Too Big To Exist

The big debate these days is if banks are too big to fail are they too big to exist? The financial crisis occurred because the economy was growing fast, it was extremely cheap to borrow money, and borrowers assumed asset values would continue to rise. Leverage in the housing, corporate, consumer, and commercial real estate sectors skyrocketed as banks and other financial institutions freely lent money to any willing borrower. Risk managers used obsolete models to value assets and determine the reserves needed to protect their institutions from volatile markets.

Long Term Capital, Amareth, Lehman Brothers (in 1998), and most financial blow-ups were caused by a simple analytical flaw. It is easy to forecast excessive returns when the growth of asset values exceeds the cost of capital. In such a scenario leverage is piled high and either the borrower will amortize the debt over time or refinance it when needed. Strong economic environments lead to healthy corporate profits and free flowing credit from the banking system and Wall Street. Risk managers assume a normal bell curve of economic and financial results to protect the downside. Unfortunately, most financial calamities occur when movements in financial markets or corporate profits gyrate to the extremes. For example, the models might assume a 2-standard deviation rise in the price of all when it actually moves 5-standard deviations or in the case of housing, home prices never go down on a national basis when suddenly they plummet.

Here we are today trying to clean up the mess of financial institutions who assumed the unthinkable would never occur as opposed to assuming the black swan is around the corner and having a contingency plan. The government and the Federal Reserve have helped to stabilize the financial industry by adding massive liquidity to the markets and infusing cash into many banks and other financial institutions. The banking system will need to maintain higher capital ratios to remain independent and relieve themselves of TARP funds and the restrictions that go along with them.

We believe in the short run, some of the larger banks will have enough excess liquidity to absorb some of the impending loan problems in the commercial real estate and consumer loan markets. As time goes on, complacency is likely to set in again. Large financial institutions will continue to grow globally through acquisition as well as organically. Risk managers may adjust their models to take into account for extreme financial occurrences but eventually new problems are likely to creep into the system. Incorrect assumptions will be made and excessive leverage will once again cause an unexpected financial disaster.

We are in the camp that says if you are too big to fail then you are too big to exist. The government has the choice to force these financial institutions to sell off assets and limit growth or to monitor their operations more closely. We don't believe regulators are capable of protecting the financial markets when a black swan pops up unexpectedly. Therefore we suggest new reserve requirements be put in place based on the size of a financial institution. If the failure of a bank can cause shock to the system, then it is too big. At the point a financial institution becomes too big then it must raise its reserves to reduce the risk of market shocks. Under this scenario, corporations can determine if the return on capital is sufficient to warrant its growth as its reserves increase with its size.

The result of this new reserve requirement system will be a self policing method. For example, if J.P. Morgan wants to make another large acquisition, their reserves may have to increase an extra 2 percentage pints. Jamie Dimon would have to determine whether such an acquisition will be accretive enough to improve or not hurt the firm's return on capital. If not, they might pass on the acquisition or sell off other assets to right size the bank. In fact, if the Federal Reserve determines J.P. Morgan is too big to fail today, and it is, then the new reserve requirements might implore the bank to sell assets today or raise additional capital.

This scaled reserve requirement concept will not be embraced by the CEO's of financial institutions but it is the government's responsibility to protect the integrity of the financial markets and stringent guidelines might be one way to do that. We are not in favor of the government dictating compensation or participating in operational decisions. However, the Federal Reserve and the government must act as chief risk manager. Set the financial parameters to protect the markets and let the corporate managers run their companies within the set guidelines.