal with cross-border insolvencies.
•  Regulators and banks have jumped past difficulties of Title I implementation to rely on Title II.


Title II - Uncertainty and Subsidy

•  Impact on competition.
–  Non- “systemically important” firms better able to innovate to provide services. Evidence:
•  Standalone investment banking partnerships;
•  Monoline mortgage originators;
•  Monoline credit card originators;
•  Monoline auto-finance firms.


Title II – Orderly Liquidation

•  Orderly Liquidation Authority – FDIC’s Single Point of Entry:
–  True liquidation would result in the replacement of management, in the FDIC’s proposed regime, key management of failed operating subsidiaries would be able to continue to manage the newly recapitalized firm.
–  Cram down that requires a huge amount of debtor-in-possession (DIP) financing from the Treasury;
–  All operating subsidiaries would remain open and operating while the top tier holding company would be subjected to an OLA resolution;
–  Creditors of subsidiaries face diminished chances of loss than in bankruptcy because the FDIC has declared that these subsidiary banks and broker dealers will probably never face insolvency proceedings;
–  Aggregation of losses to the holding company, while seeking to preserve the operating companies, imperils the ability of the holding company to remain a source of strength to the subsidiaries, including the bank.


Title II - Capital

•  Regulatory capital requirements:
–  Intended to ensure that there are adequate levels of capital to prevent insolvency.
–  Without requiring significant amounts of stable capital to serve as a buffer in case of insolvency, HoldCo investors will become increasingly uncomfortable buying the debt.
–  Federal Reserve has yet to issue rules defining the amount of required ‘buffer’ capital but it appears it will require far less than the 20-30% of equity and unsecured debt relative to assets that should be required.


Title II – New Risks

•  FDIC has authority to treat similarly situated creditors differently.
–  As market participants become concerned about the potential failure of a “systemically important” firm they will likely exacerbate the firm’s troubles and increase systemic risk by selling their holdings into an increasingly illiquid market to avoid the potential that they are treated unfairly relative to other, similarly situated, creditors.


Title II – New Risks

•  Uncertainty among creditors about which regime, Title II or the Bankruptcy Code, will be used to address the failing of a “systemically important” firm will increase the role of regulators.
•  It is very problematic, for creditors, if the same institution has the possibility of going into two different insolvency regimes, depending on the whim of regulators.
•  Returns to creditors are different under each regime (and somewhat unknowable in the Title II regime), making it difficult for creditors to make investment decisions.


Title II – New Risks

•  Because counterparties will be less prudent if they think creditors of the holding company are on the hook, and the government stands behind the holding company, market monitoring will go down leading to further distortions in capital market functioning.


Title II – More Distortions

•  210(n)5 of the Dodd-Frank Act - Bridge borrows from the FDIC, FDIC borrows from Treasury at treasuries plus a spread for average corporate bond yields.
–  Dodd-Frank does not state which bond index should be used.
–  If the FDIC chooses to index to “AAA” corporate average, funding for failed firm may be at rates market confers on only the healthiest.
–  How does one begin to value an option to obtain funding, at any price, when all other funds providers have abandoned an institution?
–  It is far larger than the spread between junk and whichever index the FDIC uses because without it the firm is dead.
–  This subsidy has value all the time, because “systemically important firms” and their creditors understand that, in good times, you get to play fast and loose, without fear of the Treasury abandoning you.


Title II – More Distortions

•  Adding to these subsidies:
–  Government has the authority to leave behind as much debt as it wants
•  Funding needs at larger companies could easily exceed 100 billion dollars.
•  Can begin to strain even the Treasury’s ability to access funds, this is the basis of the preference for guarantees over cash borrowing.
•  If they overdo it, they are able to turn the worst capitalized bank in the world into the best.
•  This inflicts great damage to relatively healthy companies that should have the ability to compete on a level playing field.


Why Do We Accept this?

•  •  Myth: “Our largest firms need to compete globally”.
–  Concentration of banking power can cause significant sovereign risk and tilt global economic playing field away from that country (Ireland, Iceland…);
–  “Unleveled playing field” argument is cited, in the name of protecting big banks from governmentally- subsidized international competition, but disadvantages 5,000+ community banks;
–  No longer supportable evidence that, beyond a cost of capital advantage, there are sustainable and tangible economies of scale arising from being the largest firm.
–  Are we to believe that if we did not have such large and globally dominant firms, US borrowers might be paying more that the 20% interest that several of the TBTF firms now charge to their credit card customers. What, if any advantages have American consumers and businesses received?
–  Europeans have accepted banks as sovereign obligations, we have decided otherwise. Bad for those banks but good for UST debt spreads.


Purpose of Central Banking

•  Since at least the rise of the Bank of England (17th c), banks were the primary drivers of financial intermediation
–  Aggregating capital (deposits)
–  Allocating capital toward productive use
•  The Deal: A fair return in exchange for public benefit.
•  The current approach violates the foundations of the deal. To the disadvantage of the public.