Executives of the largest U.S. banks warn that efforts to make the financial system safer will harm their global competitiveness. They conjure a world in which foreign institutions, supported by government subsidies, dominate the business of providing banking services to multinational corporations.
My response: Great idea. Let’s outsource fragile banking.
Large as they are, institutions such as Citigroup Inc. and JPMorgan Chase & Co. aren’t the primary source of U.S. dominance in the global financial-services industry. The country’s real advantage is in asset management. At the end of 2011, hedge funds, mutual funds and other U.S. institutions managed about $33 trillion in assets around the world, more than three times the amount commanded by the six largest U.S. banks. The asset managers’ activities support domestic and global growth, distribute risk and reinforce market discipline.
The banks differ from the asset managers largely in the risk they pose to the broader economy. The sheer complexity of their operations, and their penchant for using large amounts of debt to fund their business, make them “systemically important” and necessitate taxpayer bailouts when they get into trouble. In other words, they concentrate risk, rather than distribute it, and extract a very high price from taxpayers for whatever role they play in supporting growth.
It’s worth asking whether the costs of having such systemically risky firms in the U.S. outweigh the benefits. Automakers, for example, cut expenses by sourcing components from countries where producers enjoy taxpayer subsidies or lower labor costs. Why not outsource the most fragile parts of our financial system to countries whose taxpayers are willing to accept the burden? After all, it’s a very low-margin and low-value-added business: JPMorgan’s return on assets last year, even with the reduced borrowing rates that implicit taxpayer support provides, amounted to less than 1 percent. The bank’s higher return on equity was driven by leverage.
Since at least the rise of the Bank of England in the 17th century, banks were the primary drivers of financial intermediation, aggregating capital -- in the form of deposits - - and allocating that capital to individuals and corporations. The goal was to earn a return investing in productive businesses with increasing market opportunities. Given the social benefits of investment and the commensurate risks to society when money is misallocated, it made sense for governments -- and hence taxpayers -- to support the system, ensuring that banks could earn a fair return while operating in a safe and sound manner. This was a worthy trade-off for centuries.
Over the past 50 years, with the development of a privately managed pension system, the deregulation of trading commissions and a move to decimal pricing, assets flowed away from bank deposits to investment accounts controlled by a growing asset-management industry. The shift compressed margins at traditional banks, prompting them to secure the repeal of the Glass-Steagall Act, a change that allowed them to get into the business of securities trading.
The result is today’s giant bank and investment-bank amalgamations, which rely on taxpayer subsidies to win business from corporate clients and asset managers, and to boost returns on risky speculative trading. Functionally, they are utilities providing low-margin commodity services.
If the U.S. continues to bend markets in an effort to protect such banking juggernauts, it will imperil taxpayers while risking the global dominance of its asset managers and the depth, breadth and transparency that they add to capital markets. This would be like sacrificing the development of the automobile to save manufacturers of horse-drawn carriages.
Bankers argue that if the government reduces its support for big banks -- by increasing capital requirements or limiting bank size -- it will starve U.S. businesses of the low-cost funding they need to grow.
This seems highly unlikely. First, the U.S. has more than 7,000 smaller, systemically riskless banks that are more than able to support the needs of small business and consumers without presenting an economic threat to society. Second, the largest U.S. corporations get most of their funding from capital markets, not from big banks.
Finally, European and Asian governments remain committed to backstopping losses at their own too-big-to-fail banks. So if U.S. companies are looking for low-margin, taxpayer-subsidized lending, they can still get it.
If foreign governments want to support the underpricing of risk and the uneconomic lending that has repeatedly harmed their taxpayers, why not allow our corporations and consumers to benefit? Let other countries’ taxpayers bear the costs. The U.S. should lead the world in productivity and not be relegated to competing in a race to zero.
(Joshua Rosner is a managing director at independent research firm Graham Fisher & Co. The opinions expressed are his own.)
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