New Minneapolis Federal Reserve Bank President Neel Kashkari decided he wouldn’t really be doing his job if he didn’t warn us that a 2008 kind of financial crisis could happen again. He says the regulatory thinking in banking still hasn’t caught up with that reality.
That’s quite a debut for an executive on the job all of six weeks, but remember that in 2008 Kashkari was a young Treasury Department staffer in the heart of the maelstrom, as government officials tried desperately to restore some stability to the financial system.
The federal government stepped in to bail out the big banks in 2008 because we had to, he said at a Washington think tank last week, and then not much really changed. The structure of the industry remained the same. The top bankers got to keep running their diversified financial firms, earning eight figures to do so.
As for regulation, dropping thousands of pages of new ones on the financial industry did little to change the personal incentives that led the bankers at the biggest firms to nearly take the economy down.
Kashkari is clearly onto something important here. By making the problem of too big to fail the Minneapolis Fed’s problem to solve, he is off to a great start.
In Washington he was only announcing the start of a research project, not a recommendation. He certainly came short of calling for the breakup of the biggest banks. A better summary is that he thinks now is the time to admit the obvious, that the big banks could still rock the stability of the financial system.
Better to do something “transformational” now, while the markets are stable and the economy, if not booming, is doing pretty well. It could mean busting up the biggest banks, he said, but there could be other good ways to go about it.
It was also refreshing to hear somebody say, although he didn’t put it bluntly, that the legislative fix after the financial crisis, the Dodd-Frank law of 2010, has been a flop.
This monster of a law came to more than 2,300 pages, but because so much of it was directed to regulatory agencies the total page count of new or proposed rules has already swelled to more than 22,000, according to an analysis by the Davis Polk & Wardwell law firm last summer. That’s about the total pages of 34 copies of the literary classic — and genuine doorstop — Moby Dick.
Some good things were in the law, including the so-called Volcker rule, which sharply limited the kind of trading for their own accounts the banks could do.
Yet the basic structure in the industry is still the same. The biggest banks are still owned by the public shareholders who bear the risk, while the people working there largely get paid for the upside of short-term profits.
One of the most interesting things Kashkari said last week came in response to a question on whether corporate governance could be one answer to what more should be done. Couldn’t hurt, he responded, but he also pointed out that the two big investment banks that tipped over and helped spark the financial crisis of 2008, Lehman Brothers and Bear Stearns, both had top executives who owned a lot their own company’s stock.
They should have had plenty of incentive to keep their companies away from the kind of risks that could put them out of business, yet they didn’t seem to grasp just how much risk was being taken by the people who worked for them.
It seems clear that a get-paid-now mentality reached all the way into the executive suite before the crisis of 2008, no matter how many shares the bosses owned. Nobody who really thought of himself as the owner of Lehman Brothers would ever have let the financial leverage of the firm reach 30 to one, meaning $30 of assets of all kinds were supported by one dollar of capital. No owner would have taken that much risk.
That wasn’t the way the industry used to be structured. Wall Street firms used to be partnerships, where the partners decided who got financing and what stocks got traded because it was their own money on the line. They paid very close attention to what the 24-year-old front-line employees did with their checkbooks.
When the federal government stepped in with bailouts in 2008, this whole problem of misaligned upside and risk took on a frightening new dimension. Now it wasn’t just the public shareholders taking the lumps for business risks they probably didn’t fully understand. It was the rest of us as taxpayers standing there and catching the losses.
What lesson did the bankers take from all of this? Well, it seems clear that the people with access to powerful financial tools will still do with them what they’ve always done, and that’s try to maximize what they can make. There may be no better example of that since the financial crisis than the case of the London Whale.
This 2012 episode took place at JPMorgan Chase, and it’s actually a modern take on an old story in the financial markets, of a trader in London trying to make up for an initial investment loss with bigger and bigger bets. One irony is that it was run out of a bank investment office set up to make investments that would balance the risks taken elsewhere in the company.
In a subsequent report on the fiasco, it was noted that the bank’s own risk limits had been exceeded more than 300 times and that one of the problems stemmed from a simple spreadsheet error that dramatically understated the risk. That, combined with efforts to hide what was going on and management dithering, let the losses reach $6.2 billion.
Nearly four years after the worst financial crisis in generations, that’s the kind of thing a too-big-to-fail bank was still capable of doing.
And now it’s coming up on another four years. The transformation Kashkari is talking about can’t come soon enough.