Is It Time To Break Up The Big Banks?

There is a growing, bi-partisan movement on Capitol Hill to pass legislation to break up the big banks.  When was the last time that Democrats and Republicans worked in a bi-partisan fashion on anything?  But I digress. 

Former Federal Reserve Chairman Alan Greenspan said recently, “if push comes to shove… I would be in favor breaking up the banks.”  Conservative columnist George Will recently wrote a persuasive editorial urging conservatives to support legislation proposed by Ohio U.S. Senator Sherrod Brown (D) to break up the big banks.  Before we look at this proposed legislation, let’s look at the facts.

How many financial institutions are there in the U.S?  As of 2010, there were about 7,700 financial institutions with insured deposits from the Federal Deposit Insurance Corporation (FDIC).   

How are assets distributed among these 7,700 banks?  The top 12 banks currently hold 69 percent of the total assets of the banking industry.  Community banks, which total about 5,500, have about 12 percent of the banking industry’s assets. 

What are the problems associated with large financial institutions?

1. They are too big to fail.  We cannot allow them to fail because of the negative consequences to our economy and to the world’s banking community.  So this means that we socialize the losses (taxpayers pay the bill) but when they are profitable, as they are now, the banks are allowed to keep their full share of the profits.
2.  They are too big to manage and too complex to regulate.    The recent bank scandals – LIBOR manipulation, money laundering, robo-signing, the “London Whale” – prove the megabanks are out of control.  Though there are a lot of good things in Dodd-Frank, it can only do so much to regulate bad behavior in the banking industry.
3. They are given preferential treatment.  The 20 largest banks pay between 50 to 80 basis points less when borrowing from The Federal Reserve than what community banks must pay.  
4. They are too big to prosecute.  Attorney General Holder stated in recent Senate testimony that “some of these institutions are so large that it becomes difficult for us to prosecute them.”  So in essence, they are too big to jail.  To prove this fact, no one all Wall Street was found guilty on any charges stemming from the 2008 financial meltdown.

So what would the SAFE Banking Act, co-authored by Senator Brown and Senator David Vitter (R-La), do to solve these problems?

1. It would provide sensible limits on the amount of debt that a single financial institution could hold.  No bank could have more debt than 2% of U.S. GDP; and no investment bank could have non-deposit liabilities exceeding 3% of GDP. 
2.  Their funding would be required to come from more stable sources, with about $3 of deposits for every $1 in volatile non-deposit funding.  
3. Banks in excess of this limit would be given three years to comply by drawing up their own proposals to meet this requirement.

Which banks would be affected?  Only six banks would be broken up: JP Morgan Chase, Goldman Sachs, Bank of America, Morgan Stanley, Wells Fargo and Citigroup. 

Now that the economy is improving and there are no immediate crises at hand, we need our legislators to push this bill through Congress on a bi-partisan basis for the president’s signature.  This is something that all of us should want to have enacted.  This is good legislation.  Let’s do it!

Sources: Is Fed Signaling Stance on Bank Break-Ups?, by Kayla Tausche, CNBC.com, March 15, 2013; Senator Sherrod Brown explains why he wants to break up the big banks, by Ezra Klein, The Washington Post, March 9, 2013; Time to break up the big banks, by George F. Will, The Washington Post, February 8, 2013.

Are we experiencing a stock market bubble?

The Dow Jones Industrial Average closed today (March 8th) at another record all-time high of 14,397.07. On the surface this seems like great news.  At long last we are emerging from the Great Recession of 2008.  I read an article in today’s Oregonian which stated that with the recent rise in home prices and the robust increases in the stock market that most Americans have regained the net worth they lost five years ago due to the collapse of the economy.  Wouldn’t that be good news if it were true?  It makes me want to sing a round of “Happy Days Are Here Again.”  

The question that is on my mind, and a lot of like minded people is, “Are we experiencing a stock market bubble caused by The Fed’s quantitative easing policy?  Federal Reserve Chairman Ben Bernanke says emphatically “no.”  He recently told the Senate Banking Committee that he "does not see much evidence of an equity bubble." Yes, stocks are high he says, but that’s because The Fed’s recent policies, which have kept interest rates near zero since 2008, are working to spur spending. 

So let’s begin with the facts.  I think there are three possible reasons for the stock market surge:

• First of all the economy is not as weak as we have been led to believe.  We have seen modest growth in autos, housing and manufacturing activity.  Today’s employment report shows improvement in the private sector employment resulting in a downward tick in unemployment to 7.7%.  Not great but improving, nonetheless. 
• With The Fed’s policy of keeping interest rates at near zero is making it impossible to get an honest return on bonds, savings accounts, money market funds or CDs.  I believe investors are putting their money in equities because these other traditional forms of investment have been taken away from them.
• There is some evidence to suggest that investor confidence is surging because we have avoided the serious crises in Europe and the United States from imploding.  The euro zone crisis and the fiscal cliff crisis in the U.S. have worked their way out and investors feel more confident that we will continue to somehow muddle through. 

However when you look at the stock market fundamentals there is little justification for the recent rise in equities:

• Profit growth has been slowing.  The growth rate in the S&P 500 has slowed from 6.0% last year and is projected to be 1.2% the first quarter of this year. 
• The best long-term measure of value is the price-earnings ratio.  Currently the PE ratio is at 22.9 which is 39% above its long term average.  In other words stocks are significantly over priced.  An old rule of thumb is when investors buy assets at above average valuations they will suffer below average future returns.

It is my opinion that this bull market is not driven primarily by economic reality on the ground but by The Fed’s quantitative easing policy.  Fed Chairman Bernanke says that he plans to continue this policy for at least another two years which bodes well for the stock market for the foreseeable future.  In the short run I wouldn’t bet against The Fed Chairman.  But at some point when a new crisis emerges or an old one raises its ugly head then all bets are off.  

Sources: The Great Stock Market Rally, The Huffington Post by Jerry Jasinowski, March 8, 2013; Better than the alternatives, The Economist, March 9, 2013, Bernanke: There is no stock bubble, CNNMoney by Annalyn Kurtz, February 26, 2013.