A Threat to Capitalism?

2012 March 25
by SJ Leeds

Today, I want to start with a quick commercial and I hope you’ll forward this to anyone who you think may be interested.  We’re starting a new program at McCombs – The Master of Science in Finance.  The degree consists of 36 credit hours and takes ten months.  This is going to be a great program for recent college graduates who want to gain deep finance knowledge.  There is no prior finance training or work experience required.  If you’re interested, here’s a link to learn more.  I’m looking forward to teaching Investments in the program.  Now, on to this week’s blog…


Many times, I blog about papers or articles.  Every so often, I suggest that you should really read an article for yourself.  This is one such time.  The Dallas Federal Reserve Bank released their annual report this week.  The lead article in the report was written by Harvey Rosenblum (the Dallas Fed’s Director of Research and Executive Vice-President).  It’s titled, “Choosing the Road to Prosperity: Why We Must End Too Big to Fail – Now”.  Here’s the link.

Here are some of the most important points from the article (many lifted verbatim):

1. The road to prosperity requires a roadmap that finds ways around the potential hazards posed by the financial institutions that have been deemed “too big to fail” (TBTF).


2. The top five banks controlled 52% of bank assets in 2010.  In 1970, this was only 17%.


3. The term TBTF disguised the fact that commercial banks holding roughly one-third of the assets in the banking system did essentially fail, surviving only with extraordinary government assistance.


4. Monetary policy operates by impacting the decisions made by businesses, lenders, borrowers and consumers.


5. The Fed has kept interest rates low since December of 2008.  This has had a punishing impact on savers.


6. Usually, easy monetary policy helps the economy rebound much faster.  One problem is that banks still have toxic assets.  As a result, banks are still less willing to lend.  Individuals and businesses are concerned about the future and are less willing to borrow.  Low interest rates don’t provide the stimulus necessary.


7. Banks need more capital.  Monetary policy can not be effective when a major portion of the banking system is undercapitalized.


8. Most Americans came away from the financial crisis believing that economy policy favors the big and well-connected.  They saw a topsy-turvy world that rewarded many of the largest financial institutions that lost risky bets and drove the economy into a ditch.  These events left a residue of distrust for the government, the banking system, the Fed and capitalism itself.


9. TBTF has violated the basic tenets of a capitalist system.  Capitalism requires the freedom to succeed and the freedom to fail.  (Quoting Allan Meltzer, “Capitalism without failure is like religion without sin.”)  Capitalism requires government to enforce the rule of law.  (The privatization of profits and socialization of losses is completely unacceptable.)  Capitalism requires businesses and individuals be held accountable for the consequences of their actions.  (Virtually nobody has been held accountable for their role in the financial crisis.)


10. People disillusioned with capitalism aren’t as eager to engage in productive activities.  They’re likely to approach economic decisions with suspicion and cynicism, shying away from the risk that drives entrepreneurial capitalism.


11. There are two challenges facing the US economy in 2012 and beyond.  In the short-term, we need to repair the financial system’s machinery so that monetary policy can have a greater impact.  To secure the long-term, the country must find a way to ensure that taxpayers won’t be on the hook for another massive bailout.


12. Dodd-Frank has inadvertently undermined growth by adding to uncertainty.  The law’s sheer length, breadth and complexity create an obstacle to transparency, which may deepen Main Street’s distrust of Washington and Wall Street, especially as big institutions use their lawyers and lobbyists to protect their turf.


13. Policymakers can make their most immediate impact by requiring banks to hold additional capital, providing added protection against bad loans and investments.


14. The big banks that pose systemic risk should be forced to hold additional capital.  This will result in more “skin in the game” and add market discipline.


15. Small banks did not cause the crisis and should not have additional capital requirements.


16. The assumed future bailout of TBTF banks gives them a significant advantage in the cost of raising funds.  Requiring TBTF banks to hold more capital will level the playing field.


17. Banks aren’t being required to raise more capital until 2016 or 2017.  But, there will be advantages to banks that move quicker.  Banks that quickly clean up their balance sheet will be able to raise capital quicker.


18. The Fed’s zero-interest-rate policy assisted the banking industry’s capital rebuilding process.  It reduced banks’ cost of funds and enhanced profitability.  We are taxing savers to pay for the recapitalization of the TBTF banks.


19. We need to codify and clarify Dodd-Frank quickly.  We don’t need hundreds of pages of regulation.  We need more capital.


20. Under Dodd-Frank, future bailouts must be approved by the Treasury secretary.  This means that the President ultimately decides.  The result is that this will be a political decision.  If the new law lacks credibility, we’re more likely to have another financial crisis.


21. Ultimately, Dodd-Frank leaves TBTF entrenched.


22. The TBTF survivors (of the financial crisis) look very similar to 2008.  They maintain corporate cultures based on the short-term incentives of fees and bonuses derived from increased oligopoly power.  They remain difficult to control because they have the lawyers and the money to resist the pressures of federal regulation.  Just as important, their significant presence in dozens of states confers enormous political clout in their quest to refocus banking statutes and regulatory enforcement to their advantage.


23. We must break the nation’s biggest banks into smaller units.  (Of course, this will be difficult to do.)


24. A financial system composed of more banks, numerous enough to ensure competition in funding businesses and households but none of them big enough to put the overall economy in jeopardy, will give the United States a better chance of navigating through future financial potholes and precipices.  As this more level playing field emerges, it will begin to restore our nation’s faith in the system of market capitalism.


Have a great week.


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