Are the big banks winning?

October 24, 2012

The Dodd-Frank Act to re-regulate the big banks was intentionally tough. It was passed in the wake of the 2008-2009 financial crash to end cowboy banking; require far more capital  and much less leverage, and rein in the trading-desk geniuses who pumped up serial bubbles. Since Congress is a poor forum for crafting such a complex statute, the details were left to the expert regulatory agencies.

The big banks pay lip-service to the goals of Dodd-Frank — but they’re mounting bitter, rearguard actions in federal courts to block meaningful constraints and regulations on procedural and other grounds. This is an ominous turn of events, since these banks have the legal firepower to overwhelm budget-constrained U.S. regulatory agencies.

While Dodd-Frank is aimed at preventing another cycle of bubble-and-bust, shrinking the financial sector is crucial for other reasons. One is a mass of evidence demonstrating that hyper-financialized economies have lower growth. Another is the appalling ethical record of large financial companies. The chance of making huge paydays by risking other people’s money, it seems, can sometimes derange moral compasses.

First, the pro-growth argument for clamping down on the banks: Once the financial sector achieves a certain size, its continued expansion reduces economic growth, according to a new study by two senior economists at the Bank for International Settlements, Stephen Cecchetti and Enisse Kharroubi, using a large international data base stretching back more than 30 years.

Their conclusions are unambiguous. No country can achieve a high rate of growth without a well-functioning financial system. China, for example, lacks a deep system of consumer finance, forcing it into a lop-sided development strategy. The result is the creation of dangerous imbalances that could threaten continued rapid growth.

An outsized financial sector expansion can actually reduce economic growth, according to their data. This relationship holds for country after country, and the tipping points are fairly consistent. When private credit grows to between 90 percent and 100 percent of gross domestic product, it is tilting toward too big. In the runup to the 1997-98 Asian financial crises, Thai private credit outstanding grew to 150 percent of GDP and growth turned sharply down. As soon as credit was ratcheted back to 95 percent of GDP, however, Thai productivity picked up sharply.

New Zealand’s economy offers much the same picture. As its financial sector expanded beyond the 100 percent mark, productivity dropped sharply, then rose again as credit was brought under control. Ireland and Spain show a similar pattern.

The sector that typically bears the brunt of hyper-financialization is manufacturing – especially the heavy industries that need working capital to finance materials and work in process. The next most damaged are research-and-development-intensive businesses, perhaps because finance siphons away too much of the best science and math talent. Whatever the reason, when American finance bulked up in the 2000s, there was a cataclysmic fall in manufacturing employment.

The second important reason for curtailing the financial sector is its ethical record. By now everyone knows how our major financial institutions created a trillion-dollar bubble in high-risk mortgages and other junk paper that they sold throughout the world, even to some of their best customers. It is less appreciated that the same institutions have been skirting, often flagrantly breaking, laws and regulations for a long time. It’s almost part of their standard playbook. Here’s a sampling of pleas copped by our most august financial institutions just since 2000.

Citigroup, JPMorgan Chase and Merrill Lynch paid hundreds of millions in fines and billions to Enron shareholders for conspiring with Enron to fabricate false cash flows, debt statements, and profits in its financial reports (here, here, and here). At least seven other banks provided similar assistance on a smaller scale. Then, during the dot-com boom, executives at 10 banks, including Merrill Lynch, Morgan Stanley and Salomon Smith Barney, all issued misleading stock analyses to support the sales targets of their underwriting groups. Fines and other settlements totaled $875 million.

Our banks also resort to bribery. JPMorgan Chase, to close one deal in 2003, paid bribes to officials of an Alabama county to secure the underwriting of a $3 billion local bond issue, and to Goldman Sachs and a smaller bank to withdraw from the bidding. (The bond was a disaster for the county and forced it into bankruptcy.)

Government investigators and officials have now uncovered more than 100 cases of banks’ bribing or suborning officials in municipalities across the nation. JPMorgan Chase, Bank of America and UBS have so far paid settlements of at least $525 million.

Banks have also taken gross advantage of their customers. Twenty-one banks and securities firms, including UBS, Merrill Lynch, Wachovia, Morgan Stanley and JPMorgan Chase made settlements during 2008-9 for selling tens of billions in high-risk securities falsely labeled “as good as cash.” Thousands of small investors were among their victims. These five banks alone paid a total of $57.5 billion in settlements and restitution.

Aiding and abetting tax evasion is almost a standard bank product. UBS, a major Swiss bank, settled with American authorities to avoid criminal prosecution for helping wealthy Americans evade taxes, to the extent of smuggling diamonds and other valuables for their customers. Ten other Swiss banks have been similarly charged, as has Israel’s Bank Leumi and most recently HSBC. Money laundering has become another specialty.  Credit Suisse, Barclay’s and Lloyds Bank paid $1.2 billion in fines and other settlements for illegal money laundering for governments in Libya, Iran, the Sudan, Burma and North Korea. Credit Suisse even issued brochures boasting of their fool-proof processes for evading international regulations.

Drug money laundering, however, may be the most profitable overall. Wachovia Bank, now part of Wells Fargo, signed a settlement to avoid criminal prosecution for improperly and illegally transferring at least $398 billion from Mexico, most of it obviously drug cartel money. The banking subsidiary of American Express engaged in similar laundering on a smaller scale. Another money laundering case, possibly the biggest, is now under negotiation between HSBC and the U.S. authorities.

Nor is there any evidence that the financial crash has modified bank behavior. Nearly all the top banks have been caught manipulating LIBOR numbers to their advantage And there are signs that the old subprime lending community is making a comeback, foisting high-risk reverse mortgages on unsuspecting seniors.

Now the Wall Street ethical style is infecting the rest of industry. The private equity business, which specializes in highly leveraged buying and selling of whole companies, is a primary vector for spreading the disease. for private equity portfolio companies, strategy is subordinate to cash extraction. Employees are fungible inputs, as easily discarded as used tools. There is no compunction about relocating to ethically questionable locations like China, or the Mexican maquilladoras factories.

Wiping out employee pension funds is an acceptable, and common, private equity method of “creating value.” Portfolio companies take on huge debt loads to finance “special dividends” – massive cash extractions for the fund investors and the private equity executives.

Most corrosive, perhaps, is that new acquisitions always come with an “exit strategy.” Private equity firms have hookups, not relationships. Their properties live in spreadsheets, so they can make financial decisions without the distractions of real-life employees and communities. More and more executives of major companies are emulating the private equity style and showered with praise by the financial press for doing so.

Achieving the objectives of Dodd-Frank, therefore, is crucial. Not just to prevent another bubble, but to redirect resources to enhance growth rather than feed the Wall Street casino. And, perhaps, to save the soul of American capitalism.

PHOTO: The entrance to JPMorgan Chase’s international headquarters on Park Avenue is seen in New York.  Shannon Stapleton / Reuters


We welcome comments that advance the story through relevant opinion, anecdotes, links and data. If you see a comment that you believe is irrelevant or inappropriate, you can flag it to our editors by using the report abuse links. Views expressed in the comments do not represent those of Reuters. For more information on our comment policy, see

First you state Dodd-Frank was intentionally tough, but then end the paragraph saying Congress is a poor forum for crafting the details of such legislation. In other words, the US taxpayer got worked over again courtesy of the financial elites from Wall Street and nothing really changed.
It is time for Congress to get off its back side and do something constructive in the way of basic structural change. For openers legislation incorporating a Glass-Stegall like separation between true “banks” who deal in debt and true “investors” who deal in equity should be put in place. Incorporating these two (debt & equity) under the same umbrella has proven to a recipe for disaster.
Way too many assets are tied up in the derivatives markets which produce very little in the way of general economic benefit. These, and credit default swaps (naked bets) need to have exposure to reserve requirements that would allow state insurance regulators to weigh in. This should dramatically reduce the size and influence of this market.
Residential mortgage lending has been an area of particular concern. We drifted away from institutions that understood their local markets in favor of a one size fits all approach. Lending standards as we all know now went into the crapper. These two factors tied to the bundling of mortgage backed security issues coupled with politically driven aspirations of Congress rolled up into the crash of ’08.
The lending capital need of the industry is a constant to be taken into account for whatever structural change is adopted. Looking back, it is obvious that the S&L model did work up to when Congress’s politically motivated modifications quickly led to their demise and the resultant RTC solution. The reason S&L’s worked for as long as it did was its’ tie to the local market and reasonable lending standards. Something approximating this function needs to be resurrected as we go forward.

Posted by 4ever49 | Report as abusive

It appears that “too big to fail” should be re-worded as “too big to regulate”. And so we have an international finance system that resembles an organized crime syndicate far more than any kind of legitimate enterprise. And we appear to be on the road to electing one of the syndicate’s inner circle as US President.

Posted by Sanity-Monger | Report as abusive

“We appear to be on the road to electing one of the syndicate’s inner circle as US President.”

Remains to be seen – if he can truly balance both sides of aisle there may be hope – slim – but a chance. We already know the incumbent is compromised.

Posted by 4ever49 | Report as abusive

One point should be reconsidered. The article suggests, in support of the theory of Cecchetti and Kharroubi, that America’s fall in manufacturing employment was perhaps due to over-financialization. I quote:
“Whatever the reason, when American finance bulked up in the 2000s, there was a cataclysmic fall in manufacturing employment.”

It seems to me that even without over-financialization, America destroyed its own manufacturing base by signing the NAFTA free trade agreement, and other WTO free trade agreements relating to China, South America and other low-income, impoverished, highly populated regions. Those agreements were lobbied for by large corporations who benefited greatly from outsourcing, even while they smashed America’s middle class.

But, mainly I wanted to say this was a great article by Charles Morris.

A few years ago I read his book predicting the trillion dollar meltdown. An excellent book. Wish now I had acted upon it.

I’m glad this Reuters article appeared.

I’m going to read his new book. He is truly a great writer.

Posted by AdamSmith | Report as abusive

Obama made a big mistake by not taking these bankers to the woodshed and by appointing Rahm and Geithner who were two banker hacks.

99% of Americans wanted to see justice while the administration gave the bankers more money and failed to punish them.

Posted by theagitator | Report as abusive