A Dialogue on the Banking Crisis
May 25, 2009
By Don Shaffer
Public debate over the banking crisis in the past few months has been a fascinating examination of a system I have been studying for years. So, I have closely followed the range of opinions flooding from the pens, keyboards, and voices of economists, journalists, politicians, and others. Assessing the scale of banks and their impact on society is a topic that I see as a crucial piece of the puzzle in changing and reforming our broken financial system.
Recently I read some stimulating pieces that I’d like to share with you, the first of which was written by economist James K. Galbraith as a statement before the U.S. House of Representatives’ Committee on Financial Services. (To download and read the full statement, click here.) I believe Mr. Galbraith really hits his stride in section number three, titled: “The bank plan will not work.” As he points out, “If we are in a true collapse of finance, our models will not serve and our big banks will not serve either. You will have to replace them both. Since several very big banks are deeply troubled, there is in my view no viable alternative to placing them in receivership, insuring their deposits, replacing their management, doing a clean audit, isolating the bad assets. Since these banks were clearly too large, in my view they should be broken up, and either sold in parts or relaunched as multiple mid-sized institutions with fresh capitalization and leadership.” I would encourage you to read section three of his statement, at least, and consider his arguments with a critical mind.
Another essay I would recommend is “The Quiet Coup,” by a former chief economist of the International Monetary Fund, Simon Johnson, in the May issue of The Atlantic. (To read the essay, click here.) Please pay particular attention to the final section of the article, entitled “The Way Out.” Here, Mr. Johnson lays out a case very similar to Mr. Galbraith’s. I am particularly struck by his discussion about the inherent problems of gigantic-scale mega-banks:
“Oversize institutions disproportionately influence public policy; the major banks we have today draw much of their power from being too big to fail. Nationalization and re-privatization would not change that; while the replacement of the bank executives who got us into this crisis would be just and sensible, ultimately, the swapping-out of one set of powerful managers for another would change only the names of the oligarchs.
“Ideally, big banks should be sold in medium-size pieces, divided regionally or by type of business. Where this proves impractical—since we’ll want to sell the banks quickly—they could be sold whole, but with the requirement of being broken up within a short time. Banks that remain in private hands should also be subject to size limitations.
“This may seem like a crude and arbitrary step, but it is the best way to limit the power of individual institutions in a sector that is essential to the economy as a whole. Of course, some people will complain about the “efficiency costs” of a more fragmented banking system, and these costs are real. But so are the costs when a bank that is too big to fail explodes. Anything that is too big to fail is too big to exist.”
Lastly, I would encourage you to read the recent interview of President Obama in the New York Times magazine. (To read the full interview, click here.) The first part of the interview is entitled “The Future of Finance.” The President has some encouraging things to say, but I can’t help feeling disappointed in the overall tone and substance of his responses… in which he says, in essence, “We’ll be fine with a bit more regulation.” He seems convinced that we should just duct-tape our financial/monetary system back together, and re-acquaint ourselves with a strong and powerful Wall Street (oligarchy?) as a foregone conclusion. Mr. Obama’s choices for key leadership positions in the administration reflect these views; in particular, Mary Schapiro as Chair of the Securities and Exchange Commission has functioned as a steadfast and loyal proponent of Wall Street – most recently as head of FINRA, the financial industry trade association. Schapiro is one example, but Obama has also put into place many others with direct ties to the big commercial and investment banks.
All this said, I urge you to draw your own conclusions. Certainly no one has a crystal ball, and no one can claim to know the best path to pursue at this point. For 15 years, I have read The Wall Street Journal (nearly every day) and The Economist in an effort to understand how the financial system works.
The biggest issue for me is scale, and its relationship to power. Mostly based on my study of American history, I’m a fan of small, entrepreneurial, decentralized marketplaces—in other words, networks of people and companies trading with relatively little financial intermediation.
In short, I don’t think a $2 trillion bank (e.g., JP Morgan Chase) is much good at innovation anyway. And personally, I think services like online bill pay and convenient ATM’s are insufficient reasons for not switching to a community bank or credit union if you really think it through. With a giant transnational bank, you have no idea what loans your money is being used for, or where your funds reside at any given time. Plus, how can you trust “collateralized debt obligations” or other “structured” financial vehicles that are designed only to help the bank become a larger and larger pile of money?
Public equity markets suffer from the same issues as the banks. There is absolutely no reason why the world needs over 8,000 different mutual funds, most charging fees well in excess of the value they create. Merrill Lynch and other brokers have been exposed as hopelessly riddled with conflicts-of-interest and incentive/compensation problems.
But, Wall Street will live on. Capital markets will exist, for good reason, for companies and industries that require large-scale R&D, manufacturing, and distribution, such as airplane engines, pharmaceuticals, semi-conductors, etc. Hopefully, investors will reward only the most transparent and honest of the remaining players.
Most important, I think we will also see the growth of diversified, regional capital markets – not dependent at all on Wall Street – designed to support small-and-medium-sized, triple-bottom-line companies in sectors like food, energy, clothing, building materials, and a whole range of household products (furniture, toys, etc). The goal here is that people save more, spend a higher percentage of their overall income on basic needs, keep their investment strategies simple, and their money closer to home.
To return to the issue of scale and power, these regional capital markets will ensure a healthy democracy in the U.S. Every business student of the post-World War II era has learned about “efficient” flows of capital and how a “fragmented” market will invariably consolidate. But, I don’t think this is true anymore. The 21st century will have many fragmented markets, because investors and consumers will demand authenticity and real innovation from the companies they support. This fragmentation or diversification will only be accelerated as a result of the current financial/economic crisis. This is how nature works, too. An ecosystem rich in biodiversity is the most resilient.
At RSF Social Finance, we are excited to play a leadership role in the transformation to a more decentralized financial system:
• in the “what” (our financial and advisory support for companies and non-profits that create tremendous positive social impact), and
• in the “how” (our approach to working with investors and borrowers, and donors and grantees in each transaction that acknowledges the interconnected nature of life).
I hope we have a spirited discussion on the issues presented here and in the articles cited, both amongst the RSF staff and Board, as well as with you: our clients, partners, and friends.
Don Shaffer is President & CEO of RSF Social Finance.
- Published by Don Shaffer
- Categories: Economy, Governance, Investing, Lending, Local economies, Money, Social Finance
Nice piece, Don. One of the great things going on for the democratization of finance is that many of the conveniences formally the domain of the big banks are trickling down to the smaller community banks and credit unions. My money these days is all with a credit union (20 year member) or a communiy bank (also a small shareholder) and I have all the technological conveniences I enjoyed with BofA, plus better service. In the case of my bank, I get a chance to chat one on one with the CEO every month. I’d have to have a lot of money on deposit with BofA to pull that off!
Comment by Chris Sayer — June 2, 2009 @ 7:48 am
A strong and richly functioning financial ecosystem will have a wide range of sizes and types of financial institutions. Large ones are particularly adept at focusing rsources on innovations related to banking technology and product innovation. Smaller institutions lead with service and relationship but are not usually able to compete on price or product innovation (those are the 3 basic approaches to business success). The TBL focus will also grow out of communities and that will foster the growth of smaller businesses and banks rooted in community. However, I do not see fragmented markets as likely in the 21st century with the tremendous reach of technology interconnecting all of us. I also agree with President Obama that more vigorous regulation would have and should have prevented the abuses and excesses of the last decade. This was probably the result of the excessive political power of large institutions; the power may be a curse in some respects but it has allowed the commoditization of many products (eg ATMs, equity lines of credit, mortgages, etc)that has benefited many people.
As with any ecosystem diversity is key to our efforts to stymie the inexorable march of entropy. Dinosaurs eventually failed on their own merits. I look forward to seeing what the future brings; we need very strong oversight and regulation but would not want to see the heavy hands of government attemting to recreate the financial markets.
Comment by Vince Siciliano — June 2, 2009 @ 2:15 pm
I do think, Don, that you and RSF will be leaders in innovation in finance. I think your second commenter is right in that the “marketplace” for financial services will include large, medium, and small/local companies to provide services that appeal to the wide range of needs and values of the customers. Good regulation is clearly needed–recent history and lessons from the past have proved that over and over. Large institutions inherently pose more risk to the entire system because of the inter dependencies with other institutions. Large banks and other financial institutions enjoy a number of vital services from the government(e.g. FDIC, Fed borrowing, etc.). The appropriate services should be “risk-adjusted” so that their costs reflect the institutional risk. This is just one example where regulation and government support can better deal with risks in our financial system.
I think the biggest risk in our financial system is the special interest and political risk where preference is given to maintaining business positions of industries or institutions that use political campaign contributions to secure their economic well being. Until we solve that problem, we won’t achieve the regulation and oversight that we truly need in financial services, health care, education, the defense industry or other areas where government has to play an important role to let “free market forces” truly operate to the public good.
Comment by R. Warren Langley — June 2, 2009 @ 9:39 pm
The central problem is not as much scale as it is the Gramm Leach Bliley Act that decimatated the separation of commercial banks from other risky activities like investment banking and insurane. Had that separation remained in place we would not have had a meltdown and loss of lending ability. The investment banking activities of a Citi would not have been able to cripple the commercial lending because they would have been completely separate companies.
The economic power issue is not limited to Wall Street. Until the lobbying power of big business is minimized (if ever) little will change other than window dressing.
Comment by Lawrence Rosencrantz — June 3, 2009 @ 12:21 pm
Mr. Rozenkrantz makes an excellent point in targeting the impact of the Gramm Leach Bliley Act and then the lobbying power of big business. Correct as far as it goes, this is incomplete. The desire of politicians to expand the role of govenment is equally precarious. The social engineering in the legislation that required the issuance of mortgages to high risk applicants is an example. My point is that there’s plenty of blame to spread around. Let’s remember that the Judaeo-Christian principles of honor in business is, in the long run, the only model that is sustainable.
Comment by Robert Herrick — June 4, 2009 @ 4:54 pm
I agree with many of the comments so far — thank you for responding.
Like Vince, I do not want the “heavy hands of government attempting to recreate the financial markets”. I’m confused, though, because the current bail-out…..which has been based on threats of systemic risk that may or may not be true…..seems to be a clear application of government to address the problem…..? No? I figure that breaking the banks up, and then letting entreprenurs take it from there, is actually less government-invasive than propping up the big guys with hundreds of billions of dollars in taxpayer/government money.
My hope is for fundamental demand change…..for many smaller retail investors to pull their money out of the big bank stocks, as well as for them to pull their money out of checking/savings deposits with the big banks…..and re-allocate to community-based banking institutions.
Comment by Don Shaffer — June 5, 2009 @ 4:04 pm
Banks compete in a global marketplace today. Breaking them up (ither than separating investment banking) would only cripple US based banks versus banks in Europe, China and elsewhere. The debate here over regulation versus self-regulation (eg “Judeo-Christian principles of honor in business”) misses the point. The real issue is how much regulation of each type is appropriate. Human nature beiing what it is where economics are concerned, and with history as our guide, it is clear that the relaxation of regulation over banking has led to disaster for more than the banks. These critical institutions require regulation that red flags excess and insulates them from undue risk. That is whst the FDIC and Glass Steagall did effectively until Gramm Leach came along and threw down the gauntlet.
To expect capitalists to act in anyone’s interest other than their own is foolishnes. To over=regulate such that creativity and initiative are supressed is likewise wrong. We ought not to be debating whether to regulate or not but rather what regulations are appropriate. Clearly, where the financial markets are concerned a heavy dose of transparency would be helpful,
Comment by Lawrence Rosencrantz — June 5, 2009 @ 5:48 pm
For anyone engaged in this dialogue string, the op-ed page from last Sunday’s New York Times ran an article titled, “The Economy is Still at the Brink” by Sandy B. Lewis and William D. Cohan. They ask the really important, pointed and hard questions about Wall Street and the Banking System. One of the points they are making is that transparency is being used selectively and somewhat as a smoke screen to avoid making visible all the real issues, such as who is really benefiting from the plan. The authors also take issue with the top executives of Wall Street, not one of whom “has had the courage or decency to step forward in front of the cameras and explain to the American people in his own words exactly how and why he allowed his firm to cause the crisis.” They rightly make the case that the “storm is not over, not by a long shot,” though we may be gently lulled into thinking all will be okay if we just go back to the way it was.
The way I look at it is that we are now living in the longest sustained illusion of an economic non-collapse in history. Maybe the illusion will hold. If so I (and every other American) will be indebted to the power of positive thinking, and will likely also be further indebted when the bill comes due for mustering all that money. I know I may be confused but I thought bail out meant to evacuate the water from a sinking ship. So why are we really bailing in with all that money and calling it bailing out? Is this part of the illusion? No one of us is bigger than our collective failure to recognize and reckon with the truth. My hat’s off to Mssrs Lewis and Cohan for their unvarnished inquiry.
Comment by John Bloom — June 9, 2009 @ 12:20 am
[...] read James K. Galbraith’s statement that Don recommends in his recent blog post, but my attention was drawn to different parts of Galbraith’s testimony. The first was the [...]
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Fees paid directly to independent financial adviser – even if this agreement is still probably less common, is an alternative to be offered by the director. The actual fees charged will depend on the amount and type of investment is being made and how complex it is necessary advice. It may be cheaper to pay a fee and the customer need not worry about the objectivity of the advice, without worrying that the counselor is somewhat influenced by a commission that could derive from a particular supplier.
Commission and payment – thanks to the clarity of the relationship between adviser and client vendors, it is also possible to have a combination of both commissions and fees. This breakdown of the actual cost of the advice provided by independent financial adviser makes it much easier for customers to compare the real cost of any investment decision chosen.
Comment by UK Financial Advisors — December 27, 2009 @ 6:57 am
[...] by president & CEO Don Shaffer: “Banks for the New Economy” from 12/29/08, “A Dialogue on the Banking Crisis” from 5/25/09; and “It’s Happening Right Now” from [...]
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