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Big Banks on the Loose

Crony capitalism, simply defined, is when government officials favor friends (cronies) over others; or when the rich and powerful use their wealth and influence to gain access to governmental officials and opportunities that are not available to the average citizen. In 1832 President Andrew Jackson struck down a crony cabal that controlled the Second Bank of the United States. When he killed the American central bank, Jackson terminated a remarkably unethical arrangement, approved by Congress, that gave state-chartered banks rights superior to those of ordinary citizens and exempted the Bank’s foreign shareholders from taxes. Jackson defined crony capitalism in his July 10, 1832 veto message to Congress:

Many of our rich men have not been content with equal protection and equal benefits, but have besought us to make them richer by act of Congress. By attempting to gratify their desires we have in the results of our legislation arrayed section against section, interest against interest, and man against man, in a fearful commotion which threatens to shake the foundations of our Union.

Past and current corporate and financial titans such as J.P. Morgan, Andrew Carnegie, John D. Rockefeller, Warren Buffett, and Jeff Bezos provide leading examples of crony capitalism—men who used personal relationships with politicians to enrich themselves and their businesses. The decidedly liberal Buffett, for example, reared as the son of a decidedly conservative congressman from Omaha, grew up in Washington’s Fairfax Hotel, where he learned firsthand how to work the political world to gain advantages in business. 

But today perhaps the most visible and infuriating example of crony capitalism is the relationship between large banks and the federal government. Banks are, after all, government-sponsored enterprises, or GSEs, with access to public subsidies and protections that are not offered to truly private businesses. In credit terms, a normal business with three times as much debt as equity is generally considered investment grade, but a bank can run at 15:1 debt-to-equity leverage—not counting the oxymoron of “off-balance sheet” assets. The chief counterparty of the big banks in this loving crony capitalist embrace is the Federal Reserve System.

When we think of crony capitalism and the big banks, the problem starts at the turn of the 20th century. Modern-day regulation of banks is an offshoot of the Progressive movement, which supposed that government could stamp out evil and prevent bad acts in markets and society. The New Deal and governmental actions during World War II institutionalized many regulatory functions and advanced the liberal cause of enlarging the corporate state, culminating in a permanent bureaucracy of regulators looking after the public interest. Private business now was clearly subordinate to the regulatory framework of the federal government, later known as the administrative state.

As regulation of banking and finance expanded, the largest institutions gradually captured the regulators and their political sponsors. Writing after the 2008 financial collapse, MIT professor Simon Johnson said of the largest financial institutions: “These banks again have unfettered access to the very top of the political decision making in the United States and, [this] reflects the fact [that] their status is completely undiminished, despite all the mistakes they made and all the damage they did to the rest of the economy.” Johnson argues that unless the largest banks are broken up, another major financial crisis is inevitable. That’s a view shared by a number of other analysts.

 Prior to the Great Depression, most U.S. banks were private partnerships, and their officers and directors faced personal ruin in the event of bank failure. Many states sharply limited banks and actually required “double liability” for bank shareholders, meaning if the bank faced financial trouble its shareholders would have to match the par value of their investment with new cash. Owning a bank was a privilege and a grave responsibility to the community.

When banks began to convert to stock corporations, notes researcher and former Federal Reserve counsel Walker Todd, risk-taking behavior among bank officials changed dramatically; they took on more and more risk—and the public eventually was forced to bail them out in times of financial panic. When the government allowed banks to shift the risk of the institution from bank leaders’ personal net worth to a broad constituency of public owners, the largest banks effectively became wards of the state and ushered in what we know today as “too big to fail.”  William Cohan wrote in Barron’s in July 2017:

Prior to 1970, the Wall Street partnership structure ensured that bankers had plenty of skin in the game—essentially their full net worth was on the line every day. Requiring that Wall Street’s top executives, bankers, and traders again have a significant portion of their wealth at risk would provide much-needed accountability and reinforce the soundness and safety of the financial system. It would also unleash the power of the U.S. economy.

An important part of “too big to fail” is the tendency of the Federal Reserve and other regulators to allow mergers between weak big banks and strong ones. Lost on regulators, it seems, is the reality that, when you combine a zombie bank with a healthy institution, the result is a bigger zombie bank. The refusal of regulators to wind-down large insolvent banks has caused the U.S. banking industry to evolve into a highly concentrated market with the top 100 banks out of more than 6,000 holding 90 percent of the balance-sheet assets and huge off-balance-sheet fiduciary businesses. Many of these large banks have low or negative risk-adjusted returns on capital, compared with small banks—what might be called Main Street banks, lacking access to Washington pooh-bahs—that tend to be more cautious, more profitable, and more stable in terms of equity returns. The most stable and consistently profitable U.S. banks are the super community banks that are important lenders to Main Street. They range between $1 and $10 billion in assets, and are the least benefited by crony capitalism.  

This story of government-sponsored risk-taking actually stretches back to the Civil War, when federal support for and regulation of banks began with the National Bank Act of 1863. It expanded just prior to WWI with passage of the Federal Reserve Act of 1913. Then came President Herbert Hoover’s Reconstruction Finance Corporation (RFC) in 1932, and the formation of the Federal Home Loan Banks in 1932, and then passage of the 1933 Glass Steagall Acts (there is more than one) and legislation creating the Federal Deposit Insurance Corporation the same year.

Interestingly, both Franklin Roosevelt and Virginia’s Democratic senator Carter Glass, a leading congressional proponent of bank regulation, opposed permanent federal insurance for deposits. But in those Great Depression days of the early 1930s the deposit insurance program was enormously popular with banks as well as with a fearful public. The Panic of 1907 and the Great Depression represented two stark episodes when downward pressure on prices caused economic decline intertwined with credit constriction. In both instances banks failed in droves while masses of Americans saw their savings wiped out.  

After the bank holiday declared by FDR in March 1933, RFC chief Jesse Jones restructured the failed banks that could not qualify for the newly available FDIC insurance. As he notes in his memoir, Fifty Billion Dollars, he often warned bankers seeking assistance from the RFC that, for each dollar in new capital that came from the public, they must raise an equal amount in new private capital—or face prosecution and imprisonment. In the 1930s, and even as recently as the 1980s, the government was prepared to put failed bankers in jail.

Together with Leo Crowley, architect of the FDIC who later managed the wartime Lend-Lease program, Jones fundamentally restructured the U.S. economy in a highly efficient and transparent fashion. Under the program, the RFC nurtured failed banks back to health through bond-market funding. A big corollary, though, was a demand for tight fiscal discipline and accountability, enforced rigorously by the federal government. But this demand for discipline and accountability steadily eroded following the war as Depression-era mechanisms to limit bank risk-taking were slowly dismantled.  

Similarly, Glass-Steagall forced the separation of commercial and investment banking, prohibiting banks from dealing in nongovernmental securities or investing in non-investment grade securities for themselves. The idea was that, as banks came under federal regulation, it was crucial that taxpayers be protected from irresponsible risk-taking by these institutions.

The last vestiges of the Glass-Steagall era laws regarding banking are seen today in the Bank Holding Company Act, which gives the Fed and other regulators control over who owns a bank. By limiting the ownership of banks, the Fed also protects these poorly performing monopolies from hostile takeovers. Large industrial companies such as Walmart, Amazon, Google, and Apple would all be candidates to acquire (and rationalize) large banks, but the Fed’s regulation protects the entrenched managers of poorly performing banks from market forces.

Going back to the 1980s, the Fed has enabled bad acts by the largest banks while protecting them from the wrath of investors. The Latin American debt crisis of the 1970s and trouble in the oil sector and with farm lending brought many large banks to the brink of insolvency as President Ronald Reagan took office in 1981. “Not only was the thrift industry on the way to a huge taxpayer bailout, but nine out of the biggest nine banks in oil-centric Texas failed, along with many others, and the Farm Credit System, a government-backed lender, failed, too, and had its own government bailout,” notes Alex Pollock in a 2015 policy paper for the American Enterprise Institute.  

The Third World debt crisis beginning in the 1970s left the largest banks virtually bankrupt, spurring the Fed to loosen the rules on new risk taking and disclosure to keep these institutions from failing. Then the Federal Reserve Board under Chairman Paul Volcker, sensitive to the foreign policy dimensions of the debt crisis, discouraged banks from selling defaulted loans to Latin debtor nations. The banks complied until the mid-1980s and delayed taking significant loan loss reserves on LDC exposures until after Volcker’s departure from the Fed in 1987.

The 1991 merger of Chemical Bank and Manufacturers Hanover illustrates the reluctance of regulators to impose discipline on large banks, which have a way of growing bigger when they fail to manage their credit risks. Chemical had been weakened by commercial real estate lending while Manny Hanny, as it was affectionately known, had extended imprudent loans to developing nations. Arguably neither bank was solvent at the time of the merger, but the Fed, FDIC, and New York State regulators approved the combination anyway, proving that the convenience of regulators is always paramount when it comes to managing big zombie banks. Today those two institutions are part of J.P. Morgan Chase & Co.

This example of regulatory laxity reflected a significant change in attitude among regulators that emerged through the 1980s. Increasingly, regulators even allowed large banks to engage in off-balance-sheet financial transactions to enhance profitability. These questionable transactions, whereby the banks pretended to “sell” assets to investors, ultimately led to the 2008 financial collapse and the eventual failures of such venerable institutions as Citigroup, Wachovia, Lehman Brothers, Bear Stearns & Co. and American International Group. The Fed also actively encouraged the creation of the market for over-the-counter (OTC) derivatives for the same reason—namely to enhance the nominal profitability of large banks.    

Why was this done? Because large banks tend to be far less profitable than smaller banks in nominal terms and are often value destroyers in terms of risk-adjusted returns on equity. Only by allowing large banks to cheat in terms of reporting their true assets—Citigroup, AIG, and Wachovia are just some examples—could the Fed and other regulators keep the largest banks afloat. So, while smaller banks are routinely subject to draconian discipline by the Fed and other regulators, the larger banks were essentially given “get out of jail free” cards allowing them to violate state and federal laws with impunity.

As James Grant wrote in Money of the Mind:

With the partial socialization of the banking business, a process materially and ironically advanced during the Reagan years, the element of speculation was not removed, but its costs were shifted. The public sector’s credit increasingly supplanted the private sector’s. Government guarantees—of bank deposits, residential mortgages, farm loans, student loans—became widespread, and thereby expanded the volume of borrowing. As the marginal debtor received the marginal loan, the extra car (or house, boat or corporation) was sold. All this worked to enlarge the national income.

One dirty secret of the Federal Reserve Board is that the large banks the agency has allowed to form over the past few decades are, in fact, too big to manage effectively and as a result often generate catastrophic operational errors such as the subprime mortgage bubble of the 2000s. Look at the series of operational errors and outright fraud committed by Wells Fargo in the account-opening scandals—errors that clearly suggest insufficient internal controls at the two-trillion-dollar institution (which does not include another couple trillion in fiduciary assets). Over the past several decades, if you count all of the fines paid and extraordinary losses reported by the top banks, these institutions are really not profitable—even in nominal terms. The Fed and other regulators have consistently bent and even broken traditional prudential rules regarding market structure to give advantages and even monopoly power to the largest banks in order to compensate for this fatal lack of profitability.  

Looking at it historically, Paul Volcker is the father of the “too big to fail” doctrine. In 1982, Volcker tried to persuade then-FDIC Chairman William Isaac to bail out Penn Square Bank, a go-go oil lender located in a shopping mall in Oklahoma. Isaac famously responded that he would agree only if the Fed assumed half the cost. The Fed under Chairman Volcker, however, balked at providing an explicit subsidy to an insolvent bank.  

The FDIC subsequently took over Penn Square, which was not a large bank but had engaged in massive sales of “participations” in energy loans with other banks. In its capacity as receiver, the FDIC repudiated the unperfected loan-participation sales by Penn Square, an action that led to the failures of several larger banks, including Seafirst (1982) and Continental Illinois (1984). Three other banks, Michigan National Bank, Northern Trust, and Chase Manhattan, were badly hurt by losses tied to loan participations from Penn Square. Eventually Michigan National Bank became part of Bank One, which along with Chase Manhattan was folded into J.P. Morgan. The assets of Seafirst and Continental Illinois eventually were sold to Bank of America.

Although the Penn Square failure occurred more than three decades ago and involved a relatively small bank, it provides an example of how interconnections between lenders can lead to wider financial contagion, especially when fraud is involved. Larger banks that buy and sell loan participations and asset-backed securities, for example, face greater risk than a community bank that does not traffic in securities. Often these securities sales are “incomplete,” which, according to Supreme Court Justice Louis Brandeis (1925), “imputes fraud conclusively.” For bankers and regulators, burying such problems by merging good banks with bad is the path of least resistance.

In the early 1980s, as a result of the Fed’s attack on inflation under Fed Chairman Volcker, savings and loan institutions got into trouble because high interest rates put the entire industry under water, losing money on long-term, fixed-rate mortgages that had, by tax and regulatory preferences, become the dominant asset class of the thrift industry. As short-term interest rates rose, these S&Ls couldn’t cover the cost of this business model with the returns on the thrifts’ assets.

In a classic crony capitalism response to that crisis, Congress and the Reagan administration enacted a 1982 law to allow thrifts to “grow out” of their profound insolvency. Thrifts could expand without any effective limit in order to protect the government against any risk of loan defaults incurred as the thrifts’ deposit insurer. When President Reagan praised the law, saying it “finally freed the free enterprise system,” his crusty FDIC chairman, William Seidman, reportedly observed that he didn’t “see any of those thrift managers asking to be freed from government insurance of their deposits.”

The exuberant response of thrift managers and owners caused even bigger problems. The federal government’s thrift deposit insurer, the Federal Savings and Loan Insurance Corporation (FSLIC), started to forebear with respect to capital with weak banks. Insolvent institutions were permitted to generate bogus transactions that “manufactured” capital where none had previously existed and also to dismantle the prohibitions on fraudulent transfers of assets that dated back to the 1920s. The FDIC’s Seidman, after rescuing the government (to the extent that was possible), called the changes in asset sale rules and the phony accounting for thrifts in the 1980s “the biggest mistake in the history of government.”

In the 2008 financial crisis three decades later, short-term loans and participation “sales” among banks such as Citigroup, Countrywide, and Wachovia collapsed into a general run on liquidity. Uncertain as to whether a given institution was sound, investors ran away from these banks and frantically sought to reclaim collateral and transfer positions away from exposure to weaker institutions. This fear on the part of investors created a daisy chain of failure, a cascade of receding liquidity and defaults that started with non-bank mortgage lenders in 2007; accelerated the following year to large banks, broker dealers, and insurers; and ultimately, in 2009, caused the failure of so-called government-sponsored enterprises such as Fannie Mae and Freddie Mac. These institutions arguably had adequate capital, but the use of derivatives and off-balance-sheet financing generated investor uncertainty that ultimately caused failure.

One aspect of both debt issuance and lending that, even today, policymakers fail to understand is the degree to which structural issues and a lack of adequate disclosure can contribute to financial crises. In the 2008 calamity, for example, the structural elements of subprime mortgage and corporate debt, and derivatives such as collateralized loan and debt obligations, created a degree of opacity that made it impossible for investors to properly understand and assess the risk created by the largest banks. The fact that the Fed and other agencies were willing to allow large banks to traffic in these opaque, sometimes fraudulent financial products illustrates the degree to which banks have captured their public regulators.

Another illustration is the story of Patrick M. Parkinson. In October 2009, Fed chairman Ben Bernanke and Fed governor Dan Tarullo promoted Parkinson to the position of director of the Division of Banking Supervision and Regulation. Parkinson formerly had worked as a senior official in the supervision and regulation function at the Fed, where he was known as a brilliant researcher and also a tireless advocate for bank participation in OTC derivatives and other forms of “financial innovation.” At the time of his promotion, the Wall Street Journal reported that Parkinson “recently took a leave from the Fed to work at the Treasury, where he was an architect of the Obama administration’s proposed overhaul of financial regulation. The administration’s financial-revamp plan, now pending in Congress, would give the Fed more authority over systematically important financial institutions and move consumer regulation to a separate agency.”

The Fed’s role in championing deregulation and, in particular, broader use of OTC derivatives, on the one hand, while seeking greater supervisory authority over the biggest banks, on the other, is one of the most damning examples of crony capitalism involving the nation’s largest banks. Notice, too, Parkinson’s stint at the President’s Working Group, a semi-public entity that lobbied regulators on public policy, and even distributed white papers and other documents to federal and state prudential regulators, but was completely unaccountable to the Congress or the public.

The public mugging of U.S. Commodity Futures Trading Commission head Brooksley Born is one of the most outrageous examples of crony capitalism involving the banks. In the 1990s, Fed Chairman Alan Greenspan, Texas Senator Phil Gramm, and Treasury secretaries Robert Rubin and Larry Summers all attacked Born for suggesting that OTC derivatives should be better regulated. Meanwhile, Fed staffers such as Parkinson were constantly on Capitol Hill laying down a supporting barrage for the big banks. Instead of being disciplined for encouraging the regulatory changes that caused the 2008 fiasco, Parkinson was promoted by Chairman Bernanke to head the Fed’s key bank supervision function. Born got no recognition for her prescience and courage until years later.

Consider also the case of Citigroup, the highly political money center bank that was one of the more aggressive lenders in Latin America in the time leading to the LDC debt crisis. Political connections are essential in Latin American, and CEO John Reed knew how to use his bank’s influence to leverage those connections. Later, under the ownership of Sandy Weill, Citi featured former treasury secretary and Goldman Sachs partner Robert Rubin as a decorative, non-executive chairman.

By the time the overextended bank was rescued by U.S. taxpayers during the Great Recession, Rubin’s minion, Tim Geithner, had become treasury secretary, and he called the shots on the bailout, as brilliantly described by former FDIC Chairman Sheila Bair in her 2012 book Bull by the Horns. The company was bleeding money on losses from some $301 billion in toxic investments, and it lost 60 percent of its market value in a single week. Before the crash, it was holding $1.3 trillion off its balance sheet. With Geithner at Treasury, the taxpayers injected $45 billion into the failed financial institution.

Today Citi does not have a compelling reason to exist and would be among the first large banks to be acquired but for the Fed’s control over bank ownership.

Geithner and Summers both argued publicly that holding the bad actors on Wall Street responsible for their actions would have somehow threatened the financial stability of the Western world. But it is simply wrong for anyone to suggest that “systemic” harm arises by jailing crooked bankers; it inoculates society for a time against repeating bad acts. Indeed, while Geithner argues that reforms such as the 2010 Dodd-Frank legislation have helped to repair the U.S. economy, the failure to bring to justice those who caused the collapse of the U.S. financial markets has in fact done lasting damage to markets and investor confidence.

The Obama administration’s unwillingness to prosecute the officers and directors of large, bad banks involved in obvious acts of fraud has set a troubling standard for public policy. A 2014 report by the Financial Crisis Inquiry Commission details numerous acts of fraud and chides the Fed and other regulators for failing “to ensure the safety and soundness of the nation’s banking and financial system and to protect the credit rights of consumers.” Confirming the view that fraud and a lack of transparency caused the crisis, the FCIC report declares, “Panic fanned by a lack of transparency of the balance sheets of major financial institutions, coupled with a tangle of interconnections among institutions perceived to be ‘too big to fail,’ caused the credit markets to seize up.”  

When the dust settled on the 2009 financial crisis, the managers and owners of small banks and non-banks remained subject to the full force of the law, but the officers and directors of the largest institutions were essentially given a free pass. Jed S. Rakoff, a U.S. district judge in the Southern District of New York, in a 2014 essay on the financial crisis for the New York Review of Books, noted:

If…the Great Recession was in material part the product of intentional fraud, the failure to prosecute those responsible must be judged one of the more egregious failures of the criminal justice system in many years. Indeed, it would stand in striking contrast to the increased success that federal prosecutors have had over the past fifty years or so in bringing to justice even the highest-level figures who orchestrated mammoth frauds.

Thus can we see two central and troubling aspects of crony capitalism involving the big banks.  First, the largest banks are allowed to engage in activities that are clearly high risk but which regulators either cannot or will not regulate. In this sense the hope of Progressives a century ago to create a police corps to protect the public interest has been thwarted. Instead, regulators have become vehicles for corrupt cronyism and the institutionalization of systemic risk, irrespective of what they say in public.

Second, crony capitalism seems to be a byproduct of a democratic society. Our political system allows key regulators such as Gerald Corrigan, former president of the New York Fed, to walk across the street to work at Goldman Sachs. After his hasty departure from the Fed of New York in 1993, Corrigan became one of the chief banking industry apologists for the dangerous use of OTC derivatives. As Corrigan quipped tellingly to author and economic consultant David Smick: “You can’t eliminate risk. You can’t hedge the universe.” But neither does it seem that we can keep the largest banks from exercising monopoly control over the financial services industry and effectively controlling the Fed and other public agencies charged with overseeing them. Regulation of the largest banks, it seems, is the handmaiden of crony capitalism.

All this was distilled with telling frankness by Richard Fisher of the Dallas Reserve Bank when he said that the largest U.S. banks should be broken up to ensure they are no longer considered too big to fail—and hence are no longer positioned to menace the nation’s financial stability. “These institutions,” he told the Conservative Political Action Conference (CPAC) in 2013, “operate under a privileged status that exacts an unfair tax upon the American people. They represent not only a threat to financial stability but to fair and open competition.” Further, he argued that they are “the practitioners of crony capitalism and not the agents of democratic capitalism that makes our country great.”  

Christopher Whalen is an investment banker and author who lives in New York City. He holds a B.A. in history from Villanova University and is Chairman of Whalen Global Advisors LLC.  

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