A Minute With...

finance expert George Pennacchi

2/2/2010  8:00 am

New banking regulations proposed by the Obama administration might not safeguard against another financial meltdown or the taxpayer-funded bailouts that followed, banking expert George Pennacchi says. Pennacchi, a finance professor, dissects the proposed reforms in an interview with News Bureau Business & Law Editor Jan Dennis.

Would President Obama's proposed limits on the size and activities of the nation's largest banks prevent another deep financial crisis?

image of professor george pennacchiCurrent federal law limits a bank’s domestic deposits to less than 10 percent of the nation’s total deposits. Because large financial firms borrow from investors other than depositors, the Obama administration is proposing to also limit their non-deposit liabilities. Financial firms that own deposit-issuing banks, known as bank holding companies, also would be prohibited from owning hedge funds, private equity firms, or proprietary trading operations.

It is hard to say whether this proposal will prevent another financial crisis because the causes of crises are varied and unpredictable. One can say that the proposal, by itself, would not have prevented the 2007-2009 crisis, which developed from a real estate bubble inflated by cheap credit. Too much investor money flowed into poorly designed mortgage-backed securities and into Fannie Mae and Freddie Mac, which took advantage of their implicit government support to expand their mortgage portfolios. When the bubble burst, declines in the value of mortgages and mortgage-related securities led to the demise of many firms including Washington Mutual, Wachovia, Bear Stearns, Merrill Lynch, Lehman Brothers and AIG. But size restrictions would not have prevented these institutions’ mortgage-related troubles, and in very few cases were their losses due to hedge funds, private equity firms or proprietary trading.

That said, there are some sound general principles motivating the administration’s proposed limits. The recent crisis made surviving financial firms even bigger, exacerbating the “too-big-to-fail” (TBTF) problem, where the government is tempted to bail out large institutions in order to protect the economy. To combat TBTF, firms might be limited from growing even bigger.

In addition, restricting the activities of deposit-issuing institutions can be justified on the grounds that deposits, via Federal Deposit Insurance Corp. (FDIC) insurance, enjoy government backing that exposes taxpayers to potential losses should the institution fail. Taken to an extreme, one might require “narrow” banks where insured deposits can be invested only in near-risk free securities such as Treasury bills and similar creditworthy, short-maturity debt. Like the current crisis, during the savings and loan crisis of the 1980s, several economists – myself included – argued for a form of narrow banking.

Another justification for restricting bank holding company activities is that these institutions obtain added government support via their ability to borrow from the Federal Reserve’s “discount window.” This was one reason why Goldman Sachs and Morgan Stanley converted to bank holding companies during the most recent crisis. Essentially, the administration proposes that if a firm wants the option of borrowing from the Fed during a crisis, it cannot be exposed to the risk of hedge funds, private equity firms, and proprietary trading.

Though the administration’s proposed limits on size and activities may be motivated to prevent TBTF and taxpayer bailouts, whether they will be effective is highly questionable.

If enacted, how might the reforms change the banking industry?

Restrictions on banks’ non-deposit liabilities would affect very few institutions. For those that are affected, the law might have the perverse effect of encouraging excessive securitization. This is because a bank may choose to securitize (sell) its loans rather than fund them from non-deposit sources. Since excessive securitization in the form of poorly designed mortgage-backed securities was a major factor in the recent crisis, this restriction might make the problem worse.

Restrictions on a bank holding company’s activities may lead firms that currently own large depository institutions to sell or close down their hedge funds, private equity firms, and proprietary trading operations. Firms in this situation include Citicorp, JP Morgan Chase, and Bank of America. However, the impact would be mild since non-traditional banking activities are typically a small proportion of these banks’ profits.

Activity restrictions would be more critical to bank holding companies such as Goldman Sachs and Morgan Stanley who own relatively small deposit-issuing banks and have a greater proportion of their profits from hedge funds, private equity firms, and proprietary trading. It is quite possible that these institutions would sell their banks, give up their bank holding company charters, and revert to pure investment banks. Their cost of doing this is losing their ability to borrow from the Federal Reserve during a crisis. Of course, under existing regulation, they would also be freer from Federal Reserve supervision. Thus, limiting bank holding company activities might again have an unintended consequence of removing these activities from federal supervision.

What could those changes mean to customers and the economy?

I do not see a major impact on the availability or cost of financial services.  Customers may lose the ability to buy from a “financial supermarket,” but there is little evidence that customers value one-stop shopping when it comes to financial services.

In terms of the economy, there are serious questions whether the proposal does much to prevent future crises. Banks could still use deposits to make risky loans or purchase risky securities, such as mortgage-backed securities. Moreover, there are better measures to directly tackle the TBTF problem. Whether an institution owns a deposit-issuing bank, or not, the government may continue to bail out firms if their failure is seen as disrupting the economy. Reforms should directly confront these potential disruptions.

A better plan would be to push for requirements that all large financial firms write “living wills” that would specify how their failure would be handled without disruption to the economy. If regulators found a firm’s will to be unworkable, they could force the firm to restructure, including limiting its size and activities.

Also, reforming capital standards could go a long way in preventing crises. Mandating that firms issue “contingent capital,” which are bonds that automatically convert to shareholders’ equity when a firm starts to get in trouble, would reduce the opportunities for government bailouts.

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