In 1892, General Electric (ticker: GE) was formed, giving Thomas Edison and his many brilliant endeavors, ideas, and products a parent company through which they could commercially prosper. An umbrella company.
The umbrella expanded and expanded, and by 2007, GE was a sprawling international conglomerate with exposure to industrials, aerospace, energy, health care and finance. Finance in particular was big — between 2000 and 2015, 41 percent of all the company’s profit came from GE Capital.
It was the wrong time to be heavy on finance.
Operating earnings swiftly fell 50 percent between 2007 and 2009, and GE looked more vulnerable than ever. Last year, CEO Jeff Immelt said the company would be gutting GE Capital, its finance unit, and selling it off piece by piece.
Edison’s umbrella had finally sprung a leak, and it was time to mend it.
[Read: 10 Ways to Invest in Pharmaceuticals With ETFs.]
The company aimed to sell off $200 billion in assets, returning $90 billion directly to shareholders by 2018. In June, regulators acknowledged those efforts, taking GE Capital off the list of financial institutions that were “too big to fail.”
But the threat of too-big-to-fail banks sparking another crisis and triggering a massive taxpayer-funded bailout didn’t die with GE Capital.
In April, five banks — including the three largest U.S. banks by assets — failed to show the Federal Reserve and the FDIC that they could go bankrupt gracefully. Bank of America Corp. (BAC), Wells Fargo & Co. (WFC), JPMorgan Chase & Co. (JPM), Bank of New York Mellon Corp. (BK) and State Street Corp. (STT) — had their so-called “living wills” rejected by both regulators as unrealistic.
Two other household names, Goldman Sachs Group (GS) and Morgan Stanley (MS), had their living wills rebuked by either the Fed or the FDIC, but not both.
So why hasn’t the system changed? There’s nothing inherently wrong with big banks. The challenge is moral hazard, characterized by taking excessive risks with other people’s money — all the while knowing that bailouts will act as a safety net.
Eight years after the worst financial crisis since the Great Depression, moral hazard is as relevant as it ever has been. How?
Andrew Stoltmann, a Chicago-based securities attorney, notes the outsized role of legislation in creating today’s environment. In 1933, after rampant financial speculation led to the onset of the Great Depression, the Glass-Steagall Act was passed, forbidding institutions from playing both the role of traditional banker and investment banker.
In 1999, Glass-Steagall was repealed. That “really laid the foundation for what occurred in 2008 and 2009,” Stoltmann says. “The repeal basically turned banks into glorified casinos gambling with other people’s money — money they didn’t have.”
[Read: Are We Heading for Another Housing Crisis?]
There was attempt at reform: In 2010, the Dodd-Frank Act was passed. Arguably the most significant new financial regulation in decades, it attempted to reduce risk by disincentivizing asset swell, imposing periodic “stress tests,” quality-checking mortgages and requiring credible living wills that detailed how major financial institutions planned to die noble deaths in bankruptcy without taking the economy with them.
And while Dodd-Frank has made some meaningful changes, its impact was diluted by the banking lobby, Stoltmann says. “Wall Street probably has the best lobbying group outside of the NRA in the entire country,” he says, lamenting the “revolving door” that sends big bankers from Wall Street to Capitol Hill and back.
Needless to say, lawmakers haven’t seriously entertained re-instituting Glass-Steagall since its 1999 repeal.
The big get bigger. The too-big-to-fail ethos and the moral hazard that comes with it didn’t merely help trigger the Great Recession. It’s also a byproduct of the crisis, says Tim Yeager, finance professor at the University of Arkansas and a former assistant vice president at the Federal Reserve Bank of St. Louis.
“The financial crisis actually exacerbated the problem” he says. Weak banks “were combined with other banks, and so they became even larger.”
For example, the three largest U.S. banks by assets — JPMorgan, Bank of America and Wells Fargo — have swelled their balance sheets from a combined $3.4 trillion in 2006 to more than $5.3 trillion through the end of the first quarter. The biggest are now 56 percent bigger than they were pre-crisis.
Teddy Roosevelt, the famous trust-buster of the early 20th century, once advised: “Speak softly and carry a big stick.” Stoltmann thinks the stick should be bigger.
“We’re talking about eight years after 2008,” he says, “and the Fed keeps pushing this living will deadline out.” The offending banks have until Oct. 1 to revise and resubmit them.
Yeager thinks living wills are so ineffective they should be discarded. “I can’t imagine a situation like Lehman Brothers where they’re on the verge of failure, and lawyers say, ‘Well, gosh, I wish we had a 2,000-page manuscript that would walk us through how to do this bankruptcy filing.'”
So, with Glass-Steagall’s revival looking unlikely and living wills getting laughed out of the room, how does one solve the too-big-to-fail problem?
Federal Reserve Bank of Minneapolis president Neel Kashkari thinks there are four different ways to proactively prevent another financial crisis: Break up the banks, require that they keep more capital on hand, tax highly leveraged deals, or simply allow banks to fail.
But Malcom Wardlaw, assistant professor of finance and managerial economics in the Naveen Jindal School of Management at UT Dallas, doesn’t think breaking up the big banks is feasible.
“(It) would require an enormous political effort on the part of the Fed and the Justice Department,” he says. “Witness how difficult it was to break up the Bell Telephone system in the 1970s, and multiply that by five.”
Yeager thinks the concept of allowing big banks to fail is also a bit quixotic. “Lehman Brothers did fail and it resulted in a wave of panic. The government was very clear that they’re not going to let that happen again.” Letting systemically important banks fail is like felling a domino, and Yeager thinks it’s “a very dangerous policy.”
He agrees with Kashkari though, that higher capital ratios could prove useful, and notes that Dodd-Frank-required stress tests currently do hold bigger banks to higher standards.
But as we’ve seen, that hasn’t prevented megabanks like JPMorgan, Bank of America and Wells Fargo from ballooning into multitrillion-dollar institutions unprepared for their own demise. Unfortunately, that’s not surprising — these aren’t conglomerates like GE with loads of other businesses to fall back on. These are bankers. They bank.
So, they’ll have to be content to grow responsibly, slowly and become more efficient in order to satisfy shareholders. Imagine a slowly opening umbrella.
[Read: The 10 Best Banks of 2016.]
Surely they can be trusted to open it without tearing. Right?
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Will ‘Too Big to Fail’ Ever Go Away? It Hasn’t Yet. originally appeared on usnews.com
