For anyone curious as to why this essay is dropping on a Monday as opposed to the usual Sunday, there are two reasons. The first is that it’s a long weekend in Canada so I got lazy. The second is that most of these essays are written in response to whatever I’ve been reading during the week.
For some reason, I decided that now would be the best time to read volume one of Pollock and Maitland’s The History of English Law Before the Time of Edward I. The work is fascinating but it’s not exacting a treasure trove of financial and economic topics. So I didn’t really get the juices flowing until I finished the volume and moved on to Vera Smith’s The Rationale of Central Banking.
Despite having been first published in 1936, The Rationale remains as fresh as a daisy. For example, remember when Hank Paulson waxed poetically about the threat of ‘moral hazard’ that bailouts posed? If not, here’s an excerpt from The New Yorker regarding Paulson’s thoughts.
“Drawing on the concept of ‘moral hazard,’ which refers to the danger of inadvertently encouraging risky behavior, Paulson explained: ‘It was important that terms [of AIG’s bailout] be harsh because I take moral hazard seriously.” And he added: “When companies fail, shareholders bear the losses. It’s just the way our system is supposed to work.”
Sounds good right? A stiff-upper-lip kind of capitalism. Except that’s not how the American system – or any western banking system for that matter – works. Smith, again, writing in the 1930s, about the American system prior to the advent of the Federal Reserve notes that:
“Banks expected to receive assistance if they got into difficulties, and therefore expanded [credit operations] on the basis of these anticipations.”1
Smith writes that already by the late 19th-century:
“The Treasury had thus been undertaking some of the functions of a central bank by carrying out what was equivalent to open market operations (purchases of securities) and by lending directly to the banks.”2
Long story short, Paulson was wrong. The American system – since the nation’s industrialization – had always, to one extent or another, been one in which banks if they were ‘too big to fail’ got bailed out via injections of liquidity. Financial bailouts are not un-American; Paulson’s ‘moral hazard’ stance is.
Paulson’s an English major with an MBA. I don’t blame him for not knowing all that much about the history of finance in America. That wasn’t his job – he’s a manager, not an archivist. His mistake was assuming that banks are just like any other corporation. They aren’t. Despite what Barry Ritholtz would have you believe in terms of America becoming a ‘Bailout Nation,’ the financial sector has been backstopped to one degree or another by the federal government for a century and a half.
As always seems to be the case, what appears to be new is in fact the ghost of yesteryear haunting us once more. Stepping away from financial bailouts and towards Modern Monetary Theory, Smith shows that its promises are nothing new:
“The public mind entertained exaggerated hopes as to the power of banking. It was a widespread belief that all that was necessary to relieve a scarcity of capital was an elastic note issue, and the issue of notes was still thought to possess something akin to a magic power of transforming poverty into wealth.”3
Besides singing Smith’s praises here, I want to take a more freeform approach than usual and talk about three topics pertinent to contemporary banking: The Role of Expectations vis-à-vis Financial Crises; The Limiting Role of Domestic Economies; and The Impact of Aggregating Offerings.
The Role of Expectations
Starting with the role of expectations we can look to Paulson’s words above. For Paulson, letting one ‘bad actor’ off the hook via a cushy bailout would promote bad behavior by others in the future. This sort of thinking makes sense if you imagine that the government of the United States is in a position of strength. Implicit in Paulson’s view is the idea that the financial sector needs the federal government more than the federal government needs the financial sector. The problem here is that in 2008, it was the other way around. The banking system had America’s balls in a vice grip.
If we look at what happened in the fall of 2008, it is obvious that the federal government was in no position to be dictating terms and handing out punishments. Yes, we can argue about the morality of bailouts but the facts on the ground were that there was no way in hell that the powers that be were going to let the financial system get beaten to a pulp.
While we could follow the lead of financial pundits and attribute the global financial crisis to sub-prime lending, a glut of savings in Europe, and securitization, we would be mistaking the symptoms for the cause. This is where Smith’s words above come in. It is not the case that the major American banks simply made bad choices and then had to be bailed out. What happened was that the big banks assumed that they would be bailed out if it all went south and thus made risky choices. Expectation shaped behavior.
This expectation meant that Paulson was shit out of luck with his tough-guy stance. The expectation of salvation was the core tenet of the financial industry. It’s what shaped everyday business whether the banks realized it or not. In the event that the expectation was wrong, the whole edifice would collapse. In short, if the expectation had been that a rescue would not come in the event of a systematic crisis, then there would not have been as much counterparty risk. Ramping up such risk meant that it was a one-for-all and all-for-one situation. Put differently, the expectation was so central to the structure of the financial sector that it had to be true. If not, the whole thing was done for.
The problem today is that the events of 2008 showed that the financial sector was right in expecting government assistance during a crisis. This remains the single greatest reality present in the banking system today. Jamie Dimon could lose his job but he will never end up like Dick Fuld who watched as his stock holdings went from being worth a billion dollars to zilch.
The only anomaly in the whole crisis was the collapse of Lehman Brothers which Laurence Ball has rather definitively shown to have been an incoherent decision on the part of Paulson, Geithner, and Bernanke. As Andrew Ross Sorkin notes in Too Big to Fail, when it came time for the post-Lehman rescue package, “there was no longer any discussion of moral hazard.”4 It would seem that the policymakers quickly realized just what kind of banking system they actually had.
The Limiting Role of Government Size
Every year S&P puts out their list of the 100 largest banks in the world based on assets. Now, obviously, I do not want to equate quality with size, but we can assume that larger banks (1) get to do things that smaller ones can’t, and (2) success can often beget size.
In 2021, the four largest banks are Chinese. The fifth-largest is Japanese. The first American bank, J.P. Morgan, comes in at number six. This situation should not be surprising, America, Japan, and China are the three largest economies. Chinese dominance at the top is a function of having state-granted monopolies but even if the banking sector was competitive you would imagine Chinese firms in similar positions.
But is it necessarily the case that large economies beget large banks? Sort of. That is, a large economy needs local servicing which scales to the relevant size. However, I would like to argue that while domestic economies may provide the basis of bank growth and size, the ability of domestic governments to cover losses (i.e. bailout firms in times of crisis) is what defines the maximum size of a particular bank or consortium thereof. The effect here is that international exposure and expansion are proportional – in a sense – to what the bank’s domestic government is willing to cover.
For example, in the global financial crisis, you know who did not get bailed out by the American government despite having significant financial operations in New York? Deutsche Bank and Barclay’s. Why? Because those firms are not Uncle Sam’s business. It did not matter that they employed Americans in an American city doing American work. Their life rings got tossed to them by buddy boys across the pond.
In practice, this means that it does not matter what the size of opportunity is beyond a bank’s domestic borders. What matters is how much out-of-country risk a bank’s home country is willing to let them take on. There are two takeaways from this reality. The first is that anyone interested in working at a top-tier – in terms of size – bank has to operate within a large economy such as those of the US, China, and Japan. There is certainly something to be said about the EU but that situation is a shit show in terms of who is responsible for whom.
The second takeaway is that one should expect disparities between home economy size and current market performance to decrease with time. The obvious example here being the disparity between Switzerland as an economy and the economic footprints of UBS and Credit Suisse. There simply is no reason why – except for legacy reasons – Swiss banks should have global footprints. It is in all likelihood the case that the Swiss government is aware of the liabilities posed by such a situation – it would also help explain that government’s recent call for UBS and Credit Suisse to up their liquidity.
Aggregation of Offerings
What can we say here that has not been said before? There was like a 10 year period where all any pundit on American TV would talk about in terms of banking reform was the reinstatement of Glass-Steagall’s separation of commercial and investment banking activities. I don’t really care about that the separation of the two. What is more interesting is the effect that the combination of the two has on the power dynamics and economics of major banks.
Allow me to spew an anecdote. Once upon a time, I was chatting with a guy who works on the capital markets advisory side of things for an accounting firm that totally isn’t PwC. I asked him about what kind of clients he dealt with and he basically said – “uh, shitty ones because we can’t compete on price with investment banks who can make up margin via corporate loans.” I couldn’t help but laugh at the time because not too long before that I had asked a similar question to a corporate banker who said “we have low margins because our job is to be an add-on feature for investment banking clients.” This brings us back around to the topic at hand. You see, investment banking is the money center. Listen to any earnings call from a major bank and they will be damn sure to tell you how profits were lifted (or hit) by investment banking fees as opposed to lending.
However, when a financial crisis hits, the government doesn’t sit around and think “my god, we can’t let the investment bankers flounder.” Instead, their rationale for action has to do with rolling paper, credit facilities, consumer deposits, and what have you. So there you get the reasoning behind why some American politicians want to split up the functions. But that doesn’t really work in a jurisdiction like Canada where the investment banking operations have always sort of existed within the commercial banks.
My suspicion is that Hank Paulson’s ‘moral hazard’ schtick came from his career at Goldman Sachs where, in the partnership days, it was very much possible to imagine the firm going under and the partners losing their capital. However, at some point, Goldman aggregated enough offerings at scale to make such thoughts unthinkable. This became even more true after the firm IPO’d and became a big boy bank.
Thus, it seems plausible to me that government backing of financial institutions in a crisis has less to do with what a firm offers (commercial vs investment banking) and more to do with the amount of offerings and the scale thereof. For example, Blackrock, Fidelity, State Street, and Vanguard do not engage in commercial banking functions – they’re asset managers. But if it looked like they were all about to go belly up, then you would expect the Fed and Treasury to step in. Why? Because they’re just that big and offer enough services to be hard to replace.
So there you have it. I know this week’s essay is a bit more free form, but that’s just how the cookie crumbles.
P.S. Around half of the folks who receive this Substack are Australian. If anyone from down under could explain to me how you came across my work, that would be great. The contact is evan.johnson@dal.ca.
Vera Smith, The Rationale of Central Banking and the Free Banking Alternative, (Indianapolis: Liberty Fund, 1990 [1936]), 163.
Ibid.
Ibid, 60.
Andrew Ross Sorkin, Too Big to Fail: The Inside Story of How Wall Street and Washington Fought to Save the Financial System – and Themselves, reprint ed., (New York: Penguin, 2010),401.