It Isn’t Size or Strength but Risk that Matters Most

It Isn’t Size or Strength but Risk that Matters Most

Regulators and lawmakers, desperately trying to end (or at least end the perception of)  “too big to fail” (TBTF), are at odds of how best to do so. The conversation seems to be moving forward, or is it really just deja vu?

Let’s go back 80 years or so. In the aftermath of the stock market crash of 1929 and Great Depression, lawmakers sought to curtail risk-taking by commercial banks. Their greed led to bad loans and bad investments which, in turn, led to the great depression. Sound familiar?

The Glass-Steagall Act of 1933 was passed effectively building a barrier between commercial banking and investment banking. The banks were given a year to decide which side of the wall they wanted to stay on. The authors of the bill believed that this wall would protect insured deposits from being used to cover for poor investments. And it worked for a while.

Little by little, however, big banks started pushing on that wall. Then, in 1999, pushed by Sanford (Sandy) Weill and Citigroup, certain key provisions of the Glass-Steagall Act were repealed allowing Citigroup to merge with Travelers Insurance. The wall had been knocked down.

To his credit, Sandy Weill has said that was a mistake. From a July 2012 interview on CNBC, “What we should probably do is go ahead and split up investment banking from banking. Have banks do something that’s not going to risk the taxpayers dollars, that’s not going to be too big to fail.”

Would that have prevented the Great Recession of 2008? Probably not. It didn’t prevent the Savings and Loan Crisis of the 1980s. Nobody has yet figured out a way to legislate greed out of banking. But we don’t have to make it quite so easy.

Support has been hard to come by. The Dodd-Frank Act of 2010 includes key elements, like the Volcker Rule, that prohibits banks from doing any proprietary trading or owning any part of a hedge fund or private equity fund. But it failed to get the support needed to limit the size of banks and prevent TBTF.

Regulators decided, if they couldn’t make big banks smaller, they could make them stronger. We all know about the stress-testing now required for the big banks. And now, new capital requirements should improve both the quality and quantity of capital held by U.S. banks.

And, just last month, a new 21st Century Glass-Steagall Act was introduced by Senators Elizabeth Warren (D-MA) and John McCain (R-AZ). It aims to, once again, separate traditional banks from those that deal in riskier transactions (investment banking, insurance, swaps, hedge funds and private equity activities). A step beyond Volcker, but still not a size limit.

Whether this one gets the traction needed to become law remains to be seen. But it has two heavy hitters behind it, and it’s bipartisan, so it has a shot.

In the meantime, Citigroup puts its money where its mouth is as it takes steps to exit the business of alternative investments. Citi raised a private equity fund in 2007 with $500 million of its own capital. The fund reportedly owns such assets as a water supplier in the U.K. and a toll road in Spain.

This is a perfect example, and may give Warren and McCain a boost. This is a holding that looks great. A water company and a toll road should be great investments. What could possibly go wrong? Shareholders love it. But if the economy turns and it starts losing money… they end up getting a taxpayer bailout because they are a federally insured bank that is TBTF.

We commend Citi for taking the initiative to exit alternative investments and for realizing the risks these activities put on the deposit insurance system. But it is just one fund at one bank.