Too Big To Fail? Big Banks Up to Old Tricks

Big U.S. banks are hopping mad that they might suffer more than their European brethren under capital rules. The problem is that the new rules were written in Europe and the currency chosen for judging compliance is the euro.

The strong U.S. dollar makes U.S.-based bank activities look much bigger when they’re converted to the cheaper euro, so the U.S.-based banks would be required to hold more capital in reserve. The more capital these companies are required to hold in reserve, the less that can be used for investing or other financing activities.

Cry me a river.

I’ve little sympathy for the people that run these “banks.” They are companies like Goldman Sachs and Morgan Stanley. The names should conjure up some vague memories of how these venerable Wall Street firms came to be known as “banks” in the first place.

They were bailed out by the Fed when the financial system imploded…

The causes of the financial crisis have been beaten to death.  I’ve no interest in rehashing subprime, the Community Reinvestment Act, or the ratings agencies. But… there is one piece that often gets left out of such discussions — the Merrill Exemption of 2004.

In the early 2000s, the big investment houses were annoyed that they were required to hold so much capital in reserve. While Merrill Lynch, Goldman Sachs, Lehman Brothers and other American companies could only borrow at a leverage of 12-to-1, their counterparts in Europe regularly borrowed at 20-to-1 or more.

Since the competitors across the pond could put more money to work, they clearly enjoyed a competitive advantage. The investment banks petitioned their governrning agency, the SEC, to change the ruling and therefore level the playing field with the Europeans.

In 2004, the SEC caved and provided what was called the “Merrill Exemption.” Investment banks with $5 billion or more in capital were basically allowed to police themselves, coming up with their own guidelines for risk control.

It’s not surprising that the companies in this category felt 12-to-1 leverage was way too conservative, so they levered up. And therein lies the problem. These companies were allowed to use whatever leverage they saw fit, which proved disastrous.

By the time it failed, Lehman Brothers had a leverage ratio of 35-to-1.  For every $1 of capital, the company had invested $35. So if Lehman lost more than 2.86% of its capital, the company would be doomed. At the original 12-to-1 funding ratio, Lehman would have had to lose more than 8.33% of its capital before it got into trouble.

While Lehman was allowed to go into bankruptcy, the other investment banks were not. The only problem was that the Fed had no authority to “rescue” or lend to investment banks that were regulated by the SEC.

The Fed oversees banks. So each of these companies went through a conversion to become a traditional bank so that they could tap the bailout bucks from the Fed.

Now the same group — the very ones that took on so much leverage last time that they helped to sink the system and had to change into traditional banks to access bailout funds — is complaining that their capital restrictions will be too high if they’re required to follow the new rules.

They shouldn’t worry. I’ve got the solution.

Instead of fretting about increased capital requirements because they’re deemed big enough to be a systemic risk if they failed, each of these behemoths could simply break themselves up into a number of smaller companies. As smaller entities, the subsequent firms would be under the threshold of “too big to fail,” and therefore the higher capital limits would no longer apply.

I think I can hear a pin drop.

There’s no way any of these companies will voluntarily break themselves up. If they did, then management would no longer get bonuses based on the earnrnings of really big companies, they’d have to settle for the pittance paid at smaller enterprises.

They’d also no longer have the clout and market-moving ability they enjoy today.

Of course, the financial system of the country would be better off because we’d no longer have just a few firms controlling so much wealth. With the concentration broken up, there would be no need to backstop any company because any one failure would not be a catastrophic blow to the system.

But we’re not talking about what’s good for the health of the financial system and the economy, we’re talking about what’s good for the “too big to fail” banks that think they’re getting a raw deal when it comes to higher reserve requirements.

The Fed is currently taking comments on the system. What are the odds that the Fed will introduce some compromise that allows these banks to cut their reserve requirements?

What’s the worst that could happen?

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P.S. Lance gives you some behind-the-scenes information about quantitative easing and what the Fed does to stimulate our economy… It’s really not all it’s cracked up to be. Read on.


Rodney Johnson

Rodney’s investment focus tends to be geared towards trends that have great disruptive potential but are only beginning to catch on to main-stream adapters. Trends that are likely to experience tipping points in the next 5 years. His work with Harry Dent – studying how people spend their money as they go through predictable stages of life and how that spending drives our economy – helps he and his subscribers to invest successfully in any market.