There are many layers to the debate over derivatives trading, which is why we find David Stockman on the same side as Sen. Elizabeth Warren (D-MA). This, by itself, is remarkable. Stockman has a book and a blog wherein he bemoans the corruption of American capitalism, and Warren is an anti business populist – not to say “socialist.” Both hate investment banks. Here’s Stockman:
Banks are not free enterprise institutions; they … would not even remotely exist in their current Wall Street incarnation without state subsidies and safety nets … and deposit insurance
The debate is about the “swaps push out” provision of the Dodd-Frank reform act, which was postponed as part of last week’s crunch budget bill. This provision would have required Citigroup, notably, to move its swaps trading operation into a holding company separate from the FDIC insured bank. We mention Citi, as Sen. Warren does, because they have lobbied hardest against the provision.
[Dodd-Frank] required banks with access to deposit insurance … to move their derivatives business to separately capitalized affiliates.
Jeremiah is not among those who consider all derivatives to be “weapons of mass financial destruction.” Dodd-Frank makes an exception for traditional swaps trading, which is used to reduce risk. Swaps, like futures and options, grew out of the need to hedge things like currency risk. The textbook example of using an option to reduce risk is – buying a put temporarily to protect a long term investment.
Banks can keep what many consider more “traditional” swaps activity, including interest-rate and foreign-exchange swaps. A bank also can continue to engage in swaps to directly hedge its own risks.
Citi’s assertion that the push out provision would materially harm traditional hedging is a lie, because that’s exempt. The provision is meant to address dealers and market makers. Depending on how you feel about banks, here is a choice of policy approaches:
- Outlaw swaps trading entirely
- Outlaw swaps trading for FDIC insured banks
- Outlaw all investment banking for FDIC insured banks
- Get rid of deposit insurance entirely
Here, we are focusing on deposit insurance because that’s the most obvious source of risk to the taxpayer. The other form of federal assistance given to big banks is access to the Fed’s discount window. Once upon a time, the Fed provided liquidity “for good collateral, at a penalty rate,” but – with rates near zero and lax collateral standards – it’s a lot like free cash.
Note that, while neither the Fed nor the FDIC is funded by tax receipts, both are considered federal assistance by Dodd-Frank. The drafters considered, correctly, that market making in derivatives entails more risk than the FDIC can bear. That’s why the push out provision says swaps must be in a separate, non-deposit holding entity.
Alternatively, to compensate for the risk, swaps entities could be assessed higher FDIC premiums. That would be a free market solution. If you try to imagine what the market rate for deposit insurance might be, you get a good idea why it’s considered “federal assistance.” Deposit insurance is a subsidy to the banks, allowing them to pay less interest than they could in a free market.
In a free market, banks would display their capital ratios instead of the familiar FDIC plaque. Below are the Tier 1 capital ratios from selected banks’ most recent resolution filings:
- Goldman Sachs: 16.7%
- Morgan Stanley: 15.6%
- J.P. Morgan Chase: 11.9%
- Bank of America: 11.9%
- Citigroup: 11.1%
These are the consolidated entities. As a depositor, you would want to look at your consumer banking entity – and you would want to know that it’s not funding the swaps entity. You would also want to look at how much capital your bank is projected to have in an “adverse scenario,” a.k.a. the Fed stress test. Note that Citigroup places last and, indeed, had failed the stress test.
The Fed has consistently raised the standards of its annual stress tests, leading some bankers to grumble that the regulators’ efforts … may be choking off credit to the broader economy.
This is the devil’s bargain we made with our banks. We need lots of credit to support our lifestyle, and the banks can’t survive in a free market. Instead, we pamper them with guarantees and smother them with regulation. We also worry about competition from similarly subsidized foreign banks.
Sound familiar? Regular readers will recognize this dynamic from industrial protectionism, which always cuts two ways. Protect the American steel industry, and you tax our car makers. Block cheap imports, and you raise consumer prices.
In the case of banking, we wanted our banks to compete internationally, so President Clinton repealed the Glass Steagall Act. We also want cheap credit for investment and – for you Keynesians – consumption. We pay the price in government guarantees, financial repression, regulation, and compliance.
It is ironic that the supposed heart of capitalism is, as Stockman says, a “ward of the state.” We know that bank protectionism leads to stagnation, because Japan and Europe are already there. We don’t need to join the zombie bank competition.
What we need to do is systematically reduce federal assistance, segregate investment banking, cull the TBTF ranks, and tighten the discount window. In short, we need to expose American banks to market discipline.
Contrary to the hype, our economy does not depend on investment banking. This industry can be overinvested just like any other. This means resources that could be employed better elsewhere – resources like capital, government attention, and bright young kids who should have been engineers.