Fed Bailout of Wall Street: Not Fair to the Commercial Banks

Consider the investment bank model: no financial regulation, no bank holding company restrictions, and no federal insurance premiums.

In the midst of the current financial crisis, we have the spectacle of the Treasury secretary, a former chairman of the ultimate investment bank, Goldman Sachs (GS), leading the bailout of Bear Stearns (BSC) and proposing to back all investment banks by granting them access to the Federal Reserve’s discount window.

Our current financial regulatory structure was created in the midst of the Depression. Commercial banking and investment banking were separated to protect bank depositors.

A deal was struck—the commercial banks would get federal deposit insurance in return for stringent supervision, limiting their activities to lending and deposit gathering, a prohibition on equity ownership and trading, and an implied agreement to limit compensation. The investment banks traded a lack of federal guarantees for complete product and operating freedom (except for deposit gathering), a lack of financial regulation, and unlimited compensation.

Advantage: Investment Bankers

It has been obvious for years that the investment banks got the best deal by far. With no regulation and unlimited operating freedom, the sky has been the limit.

But now that the unlimited risk exposures have been exposed, not by regulation but by the market, the investment banks go hat in hand and receive a federal bailout. They even get to borrow cheaply directly from the discount window, a right that was formerly reserved for the highly regulated banks and severely frowned upon even then. Now the Fed has become a cheap source of Wall Street funding.

How did this happen? How did Wall Street get the upside and our banks get the burden? How can the Fed lend to unregulated run-and-gun financial casinos?

A Mismatch

Let’s take a look at the relative positions of the commercial banks and the investment banks.

Regulation. Banks are micromanaged by examiners based within the banks, and the banks pay for their examination. Regulation covers every aspect of a bank’s operations: financial, managerial, credit, risk management, liquidity, compliance, capital, compensation, and so much more. Though the investment banks face SEC compliance, where is the financial regulation, the risk management, the liquidity planning, the credit and credit derivatives?

Business opportunities. Banks are limited to basic lending and deposit gathering, with very limited freedoms in other areas. They cannot invest in equities, invest in other businesses, or expand easily. For the investment banks, there seem to be no limitations. They have maneuvered around the deposit restrictions. They can create and trade exotic products and invest in almost anything.

Capital. If you are a banker, does 35-to-1 leverage seem excessive? If you were operating with such a 3% capital ratio, how long would regulators let you continue? The investment banks seem to have no practical capital constraints, and that is without considering the derivatives and credit swaps that no one seems to know how to value, and for which there seems to be no capital. It’s no wonder investment banks enjoy such spectacular returns. Banks would, too, with no capital--and they’d also face such explosive busts.

Credit. Banks make loans under stringent supervision to support the economy. Investment banks make loans to trade. Who examines their loans? And where is the rigorous credit support and administration mandated for commercial banks?

Compensation. Bankers know that excessive compensation brings down the wrath of the regulators, who argue, "We insure your deposits, and you are not entitled to outsize compensation." Compare that to Wall Street, where compensation is unlimited. Staff members get incentives to take risk, and a $100 million comp package is normal. At a commercial bank, that amount would be heresy.

Politics. The political process controls our financial lives, including the regulatory environment. Banks are legally prohibited from participating, PACs are frowned upon, and managers are encouraged not to participate. At the investment banks, politics is mother’s milk. Wall Street is always one of the top funding sources for all parties. Do you think there is some cause and effect here?

Ownership restrictions. If you are a commercial bank, your holding company, your ownership, and your capital raising are severely restricted. Shareholders with more than a 9.9% stake are prohibited from engaging in other businesses, must become sources of strength, and must become bank holding companies. Investment-bank ownership is unrestricted and unexamined. Their deposit-gathering units have circumvented bank regulators by becoming thrift holding companies regulated by no one.

There are many more examples of the totally unfair playing field.

Unfair Advantage

As Americans, investors, and bankers, are we going to let this continue? Are we going to let the investment banks use their political clout to obtain even larger competitive advantages?

The solution is not bank-style regulation for the investment banks, but a level playing field.

This article originally appeared in American Banker.

Comments

[venividivici]

You are dead right mate. It is a sick farce, but will anything change? I very very much doubt it.
The basic problem is that America is a plutocracy. It is run by the rich and well connected for the rich and well connected. Look at the primaries for the presidential contest. Over $500 million spent. Money is all that counts in this country.

[monday1929]

Welcome to Crony capitalism. The Commercial Banks should bribe the necessary politicians to gain some regulatory relief and better tax breaks, like the billions in tax breaks headed to the home builders. A well timed public relations campaign (first pay the bribes) could help dampen what little public outcry might result. I assume any MBA could guide you through this process. Good luck.

[helplessobserver]

This is an excellent article. How in the world can GS pay employees 27B in compensation?

[flow5]

great topic

[Mike Stathis]

Nice commentary and great industry insight.

A note: Bear Stearns was not bailed out. In fact, the Fed refused to bail them out but granted unlimited cash to IBs in the future. Bear got a bad deal.

Perhaps we should all be wondering how it was that JPM got such a sweet deal - virtually no risk of loss and the world's most highly coveted clearing and prime brokerage business units from Bear, which I would estimate to be worth in excess of $18 billion.

Either way, both the commercial and IBs come out of this mess with the support of taxpayer dollars, which is debasing the dollar further, causing further inflation and higher oil prices.

I think a better title for your article might be "Fed Bailout of Wall Street Not Fair to Taxpayers."

I regard U.S. banks as the enemy of the American people, both commercial and investment alike. America is now more preoccupied with making interest than making products and the full effects of this disasterous strategy has only begun to surface.

Having worked on Wall Street, I've seen the fraud and corruption. And I left the industry because I did not want to be anywhere near that type of "business."

As a consumer, I have been exploited, lied to, and even had money stolen from me by one very large commerical bank. In fact, as it stands today, the commercial banking industry now joins the ranks of the worst run industries in America, along with the auto and airlines.