The Future of Banking: Dodd-Frank at One Year

Well, we have suffered through one year of the new financial reform act passed in 2010.

“Some critics of the law contend that it skimped on the details, leaving regulatory agencies with too heavy a burden” having to write up the specific new rules and regulations.)  

Of the 400 new rules due from the reglators, only 12 percent have been finalized while 33 percent have missed the deadline set for their finalization.  There are still 55 percent of these rules that have a future deadline.

Barney Frank, co-author of the act, said Congress had no other choice.  “We didn’t punt anything.  It’s precisely because we knew we couldn’t get everything exactly right that we did leave room for the regulators.” (http://dealbook.nytimes.com/2011/07/20/barney-frank-financial-overhauls-defender-in-chief/?ref=todayspaper)

Part of this is because Frank…and others…didn’t really know what they were doing.  The article continues “Even he (Frank) concedes that arcane financial matters were never his strong point.” Frank jokes: “I know more now about repos and derivatives than I ever wanted to know.”

The result: we have a Congressional law, the Dodd-Frank Act, aimed at preventing 2008-2009 from happening again, written by people who knew little about banking and finance but had to do something to save the world from the people who ran Wall Street. 

The major concern of Congress was about institutions that were too big to fail.  These “large” banks were to create “living wills” that provided a blueprint of the organization’s operation that would allow regulators to dismantle the bank in an orderly fashion.  (These, of course, have not been written yet.)  And, there were other things about proprietary trading and derivatives and disclosure and so forth.

My conclusion from one year of Dodd-Frank is that the financial industry will survive…in some form…and will do very well over time although not in the way Congress will like.

I must admit, my awareness of the banking and finance industry began in the 1960s.  This was really the first decade that the laws and regulations coming out of the period of the Great Depression were really tested.  The 1940s was a period the United States was focused on war; and the 1950s were devoted toward the country getting back to some kind of normality following an era of world-wide depression and world war.

In the 1960s the fifty-year period of credit inflation got its start and this changed everything.

Since this period has spanned my professional career the evolution that took place is very real to me.  The period started out very calm and contained.  Banks were very limited in what they could do and they were especially constrained geographically.  There were unit banking states where a bank could only have one office; there were limited branching states where a bank could have multiple offices although the number were limited; and there were states that allowed state wide branching.  However, banks could not cross state lines and branch in other states!

There was a definite line between different types of financial institutions.  There were, of course, the commercial banks…and the savings and loan associations…and the mutual savings banks…and the investment banks…and so on and so forth.

The products and services offered by each type of institution were severly limited and closely regulated.  Interest rate ceilings were present to protect depository institutions engaging in “destructive” competition that would weaken the banking system. 

In my mind, two major things occurred as a result of the initiation of credit inflation in the early 1960s.  First, United States corporations grew bigger and bigger.  Second, international flows of capital were freed up from earlier constraints in order to support the growth of world trade. 

The consequence of this was that financial institutions, especially commercial banks, had to break out of their constraints so that they could serve there larger customers, both within the United States and in the world. 

Financial innovation began to roll.  The four biggest financial innovations that took place in the 1960s, I believe, were the formation of bank holding companies, the creation of the negotiable CD, the allowance of bank holding companies to issue banker’s acceptances, and the invention of the Eurodollar deposit.  These innovations basically over came state laws and allowed American commercial banks to become world bankers. 

By the start of the 1970s, state banking restrictions were effectively dead and the freed-up international flow of capital doomed the gold standard which was officially buried by President Richard Nixon on August 15, 1971 when the floated the United States dollar. 

As the credit inflation continued through the last half of the century financial engineering and financial innovation dominated just about everything else other than the growth of information technology.  Perhaps the final nail in the coffin of the 1930s financial regulation was delivered in 1999 as the United States Congress repealed the Glass-Steagall Act of 1933.  This was the act that separated commercial banking from investment banking into separate organizations.

My point in reviewing this history is to make the claim, again, that “economics works.”  If there is an economic reason for an individual or institution to “get around” laws and regulations, then that individual or institution will “get around” those laws and regulations.  Some laws and regulations will fall earlier than others but these latter laws and regulations will be circumvented over time as there develops more and more reason to do so.

In other posts I have argued that the banks that were too big to fail before are now bigger and more prominent than before the recent crash.  Also, financial institutions have already moved way beyond the “intent” of the Dodd-Frank Act in the areas that have the most economic promise, have “cooled it” in other areas, and in some areas where it has not really been worthwhile for them to fight they have relinquished those minor facilities. 

Especially in this “Information Age” finance and financial arrangements are going to be harder than ever to regulate and police.  Finance is nothing more than information, nothing more than 0s and 1s (see many of my posts in the past) and information can be “sliced and diced” almost any way one wants to slice and dice it and can flow, almost instantaneously, throughout the world.

The only thing of benefit that has come out of the new financial reform act has been some increases in transparency but this has not come anywhere close to the level I would like to see happen. 

These are some of the reasons for my conclusion of one year of Dodd-Frank that the financial system will survive.  However, the system that is evolving will be a lot different than what we see now and a lot different from what the Congress and the regulators would like to see.  Also, I am still predicting that the number of financial institutions in the system will drop below 4,000 (from a little less than 8,000 now) over the next five years. 

Let’s just hope that Congress and the regulators don’t chase most of the finance offshore.    

Bank Re-regulation Forgot to Consider Google and Twitter

One of the clearest comments I have heard recently about the financial reform actions of Congress and the regulators is that those passing the new laws and establishing the new regulations completely ignored the fact that something like Google and Twitter had been created.

In other words, times have changed and those in Congress and in the regulatory bodies have kept their focus just on the past.

Financial regulation, however, is not the only thing that is falling victim to a backward looking focus.

We are seeing a concentration on the past in dealing with state and local government problems, problems with pensions, bargaining power, and employment. The law just passed in Michigan giving the state government broader powers to intervene in the finances and governance of struggling municipalities and school districts…” has been fought by those that argue that the law “undermines collective bargaining and threatens to subvert elected local governments.” (http://professional.wsj.com/article/SB10001424052748704360404576206603444375580.html?mod=ITP_pageone_1&mg=reno-wsj.)

Times have changed.

The years of inflation which began in the early 1960s has reached a tipping point in many areas. The days of inflated state and local government budgets, of passing on the fiscal impacts of lucrative union bargaining agreements in the form of higher property taxes, and of using the accounting gimmicks that postponed dealing with pension obligations is over. Adjustments must be made

But, that is not how people deal with the unpleasantness of current dislocations.

The inflation benefit for labor unions in manufacturing industries gave out years ago.
Manufacturers of cars and steel and so forth could neither pass on lush labor agreements to the public nor hide the increasing labor costs is limited technological advancements in their products or the production of their products.

And, the labor unions that still exist in these areas of manufacturing have shrunk, both in numbers and in terms of bargaining power.

State and local governments are now having to deal with this phenomenon.

And, what about debt?

The taking on of debt thrives in periods of credit inflation and Americans have had at least fifty years to get on this bandwagon.

And, now people have not really been borrowing. The real question is, should they start borrowing again? I have addressed this in my post “Does Getting Out of Debt Mean that People Should Start Spending More?” (See http://seekingalpha.com/article/257772-does-getting-out-of-debt-mean-people-should-start-spending-more.)

What has this debt done for people? If the number of foreclosures and bankruptcies over the last few years and the number of foreclosures and bankruptcies pending or near the edge are any indication, many people may not want to jump right into the “debt circus” again any time soon.

What accounts for the popularity of the finance guru Dave Ramsey? Take a peek at his new book, “The Total Money Makeover: A Proven Plan for Financial Fitness.” And, what is his recipe for financial fitness and greater happiness?

GET OUT OF DEBT! ALL OF IT!

This advice doesn’t apply to just families. It applies to small businesses, and medium-sized businesses, and others.

GET OUT OF DEBT!

Pass that message on to Chairman Bernanke.

And, what is the solution of Chairman Bernanke and other leaders in Washington, D. C.?

Let the presses role! Start the credit inflation once again!

The question is, will this new round of credit inflation succeed. It seems as if over the past fifty years that every time we entered a new round of credit inflation, some things got worse.

For example, capacity utilization in manufacturing continued to drop since the 1960s. That is, every subsequent peak in capacity utilization during this time period was lower than the previous peak. Furthermore, after almost two years of economic recovery, capacity utilization still remains just a little over 75%.

Underemployment has continually risen over the last fifty years and now about one out of every five individuals of working age in the United States is underemployed.

In addition, the inflationary environment of the last fifty years has benefitted the wealthy who can either take advantage of the inflation or protect themselves against it and has been exceedingly costly for the less wealthy, who cannot protect themselves. As a consequence, we have the worst skewing of the income distribution toward the wealthy in United States history.

And, there is more!

But, this is not the point.

The point is: the times have changed!

If we do not accept this fact in financial regulation, in the management of state and local governments, in our own finances, and in the federal governments budgetary policy, we will all be the sorrier for it.

Who has the credit inflation of the last fifty years really helped? The financial industry. And, I have asked the question, who is the “Bernanke Credit Inflation” going to help? This time, will the financial industry just dance alone? (See http://seekingalpha.com/article/255748-will-the-financial-industry-dance-alone.)

U. S. Financial Rules and Regulations are Making U. S. Financial Institutions and Markets Irrelevant

I can’t recommend highly enough the opinion piece in the Wall Street Journal this morning “The SEC’s Facebook Fiasco,” by Jonathan Macey. (http://professional.wsj.com/article/SB10001424052748703954004576089840802830596.html?mod=WSJ_Opinion_LEFTTopOpinion&mg=reno-wsj) I have written something myself on the issue: see “The Pace of Financial Overhaul.” (http://seekingalpha.com/article/247281-the-pace-of-financial-overhaul)

Macey sticks with the problems of the SEC and the regulatory structure and philosophy that surrounds it. But, the points he makes are also directly applicable to the regulatory structure and philosophy that surroundsl the laws and regulations impacting financial services and financial markets.

Let me restate some of the points that Macey makes and then add a couple of my own.

1. Banking has become so international that companies can side-step rules and regulations with ease.

2. Many of the rules and regulations that exist are crippling for United States financial transactions.

3. Banks have been moving brokerage and banking business offshore for decades. They are well positioned in Asian and European capitals to continue to do so.

4. The whole capital formation process is moving offshore.

5. The number of United States companies listing their shares for trading and doing business exclusively in foreign markets has risen steadily for the past five years.

6. Banks have to conduct the business they currently do in the United States so that they can avoid more egregious and intrusive regulations in the future.

7. In an effort to protect the unsophisticated small investor, rules and regulations are driving banks to provide “good deals” to wealthier clients avoiding where ever they can the less wealthy.

This is a pretty good list, but let me just add three more to it.

8. The rules, regulations, and economic policies of the United States over the last fifty years has created an environment that benefits the larger institutions and has made it more and more difficult for smaller financial institutions to survive. The larger institutions are the ones that are more capable of acting in the way described in the previous seven points listed above.

9. More and more assets in the United States are held by foreign banks than ever before and foreign banks are actually being encouraged to acquire banks within the United States, especially troubled banks. These foreign banks already have an international presence.

10. The application of more and more information technology to the financial services industry is just going to accelerate all the movements listed in the above nine points.

Macey closes his opinion piece by stating that the review of regulations proposed by President Obama should include the rules “promulgated by the SEC, lest we continue to see U. S. capital markets fade into irrelevance.” I believe that Mr. Macey’s statement can be broadened to include the rules and regulations applying to financial institutions and financial markets in general.

Commercial Banking in 2011

Commercial banking in the United States is going to change substantially in the next five years.

Most of my comments on the banking industry over the past year have been spent on the “smaller” banks, the banks are not among the 25 largest commercial banks in the industry, the banks that control about 30% of the banking assets in America. At last count there were a little less than 7,800 of these banks. The average size of the banks in this category is about $480 million, pretty small.

My concern about these banks is their solvency. The FDIC placed 860 commercial banks on its list of problem banks at the end of the third quarter. The question that is still outstanding is how many more banks are seriously challenged to remain in business. That is, how many banks are not on the problem list but “near” to being on the problem list. Elizabeth Warren gave testimony in front of Congress in the spring and stated that 3,000 commercial banks were threatened by bad loans over the next 18 months.

Commercial banks have been closed at the rate of approximately 3.5 per week during 2010 and many other acquisitions have taken place. So, the industry is shrinking. I still believe that there will be fewer than 4,000 commercial banks in the United States by the end of the upcoming decade.

However, something new is going to happen at the other end of the banking spectrum. International banks are going to play a much bigger role in the United States in the future and this is going to substantially change the playing field and will help to accelerate the decline in the number of banks in the American banking system.

What’s going on? Just in the recent past we have had the news that the Bank of Montreal, the fourth largest bank in Canada, acquired the banking firm of Marshall and Ilsley Corp., which has $38 billion in deposits, 374 branches throughout the Midwest, and is the largest lender in Wisconsin. Then we learned that TD Bank, the second largest bank in Canada, is acquiring Chrysler Financial, the former lending wing of the Chrysler Corporation.

We also learn that Deutsche Bank AG and Barclays PLC have moved up the rankings of global business when compared to other Wall Street organizations. (See the Wall Street Journal article “New Banks Climb Wall Street Ranks,” http://professional.wsj.com/article/SB10001424052748703581204576033514054189044.html?mod=ITP_moneyandinvesting_2&mg=reno-wsj.) These organizations have grown substantially filling in some of the hole left by the collapse of Lehman Brothers, and the moving of Bear Stearns and Merrill Lynch into other banking firms.

The point is that the American banking scene is much more open to foreign competition on its own turf in the 2010s than it was previously. This has the potential for causing even more changes in the structure of banking in the United States and in the world than we have seen over the last fifty years.

If we go back to the start of the 1960s, the United States contained some 14,000 commercial banks and a large, prosperous thrift industry. But, things were changing. Let me point out just three of the major factors impacting the banking and thrift industries by the start of the 1970s. First, was the beginning of the credit inflation that was to spread throughout the economic system that would result in the rising interest rates which would eventually bankrupt the thrift industry and drive it out of business.

Second, the United States commercial banking system at the start of the 1960s was a mish-mash of banking rules. For one, the branching laws were such that banks could not branch across state lines, and in some states banks could only have one office, in others they faced severe limits on the number of branches they could have, while in other states there was unlimited state-wide branching.

What broke this structure down? Information technology. With the spread of information technology banks could not be constrained from branching across state lines. The death knell for state control and limited branching was sounded. National competition became the new norm and banks had to compete.

The third factor was the freeing up of the flow of funds internationally. By the end of the 1960s the capital flows were basically unrestricted between the United States and Europe. One of the major signs of this openness was the creation of the Eurodollar deposit which became an important tool in the move to “liability management” which freed up American commercial banks from limits on their ability to grow their balance sheets. This factor contributed to the demise of the “Bretton Woods” system of international finance.

All three of these factors played a big role in the changes in the financial system of the United States and the world and to the movement away from “relationship finance” and “arms-length finance”. For more on the changes in the banking system and the growing “impersonal” nature of the financial system see the book “Saving Capitalism from the Capitalists” by Raghuram Rajan (the winner of the Financial Times/Goldman Sachs award for the best business book of the year, “Fault Lines”: http://seekingalpha.com/article/224630-book-review-fault-lines-how-hidden-fractures-still-threaten-the-world-economy-by-raghuram-g-rajan) and Luigi Zingales, both of the University of Chicago.

All of these factors are still at work but we are now seeing another important factor coming into play, “competition from the outside.” Just as the forces inside the United States have been attempting to build up walls to constrain the finance industry, America is now coming to experience a breaking down of the barriers. Unless the Congress puts up restrictions on foreign financial interests acquiring domestic companies, it seems as if the door is opening for more and more banks from outside the United States to come knocking.

The result of this “opening up” according to Rajan and Zingales is that the new competition really “shakes things up.” I have contended throughout the events which began in late 2008 that by the middle of 2009 the largest 25 commercial banks in the United States had moved beyond most of the structural problems that contributed to the financial collapse. Furthermore, by the time that the Dodd-Frank Financial Reform bill got passed, these banks had moved beyond most of the onerous portions of the legislation.

Now with these foreign financial organizations moving into the competitive space of the United States banks, all banks will be using information technology and uncontrolled capital flows throughout most of the world to further outpace efforts of regulatory reform.

Another consequence of this will be the pressure on the larger banks to continue to merge and acquire and diversify their businesses in ways we have not yet imagined. And, when one brings into the picture the things that information technology can do and the progress the “Quants” have made in finance, one can only guess at how exciting the near-term evolution of the banking system is going to be.

Merry Christmas and Happy New Year to Everyone!

Is Greece the "Surprise" that Breaks the Camel's Back?

As people move through a financial crisis, the hope is that future ‘surprises’ will be avoided. In making things better and getting the system operating once again, efforts are made to identify problems and then set out to resolve the problems. Problems are not solved over night, but being aware of the problems and then honestly working them out is the way to put things right.

The fear is the unknown...a surprise!

Last Thursday the financial markets got a surprise. Greece’s budget deficit was worse than had previously been reported.

Was this incompetence or lying?

That is not the matter now, the fact is that Greece’s budget deficit is worse than had been expected.

The market sold off and the Wall Street Journal reported in “Traders Bet On a Default From Greece” (http://online.wsj.com/article/SB20001424052748704830404575200573581527764.html#mod=todays_us_money_and_investing) the following:

“Greek bond prices posted a drastic decline Thursday as traders began betting a debt default is inevitable, even if the country receives a massive bailout.

The Greek bond market is now priced for a "catastrophic event," says Sebastien Galy, senior foreign-exchange strategist at BNP Paribas.

Greece's woes helped sink the euro to an 11-month low before the common currency recovered some of its losses.”

Thursday, Moody's Investors Service downgraded Greece's debt rating and warned that additional cuts could be on the way. Tuesday, Standard & Poor’s lowered their rating of Greek debt to “Junk” and at the same time reduced the rating on Portugal’s bonds two levels.

The question plaguing the financial markets now has to be the reality of the ratings on other sovereign debt. This always happens when the market gets a shock! If the figures on the deficit of Greece were wrong, what about Portugal? What about Spain? What about Italy? What about Great Britain? What about the United States?

How far this uncertainty travels depends upon the time and the state of the market. European stock markets sold off yesterday. The Dow-Jones index closed down by 213 points. The Dow stock futures had been down by 30 to 60 points. Markets hate uncertainty!

How can we make the world more transparent?

Eventually the numbers all come out. As Warren Buffet has said, once the tide goes out one discovers who is not wearing a bathing suit.

And, this is an argument for short selling and Credit Default Swaps! Yes, those that cut corners and those that cheat and those that don’t reveal the full extent of budget deficits hate short sellers and the CDS. They hate them because they reveal that the “Emperor is not wearing any clothes” let alone a bathing suit.

The response? Point the finger at the “other guy”, the greedy trader! Divert attention! It is people like those “greedy traders” that give capitalism a bad name! Ban short selling! Eliminate Credit Default Swaps! Those greedy bastards!

Well, the surprise is out! Now we have to see how far the contagion spreads.

The press is having a ball with the title, the PIIGS!

Portugal, Italy, Ireland, Greece, and Spain ate from the trough till they were fat and happy and then they were too bloated to deal with the consequences. So the focus is on them.

This is great for the United States because we now get another “run to quality” boost. Monday, we saw the headline in the Wall Street Journal, “All Signs Point to a Costly Auction”: (http://online.wsj.com/article/SB20001424052748704388304575202493992895602.html#mod=todays_us_money_and_investing). The lead statement: “The U.S. Treasury market faces a challenging week, as investors deal with hefty debt auctions, the uncertainty of a Federal Reserve meeting and key economic data that will likely show the economy continued to grow in the first quarter.

That combination likely means the government may have to pay to sell the $129 billion securities.”

This morning we read in “European Jitters Give Two-Year Auction a Boost” (http://online.wsj.com/article/SB20001424052748704471204575209880025823948.html#mod=todays_us_money_and_investing):

“Treasury prices rose Tuesday as investors sought safety in low-risk securities after S&P cut its ratings on Portugal and Greece, sending Greek sovereign debt to ‘junk.’

The reach for safer securities helped to buoy the $44 billion two-year auction, which attracted good demand and helped keep Treasury prices higher.

The auction, the first of several note sales this week, was more than three times oversubscribed.”

The Euro has dropped below $1.32, a level it had not been at since April 28, 2009.

Unfortunately for Goldman Sachs this news is not yet eclipsing the headlines that it is receiving concerning the government’s case against them. But, at least, there is another “finance” story on the front pages of the major newspapers. Good for Goldman, bad for finance!

Still, the issue is about disclosure, transparency, and openness. There are many in finance who do not like “day light”! If anything comes out of the efforts to reform the financial system it should relate to disclosure. If people want to be in the ‘ballgame’ they must fully disclose. If they don’t want to disclose, then they must be excluded and pay the penalty.

And, full disclosure includes “mark-to-market” requirements. People who place bets by mis-matching maturities must also “fess-up.”

Anyway, we have been surprised! Now, the system must re-evaluate everyone so as to identify any other surprises that might exist. In the process, everyone else pays!

E-Mails, Investment Banking, and the Rating Agencies

Thank goodness for emails! Now we know what was really going on at Goldman Sachs and Moody’s and Standard & Poor’s. How about Congress including in their bill on financial reform the requirement that all financial institutions and rating agencies and all other organizations having to do with finance (say the Federal Reserve and the Treasury and Fannie Mae and Freddie Mac…and Congress…and the White House) release all of their e-mails a week after they were written.

This would really provide the financial markets with transparency!

The thing that strikes me so much about the release of these e-mails over the past week or so is their humanity. These Wall Street villains talk like human beings, like you and me.

Gillian Tett, in my mind, has a terrific opinion piece in the Financial Times this morning titled “E-Mails throw light on murky world of credit” (http://www.ft.com/cms/s/0/a9da1aa4-508b-11df-bc86-00144feab49a.html). Her reflection on the e-mails is captured in the following sentence: “It is fascinating, almost touching, stuff.”

But, even more important she states that “Reading these e-mails with the benefit of hindsight, there is little suggestion that rating officials were engaged in any deliberate malfeasance. Many appear conscientious and hard-working.” These people are just human beings trying to do their job.

The same can be said of those people that wrote the e-mails at Goldman. This is captured in an article by Kate Kelly in the Wall Street Journal titled “Goldman’s Take-No-Prisoners Attitude” (http://online.wsj.com/article/SB20001424052748703441404575206400921118356.html#mod=todays_us_money_and_investing.)
Kelly speaks of a world, which Tett describes as “so detached and rarefied”, in which betting applied to almost anything. The scene she presents in her article is one in which mortgage traders from Goldman Sachs “cast bets on a White Castle hamburger-eating contest” in December 2007. (Note that the problems in the subprime mortgage market were so severe at this time that the Federal Reserve announced the creation of a Term Auction Facility (TAF) on December 12, 2007 with the first auction being held on December 17, 2007.)

This behavior, Kelly reminisces, “resembled a scene out of ‘Liar’s Poker,’ a book (by Michael Lewis of the book ‘The Big Short’) depicting bawdy antics of (mortgage) bond traders at Salomon Brothers in the 1980s.” She argues that “It was a lower-stakes version of what went on ever day in the group: aggressive, take-no-prisoners trading.”

To Kelly, the world apparently didn’t change much between the 1980s and the 2000s!

Tett draws some conclusions from the picture present in the e-mails. She writes “by 2007 they (the bond raters), like the bankers, had become tiny cogs in a machine that was spinning out of control. Their world was also a strange, geeky silo, into which few non-bankers ever peered.”

And, Tett goes on, “Indeed, this world was so detached and rarefied it is, perhaps, little wonder that S&P struggled to deal with the press, or that Goldman traders felt free to celebrate the mortgage market collapse.”

“Few expected external scrutiny or imagined their e-mails would ever be read.” They were just being human.

But, something was wrong! Something bigger than the traders or the raters had taken control and was driving the system.

And, this leads Tett to the first of two lessons she draws from the information in the e-mails: “what went wrong in finance was fundamentally structural, as an entire system spun out of control! It might seem tempting to lash out at a few colorful traders but that is a sideshow…”

She concludes: “what is needed is systemic reform that removes conflicts of interest.”

This is the only point on which I disagree with her. To me this whole “spinning out of control” was a result of the credit inflation that had been prevalent in the financial system for the past fifty years or so. The whole effort to inflate the American economy had resulted in the excessive creation of credit during this time period, the almost fanatical drive toward financial innovation (led by the federal government), and the assumption of more and more risk by the private sector in a search to sustain its returns.

The reference to the book “Liar’s Poker” is particularly relevant because the main story in that book is about the trading going on in mortgage-backed securities, something that did not exist until the early 1970s when the federal government created the instrument. Please note that the first mortgage-backed security was issued by the Government National Mortgage Association (Ginny Mae) in 1970. Before then mortgage-related issues were not traded on capital markets. By the time of the writing of “Liar’s Poker”, government-related mortgage-backed securities had become the largest component of capital markets.

As I have stated many times, the purchasing power of the United States dollar declined by roughly 85% between January 1961 and the present time. Although consumer price inflation was kept relatively low over the past decade or so, credit inflation permeated the asset markets as bubbles appeared in stocks and housing. House prices got so out of line with rental prices during this time that the collapse of the housing bubble became inevitable.

So, I agree with Tett in her statement that “what went wrong in finance was fundamentally structural, as an entire system spun out of control!”

But, human beings acted like human beings during this time. Again, to quote Tett: “they (the bond raters), like the bankers, had become tiny cogs in a machine that was spinning out of control.”

And, as Chuck Prince, former CEO of Citigroup, called it: as long as the music is playing, people must keep on dancing. This doesn’t excuse them, but it puts, I think, the behavior in perspective. This was not the well-thought-out plot of evil people.

Lesson: inflation creates incentives that can get out of hand. If the government wants to conduct economic policies with an inflationary bias then they must deal with the consequences at a later time.

I do agree with Tett on her second lesson learned: “the whole murky credit business must be taken out of the shadows. So few people spotted that finance was spinning out of control because the financial system was so separated into silos that its practitioners lost any common sense.”

Tett “welcomes the publication of these emails” but warns us to “keep braced for the next installment.” She “suspects that US regulators and politicians have not finished publishing all those damning e-mails yet.” I look forward to these revelations, as well.

The Changing Banking System

I remember when there were more than 14,000 banks in the United States. I also remember when there were 12,000 banks in the banking system. Even in those days, the financial industry only accounted for no more than about one-sixth of total domestic profits in America.

Now there are about 8,000 banks in the United States and about one in eight of these banks is either on the problem bank list of the FDIC or in rather serious trouble. The FDIC is closing three to four banks a week and it is expected to continue on this pace for another twelve to eighteen months.

The biggest banks in the banking system are doing well, profit wise. The reported earnings this week of JPMorgan Chase, Goldman Sachs, Morgan Stanley, Bank of America, Citigroup, and so on just re-confirmed the recovery of these giant institutions. Of course it is not the banking side of the business that is producing these results, although their loan problems seem to be diminishing. It is the trading side of the business that is creating such significant gains subsidized by the Federal Reserve zero interest rate policy. This is the “quiet” bailout of these banks because it does not require Treasury funds to support the effort and it helps bank assets improve so that insolvency becomes less and less of a problem.

Furthermore, regional banks appear to be recovering. PNC and BB&T have been doing well, but those lagging behind, Fifth Third Bancorp, KeyCorp, SunTrust Banks, and Huntington Bancshares all seem to be showing improvements which respect to their problem loans. PNC and BB&T actually reported profits for the first quarter, $671 million for PNC and $194 million for BB&T. So, the improvements continue down the supply chain (http://online.wsj.com/article/SB20001424052748703876404575200240959419542.html#mod=todays_us_money_and_investing.)
We are still waiting for the small- to medium-sized banks to start perking up. But, this is where more of the problem or troubled banks lie and where most of the bank closures or acquisitions are going to be.

This fact points to one of the major changes taking place in the banking system. We are going through another period where the number of banks in the banking system is declining. I would not be surprised at all if the number of banks dropped to the 5,000 to 6,000 range over the next few years.

This movement will continue the consolidation of the banking industry in the United States. Right now, $2 out of every $3 in domestic banking assets resides in the largest 25 banks in the country. These are the huge banks mentioned above and the large regional banks mentioned above.

How high might this concentration go? I believe that regardless of what Congress does with respect to financial reform and trying to limit the size of banks that the total amount of domestic assets residing in the largest 25 banks in the country will go to about $4 out of every $5 in the relatively near future. This means that there will be at least 5,000 banks competing for that other $1!

Another change that is taking place in the United States banking system is the presence of more and more foreign banks. This seems to be a perfect time for foreign owned banks to pick up acquisitions in the United States and not only gain size but also gain presence in different regional markets. In this respect, note the article “Foreign Firms Scoop Up Failed U. S. Banks” in the Wall Street Journal, http://online.wsj.com/article/SB10001424052748704830404575200134085458128.html#mod=todays_us_money_and_investing. Canadian banks are especially taking advantage of the banking situation in the United States, but banks in Japan and other countries are seizing the opportunity as well.

In March, foreign-related institutions controlled over 11% of the assets in the United States banking system. This is up substantially from thirty years ago and is expected to climb further in the near future. My guess is that this number will be in the 15% to 20% range over the next five years or so. And, these assets will not be owned by small- or medium-sized financial organizations.

This is the problem now faced by President Obama and the Congress in terms of financial reform. I just don’t see these trends reversing themselves. And, as banks get bigger they will also be controlling more and more of the banking assets in the United States. And, as the banks get bigger they will continue to move into more and more areas of the financial market and they will continue to create more and more financial innovations.

And, if they are not done in the United States they will be done somewhere else in the world for commercial banking is, in fact, worldwide and not just the playing field of Americans. Big foreign banks are becoming a bigger part of the United States banking scene just as big United States banks are becoming a bigger part of the banking scene in other countries.

The difficulty in writing regulations that try to control what these banks can do is, in the words of economists Oliver Hart of Harvard and Luigi Zingales of the University of Chicago, “doomed to fail because such regulations are extremely easy to bypass. It takes no time for a clever financier to design a contract that gets around most restrictions.” Finance is just information and information can be restructured in almost any way that someone wants it to be structured.

The evolution of the financial system is going to continue to be fought by those constrained to the old Keynesian fundamentalism. The current financial environment has been created by fifty years of government policy conforming to a dogma that considers an inflationary bias to the economy an necessary pre-requisite for sustaining high levels of economic growth and low levels of unemployment.

Well, this inflationary environment has fostered the undisciplined expansion of credit, the excessive leveraging of financial capital, and the creation of more and more financial innovation to underwrite both the expansion of the debt and the aggressive financial leveraging. It has also resulted in the relative growth of the financial industry.

Many of these same commentators have remarked about how the financial sector has grown relative to the rest of the economy. For example, Paul Krugman in “Don’t Cry for Wall Street”, has written: “In the years leading up to the 2008 crisis, the financial industry accounted for a third of total domestic profits — about twice its share two decades earlier.” He then makes the value judgment that “the fact is that we’ve been devoting far too large a share of our wealth, far too much of the nation’s talent, to the business of devising and peddling complex financial schemes — schemes that have a tendency to blow up the economy. Ending this state of affairs will hurt the financial industry. So?” (See http://www.nytimes.com/2010/04/23/opinion/23krugman.html?hp.)

Well, this is the financial industry that a government following the Keynesian economic philosophy has created. Two final comments: first, care needs to be taken in creating economic policies because the long run effect of the policies may not be what you want even though the short run effects are what you want; and second, once the size and structure of an industry has been created, it does not go away until the industry becomes technologically obsolete. The financial industry is thriving using information technology, a field that is just in its infancy. Finance and information technology have a long way to go.