A Turning Point:
Defining the Financial Structure
Thomas M. Hoenig, Vice Chairman
Federal Deposit Insurance Corporation
presented to 22nd Annual Hyman P. Minsky Conference
at the
Levy Economics Institute
of
Bard College; New York, NY
April 17, 2013
The discussion of financial firms being too-big-to-fail has taken on renewed prominence
in the United States, putting us on a course that will do much to shape the economic
landscape for decades ahead.
Driving this interest is the perception among many Americans that they remain
financially vulnerable to the largest, most complex firms. The reported lapses in controls
and failed risk-management systems disturb them. Each new scandal adds to their
doubts about the ability of any one person to manage these conglomerates and any
bank supervisor to understand and regulate them.
There is concern that the financial system has become ever more concentrated, with
the largest firms holding increasing sway over the allocation of economic resources.
The 10 largest U.S. banking companies, for example, held assets the equivalent of 25
percent of GDP in 1997, 58 percent in 2006 and, since the crisis, it has increased to
over 71 percent.
The public remains uneasy that the current structure of the largest firms puts the entire
economy in jeopardy should they falter. History and current events suggest that unless
the companies are reconfigured, the government's impulse will be to protect creditors
with public funds rather than risk a market breakdown.
As we renew discussions about the structure of our financial system, the debate should
be vigorous, for much is at stake.
The Consequences of Maintaining the Status Quo
I share the view that the current configuration of the financial system remains a risk to
the public and an impediment to the competitive vitality and strength of our economy.
Coming out of the crisis our financial system is more concentrated, and under current
policies this trend almost certainly will continue. These conglomerates will become yet
more complex, and their financial position will define financial stability for the broader
economy.
Defining the Financial Structure
Thomas M. Hoenig, Vice Chairman
Federal Deposit Insurance Corporation
presented to 22nd Annual Hyman P. Minsky Conference
at the
Levy Economics Institute
of
Bard College; New York, NY
April 17, 2013
The discussion of financial firms being too-big-to-fail has taken on renewed prominence
in the United States, putting us on a course that will do much to shape the economic
landscape for decades ahead.
Driving this interest is the perception among many Americans that they remain
financially vulnerable to the largest, most complex firms. The reported lapses in controls
and failed risk-management systems disturb them. Each new scandal adds to their
doubts about the ability of any one person to manage these conglomerates and any
bank supervisor to understand and regulate them.
There is concern that the financial system has become ever more concentrated, with
the largest firms holding increasing sway over the allocation of economic resources.
The 10 largest U.S. banking companies, for example, held assets the equivalent of 25
percent of GDP in 1997, 58 percent in 2006 and, since the crisis, it has increased to
over 71 percent.
The public remains uneasy that the current structure of the largest firms puts the entire
economy in jeopardy should they falter. History and current events suggest that unless
the companies are reconfigured, the government's impulse will be to protect creditors
with public funds rather than risk a market breakdown.
As we renew discussions about the structure of our financial system, the debate should
be vigorous, for much is at stake.
The Consequences of Maintaining the Status Quo
I share the view that the current configuration of the financial system remains a risk to
the public and an impediment to the competitive vitality and strength of our economy.
Coming out of the crisis our financial system is more concentrated, and under current
policies this trend almost certainly will continue. These conglomerates will become yet
more complex, and their financial position will define financial stability for the broader
economy.
The incentives toward risk-taking remain essentially unchanged from pre-crisis times.
The safety net of central bank loans, deposit insurance and ultimately sovereign support
has been expanded beyond where it is needed, covering more types of businesses and
activities; the funding advantage for the largest most complex firms appears as great as
before the crisis; and the incentives that encourage excessive leverage and risk remain
compelling.
As this trend continues, ever-more complex regulations will follow in an attempt to
control these banks’ actions and the risk to the safety net that protects them. Over time I
suspect the industry will be treated like and eventually become public utilities.
This is a discouraging trend. However, there are choices.
Structure Matters
One alternative to continuing our current policies is to rethink the safety net and the
structure of the industry for which it would be available. The objective would be to
confine the safety net to a limited set of financial services and activities directly tied to
the payments system and longer-term lending, and place other activities outside the net
in order to encourage a more competitive, market oriented and pro-growth financial
system.
In considering this choice, it is helpful to first briefly consider the role of the safety net in
helping to create the too-big-to-fail situation. As you are aware, following the Great
Depression, the safety net was expanded to include FDIC insurance, which was in
addition to the Federal Reserve’s discount window. In doing this, lawmakers understood
it would deepen a moral hazard problem because depositors and other creditors would
be less attentive to the banks’ condition, relying instead on government oversight and
possible bailouts. To confine the moral hazard, FDIC insurance was made available
only to commercial banks and their retail customers. For the same reason, higher-risk
investment banking and broker-dealer activities were forced out of commercial banks
and away from the safety net. These restrictions were codified into the Glass-Steagall
Act in 1933.
For several decades, this structure coincided with relative stability within the financial
system. However, with this stability, market players, academics and others began to
argue that the separation between commercial and investment banking was
unnecessary and that the market would be more competitive and consumers better
served if investment and commercial banks were allowed to compete directly. This view
eventually became law as part of the Gramm-Leach-Bliley Act of 1999.
While competition might have increased temporarily, the unintended consequence was
to extend the safety net to an ever-greater number and range of activities and financial
firms. This extended a rich subsidy that encouraged leverage and facilitated
management's reach for ever-higher return on equity -- something that would have been
far more difficult and unsustainable without the safety net’s subsidy.
The safety net of central bank loans, deposit insurance and ultimately sovereign support
has been expanded beyond where it is needed, covering more types of businesses and
activities; the funding advantage for the largest most complex firms appears as great as
before the crisis; and the incentives that encourage excessive leverage and risk remain
compelling.
As this trend continues, ever-more complex regulations will follow in an attempt to
control these banks’ actions and the risk to the safety net that protects them. Over time I
suspect the industry will be treated like and eventually become public utilities.
This is a discouraging trend. However, there are choices.
Structure Matters
One alternative to continuing our current policies is to rethink the safety net and the
structure of the industry for which it would be available. The objective would be to
confine the safety net to a limited set of financial services and activities directly tied to
the payments system and longer-term lending, and place other activities outside the net
in order to encourage a more competitive, market oriented and pro-growth financial
system.
In considering this choice, it is helpful to first briefly consider the role of the safety net in
helping to create the too-big-to-fail situation. As you are aware, following the Great
Depression, the safety net was expanded to include FDIC insurance, which was in
addition to the Federal Reserve’s discount window. In doing this, lawmakers understood
it would deepen a moral hazard problem because depositors and other creditors would
be less attentive to the banks’ condition, relying instead on government oversight and
possible bailouts. To confine the moral hazard, FDIC insurance was made available
only to commercial banks and their retail customers. For the same reason, higher-risk
investment banking and broker-dealer activities were forced out of commercial banks
and away from the safety net. These restrictions were codified into the Glass-Steagall
Act in 1933.
For several decades, this structure coincided with relative stability within the financial
system. However, with this stability, market players, academics and others began to
argue that the separation between commercial and investment banking was
unnecessary and that the market would be more competitive and consumers better
served if investment and commercial banks were allowed to compete directly. This view
eventually became law as part of the Gramm-Leach-Bliley Act of 1999.
While competition might have increased temporarily, the unintended consequence was
to extend the safety net to an ever-greater number and range of activities and financial
firms. This extended a rich subsidy that encouraged leverage and facilitated
management's reach for ever-higher return on equity -- something that would have been
far more difficult and unsustainable without the safety net’s subsidy.