Steve Waldman Believes Banking Industry Sick Since At Least the S&L Crisis

Steve Waldman makes some bold claims in tonight’s post:

In two recent Surowiecki posts (here and here), Surowiecki points out that during the banking crises of the early eighties and early nineties, banks were arguably as insolvent as our banks are today, but hey, with a little time and without any radical changes, everything turned out great….

The fundamental difference between my perspective and Surowiecki’s is that I don’t think those previous recoveries were real. My view is that the crisis that we’re in now is precisely the same crisis we’ve been in since at least the S&L crisis. We’ve had a cancer, with some superficial remissions, but fundamentally, for the entire period from the 1980s to 2008, our financial system in general and our banks in particular have been broken. They have profited from allocating capital poorly, from funneling both domestic loans and an international deficit into poor investments (current consumption, luxury housing) rather than any objective that might justify arduous promises to repay. We all got a reprieve during the 1990s, because internet enthusiasm persuaded many investors to fund our consumption via equity investment, which we could wash away relatively painlessly in a stock market crash. Debt investors don’t go so quietly. Thanks to the cleverness of our banking system, we have a very great many lenders, both domestic and foreign, who’ve invested in trash but who demand to be made whole at threat of social and political upheaval. That is the failure of our banks. That they are insolvent provides us with an occasion to hold them accountable, and to reshape them, without corroding the rule of law or respect for private property…

There are profound economic problems in the United States and elsewhere that our financial system has proved adept at papering over rather than solving. Those of us who’ve played Cassandra over the years have been regularly ridiculed as just not getting it, as economic illiterates and trade atavists. Unfortunately, as Dean Baker frequently points out, the people who could never see the problems are the only ones invited to the table when the world cries out for solutions. The solutions on that table are those Surowiecki tentatively endorses, weather the storm, take some time to repair, the temple is structurally sound. But the temple is not sound. We either build a decent financial system, or suffer real consequences, in unnecessary toil and lost treasure, in war and conflict over false promises set down in golden ink.

The banking crisis and the high unemployment rate are not the crisis, they are symptoms. This is not “dynamo trouble”, it is a progressive disease, and what is failing is the morphine. Those of us who believe that financial capitalism is a good idea, that it could be the solution, not the problem, do their cause no favors by resisting radical changes to a corrupt and dysfunctional facsimile of the thing. We need to approach financial capitalism as engineers, and to largely rearchitect a crumbling design. If we don’t, we may be so unfortunate as to suffer yet another superficial remission. But error accumulates, and error on the scale now perpetrated by national and international financial institutions are unlikely to be without consequence. I’d love him to tease this out further, and I am a bit too fried to give this a long form treatment, but let me volunteer a few thoughts:

A very short and grossly simplified history of banking in the last 40 years is banks used to be tightly controlled, profitable, and not (for the most part) able to do much damage. For instance, deposit rates were regulated. Nevertheless, very creative banks nevertheless managed to get themselves in lots of trouble (Citibank and its buddies in the sovereign lending crisis, for instance).

The inflation of the 1970s created a huge mess for this model. Even with regulated deposits (and depositors were very unhappy with negative real yields and aggressively sought other cash-stowage options), many banks also funded some of their balance sheet in the money markets. You had spectacles like banks bleeding on their credit card portfolios (and remember, those yielded a lot better than a lot of other types of loans) because short term rates shot up to 22%.

Various aspects of banking were deregulated (deposit rates, usury ceilings,interstate banking, the division between banking and securities was chipped away at over years, with the playing field pretty much open before Glass Steagall was formally abolished in the late 1990s).

But the interest rate volatility was and still is a real mess for banks. From what I can tell, the hedges (using product design to put more of the risk back on customers, explicit hedges, astute asset liability management) only partly remedy this problem. In an increasingly competitive environment, my impression is banks have not been able to extract enough additional margin for assuming this risk. Anyone know of any work in this area?

Second is that investment banks ate commericial banks lunches for a very long time. I read from time to time that the reason securitization became more prevalent was that banks felt it was less attractive to hold assets on their balance sheets, i.e., this was an opportunistic move.

While technically, that isn’t wrong, that isn’t how I’d frame it. I recall when I was at McKinsey in the mid 1980s and securitization was taking off that one of the standard charts showed banks that securitization was cheaper than on balance sheet intermediation due to the cost of bank equity and FDIC insurance. That was seen as a bad thing for banks back then because it meant they were losing market share big time to investment banks.

Third is bank consolidation proved to be a very bad idea, and I see NO ONE addressing this issue. It isn’t simply because it created huge concentration and too many too big to fail banks (a lot of countries have highly concentrated banking systems, such as Canada and Australia, but their banks are kept on shorter leashes).

The reason is that bank consolidation delivers NO economic benefits. The big lie is big banks are more efficient. They aren’t. Every study ever done of banks in the US has found that once banks reach a certain size threshold, they exhibit a slightly increasing cost curve, meaning they are more expensive to operate.

But you might protest, when those banks buy each other, they may big noises about cutting costs. Right. They could have taken those costs out without a merger. It just gave cover for measures that would be too painful to execute in stand-alone entities.

The real reason for bank mergers is CEO pay is highly correlated with a bank’s total assets (and the CEO of the acquired bank is enriched sufficiently to get his acquiescence).

And worse, big banks have completely abandoned the notion that the knowledge that local managers have by virtue of being in a community (in terms of improving lending decisions) has value and can be leveraged. Instead, they all went full bore for FICO and other faux-science credit scoring models, and have perilous little to fall back on now that those have proven to be badly flawed.

I do think Waldman is on to something here, and hope his post elicits further comment. I’d be particularly curious to see John Hempton pick this one up, since he keeps defending the native earning power of US banks.


Originally published at Naked Capitalism and reproduced here with the author’s permission.

One Response to "Steve Waldman Believes Banking Industry Sick Since At Least the S&L Crisis"

  1. Anonymous   March 14, 2009 at 3:58 pm

    Looking back from our future history, todays’ bailouts will appear to be the final capitulation in the investment banks’ half century siege on sovereignty over money.