Dancing Over a Cliff

January 5, 2012

At the November 2011 meeting of the G20 held in Cannes, the names of 29 banks that are too-big-to-fail were released.  The list includes eight US banks, 17 European banks, three Japanese institutions and one from China.

The fear is that should any of these banks collapse, as in 2008, they could bring down a large part of the financial system. This is the fact of life in a globalized world where banks are interdependent, and the rest of the economy now depends on their well-being.

This was not always the case, but since the 1970s, the banks, particularly in the US and UK, have undertaken a concerted and highly successful lobbying campaign to remove regulations that stood in the way of their expansion. The argument was that to trade competitively in a global market, they had to have size to match. Ignoring anti-trust legislation, tame regulators and spineless legislators let the banks have their way.

What is even more inexcusable is that, after the global financial crisis, banks have been allowed to get even larger, as “healthy” banks gobbled up ones that were basket cases. “Healthy,” in this context, is a relative term, and many of the banks that have grown larger have also gambled unwisely during the boom times and may go under the next time around.

For example, JPMorgan Chase took over Washington Mutual and Bank of America absorbed Countrywide, as well taking over the carcass of Merrill Lynch.  The same happened in Europe. For example in August 2011, the Greek Alpha Bank and EFG Eurobank merged. In the UK, HBOS was forced to merge with LloydsTBS, while in Germany Deutsche Bank took over Dresdner Bank in November 2010.

So, taxpayers look like they could be in for another spat of bailouts should the current debt crisis in the Eurozone blow up the global financial system.

While there is no question that there is a problem of banks that are too large to fail, breaking those up may not necessarily solve the problem.

To understand why, we need to turn to John Maynard Keynes, who provides a compelling picture of how markets were subject to “animal spirits.”  In General Theory of Employment Interest and Money, published in the wake of the Great Depression, Keynes compared the market to a beauty contest. He argued that the judges will not pick the prettiest contestant but will try to guess the person the other judges might choose. Applying this analogy to the stock market, Keynes was arguing that people don’t price a share based on the fundamental value but rather on their assessment of what everyone else might think the share is worth.

We can see how the share market, before the last financial meltdown, operated in the way Keynes described.  The head of Citicorp, Chuck Prince, referring to the firm’s leveraged lending practices, is quoted as saying in July 2007: “When the music stops, in terms of liquidity, things will be complicated. But as long as the music is playing, you’ve got to get up and dance. We’re still dancing.”   In this quote, we see that Prince understood that his bank was skating on thin ice; but while the other banks were doing the same, he decided that Citicorp would not break from the pack.  As a result, in 2007, Citigroup found that it was in deep trouble, and the bank had to be bailed out by the US government to the tune of $45 billion.

So even if the government broke up a small number of banks that are too-big-to-fail, they would nevertheless face a number of important banks that all pursue the same business strategy. If that strategy turns out to be wrong, they could all be dancing off a cliff. However, with governments facing debt crises of their own, they may not be able to bail out banks this time around.

If there is a solution to this dilemma, it would be to reduce the financialization of the economy.  Financialization has occurred because the size of trading financial products has now overshadowed the real economy, where stuff is made and real value resides.  Currently, the financial sector represents nearly half of total corporate profits, compared with 14% in 1981.

So unless financialization of the economy is not reversed, the banks will continue to hold governments ransom whenever they get into trouble.

5 Comments for this entry

  • Samantha says:

    There is always a rumor with “big” banks failing. They are also increasing their fees to just about anything and everything. The rencent one Bank of America has passed was charging customers for the use of their own debit cards. I personally believe they are using this as a way to get money from customers to help keep them from failing.

  • Gale Graham says:

    How can bankers claim such high bonuses and be so stupid?

    • Harry says:

      The problem is that shareholders are unwilling (and often able) to rein in the executives that run banks. A few countries are providing new powers to shareholders to votes against bonuses. It’s too early to say whether this will work.

  • Freya Santos says:

    Big banks means big bonuses for bankers. That’s why bankers resist efforts to break them up.

  • Charles says:

    Good essay. And I bet Ben Chifley is looking down upon you approvingly; He wanted to nationalize the banks!

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