[Cross post from Daily Kos]

There’s a diary published yesterday which reaches various conclusions from Bernie’s interview with the editorial board of the NY Daily News. I believe those conclusions are largely wrong.

Let me start with a section of this diary I find truly remarkable:

Moreover, breaking up banks now would likely cause new chaos as “interwoven asset and liability threads around the globe” would have to be “disentangled,” “millions of contracts would have to be renegotiated,” and “lines of credit might have to be terminated because smaller banks can't afford to finance them.”

This is magical thinking.

The diarist claims it would be chaotic to break up a financial institution (or implement it’s own living will) in a period of relative calm. But the diarist also assumes it would be possible to accomplish this during a financial crisis.

This argument demands one be completely oblivious to the dynamics of a financial crisis in a credit-centered system. When a panic has begun, any whiff of a failure immediately leads to a run, generating a cycle of withdrawals which force liquidations, which lead to margin calls, which lead to falling asset prices, which lead to more margin calls and so on till credit has contracted to the point where participants are exhausted or sanguine.

Trying to liquidate a complicated balance sheet during such a panic virtually guarantees severe losses. It was precisely this realization that led to the creation of the Troubled Asset Relief Program. TARP did exactly what the name suggested, purchased “troubled assets” from financial institutions because they could not be sold on the market, sometimes at any price. Implementing this price floor (backed by tax-payers) and effectively re-capitalizing the banks is why we say TARP was a bailout.

This is also the reason Neel Kashkari (the guy who ran TARP and bears an uncanny resemblance to yours truly) said recently he believes SIFIs must be broken-up prior to the next crisis. In a crisis, regulators will not have the will or the ability to do so without exacerbating the panic. I discussed his comments a couple of months ago.

By the way, the Bloomberg article the diarist links to was written by Paula Dwyer, who also wrote a book with Arthur Levitt. Levitt was chairman of the SEC from 1993 to 2001. Under his watch, we saw the largest bubble in US equities in two generations, facilitated by enormous levels of shoddy underwriting and outright fraud in research divisions across the street and in C-suites. He was appointed to his position by (wait for it) Bill Clinton. After leaving the SEC, he worked for Goldman (post-crisis) and AIG (leading up to the crisis). I would take what Paula Dwyer has to say about Bernie Sanders with a large pile of rock-salt.

More below the fold…

I’m going to run through some of the Sanders quotes in the interview to explain what I believe he was saying. But in essence it is that the authority to break-up financial institutions does exist under current law, but it has not been utilized. In fact, it has never even been seriously considered by the regulators entrusted with that authority. The regulators are uncertain of the authority they have been given under Dodd-Frank, and absent direction from either Congress or the administration, the assumption seems to be that this is “in case of emergency, break-glass” authority. The argument Sanders is making, and I would make, is that by the time you are ready to break the glass, it is too late.

This realization is exactly why Bernie has repeatedly introduced (since 2009) legislation that would clarify this authority and require the breakup of SIFIs. The text of the legislation can be found here. It requires:

1. The FSOC draw up a list of institutions deemed Too Big To Fail
2. Secretary of the Treasury would break-up, unwind, or force divestiture of business lines till institutions were no longer TBTF.
3. Instructs the Fed to close the discount window and any other form of financing to institutions deemed TBTF.
4. Prohibits use of insured deposits for various purposes deemed speculative (this is the Glass-Steagal like provision).

It’s a short bill, which is fine since I like my financial regulation short and simple. It demonstrates an understanding of what caused the crisis and how to remedy it at the root.

Back to the interview Bernie gave and my take of what he was saying and how it seems to have been systematically misinterpreted.

Sanders: How you go about doing it is having legislation passed, or giving the authority to the secretary of treasury to determine, under Dodd-Frank, that these banks are a danger to the economy over the problem of too-big-to-fail.

Daily News: But do you think that the Fed, now, has that authority?

Sanders: Well, I don't know if the Fed has it. But I think the administration can have it.

The Fed doesn’t have the ability to mandate liquidation or a break-up of a large financial institution on its own. The Financial Stability Oversight Council has to act in concert with it under Dodd-Frank. It’s chaired by the Treasury Secretary, and has the heads of various regulatory agencies as members (Fed, OCC, CFPB, SEC, FDIC, CFTC, FHFA, NCUA). They are all presidential appointees. So yes, the administration through the heads of regulatory agencies who are appointed by the President can set this in motion. That said, it is unlikely the current composition of the FSOC would take embark on such a quest.

It is not clear the 7/10 votes required would be available on the FSOC. Nor is it clear that 4 out of 10 Fed governors would make the required determination that an institution posed a grave risk to the financial system as mandated in section 121. Neither the Fed, nor other regulatory agencies appear to have examined this authority seriously or made any plans to use it.

Why would they? No one has told them they need to use this authority. Electing Bernie Sanders would be a enormous signal that the American electorate expects regulators to use this authority. If this signal is delivered, they will use it. That’s how politics works.

Daily News: How? How does a President turn to JPMorgan Chase, or have the Treasury turn to any of those banks and say, "Now you must do X, Y and Z?"

Sanders: Well, you do have authority under the Dodd-Frank legislation to do that, make that determination.

Daily News: You do, just by Federal Reserve fiat, you do?

Sanders: Yeah. Well, I believe you do.

Once again, it’s the Daily News Editorial board that is confused about this, not Sanders. They’re the ones suggesting the Fed drives a break-up or could force it. As I’ve discussed, the Fed can initiate the process under current law, but there is no requirement for them to do so today. The Fed can also do many other things that would immediately force the unwinding of an financial institution.

The Fed is under no obligation to lend at the discount window to any particular institution, or indeed any institution. If the Fed were to refuse to lend to an institution today, it would guarantee a wind-down of the institution under whatever terms the Fed sets by tomorrow.

In general terms, under a fractional reserve banking system like ours, no large depositor or counterparty will continue to do business with a bank that does not have access to the lender of last resort. The very survival of Goldman Sachs and Morgan Stanley in 2009 hinged on them converting their parent entities into bank-holding companies and thus gaining access to the discount window. That access gave them a theoretically unlimited credit line to draw upon. This signal is what prompted counterparties in the money-markets to begin dealing with these firms again and permitted them to finance their overnight liabilities and complete day to day activity without onerous terms being imposed by the other side.

Daily News: I get that point. I'm just looking at the method because, actions have reactions, right? There are pluses and minuses. So, if you push here, you may get an unintended consequence that you don't understand. So, what I'm asking is, how can we understand? If you look at JPMorgan just as an example, or you can do Citibank, or Bank of America. What would it be? What would that institution be? Would there be a consumer bank? Where would the investing go?

Sanders: I'm not running JPMorgan Chase or Citibank.

Daily News: No. But you'd be breaking it up.

Sanders: That's right. And that is their decision as to what they want to do and how they want to reconfigure themselves. That's not my decision. All I am saying is that I do not want to see this country be in a position where it was in 2008, where we have to bail them out. And, in addition, I oppose that kind of concentration of ownership entirely...

This is entirely reasonable. It is not necessary for the administration, or the President to dictate how a group should be re-organized to reduce its size. That can be left up to the group itself. What the administration would have to do is set the terms under which such a break-up would be mandated. We do not currently have these, apart from the vague “grave” financial risk provision which as I noted the regulators have not treated seriously. We do have a 10% concentration limit on institutions that withholds regulatory approval for acquisitions/mergers if the resulting institution would have an excess of 10% of financial sector liabilities.

In the past, various US adminsitrations have also used the powers of the Sherman antitrust act to mandate breakups. The two big examples are AT&T and Standard Oil. The Libor rate-rigging, CDS price-fixing and mortgage underwriting investigations all pointed to forms of price-fixing, collusion, or anti-trust activity. They could also form the basis of a settlement that mandated a breakup. If, that is, the relevant heads of agencies wished to act.

These and other laws covering investor disclosure and securities fraud could form the basis for prosecuting individuals. The lack of prosecution of individuals is something I’ve written about before (here and here). What Bernie is getting at with his insistence on prosecuting individuals is the fundamental injustice where senior managers making these decision are effectively let off the hook with light financial penalties and possible impact to their career. The heavy financial penalties are borne by the institutions, i.e. their shareholders and employees. This is most likely an insufficient and ineffective deterrent. It is also fundamentally unfair when we consider the very punitive levels of incarceration for drug-related offenses. Once again, this will not happen till agency heads are given the mandate to do so by an administration.

But the diarist is eager to jump to the conclusion that it would be the Fed mandating a breakup. It was the Daily News Editors who suggested that, not Sanders. Sanders just says that he believes the administration, working through agencies, regulators and the justice department likely has the authority to break up banks. And indeed it does. But it is so much easier to argue against the strawman which Bernie never actually made.

So first, we have Sanders admitting that he is not familiar with how the current regulatory scheme under Dodd-Frank works. A president doesn’t just decide that a bank is too big to fail and tell the Fed to break it up. An institution would have to meet the criteria established by the FSOC and Office of Financial Research at the Treasury to be subject to such a fate. Further, given the reforms already in place under Dodd-Frank, it is highly unlikely that such action would be warranted.

The diarist then quotes this line (which Bernie uses in all his stump speeches):

Sanders: Let me be very clear about this. Alright? Let me repeat what I have said. Maybe you've got a quote there. I do believe that, to a significant degree, the business model of Wall Street is fraud.

And ran with it to reach these conclusions.

Sure, there was fraudulent activity and abuse in connection with subprime mortgages. But to say that the “business model of Wall Street” is fraud “to a significant degree” is completely irresponsible. Do you know what else is part of their business model? Helping enterprises raise capital in order to innovate and grow and provide goods and services to the economy. Helping individuals invest retirement income so it grows at a faster rate than inflation and providing the liquidity for such a system. I could go on. This is not going to go over well for New Yorkers in the upcoming primary.

First things first. Asset Management is not a big part of what “Wall Street” (Broker/Dealers) does. Asset Managers are customers of “Wall Street”. So let’s forget about the “helping individuals invest retirement income” bit. That business is done by investment advisers like mutual funds, ETFs, financial advisers, who do not generally employ multi-digit leverage and who do not become hubs in the markets. They are generally spokes. No one is advocating breaking up Vanguard.

When you look at the income statements of the large banks Bernie is talking about (let’s pick JP Morgan, Citibank and Goldman), what you quickly see is that IBs generate a significant fraction of earnings (prior to 2009 it was even more skewed). Most of the consumer/commercial banking revenue is net interest income (spread between lending and deposit rates), though the credit card businesses also deliver large amounts in fees.

From: GS page 35, 2014 Annual report, JPM page 80, 2014 annual report, C page 2014 Annual report (Citi doesn’t break out consumer and commercial at the global level and I don’t have the time or inclination to do it for them).

Tier 1 capital is the value of the bank’s common stock and reserves as a percentage of it’s total balance sheet. You can think of this, roughly, as the amount of loss a bank could suffer without becoming insolvent (i.e. unable to pay liabilites). A key reform under Basel-III is to mandate a minimum requirement for Tier 1 capital, this will steadily rise to 11% within 3 years for G-SIBs. For a large banking institution, this is actually pretty robust.

But I guess this is where I part ways with Dodd-Frank and enter the Bernie camp. I understand the cushion that double digit tier 1 requirements provide. Leverage ratios in the high single-digits should be prudent for a well-managed institution. But I also know that every financial crisis is unexpected, and the rot starts at poorly managed institutions. Whether 10% or 11% is sufficient depends on how you view the stress-loss models used by regulators and whether or not you think they capture tail risk well.

Let’s talk about the business of helping enterprises (and governments) “raise capital”. This is the preferred example presented by Investment Banks when asked what they do. It’s convenient because it’s generally considered worthwhile to help with Tesla’s IPO or a follow-on offering. That business is the “Fees/Underwriting” line below.

From: JPM (pg 92), GS (pg187), C page 24 of 10-K.

Treasury/Lending is largely net interest revenue. But the biggest portion is Markets/Trading. This is the juicy business in investment banking. And it’s everything from market-making, to derivatives structuring, to clearing, to commissions for routing trades. I’m not about to tell you this business has no social worth. I’ve spent most of my professional career working in or around it in some form. But we must be clear, this is what Wall Street does primarily. Not underwriting. Underwriting revenue used to be the biggest game in town, but it has not been that since at least the late 1980s.

Firms of various sizes operate in this business successfully. This is where trillions changes hands each day, and where losses can accumulate very rapidly, either through error, malfeasance, or excess risk-taking. Can such losses burn through enough equity to put a large firm at risk? Yes. During the financial crisis, a number of firms realized losses that were on the order of tens of billions. Could they absorb such losses again? Perhaps. But this was a man-made crisis. What if we had a simultaneous environmental crisis that devastated asset values like the drought in the dust bowl did during the great depression? Would we permit an institution with a Trillion dollar balance sheet to fail under such a scenario? How many Trillion dollar balance sheets would we rescue? Those are the questions to ask, and no one except Bernie seems to be asking them in this primary.

Mouthing terms like “shadow banking” or “high-frequency trading” is meant to impress the gullible with the sense that you know what you’re talking about. But banking is actually very simple. And size matters in banking, particularly in a crisis. How small does an institution have to be before our politicians will accept the risk of letting it fail. That is the tough question to ask. That is the question that senior managers do not want you to ask. Because 70 million in comp with an equity grant sweetner looks reasonable when you’re running an institution with a trillion dollar balance sheet and 40 billion in revenue. Take away a zero though, and things look very different.

Lastly, Bernie can talk to all of this quite well, but he understands his audience and the readership of the Daily News. His message discipline and presentation of the issues as a matter of “where there's a will there's a way” is spot on. Legislative name dropping is more likely to impress the readership of New York’s broadsheet, the NY Times. For the record, I read both.