‘All You Need for a Financial Crisis…’

‘. . . are excess optimism and Citibank.’

That’s a saying that someone, probably Simon, repeated to me a few years ago. Crash of 1929, Latin American debt crisis, early 1990s real estate crash (OK, that wasn’t a financial crisis, just a crisis for Citibank), Asian financial crisis of 1997–1998, and, of course, the biggie of 2007–2009: anywhere you look, there’s Citi. Sometimes they’re just in the middle of the profit-seeking pack, but sometimes they play a leading role: for example, the Citicorp-Travelers merger was the final nail in the coffin of the Glass-Steagall Act and the immediate motivation for Gramm-Leach-Bliley.

Citigroup is also the poster child for one of the key problems with our megabanks: the fact that they are too big to manage and, on top of that, the usual mechanisms that are supposed to ensure half-decent management don’t work. Around 2009, if you were to describe the leading characters in the TBTF parade, they were JPMorgan, the last man standing (not so much anymore); Goldman, the sharks who bet on the collapse; Bank of America, the ego-driven empire-builder; and Citi, the incompetent (“I’m still dancing”) fools.

For these reasons, Art Wilmarth thinks it’s important to understand exactly what went wrong at what was, relatively recently, America’s largest bank. He has a new paper out discussing the many failings of Citigroup in the decade leading up to the financial crisis in great detail. I don’t think it contains any new facts that weren’t in the public record, but he does draw a lot of his examples from court documents (such as the Enron bankruptcy examiner’s report) that most of us haven’t read, so you will probably learn something.

The picture he paints is one of constant attempts by executives to take more risk, either by exploiting regulatory loopholes or by turning a blind eye to employees who raised red flags. From Enron and WorldCom through biased equity analysts, predatory lending, market-rigging, and Japanese private banking violations to the spectacularly late plunge into CDOs and the nutty decision to buy Vikram Pandit’s mediocre hedge fund, the only question is whether top executives encouraged lawbreaking and irrational risk-taking or whether they were too clueless to realize it was going on (Robert Rubin’s famous defense). At the same time, Citi was being aided and abetted by regulators, all the way up to New York Fed President Tim Geithner, who made little effort to ensure that the bank had appropriate risk management and compliance processes. And Wilmarth even leaves out a few, like auction-rate securities (Citigroup settled with the SEC in 2008) and LIBOR (Citigroup was the bank that hired Tom Hayes away from UBS in 2009).

Most importantly, there’s little evidence that our biggest banks are any more ably run now than they were in the past decade. The once-lauded JPMorgan is now Exhibit A (London Whale, overlooking Bernard Madoff’s Ponzi scheme, money laundering, bribing Chinese officials by hiring their relatives). People like to talk about how the financial system is safer than it was seven years ago—something I’m skeptical about. But even if it is, the too-big-to-manage problem is bad for lots of reasons other than overall stability: just ask people who bought WorldCom stock, or invested with Bernie Madoff, or took out LIBOR-linked loans, or pay inflated aluminum prices because banks are artificially limiting supply. Yet their stock prices continue to climb, because investors realize that the further the financial crisis fades into the rear-view mirror, the more easily the megabanks can find new sources of profit by exerting market power and skirting regulations.

This piece is cross-posted from The Baseline Scenario with permission.