Market failure in the US Banking sector

NYT has an excellent graphic that illustrates the enormity of the huge concentration of market power in the US banking industry. Of the more than 8000 banks in the US, the top 3 have 44% of market share while the top 20 take 92%.



The Times article is spot on its assessment of the US banking sector in the aftermath of the sub-prime mortgage crisis,

Failure is as important to healthy capitalism as success. The nation’s handful of huge banks, however, are spared the indignity of failure... It’s extremely likely that all of the nation’s largest banks would have collapsed over the past three years without enormous help from the Federal Reserve. In any normally functioning market, they would have subsequently had trouble making huge profits. Instead, they’ve gotten bigger and richer.

In this context, more often than not, regulatory expansion will favor the existing entrenched big firms. In fact, even the current credit squeeze, by hurting the smaller firms disproportionately and also subsidizing the bigger firms, will only amplify the market power of the latter. This is a classic market failure, with potentially catastrophic systemic risk consequences (the TBTF moral hazard), crying out for policy intervention. The only way out of this systemic risk gridlock is to break-up the larger firms and disaggregate the concentration of market power and thereby risk.

In light of both the obvious danger of systemic risk caused by a few large firms and the fresh memory of the banking sector trends in the aftermath of the sub-prime crisis, one can only assume that policy makers are being deliberately obtuse if they can't get round to pulling the plug on the banking behemoths.

The emergence of corporate monopolies in the US

Nancy Folbre points to a Monthly Review article which notes that in 1995, the six largest bank-holding companies (JPMorgan Chase, Bank of America, Citigroup, Wells Fargo, Goldman Sachs and Morgan Stanley) had assets equal to 17 percent of gross domestic product in the United States. By the third quarter of 2010, this had risen to 64 percent. This graphic from Mother Jones captures the evolution of this concentration of market power over the last decade.



The Monthly Review article points to similar concentration of market power and emergence of monopolies across different industries. The number and percentage of US manufacturing industries that have a four-firm concentration ratio of 50 percent or more have risen dramatically since the 1980s. More and more industries in the manufacturing sector of the economy are tight oligopolistic or quasi-monopolistic markets characterized by a substantial degree of monopoly.



This concentration of market power has been a constant theme across sectors. The graphic below shows the rise in four-firm concentration ratios in six key retail sectors and industries, over the fifteen-year period, 1992-2007. Most remarkable was the rise in concentration in general merchandise stores (symbolized by Wal-Mart), which rose from a four-firm concentration ratio of 47.3 in 1992 to 73.2 percent in 2007; and computer and software stores from a four-firm concentration ratio of 26.2 percent in 1992 to 73.1 percent in 2007.



Another graphic highlights the rising share of the top 200 US corporations as a percentage of total business revenues in the US economy over the 1950-2008 period. The revenue of the top two hundred corporations has risen steeply since the mid-nineties.



In this context, a pathbreaking scientific study of the network of global corporate control by Stefania Vitali, James B. Glattfelder, and Stefano Battiston has thrown up several astounding insights. They mined the Orbis 2007 database of 37 million companies and investors worldwide and mapped the ownership and control networks of all the 43060 trans-national corporations (TNCs). Then they constructed a model of which companies controlled others through shareholding networks, coupled with each company's operating revenues, to map the structure of economic power. They write,

"We find that, despite its small size, the core holds collectively a large fraction of the total network control. In detail, nearly 4/10 of the control over the economic value of TNCs in the world is held, via a complicated web of ownership relations, by a group of 147 TNCs in the core, which has almost full control over itself. The top holders within the core can thus be thought of as an economic "super-entity" in the global network of corporations. A relevant additional fact at this point is that 3/4 of the core are financial intermediaries."

Too Big To Fail fact of the day

Zero Hedge quotes the latest report from the US Office of the Currency Comptroller and writes about the extreme concentration of derivatives risk in the US financial markets,

"Of the $250 trillion in gross notional amount of derivative contracts outstanding (consisting of Interest Rate, FX, Equity Contracts, Commodity and CDS) among the Top 25 commercial banks (a number that swells to $333 trillion when looking at the Top 25 Bank Holding Companies), a mere 5 banks (and really 4) account for 95.9% of all derivative exposure... The top 4 banks: JPM with $78.1 trillion in exposure, Citi with $56 trillion, Bank of America with $53 trillion and Goldman with $48 trillion, account for 94.4% of total exposure."

And more worryingly, the TBTF problem keeps getting worse, posing even greater systemic risks,

"The biggest banks are not only getting bigger, but their risk exposure is now at a new all time high and up $5.3 trillion from Q1 as they have to risk ever more in the derivatives market to generate that incremental penny of return."

The TBTF moral hazard gets even bigger

Excellent post by Simon Johnson highlighting the too-big-to-fail moral hazard that big financial institutions like Goldman Sachs enjoy. Far from being sensitized and forced into taking action to address this problem in the aftermath of the sub-prime crisis, public policy has regressed further. The TBTF moral hazard appears to be even more deeply institutionalized into the global financial markets.

In fact, while in 1999, the five largest US banking organizations had about 38 percent of total banking assets, the top five banks today have 52 percent of all bank assets. Prof Simon Johnson, writes about the TBTF hazard posed by the $900 bn giant, Goldman Sachs,

"If a bank like Goldman were in trouble, there remain the same unappealing options that existed for Lehman in September 2008 – either to let it fail outright or to provide some form of unsavory bailout. The market knows this and most people – including everyone I’ve spoken to in the last year or so – regards Goldman and other big banks as implicitly backed by the full faith and credit of the United States Treasury.

This lowers Goldman’s cost of funds, allows it to borrow more, and encourages Goldman executives – as well as the people running JPMorgan Chase, Citigroup and other large bank-holding companies – to become even larger."

Permitting TBTF institutions to fail, an orderly winding down through a resolution authority, while theoretically appealing, is not practical,

"But the resolution authority would not helpful in the case of Goldman Sachs, a global bank that operates on a vast scale across borders. Such a case would require a cross-border resolution authority, meaning some form of commitment among governments. As this does not exist and will not exist in the foreseeable future, Goldman is, as a practical matter, essentially exempt from resolution."

In this context, given the aforementioned, there are only two options - break up the TBTF institution or raise reserve capital requirements steeply. The former, while the most appropriate policy choice, stands no chance of success given the lobbying power of the banking industry. As Simon Johnson writes,

"Given that this is the case, the only reasonable way forward is to follow the lead of Prof. Anat Admati and her colleagues in pressing hard for much higher capital requirements for Goldman and all other big banks. If they have more capital, they are more able to absorb losses – this would make both their equity and their debt safer."

But the Basel III, which look likely to raise capital requirements to no more than 10 percent of Tier 1 capital, does not go far enough on this. This is despite the bankers arguement that equity is expensive (and possibly harmful to the banking industry's innovation and growth potential) being fairly comprehensively refuted by many leading finance academicians.

The final word on TBTF moral hazard should go to Neal Barofsky, the outgoing inspector general for the Troubled Asset Relief Program (TARP), who said in his final testimony before the Senate,

"For all its help in rescuing the financial system from the brink of collapse, TARP may have left a truly frightening legacy. It has increased the potential need for future government bailouts by encouraging the 'too big to fail' financial institutions to become even bigger and more interconnected that before, therefore increasing their ultimate danger to the financial system."

Back to square one - financial market regulation?

The bitter lessons of the sub-prime crisis appears to be slowly receding away from memory and the unhealthy practices that inflated the sub-prime bubble era are returning back with vengeance. Now that the markets are back to normal, atleast in appearances, the urge to return to the boom days is proving irresistible.

The latest evidence comes from the US Federal Reserve’s recent decision to allow major banks to increase their dividends and to buy back shares. The decision comes in the aftermath of the Fed's Comprehensive Capital Analysis and Review (CCAR), a cross-institution study of the capital plans of the 19 largest US bank holding companies.

In an excellent post, Simon Johnson has strongly contested this decision and the validity of the CCAR to reliably assess the strength of banks

"The Fed’s decision on dividends effectively lets the banks pay out shareholder equity, making the banks more highly leveraged... Bank executives and other key personnel are paid on a "return on equity" basis, so this increases their upside — that is, what they will make as long as the economy and their sector does well... Any individual bank will want to keep its equity levels low, because its executives and owners are not worried about system-wide spillover costs, such as what happens to other banks when one bank fails."

The failure risk for big banks is mitigated by the blanket insurance provided by the too-big-to-fail problem - governments cannot allow such institutions to sink for fear of a financial market meltdown. The bank executives, creditors, and even shareholders, all suffer from the moral hazard problem arising from this.

In a letter to the Financial Times, Anat R Admati and her colleague financial academics, had this to say about dividend payouts and share buybacks,

"A dollar paid out to shareholders through either dividends or share repurchases is a dollar that would not be accessible to creditors in a situation of financial distress. For this reason, and to prevent the shifting of value from debt holders to equity holders, debt covenants typically restrict dividend payments when leverage is high... taxpayers should be concerned when banks pay dividends and remain thinly capitalized, because, as we have seen, taxpayers are the ones who are likely to end up covering the banks' liabilities in a crisis... retaining earnings is generally viewed as the least costly way to raise funds and build capital, as it avoids the transactions costs associated with new equity issuance."

This debate revolves around one of the most fundamental problems in modern financial markets - who will bear the cost of addressing the systemic risks (with its massive negative externalities) that are generated by certain actions of banks, what should be that cost, and in what form should it be levied?

The sub-prime crisis has drawn attention to the dangerous consequences of excessive risk-taking and leverage, and the systemic risk created by too-interconnected to fail big financial institutions (the TBTF problem). The tax payers had to bear the burden of the massive amounts required to bailout financial institutions in the aftermath of the bursting of the mortgage bubble. It is therefore universally accepted that these financial institutions have to internalize the cost of addressing the systemic risks generated by their actions.

It is widely acknowledged that adequate equity capital and reasonably high enough counter-cyclical risk weighted capital reserves are necessary to meaningfully resolve these problems. The global banking regulators recently announced the Basel 3 regulations in an effort to mitigate the systemic risks that arise in the financial markets. However, a large number of influential financial economists have argued that the capital reserves required to address such risks are much higher than what is proposed under the Basel 3.

In an excellent NYT article Gretchen Morgenson points to a few other instances of attempted regulatory dilution as the Dodd-Frank Law becomes operational. These measures are being pushed by taking the cover of getting the securitization, derivatives and the mortgage market moving again and to buoy falling home and other asset prices.

One of the biggest achievements of the new legislation was to route all derivative trades through clearing houses and exchanges. However, now bankers are calling for exempting currency swaps from Dodd-Frank citing a provision that permits the Treasury secretary to exempt foreign-exchange swaps from the regulation. Foreign exchange swap trades are in the range of about $4 trillion a day, and trading in foreign-exchange contracts generated revenue of $9 billion in 2010 in the top five US banks, more than was produced by any other type of derivative.

Critics say that the only the only reason this market did not seize up like others during the meltdown was that the Fed lent huge amounts — $5.4 trillion — to foreign central banks through so-called swap lines during the fall of 2008. However, the Treasury Secretary Tim Geithner looks inclined to providing the exemption.

There are details of interpretation of specific provisions in the Dodd Frank law that could determine whether the relevance or otherwise of the regulation. One concerns how regulators define a 'qualified residential mortgage'. Morgenson writes,

"Issuers of asset-backed securities that are made up of such loans needn’t keep any credit risk of those securities. But sellers of loan pools that don’t consist of qualified mortgages are required to retain some of the risk in them. This provision was meant to eliminate the perverse incentives of the mortgage boom, when packagers of loan pools were encouraged to fill said pools with toxic waste because they had little or no liability for the deals once they were sold.

What constitutes a qualified mortgage has become a battleground issue because of the risk-retention rules under Dodd-Frank. Qualified mortgages should be of higher quality, based upon a borrower’s income, ability to pay and other attributes to be decided by financial regulators... Among the questions to be considered is how much of a down payment should be required in a qualified loan, and whether mortgage insurance can be used to protect against the increased risks in loans that have smaller down payments.

The use of mortgage insurance during the boom effectively encouraged lax lending. Investors who bought securities containing loans with small or no down payments were lulled into believing that they would be protected from losses associated with defaults if the loans were insured. But when loans became delinquent or sank into default, many mortgage insurers rescinded the coverage, contending that losses were a result of lending fraud or misrepresentations. When they did so, the insurers returned the premiums they had received to the investors who owned the loans.Lengthy litigation between the parties is under way but has by no means concluded.

Clearly, for many mortgage securities investors, this insurance was something of a charade. So any argument that mortgage insurance can magically transform a risky loan into a qualified residential mortgage should be laughed off the stage. And yet, mortgage insurers are making those arguments vociferously in Washington."

She also points to the battle to re-open trade on covered bonds - pools of debt obligations that have been assembled by banks and sold to investors who receive the income generated by the assets, while the issuing bank retains the credit risk. The problem with this is that since the investors who bought the covered bonds would have first call on the banks' assets (over that of the FDIC), this would wind up bestowing a new form of government backing (FDIC's deposit insurance) to the major banks issuing the bonds.

And confirmation that things are indeed getting back to normal comes from the graphic below of financial sector (it accounts for less than 10% of the value added in the economy) profits, which have regained its pre-crisis share and is back to more than 30% of all domestic US profits



Felix Salmon should have the last word,

"Banks are still extracting enormous rents from the economy, and profits which should be flowing to productive industries are instead being captured by financial intermediaries. We’re back near boom-era levels of profitability now, and no one seems to worry that the flipside of higher returns is higher risk. Any dreams of seeing a smaller financial sector have now officially been dashed. And the big rebound in corporate profits since the crisis turns out to be largely a function of the one sector which we didn’t want to recover to its former size."