Good Corporate Governance demands that our large universal banks be broken up!

Over the years we have come to accept corporate scandals as normal fare in our capitalistic system. Still, when they are uncovered, these cases are nowadays generally dealt with little tolerance.

In the ultimate conclusion the ongoing financial crisis was caused by a monumental failure of governance. The discussion on re-regulation is thus a case of implementing a sensible system of governance. So, how are we doing? Are we on the right track? If not, why?

We know all about the breakdown of checks and balances in property lending, the rating agencies with perverse incentives and lack of independence or insurance companies who crossed over into capital markets without capital and/or know-how.

Certainly, some sensible changes seem under way, yet we continue to pull a blind eye on the largest and most harmful failures of corporate governance: the Federal Reserve and Commercial Banking.

The Federal Reserve is the institution at the top of our global financial system that has not only failed to govern the system but is itself a case of bad governance. Yet, it is not even questioned, instead it is being hailed as the savior from the crisis and an expansion of its role is being discussed.

Commercial banks on the other hand are fighting Paul Volcker and a growing number of elder bankers such as John Reed ex Citi, Nicholas Brady ex Dillon Read and head of Treasury under Reagan or John Bogle ex Vanguard who are pushing aggressively for a new version of Glass Steagall.

The bankers’ main counter to a break-up is the threat of a depression.  I cannot support this argument. How could restoring rules in place before the crisis was built be any worse than what we have now?  But it is true that there has to be a basic global arrangement. Finance more than any other industry is enormously fungible and globally mobile. Any country’s solitary action would simply lead to migration. Thus, on top of all the local hurdles, we need to come together and agree on a minimum standard for corporate governance within our global system.

When Glass Steagall was abolished in 1999, commercial banks expanded into everything that promised to lift profitability, from proprietary trading and investment to investment banking, investment advice, asset management, insurance and financial engineering. At that time European banks were already happily at it. However, instead of the world following the US with a good idea, the US followed the world with a profitable idea.

If politicians were sold on a model of dispersing or diversifying risks, in actuality risk became more concentrated. The financial system is not like the car industry, it is more like the transportation industry. Imagine a company were to build trains, planes, cars, boats and bicycles. The difficulties of integrating a full range of financial businesses and risks into one balance sheet have been fully exposed by this crisis.

It is not money or the financial system per se that creates innovation, growth and an improvement in the quality of our lives. Finance is merely the means to an end, the tool to create the optimum condition for valuable production or services. If, as is the case today, the lubricant, the catalyst within a system accounts for 40% of a system’s value, something has gone horribly wrong. The numbers are staggering and they point squarely at the banks, the global top 20 of which managed a combined balance sheet of more than $40 trillion in 2007 with their core businesses shrunk to often less than 20%. Bernie Maddoff may be an attractive Media target but his $50 billion fraud looks rather unsubstantial.

Bankers made the argument that spreading their wings into different areas of finance would help them diversify their business risks, i.e. reduce the volatility of their cash flows. The assumption is correct but it does not result in proper risk management, often quite the opposite. The supposedly reduced risks, indicated by a reduction in cash-flow and market-price volatility justified banks to expand businesses and leverage further in a reflexive cycle fed by derivative structures and the Federal Reserve. The ultimate result of this madness is that the stability of the system has come to rely on the ability to expand liquidity instead of sound structures that rest on sensible governance structures.

One of the most clear-cut distinctions between business models and risk structures in finance can be made between businesses dealing primarily with deterministic services and those that deal with an array of (often uncollateralized) uncertainties and time-frames that are not deterministic by definition.

Commercial banking concerns itself with largely deterministic, low risk finance. Banks take deposits, offer transaction and payment services and lend money attached to low-risk collateral. Commercial banking is very local and relationship based. The process is simple, involved, yet factory-like, with pretty much one contract matching the next, administered and overseen by a well-run back office in a secure and organized process. With all the ancillary functions—trade finance, foreign exchange, capital market access, payment services—a large national or global bank is a layered and multifaceted bureaucratic organization. Technology and experience have matured commercial banking into a commoditized, fairly low margin business whose risk is defined principally by overall economic stability and the leverage it is allowed to take on.

As such commercial banks are not set up to analyze or take non-collateralized risks, i.e. to manage funds and advise on investment. The management of non-collateralized risks and longer time-frames is generally very specialized, independent and most successful in entrepreneurial set-ups.

Fortunately, commercial banking is quite easily definable and detachable from the rest, in particular as there doesn’t have to be a strong line of separation. I see no reason not to allow commercial banks to engage in trading, investment banking, insurance or any other financial services that a client of theirs might require, as long as they remain marginal and account for less than 20% of the business, compared to often up to 80% today.

There is no alternative to ultimately breaking up these behemoths and contrary to what bankers have us believe, it is not difficult and not nearly as dangerous as the course we are pursuing now. It is not primarily a matter of technicalities, or global economic Armageddon, it is a matter of political will… to be continued

At the State of the Union, last week the President again delivered an inspiring speech. Certainly, one feels compelled to follow the lead. His number one priority in 2010 is to revive the economy and to create jobs. Yet, as convincing as the President lays out his plan, it smacks of Sisyphus and contrary to his opening remarks avoids the tough but necessary choices.

Looking back one year, the President’s assessment is that an economic crisis of the scale of a (Great) Depression, was avoided. However, irrespective of stock-market prices and the few positive signs of economic revival he can point to, the fact remains that the US economy remains flat on its back. Worse, the fundamental causes of this developing crisis remain firmly in place. The architects of the “successful” rescue plan are showered with praise for providing the financial system with the equivalent of a huge adrenalin shot, which achieved no more than to stop the decline and send the liquid asset markets into a frenzy. One year on we are looking at the highest stock market valuation in a century of data (Dow Jones and S&P, based on four quarter trailing earnings). Wall Street said thank you with record bonuses and Time Magazine celebrated with the man of the year, Ben Bernanke.

Despite the “good news”, the President concedes, much has to be done. He lays out his plan in some detail, mentioning small businesses, tax breaks and credits, lending programs, infrastructure programs, clean energy investments and importantly, investment in education.  Most sensible observers – outside the silly right wing supply side clique – agree with the President on the necessity of these programs. Although, the devil will be in the details and there is more than just a whiff of government activism. The President’s plans are not simply an attempt to create jobs but are in my view essential to rebuild the country’s basic infrastructure that has been wholly neglected during the past decades. Despite dim-witted proclamations of still too many political leaders blindly misquoting Thatcherism or Reaganomics, there is a role to be played by government (besides waging war) such as the provision of basic infrastructure, basic education, fundamental research or a sensible regulatory frameworks. The notion that industries should regulate themselves is unjustifiable, self-serving non-sense.

As the President further points out, his measures have been (and will be) insufficient to make up for all the jobs lost and in bringing back the economy to a sustainable growth path. As many ideas that spring from his creative mind, disappointingly, the President’s carefully avoids addressing the country’s historic level of debt that has to be digested and reduced. He dares not mention the realities of this inevitability, its deflationary and destructive reality for asset prices as well as economic growth. The US alone has accumulated a debt close to 4 times its GDP, mostly carried by its financial institutions and its consumers. Put that into relation to 1.6 times GDP prior the Great Depression. And, as I have been pointing out time and again, this enormous liability was built on the backdrop of investment and risk management tools that have corrupted any semblance to efficient markets during the past couple of decades (you will find a more detailed analysis of this in the book) and have divorced finance from the real economy.  It is truly a monumental mess. Our leaders dare not mention it.

Any sensible strategy to heal our economy has to focus on the financial industry and its key agent, the Fed and how to reduce the exorbitant levels of debt they have accumulated. Yet, the subject was a paltry side-note in the President’s speech. Now, that might have been a political decision. Admittedly, more recently, the President has spoken with a new-found toughness in dealing with special interest groups and Wallstreet in particular, demanding a “fee” of more than 100 billion from the large banks as well as regulatory changes. A modern version of Glass-Steagall seems to be in discussion, finally! and Paul Volcker is given a stronger voice (he hits the nail on the head in the New York Times http://www.nytimes.com/2010/01/31/opinion/31volcker.html?).  Yet, shockingly, there is hardly any mention of the Fed and the fundamental reform that is needed to restore some semblance of sensible monetary management. In fact, Fed Chairman Bernanke has just been reappointed, which endorses the policies that have led us into this mess and assume that they have saved us from a further bigger mess. However, if that leaves us hopeful for any reform at all in our financial system, it will be half-hearted at best and while politics justifies half-heartedness as pragmatism, in this particular case, half-heartedness will most definitely make matters worse.

On the one hand, not splitting up our universal banks (into good banks and bad banks) means that the entire financial system that is visibly and predictably retrenching in deflationary mode will be forced into even greater cut-backs. On the other hand, the practices and risk models applied on Wallstreet will continue to distort our financial system’s processes, reinforce its detachment from the real economy and propagate the excesses of the past. All the while, the Fed will be allowed to continue to conduct its monetary policy of the most foolish sort, steering us straight into the abyss.

With absolute certainty the US (and much of the rest of the world) finds itself in the early stages of a deflationary de-leveraging process. There is no point in fooling ourselves, this will be painful for Wallstreet and Mainstreet. However, fighting inevitability with frantic activity, makes this much more painful for the real economy than is necessary. The President tells us about his conviction that he is absolutely sure to have done the right thing, the necessary thing even though it was “as popular as a root-canal” to everyone involved. Henry Paulson, one of the architects of these policies and former Chairman of Goldman Sachs admits today that they had “no idea what they had to do”. Listening to Larry Summers, giving interviews in Davos gives no indication that he knows any more, a year and a half on.

And so the big plan they came up was to save a number of large commercial banks, which had really become oversized hedge-funds. Although they had no idea what to do, they came to the conclusion they needed to “save” a few global financial superstores to save the world. But it was not the necessary thing to do, nor the right thing to do, it was the easy thing to do: there is no way back, hence full steam ahead, continuing in the tracks of the same policies that have arguably caused the crisis in the first place.

The necessary and courageous strategy fundamental to saving the financial system would have been and continues to be splitting off the commercial banking books from the mostly toxic and leveraged “asset plays”. This means removing the essential commercial banking businesses from the crushing weight of their often many times larger and more “profitable” hedge fund businesses. If we indeed want the economy to start creating jobs, it will not be without the help of a healthy commercial banking system. Saving the monstrous hedge funds that we have allowed to build achieves the opposite, as it inevitably paralyses lending further.  When we fight deflation, we have to fight the deflation of our commercial banking system and the subsequent deflation of our (still healthy) businesses and shield them as much as possible from the necessary and unavoidable deflation of the towers of debt we have built, mostly on non-cash flow generating bets. Most of these “too big to fail” bets are about as far removed from the real economy as we can imagine. We haven’t saved the system, we pumped air into it, jobless fluff.

Allowing our banks, i.e their hedge-fund books to be exposed to the market mechanism would certainly bring down asset prices in a hurry and would likely result in a bit of a shock to the system. Let us remember though, asset prices are a price tag of the economy, they don’t determine or create value, they price it. Who wants to argue the real economy would stop in its track and we would all go home and retire because assets are re-priced? Indeed, a continuance of current liquidity pumping and fiscal bail-outs is sure to paralyze the financial system, and over time deflate our (still) healthy businesses; then we can go home and retire.

Sisyphus is busy plugging the holes punched into the system over the past decades, frantically distributing “sand-bags” and “duct tape”. He is a well-meaning and hard-working fellow but we cannot close our eyes to the root problems of this crisis. Current policy lacks a clear strategy, it is an accumulation of tactical measures that is likely to create less jobs than are being destroyed by the lack of decisiveness and spine in dealing with the financial system. Job creation leads through the financial system!