“There was disheartening news last week regarding the way the U.S. financial system operates. I’m not referring to the opinion piece by a departing Goldman Sachs Group Inc. employee, which suggested that the company has little respect for its customers.
If you have a complex derivatives transaction in place with Goldman — or any other big Wall Street firm — and you didn’t know they thought of you as a malleable “muppet,” it may be time to replace your chief financial officer.
Anyone who thinks this kind of hubris is new should read Frank Partnoy’s inside account, “F.I.A.S.C.O.,” published in 1999. Wall Street became a more aggressive and risk-loving place when trading increased as a line of business, but this happened way back in the 1980s by most accounts.
The truly dreadful news last week was conveyed in the resultsof the Federal Reserve’s latest bank stress tests. As presented by the Fed, most of the news was good. Some large financial institutions were judged likely to have sufficient equity capital even if the U.S. economy were to experience a significant downturn. With that, banks such as JPMorgan Chase & Co. were allowed to increase their dividends and buy back shares. Naturally, bank stocks rallied.
Economic Uncertainty
But there’s a problem, and it’s not a small one. If you buy the Fed’s view of what is likely to constitute stress, there is some justification for its action. Even then, you should ask the question that Anat Admati, a Stanford University finance professor, has been pressing: Why would we let banks reduce their capital in the face of so much financial and economic uncertainty around the world? If you leave shareholder equity on bank balance sheets, it still belongs to shareholders. Let it stay there as loss-absorbing capital in case the world turns nasty again.
Reducing bank capital, according to Admati and her colleagues, doesn’t help the economy. Bankers like lower capital levels because their pay is based on return-on-capital unadjusted for risk. Shareholders are willing to go along either because they don’t understand the risks of thinly capitalized and therefore highly leveraged businesses, or they expect to share in the downside protection that will be provided by the government.
Make no mistake: Lower equity at big banks means higher expected losses for taxpayers down the road. Don’t let anyone fool you into thinking that banking crises are costless. The disaster of 2008 caused about a 50 percent increase in U.S. debt relative to gross domestic product — the second largest shock to the country’s balance sheet after World War II. (The details of this calculation and a broader perspective on today’s fiscal risks are in my new book with James Kwak, “White House Burning: The Founding Fathers, Our National Debt, and Why It Matters to You,” which will be published April 3.)…”
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