Fortress balance sheets at financial institutions

September 25, 2009

bob-bench– Robert Bench, a former Deputy Comptroller of the Currency in the Reagan administration, is a senior fellow at the Boston University School of Law Morin Center for Banking and Financial Law. The views expressed are his own. –

Financial Institutions inherently are fragile, simply because they are intermediaries exposed to both exogenous and endogenous forces.

Externally, they are vulnerable to wars, weather, or worn-out economic conditions. Internally, they always are susceptible to excessive risk takings as well as inadequate controls over operations.

Therefore, financial institutions historically have projected strength two ways. First and most obvious have been their buildings, designed of granite, with strong doors and deep vaults, to show the institution was a “fortress” against troubled times. Less obvious, but more importantly, they maintained “fortress balance sheets” comprised of high levels of capital, high levels of liquidity, and massive “hidden” and “inner” reserves.

Accounting, tax, and regulatory policies accommodated salting away profits in good times, so they would be available to draw down during bad times, which were sure to occur. The policy bias in both the private and public sectors was to preserve stability within the “public utility” that is the financial system.

But the recent history of financial policy has been to abandon these historical building blocks in the financial fort. Tax policies no longer accommodate the build-up of loan loss reserves. The Securities and Exchange Commission set policy when they complained to a major institution that it had tucked away too much money in reserves. The SEC also permitted investment banks to operate with 50 percent less capital while the banking regulators allowed the banks themselves to decide how much capital and reserves they needed.

The mantra of “maximizing shareholder value” led to religious attempts to precisely measure risks and profits without any recognition of the history as to how financial institutions are absolutely unlike commercial firms.

So we as citizens have been exposed to the procyclicality dangers of finance because the countercyclical protections we used to have were abolished. A procyclical financial system amplifies booms and busts. History shows we want a countercyclical financial system that dampens booms and cushions us against trouble.

The collapse of the procyclical financial system has required staggering taxpayer assistance to restore stability. European taxpayers have had to nationalize and/or intervene to save their financial system. According to the Federal Deposit Insurance Corporation, the American taxpayer has made available some $13.9 trillion in support facilities to U.S. financial institutions while also doubling the national debt as taxpayers were forced to take over some $5 trillion in liabilities of Freddie Mac and Fannie Mae.

The G20 initiatives to require more capital, in terms of liquidity and reserves, at financial institutions represent a return to countercyclical policies for the financial system. Indeed, the initiatives in the short term comprise a quid-pro-quo for the massive taxpayer bailout that has occurred. We have been through the rescue, are into repair, and now beginning the reform and retribution stages of recovery.

The recent public policy of privatizing profits and socializing losses is unacceptable to taxpayers. The financial and economic destabilization of the past year has been difficult for millions of households. So for the long term the G20 proposals intend to lessen the event of future instability. But when it does occur, shareholders will absorb the losses, not the taxpayers. In essence, we are transitioning from “too big to fail” to “too safe to fail.”

For sure, these new government requirements will lead to altered and perhaps less profitable business models. Financial institutions will become less dynamic and more cautious. But the financial system and the economy likely will be less volatile, more stable. Financial institutions will return to serving commerce, households, and governments — rather than serving themselves

Indeed, the fundamental question inherent with the G20 initiatives is what do societies want the financial system to do and how do financial institutions get on with the job? The invisible hand of the marketplace failed. It is being replaced with the very visible guiding hand of government. The Reagan/Thatcher period of deregulation is over. The financial system is a public good mandating robust public regulation and oversight. Expect that solid, “fit and proper” financiers will welcome the G20 initiatives.

It is in the best interest of the financial institutions themselves to fortify their financial conditions so as to restore trust in the marketplace. Normality will not return to the financial system until trust is restored in the competence of government oversight as well as in the integrity of governance exercised by directors and management of financial institutions.

5 comments

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Here’s a novel solution the US government should take over one of the banks it has a large shareholding in. It could then offer cash rates on deposits and loans with a small margin, enough to make the other banks still make some profits. All other riskier activities could be taken out of the banks therefore getting rid of the systemic risk. Then If people want to invest in the riskier activities they can. Being fully aware that they can loss the lot and the government will not bale then out because they don’t represent that systemic risk.

Instead we get the G20 meeting. They should have all been wearing party hats, coloured wigs, big red noses and oversized shoes! The Bankers must have wet themselves with laughter, bring the world to the brink and be told they will still continue to be baled out. Talk about encouraging moral hazard. All the bankers need to do is call there company something other tan a bank and then get back to their old habits. Taking on more risk and bigger bonuses. Well done G20 !

Posted by gd | Report as abusive

Good article.

gd, the US Government already has it’s own bank, its called the Federal Reserve Bank.

Posted by Casper Lab | Report as abusive

Casper Lab

I’m talking about a bank that doesn’t encourage systemic risk and GFC’s. Therefore I don’t think the Fed qualifies.

Posted by gd | Report as abusive

Sorry I also forgot about moral hazard.

Then of course these’s that guy leading it all Ben.
Have a look on you tube to see what his response was at the start of the GFC. He used words like limited, contained. 11 trillion dollars is limited is it Ben?
Then Ben now tells us it’s over , what he doesn’t tell you that take away the programmes and the printing money and the dodgy accounting rule changes and there is no recovery. But good old Ben just keeps cheering the market on, he wants the DOW going up 1% every day.

Posted by gd | Report as abusive

gd, I am not particularly good with acronyms and I don’t know who ‘Ben’ is, but from what I have read, they will cock that imaginary bank up too.

Posted by Casper Lab | Report as abusive