Note: This essay was also posted on Mr. Johnson’s blog Baseline Scenario.
Two diametrically opposed views of Wall Street and the dangers posed by global megabanks came more clearly into focus last week. On the one hand, William B. Harrison, Jr.—former chairman of JP Morgan Chase—argued in the New York Times that today’s massive banks are an essential part of a well-functioning market economy, and not at all helped by implicit government subsidies.
On the other hand, there is a new powerful voice who knows how big banks really work and who is willing to tell the truth in great and convincing detail. Jeff Connaughton—a former senior political adviser who has worked both for and against powerful Wall Street interests over the years—has just published a page-turning memoir that is also a damning critique of how Wall Street operates, the political capture of Washington, and our collective failure to reform finance in the past four years. The Payoff: Why Wall Street Always Wins is the perfect antidote to disinformation put about by global megabanks and their friends.
Specifically, Mr. Harrison makes six related arguments regarding why we should not break up our largest banks. Each of these is clearly and directly refuted by Mr. Connaughton’s experience and the evidence he presents.
First, Mr. Harrison claims that megabanks are the natural outgrowth of requests from customers, rather than the result of extraordinary resources spent on lobbying over the past 30 years. Mr. Connaughton’s book contains all you need to know—and more than you can stomach—about the realities of how the influence industry has worked diligently to build and defend megabanks. The people who really wanted the banks to become bigger were the executives in charge of those organizations—like Mr. Harrison. They spent a lot of money to make this happen.
Second, Mr. Harrison takes the view that global megabanks at their current scale provide some special services that cannot be otherwise provided by smaller financial institutions.
As Mr. Connaughton points out—including in a new blog post—there are no economies of scale or scope in banks with over $100 billion of total assets. Our largest banks, properly measured, now have balance sheets between $2 trillion and $4 trillion. Plenty of people have attempted to show that megabanks produce some magic for broader economy-wide productivity or multinational nonfinancial firms, but there is simply no evidence. Again, read Mr. Connaughton’s book for more detail—or look at my book with James Kwak on this topic, 13 Bankers.
Third, Mr. Harrison claims “large global institutions have often proved more resilient than others because their diversified business model ensures that losses in one part of the enterprise can be cushioned by revenues in other parts.”
Mr. Connaughton’s book reminds us, with some eloquence, that Citigroup and Bank of America—the largest US financial institutions in 2008—would have failed if it were not for the government bailouts that they received. As a matter of simple historical fact, the “more resilient” in Mr. Harrison’s version of history is exactly the same as observing that those banks were seen by officials as “too big to fail.” Their resilience came solely from support provided by the government and the Federal Reserve.
Fourth, Mr. Harrison denies that very large banks receive any implicit government subsidies. To support this view, Mr. Harrison suggests we should compare borrowing costs across financial and nonfinancial firms that share a similar bond rating (e.g., AA); he points out that the interest rate paid by financial firms in this comparison is higher. But the interest rate at which a company borrows depends not just on the risk of default, but also on the “recovery value” in the case of default (i.e., how much do creditors end up with after the company has been wound down). If you think you will recover less when I default, you should charge me a higher risk premium—and thus a higher interest rate.
Mr. Harrison compares apples (finance) with oranges (non-finance)—and fails to mention that the recovery rate in the latter case is much higher. How much will investors recover in the case of Lehman, for example—perhaps 25 cents after more than four years? For most nonfinancial companies, default does not by itself result in a big reduction in value (the deadweight costs for bankruptcy of such firms in the US are quite small); large financial firms are quite different (the deadweight bankruptcy costs are typically huge). Mr. Harrison’s proposed comparison is simply uninformative—you need to look at comparisons within the financial sector.
The right comparison is the funding cost of financial firms with and without implicit government support. The funding advantage for those perceived as “Too Big To Fail” is estimated to be between 25 and 75 basis points; most people close to the issue think it is at least 50 basis points. The idea that megabanks do not get huge, implicit subsides is simply priceless—again, read Mr. Connaughton’s account to see the lengths to which the banks will go to ensure these subsidies are kept in place.
Fifth, Mr. Harrison says that “complexity can be an antidote to risk, rather than a cause of it.” On the contrary, the evidence suggests that management has consistently lost control over financial institutions with hundreds of thousands of employees in 50 to 100 countries. Think about the scandals of this summer: Barclays and Libor; HSBC or Standard Chartered and money laundering; and the severe breakdown of risk management at JP Morgan Chase. In each case, executives claim they did not know what was going on. The very largest banks have become too big to manage.
Sixth, Mr. Harrison claims regulators are not cowed by banks. The Payoff is all about how lobbying really works—and how legislators and regulators are brought to heel. Money brings influence and influence is used to make more money. It is not about “cowing” anyone; it is about persuading them that you are right and should be allowed to do exactly what you want to do, even though your arguments are completely specious. Mr. Harrison’s op ed is a nice example of the genre.
Some regulators have started to stand up to big banks on some issues, and this should be encouraged. But overall, Wall Street prevails on all the major issues, and most top officials at Treasury and the Federal Reserve are only too happy to cooperate.
Mr. Harrison makes strong claims. All of his arguments are demonstrably false. If you think Mr. Harrison and the other defenders of megabanks have even the slightest veneer of plausibility, you must read Jeff Connaughton’s book.