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Fantasy Politics: On Reforming the Banking System

Gary North - January 22, 2013
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Reality Check (Jan. 22, 2013)

The largest banks are immune to reform or regulation. They control the Federal Reserve System, and have since the beginning in 1914, when it opened for business. The Congress defers to the FED. So, the banking system never changes much. There is never a significant reform.

Today, the 12 largest U.S. commercial banks hold 69% of the deposits. If you think the free market produced this allocation, you are the victim of a Keynesian economic theory. The centralization continues relentlessly. All the "democracy" chatter in Congress is simply a form of self-delusion.

Woodrow Wilson, the so-called reformer, signed the Federal Reserve Act of 1913, passed in the final hours before the Christmas recess. He signed it within two hours after the Senate passed the bill.

The fix was in.

The fix has been in ever since.

There are three main approaches for banking reform: the Austrian approach (end the FED: the free market precious metals coin standard), the monetarist approach (reduce bank regulation: automatic fiat money), and the Greenback approach (bank nationalization: fiat money). None of this is likely until after Washington defaults.


Richard Fisher is the president of the Federal Reserve Bank of Dallas, a privately owned regional central bank that operates under the monopoly-granting authority of the United States government. This year, he is a member of the Federal Open Market Committee (FOMC). The FOMC is described as follows on the website of the Federal Reserve System, a government agency.

Fisher is the FOMC's lone monetarist. He is a disciple of Irving Fisher (no relation), the Yale University economist whose monetary theories were adopted by Milton Friedman. Friedman called him America's greatest economist. In a previous article, I have argued that Irving Fisher was a true crackpot. He was a racist. He was a leading eugenicist. He believed that science could be used by the government to reverse the negative effects of mentally and morally inferior races that reproduce more rapidly than whites do.

Richard Fisher wrote this laudatory recommendation of Irving Fisher's monetary theory.

During the first quarter of the 20tth century, Irving Fisher was one of America's most celebrated economists. But sadly, most Americans today have not heard of him. Even as his reputation among the public faded with the years, his reputation within the economics profession has steadily risen. Fisher (no relation to the undersigned, though I would like to claim access to his gene pool) was a pioneer in many theoretical and technical areas of economics that today are the foundation of central bank policy. One such achievement was the creation of indexes to measure average prices, the bedrock for all current monetary policy.

Ludwig von Mises in The Theory of Money and Credit (1912) spent many pages refuting Fisher's monetary theories. I can do no better than to parrot Richard Fisher: "But sadly, most Americans today have not heard of him."

Fisher was correct when he said that Irving Fisher's reputation has been restored among professional economists. I have described this rehabilitation as an aspect of academia's war against free market money.

Richard Fisher was a vocal opponent of Ron Paul.

As I said, Richard Fisher is a member of the FOMC this year. What is the FOMC? Here is a description on the website of the Federal Reserve System.

The Federal Open Market Committee (FOMC) consists of twelve members--the seven members of the Board of Governors of the Federal Reserve System; the president of the Federal Reserve Bank of New York; and four of the remaining eleven Reserve Bank presidents, who serve one-year terms on a rotating basis. The rotating seats are filled from the following four groups of Banks, one Bank president from each group: Boston, Philadelphia, and Richmond; Cleveland and Chicago; Atlanta, St. Louis, and Dallas; and Minneapolis, Kansas City, and San Francisco. Nonvoting Reserve Bank presidents attend the meetings of the Committee, participate in the discussions, and contribute to the Committee's assessment of the economy and policy options.

The FOMC holds eight regularly scheduled meetings per year. At these meetings, the Committee reviews economic and financial conditions, determines the appropriate stance of monetary policy, and assesses the risks to its long-run goals of price stability and sustainable economic growth.

Notice: the government's members, meaning the Board of Governors, have a majority vote if they vote as a bloc. They usually do. Notice also that the New York FED has a permanent vote. This is where the power resides among the 12 regional FED banks.

With this as background, I will now analyze a January 16 speech by Fisher on banks that are too big to be allowed to fail.

As you read this, remember: Fisher is the closest thing to a free market economist on the FOMC.


Fisher refers to "the injustice of being held hostage to large financial institutions considered "too big to fail," or TBTF for short." He describes the situation correctly. The problem comes when he gets to a solution. He calls for a government-enforced break-up of the large banks. He does not believe that free market competition is adequate to do this. In this, he follows his mentors: Irving Fisher and Milton Friedman.

I submit that these institutions, as a result of their privileged status, exact an unfair tax upon the American people. Moreover, they interfere with the transmission of monetary policy and inhibit the advancement of our nation's economic prosperity.

He wants to free up "the transmission of monetary policy." Whose policy is that? Not the free market's policy, which is achieved through unregulated open entry and competition. It is the FED's policy, which has been ad hoc hyperinflating of the monetary base ever since later 2008. There is policy; there is no theory undergirding policy.

Where do they get their privileged status? Where all privileged status originates: from the State. So, why not just revoke this privileged status? Because that would not be scientific, according to Irving Fisher.

In this policy to break up the banks, he stands alone on the FOMC, and he knows this.

Now, Federal Reserve convention requires that I issue a disclaimer here: I speak only for the Federal Reserve Bank of Dallas, not for others associated with our central bank. That is usually abundantly clear. In many matters, my staff and I entertain opinions that are very different from those of many of our esteemed colleagues elsewhere in the Federal Reserve System. Today, I "speak forth my sentiments freely and without reserve" on the issue of TBTF, while meaning no disrespect to others who may hold different views.

Problem: if the other views have led to the injustice of the hostage-taking large banks, disrespect is called for. But Fisher is a well-paid team player. He is a lonely voice, but it is a polite voice.

He leads off with this:

Everyone and their sister knows that financial institutions deemed too big to fail were at the epicenter of the 2007--09 financial crisis. Previously thought of as islands of safety in a sea of risk, they became the enablers of a financial tsunami. Now that the storm has subsided, we submit that they are a key reason accommodative monetary policy and government policies have failed to adequately affect the economic recovery.

Everyone and "their" sister had no input with Secretary of the Treasury Hank "Goldman Sachs" Paulson in the bailouts of late 2008. The FOMC provided a trillion dollars of newly created fiat money to tide the big banks over. It has subsequently added another $800 billion or so. The FOMC says it will add lots more: $85 billion a month.

When you subsidize failure, you will get lots more failure. It's a matter of supply and demand.

Congress thought it would address the issue of TBTF through the Dodd--Frank Wall Street Reform and Consumer Protection Act. Preventing TBTF from ever occurring again is in the very preamble of the act. We contend that Dodd--Frank has not done enough to corral TBTF banks and that, on balance, the act has made things worse, not better. We submit that, in the short run, parts of Dodd--Frank have exacerbated weak economic growth by increasing regulatory uncertainty in key sectors of the U.S. economy. It has clearly benefited many lawyers and created new layers of bureaucracy. Despite its good intention, it has been counterproductive, working against solving the core problem it seeks to address.

I agree. Congress never makes things better. It makes things worse.

Why should Fisher ever trust the judgment of Congress? But he does, as we shall see. He thinks Congress has mandate successful reforms.

Let me define what we mean when we speak of TBTF. The Dallas Fed's definition is financial firms whose owners, managers and customers believe themselves to be exempt from the processes of bankruptcy and creative destruction. Such firms capture the financial upside of their actions but largely avoid payment--bankruptcy and closure--for actions gone wrong, in violation of one of the basic tenets of market capitalism (at least as it is supposed to be practiced in the United States). Such firms enjoy subsidies relative to their non-TBTF competitors. They are thus more likely to take greater risks in search of profits, protected by the presumption that bankruptcy is a highly unlikely outcome.

This is a good definition. The question is this: How did they get in this position? It is a government-sanctioned policy. They got it because Congress has deferred to the FED on everything, no questions asked.

The phenomenon of TBTF is the result of an implicit but widely taken-for-granted government-sanctioned policy of coming to the aid of the owners, managers and creditors of a financial institution deemed to be so large, interconnected and/or complex that its failure could substantially damage the financial system. By reducing a TBTF firm's exposure to losses from excessive risk taking, such policies undermine the discipline that market forces normally assert on management decision-making.

I ask: Why not just reverse the policy? The answer: because government's decision-makers want control.

The reduction of market discipline has been further eroded by implicit extensions of the federal safety net beyond commercial banks to their nonbank affiliates. Moreover, industry consolidation, fostered by subsidized growth (and during the crisis, encouraged by the federal government in the acquisitions of Merrill Lynch, Bear Stearns, Washington Mutual and Wachovia), has perpetuated and enlarged the weight of financial firms deemed TBTF. This reduces competition in lending.

Correct again. So, again, what can be done about it? "Dodd--Frank does not do enough to constrain the behemoth banks' advantages. Indeed, given its complexity, it unwittingly exacerbates them." Quite correct. What can be done about it?

Regulation failed. He admits this. Dodd-Frank fails. What to do?

He has a plan.


Just re-define what FDIC insurance covers. Limit it to traditional lending. Not more credit default swap insurance. No more derivative insurance.

In a nutshell, we recommend that TBTF financial institutions be restructured into multiple business entities. Only the resulting downsized commercial banking operations--and not shadow banking affiliates or the parent company--would benefit from the safety net of federal deposit insurance and access to the Federal Reserve's discount window.

Note the use of the passive voice: "be restructured." This conceals the central issue: Who is to do this? Who is to take responsibility for doing this? "Everyone who is ready to bear the consequences for all of the unintended consequences of such a change, please stand up." As Ben Stein put it in Ferris Bueller's Day Off, "Anyone? Anyone?"

Fisher then describes the enormous concentration of wealth in large banks.

As of third quarter 2012, there were approximately 5,600 commercial banking organizations in the U.S. The bulk of these--roughly 5,500--were community banks with assets of less than $10 billion. These community-focused organizations accounted for 98.6 percent of all banks but only 12 percent of total industry assets. Another group numbering nearly 70 banking organizations--with assets of between $10 billion and $250 billion--accounted for 1.2 percent of banks, while controlling 19 percent of industry assets. The remaining group, the megabanks--with assets of between $250 billion and $2.3 trillion--was made up of a mere 12 institutions. These dozen behemoths accounted for roughly 0.2 percent of all banks, but they held 69 percent of industry assets.

This makes Vilfredo Pareto's 20-80 law look like mass democracy.

How is any deviation from the 20-80 law on this magnitude possible? The words: Federal Reserve System.

The 12 institutions that presently account for 69 percent of total industry assets are candidates to be considered TBTF because of the threat they could pose to the financial system and the economy should one or more of them get into trouble. By contrast, should any of the other 99.8 percent of banking institutions get into trouble, the matter most likely would be settled with private-sector ownership changes and minimal governmental intervention.

Owners of small banks know that they will not get bailed out. Their banks will be swallowed up. Their banks' stock will fall to zero over the weekend. These people are self-interested. They will take steps to keep this from happening.

Do the owners and managers of a banking institution operate with the belief that their institution is subject to a bankruptcy process that works reasonably quickly to transfer ownership and control to another banking entity or entities? Is there a group of interested and involved shareholders that can exert a restraining force on franchise-threatening risk taking by the bank's top management team? Can management be replaced and ownership value wiped out? Is the firm controlled de facto by its owners, or instead effectively management-controlled? In addition, we ask: To what extent do uninsured creditors of the banking entity impose risk-management discipline on management?

Small banks fail. But not that many of them fail.

Community banks often have a few significant shareholders who have a considerable portion of their wealth tied to the fate of the bank. Consequently, they exert substantial control over the behavior of management because risk and potential closure matter to them. Since community banks derive the bulk of their funding from federally insured deposits, they are simple rather than complex in their capital structure and rarely have uninsured and unsecured creditors. "Market discipline" over management practices is primarily exerted through shareholders.

Megabanks do not have comparable restraints.

This is unfortunate because their failure, if it were allowed, could disrupt financial markets and the economy. For all intents and purposes, we believe that TBTF banks have not been allowed to fail outright. Knowing this, the management of TBTF banks can, to a large extent, choose to resist the advice and guidance of their bank supervisors' efforts to impose regulatory discipline. And for TBTF banks, the forces of market discipline from shareholders and unsecured creditors are limited.

Senior managers get away with this. "Having millions of stockholders has diluted shareholders' ability to prevent the management of TBTF banks from pursuing corporate strategies that are profitable for management, though not necessarily for shareholders."

There is a huge subsidy available to these huge banks.

Recent estimates by the Bank for International Settlements, for example, suggest that the implicit government guarantee provides the largest U.S. BHCs with an average credit rating uplift of more than two notches, thereby lowering average funding costs a full percentage point relative to their smaller competitors. Our aforementioned friend from the Bank of England, Andrew Haldane, estimates the current implicit TBTF global subsidy to be roughly $300 billion per year for the 29 global institutions identified by the Financial Stability Board (2011) as "systemically important."[9] To put that $300 billion estimated annual subsidy in perspective, all the U.S. BHCs summed together reported 2011 earnings of $108 billion.

In a crisis, this subsidy shoots upward. There are no upward limits. The governments intervene. They put their credit on the line to borrow from other banks. Then they bail out the troubled one. Fisher does not mention "the sky's the limit" aspect of this arrangement.

You think Lehman Brothers was a problem?

For perspective, consider the sad case of Lehman Brothers. More than four years later, the Lehman bankruptcy is still not completely resolved. As of its 10-K regulatory filing in 2007, Lehman operated a mere 209 subsidiaries across only 21 countries and had total liabilities of $619 billion. By these metrics, Lehman was a small player compared with any of the Big Five. If Lehman Brothers was too big for a private-sector solution while still a going concern, what can we infer about the Big Five in the table?

Dodd-Frank's solution? Nationalize an insolvent bank.

Dodd--Frank addresses this concern. Under the Orderly Liquidation Authority provisions of Dodd--Frank, a systemically important financial institution would receive debtor-in-possession financing from the U.S. Treasury over the period its operations needed to be stabilized. This is quasi-nationalization, just in a new, and untested, format. In Dallas, we consider government ownership of our financial institutions, even on a "temporary" basis, to be a clear distortion of our capitalist principles.

But what is the alternative? These days, M&A: mergers and acquisitions.

Of course, an alternative would be to have another systemically important financial institution acquire the failing institution. We have been down that road already. All it does is compound the problem, expanding the risk posed by the even larger surviving behemoth organizations. In addition, perpetuating the practice of arranging shotgun marriages between giants at taxpayer expense worsens the funding disadvantage faced by the 99.8 percent remaining--small and regional banks. Merging large institutions is a form of discrimination that favors the unwieldy and dangerous TBTF banks over more focused, fit and disciplined banks.

The Dallas FED has another suggestion.

Our proposal is simple and easy to understand. It can be accomplished with minimal statutory modification and implemented with as little government intervention as possible. It calls first for rolling back the federal safety net to apply only to basic, traditional commercial banking. Second, it calls for clarifying, through simple, understandable disclosures, that the federal safety net applies only to the commercial bank and its customers and never ever to the customers of any other affiliated subsidiary or the holding company. The shadow banking activities of financial institutions must not receive taxpayer support.

In short, it rests on the assumption that the FDIC is legitimate: federal insurance for failed banks.

What is free market about this?

He says we need regulation.

We recognize that undoing customer inertia and management habits at TBTF banking institutions may take many years. During such a period, TBTF banks could possibly sow the seeds for another financial crisis. For these reasons, additional action may be necessary. The TBTF BHCs may need to be downsized and restructured so that the safety-net-supported commercial banking part of the holding company can be effectively disciplined by regulators and market forces. And there will likely have to be additional restrictions (or possibly prohibitions) on the ability to move assets or liabilities from a shadow banking affiliate to a banking affiliate within the holding company.

The basic suggestion is this:

Under our proposal, only the commercial bank would have access to deposit insurance provided by the FDIC and discount window loans provided by the Federal Reserve. These two features of the safety net would explicitly, by statute, become unavailable to any shadow banking affiliate, special investment vehicle of the commercial bank or any obligations of the parent holding company.

But wait! We already have this! "This is largely the current case--but in theory, not in practice. And consistent enforcement is viewed as unlikely."

Let me get this straight. The laws are not being enforced. So, we need more laws.

To reinforce the statute and its credibility, every customer, creditor and counterparty of every shadow banking affiliate and of the senior holding company would be required to agree to and sign a new covenant, a simple disclosure statement that acknowledges their unprotected status. A sample disclosure need be no more complex than this:

This two-part step should begin to remove the implicit TBTF subsidy provided to BHCs and their shadow banking operations. Entities other than commercial banks have inappropriately benefited from an implicit safety net. Our proposal promotes competition in light of market and regulatory discipline, replacing the status quo of subsidized and perverse incentives to take excessive risk.

As indicated earlier, some government intervention may be necessary to accelerate the imposition of effective market discipline. We believe that market forces should be relied upon as much as practicable. However, entrenched oligopoly forces, in combination with customer inertia, will likely only be overcome through government-sanctioned reorganization and restructuring of the TBTF BHCs. A subsidy once given is nearly impossible to take away. Thus, it appears we may need a push, using as little government intervention as possible to realign incentives, reestablish a competitive landscape and level the playing field.

So, the system has protected the TBTF banks. It must be revised. The TBTF banks must be told: "No more subsidies."

Every eight weeks, Fisher is outvoted 11 to 1. Does this provide an indication of his John the Baptist status, crying in the wilderness?

If the 12 largest banks control 69% of the deposits, where does political power lie?

Think about it this way: At present, 99.8 percent of the banking organizations in America are subject to sufficient regulatory or shareholder/market discipline to contain the risk of misbehavior that could threaten the stability of the financial system. Zero-point-two percent are not. Their very existence threatens both economic and financial stability. Furthermore, to contain that risk, regulators and many small banks are tied up in regulatory and legal knots at an enormous direct cost to them and a large indirect cost to our economy. Zero-point-two percent. If the administration and the Congress could agree as recently as two weeks ago on legislation that affects 1 percent of taxpayers, surely it can process a solution that affects 0.2 percent of the nation's banks and is less complex and far more effective than Dodd--Frank.

Got that? "If the administration and the Congress could agree as recently as two weeks ago on legislation that affects 1 percent of taxpayers, surely it can process a solution that affects 0.2 percent of the nation's banks and is less complex and far more effective than Dodd--Frank."

Surely, Fisher lives in a political fantasy world.

The time has come to change the decisionmaking paradigm. There should be more than the present two solutions: bailout or the end-of-the-economic-world-as-we-have-known-it. Both choices are unacceptable.

The time came in late December, 1913, when the Federal Reserve Act was signed into law. It has been downhill ever since.

The next financial crisis could cost more than two years of economic output, borne by millions of U.S. taxpayers. That horrendous cost must be weighed against the supposed benefits of maintaining the TBTF status quo. To us, the remedy is obvious: end TBTF now. End TBTF by reintroducing market forces instead of complex rules, and in so doing, level the playing field for all banking institutions.


As long as we are talking fantasy politics, let me offer my suggestion. The Congress begins discussing this law: The Federal Reserve Act of 1913 is hereby repealed. That's it. Eight words and one date.

If you want a free market in banking, pass this law: The United States government hereby ends all connections with and support of the Federal Deposit Insurance Corporation and the National Credit Union Administration.

The free market will take over as the regulatory agency.

That is Mises' solution. It is not Fisher's: Irving or Richard.

This is too radical, Fisher thinks. Ron Paul was too radical, he thought. The monetarists are choir boys for the Keynesian preachers. We are told we can never go back to monetary liberty. We can never go back to competitive banking without the FDIC. The pain would be too great. The unemployment! The bank failures!

We are in a lobster trap set by central bankers. Once in, we cannot get out, they insist. Once we have surrendered to the central bank, the bank's economists tell us that it must be forever. There is no way back to freedom, where the market allocates bank loans. That is the Party Line.

The market will eventually break this control. But it will not be painless. The reform will be imposed by the market. The TBTF banks will fail. The banking system will get back to 20-80.

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