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TBTF and Economic Moral Hazard

Financial Services & E-Commerce Newsletter - Volume 3, Issue 3, Fall 1999
By R. Crosby Kemper III
November 01, 1999

Remarks made at the St. Louis Banking conference by R. Crosby Kemper III*

My remarks are going to be somewhat different than George Kaufman's and Bert Ely's because, though I think George, Bert and I end up in the same place — we end up in love with the market — we see history a little bit differently, and we see the nature of the current system a little bit differently. As I see it, George Kaufman thinks that the current system works pretty well, but he would like to scrap it and let the market work. Bert Ely thinks the system works pretty well, but he would like to scrap it and let Bert's cross-insurance system work, which is a market-based system. I don't think the current system has worked all that well, and I would like to scrap it and get to a marketbased system. I think we end up in the same place, but I think we have a little different vision of history.

I also have a little different vision of the moral hazard that is out there today. I think it exists, and I think it is very big. I don't think it will bring the system down, but I think it will cost you as taxpayers, you as depositors, and you as bank shareholders (if you should be a bank shareholder) some money. And more importantly, the moral hazard I'm concerned about does not concern the regulators, and it does not concern the depositors or the shareholders. Instead, it is really a moral hazard concerning the discipline of the economy, and that is where I differ with George and Bert.

Now, let me explain my vision. We are entering a brave new world. You have heard discussed today in a number of panels what is happening to the financial system, and it is changing dramatically. It is a brave new world, and, oh, what creatures there are in it — Citicorp and Travelers! With my vision of moral hazard, I was amused by the fact that Citicorp and Travelers got their ultimate regulatory approval on the same day that the Federal Reserve announced the bailout of Long-Term Capital Management. I happened to be having breakfast with three Federal Reserve Board Governors on that day, and we were discussing this coincidence. And one thing that was clear to me was that the whole notion of off-balance-sheet liability was one they hadn't thought about a lot. And there is a tremendous degree of off-balance-sheet liability today in the financial system.

I also note today in the New York Times that a global group of regulators have gotten together and announced they are going to regulate derivatives of some of the off-balance-sheet stuff as Long-Term Capital Management did. An international banking panel proposes a way to limit risk. There we go. I am not a big fan of what the regulators are doing with this kind of risk, and I don't think the regulators can regulate the off-balance-sheet risk of the kind that Long-Term Capital Management created — the derivative risk. But before I get to that, I will tell you a little more about derivative risk and the hedge funds. It is interesting they call them hedge funds, because the last thing that Long-Term Capital Management was doing, or the folks Bank America had in New York that lost them a billion or two were doing, was hedging risk. In my case, as my father likes to say, the only perfect hedge is in a Japanese garden.

My underlying assumption is that the market works. I am libertarian, and my conclusion will be Hayekian, but you are going to see that I get there in a different way and so I want you to bear with me. I do believe that the market will ultimately work, but it is not working today in part because of the policy known as "Too Big To Fail."

We have enormous underwriting risk in the system today. One of the panelists from an earlier panel said that through the Internet and electronic commerce, we are going to be underwriting small business loans. That is actually going on right now, and more and more of this is going to happen. My question would be, is it going to be done successfully?

You heard John McCoy of Bank One quoted earlier about internet commerce. Well, this may have not been internet-related, but it certainly involved electronic commerce — Bank One just took a $90 million hit on a subprime auto lender that it owned, where they are taking in direct paper from dealers around the country, and they didn't know what they were doing. And they took this hit at a time when we have full employment, when we are still in the Reagan-Volcker-Greenspan-Weidenbaum 17year economic expansion. We have full employment, we have the finest economy we have had, I believe, in the history of this country, and Bank One took a $90 million hit on this very simple underwriting challenge of underwriting subprime auto loans. Here is how it works — you have a list of criteria, usually about a hundred of them. It takes you about half an hour to read the list, you pick an empirical score, and you underwrite it. And they can't do it.

This leads me to the preface to my Hayekian conclusion, which is that nobody knows everything. And the underlying assumption of both the regulators and some of our larger financial institutions — which are coming together, I think, in a symbiosis of incredible risk for a financial system — is that they do know everything.

We are also underwriting all kinds of new things. Citicorp is now going to be underwriting insurance. They are not just underwriting loans any more — small business loans, or installment loans — they are underwriting insurance. They are underwriting investments. They are out there in the capital markets underwriting things that insurance companies used to underwrite on a longterm basis, and underwriting more things than they have ever underwritten before.

There is more transaction risk than ever. The internet has come to us; electronic commerce has come to us. The speed of transactions is amazing and the potential for mistakes is absolutely enormous. And I am not just talking about Y2K. I think the banking industry is pretty much on top of that, although I guarantee you that there will be some problems in the transactional system on January 1, 2000. In the future, the risk at the transaction level will be magnified by the speed of what is going on, and I don't think there is anything that the regulators can do about that. However, I think they think they can do something about it, which is a moral hazard.

We also have systemic and subliability risk in the marketplace of kinds that we have never had before. This relates to derivatives, to the nature of balance sheets, and to the fact that so much of the earning power of our largest financial institutions is, in fact, off balance sheet today. If you look at the growth in revenue of most of the largest banks in the United States over the last five years, at a time when we have been making more money than we have ever made before, you will find that the growth in revenue has been in trading income, in credit card securitization, and in various forms of fee income and underwriting income that are not traditional bank businesses and have fluctuations that are very different from traditional bank businesses. I don't think these differences have been factored in.

One of the people who invented this brave new world is Frank Newman at Bankers Trust. When he was Undersecretary of the Treasury, I was in an American Bankers Association meeting with him where he explained that he had sent his assistant, a young graduate student from Harvard, around to the various banking systems in the world. He visited the English system, which we heard about earlier today, and the Japanese system and whatnot, and he came to the conclusion that those systems were much better than ours because they had fewer banks. Therefore, the United States regulators were going to try to get ours down to a system where we would have many fewer, much larger banks, making them much easier to regulate.

And my reaction to that was that maybe one of the strengths of the Reagan-Volcker-Greenspan-Weidenbaum expansion was the fact that we have had so many banks, so many financial institutions, so many different locations for the borrowing of capital and for the use of capital, whereas other countries have had so few. Relatively few decision makers making relatively few decisions based on relatively little knowledge is to me, again, according to my Hayekian bias, a recipe for huge inefficiency if not disaster. And if that inefficiency is in the direction of hazard, it could be a much larger hazard.

One of the problems with dealing with regulatory issues today is that we have had this incredible expansion, and it is hard to tell what risks are actually out there. There is an old saying — "you don't know who is swimming naked until the tide is out." But I think we are about to find out. I don't believe the business cycle has been done away with any more than the tide, and I think we are going to find some interesting things.

Bert Ely will probably not remember this, but one of the high points of my media career was a National Public Radio show on banking in about 1992 or 1993 on which Bert was the featured guest, and he was talking about what a great deal Citicorp stock was at that time. But I called in to that show and I said, "Bert, I disagree with you. What Citicorp is doing is not a good risk today because they are doing these crazy things (and I brought up Too Big To Fail in the course of this conversation), and they are making all these crazy loans." I had recently read that they had made $400 million in moped loans in India. And I thought, you know, that may be the definition of moral hazard right there. And Bert disagreed with me. Of course, Bert was right, Citicorp recovered and they did well.

However, I continue to read the New York Times, and I found an interesting article on May 25th. Citibank in India used collectors accused of strong arm tactics. Credit card debtors tell of scares despite a code of conduct the bank has, et cetera, et cetera. They threatened to remove their kidneys. My favorite example is they were using eunuchs to collect loans because there is some shame attached to being seen with a eunuch. Now, you know, Bert is right, they are probably collecting the loans right now, but at some point there is going to be a problem with making consumer loans in India if you don't understand the culture and you don't know how to get the money back. The globalization of credit has created moral hazard. The description you have heard of the international system or the financial system so far has been mistaken concerning where the moral hazard has led us and where Too Big To Fail has led us.

I disagree with George Kaufman to a degree on whether or not we have had failed banks: We have had failed banks. Citicorp was insolvent in the early 1990s. The Chairman of the FDIC told me that they had to bail it out. Manufacturers Hanover was broke. Many of the larger banks survived but were essentially broke and the regulators saved them one way or another. I don't think J.P. Morgan was going down, but there were rumors. You could see it on the Bloomburg newswire in November that J.P. Morgan was broke partly because of their derivative exposure in Asia, which was absolutely enormous, and the Feds were lending them money. They had to go to the window.

Now, maybe we shouldn't have let J.P. Morgan go down. Maybe it was great that we organized a Long-Term Capital Management bailout, I don't know. But what happens in a bailout is that money is flowing from efficient places in the economy, from places where some banks or other financial institutions are making successful loans, to people who are loaning on empty buildings in Korea. And I don't take that as a description of a functioning market.

As I said, I am with Bert and George in where I want to end up. I want to end up with a market. We haven't had a free market; we haven't had a well priced market. We have used the regulatory agencies to bail out people doing idiotic things. The Japanese banking system is a good example of an extreme version of what we have been doing. They have bailed everybody out, until very recently. They are beginning to turn around now because they have let some banks go down. They have let some shareholders take a hit. It is exactly what happened in the savings and loan crisis here when we finally let some pain out. We finally took some shareholders' money first and then took some money from a few depositors. That's right — not everybody was bailed out in the S&L crisis. Most people were, including those with over $100,000 in most institutions. But a few people took a hit. It was at that moment that things turned around, when we allowed some credit discipline — not very much — but some credit discipline to hit.

If you think there cannot be a problem that would be systemic, I would point out the statistics on the notional amount of derivative contracts in March of 1998. These statistics are fairly old. They are the most recent ones that I have, and I think the numbers are actually larger today. This is about the time that Long-Term Capital Management went down. The notional amount of derivative contracts that Morgan Guaranty had was $6 trillion on March 31, 1998. Citibank had $3 trillion; Chase Manhattan had $7 trillion. Now, most of that they are claiming to do as agent for someone. But there also were a substantial amount of derivatives that were on their balance sheets where they were the beneficiary, and I will give you the biggest one there — Morgan Guaranty had $23 billion, which was at that point somewhat larger than its capital. And that money is essentially interest rate speculation. What Long-Term Capital Management was doing was interest rate speculation. It was not a hedge fund. They were betting on the direction of Russian bonds. They were betting on the spreads between certain kinds of contracts, various futures and forwards and swaps. They were betting on things.

And though the Federal Reserve didn't put any money at risk when they bailed out Long-Term Capital Management, they did put something else at risk, they put the credibility of the regulatory system and the financial system on the line behind Long-Term Capital Management. What they should have done is let Long-Term Capital Management go down. Fewer stupid things would have been done in the last year than were done in the previous year if the regulators had done that.

I would like to scrap the regulatory system. As a practical matter, that won't happen. I would like to go to the perfect market. As a practical matter, that won't happen. As a practical matter, we won't get to Bert's crossinsurance, though I would be in favor of that; I think that is a very good idea. But we can reduce the moral hazard in the system by telling the regulators that Too Big To Fail is a bad idea. We can let some of these guys take a loss every once in a while. If they had let Continental Bank go down, there would have been an effect in the marketplace and perhaps, I don't say this is a certainty, but perhaps the S&L crisis wouldn't have happened to the degree that it happened if they had really let some people take a hit at Continental.

It is true that most of the correspondent banks, and we were one of them, had relatively small risk. But, Continental was the largest funder through certificates of deposit of money market funds in the United States. And the money market funds would have taken some hits. We would have broken the buck, as they call it, for the first time if they had allowed Continental to go down. Would that have been a good idea or a bad idea? I think it would have been a good idea, because I think the amount of speculation in the economy would have been reduced. I think there would have been a flight to quality, and I think a flight to quality is always a good thing because it ends up with a more efficient system, a more marketbased system, prices that reflect reality and economic activity that reflects reality.

So, do I agree with the conclusions that Bert and George reach? Absolutely. I think the market should work. Do I think the market has been working? No. Do I think there are problems out there? Yes. I think we have been floated by the economy for a long time, and I think in the next business cycle we are going to see the problem with the kind of regulation we have had, and I think H.R. 10 (now S. 900), and the various financial modernizations that have gone on are in fact Trojan horses. There is an enormous amount of regulation buried in them, and I think there is an enormous amount of regulation out there coming from the financial regulatory institutions.

We have broken out of GlassSteagall, and we are allowing people to do a lot of things that they weren't able to do before. But as soon as we allow them to do derivatives, we will get another Long-Term Capital Management. As soon as we allowed Bankers Trust to underwrite the kinds of things that they were underwriting, it was underwriting that got them into trouble (along with trading and derivatives). As soon as we allow them to do it, and something goes wrong, we step in and we re-regulate, or we force a sale.

So it is my belief that what we need to do is undertake a steady march towards the market. We need to get rid of Too Big To Fail, or at least modify it as much as we can. FDICIA did modify it to a great degree. But the market has never really been tried. We will see how well FDICIA works the next time we have a truly big bank failure.

The other hazard that is out there that almost no one has identified, and the regulators certainly haven't identified, is the interest rate problem. Historically, banks are a middle man on interest rates, and the job of a bank has been to speculate as little as possible. Lean, obviously, in a direction you think interest rates are going to go, but do not speculate. Shortterm assets, shortterm liabilities. We now have financial institutions of all kinds, particularly larger banks, speculating on interest rates, and the problem with this is, and the regulatory failure on this is, we have forgotten that interest rates can rise or fall dramatically. For about ten years now interest rates have had one or two relatively small blips. In 199394 we had one of those small blips. I think Alan Greenspan brilliantly managed it, and maybe even deliberately managed some of it. But we had a lot of those early derivative losses — people taking $100 million losses to the common fund such as Proctor and Gamble. Bankers Trust was in trouble at that point. If we had let them go down at that point, maybe we wouldn't have had the subsequent Bankers Trust problems.

But historically, interest rates can rise very dramatically. If you look at the stress tests that the regulators give banks today, it is, depending on what is being tested, a 200 basis point or a 300 basis point rise in interest rates. Well, interest rates went up 300 basis points in a matter of weeks in the early 1980s and went up much more than that over relatively short periods of time, and that will happen again. I am not going to tell you it is going to happen today or next year, but it will happen again, and at that point the moral hazard of Too Big To Fail is going to hit like a whirlwind.

* Mr. R. Crosby Kemper III, President UMB Bank -- St. Louis Region.