Big Banks: The Illusion of Strength

Posted on by Phil Querin

“I don’t care about being strong; I just want to look strong.” [Heard in the gym from a steroid-infused bodybuilder]   

This statement could have been quietly uttered by any number of CEOs and CFOs today when speaking privately about their Big Banks.  In an interesting Bloomberg article [“Breaking Up Banks Is Hard With Traders Hooked on Deposits”] the reporter cogently explains why Big Banks want to remain big, despite the calls for breaking them up.  His take is that getting bigger has less to do with “economies of scale,” as frequently explained by bank apologists, and more to do with keeping up appearances.

Too Big to Fail.  Notwithstanding the government’s position that there is no such thing, and that Dodd-Frank, Basel III, and other regulatory controls will prevent the U.S. taxpayer from ever having to bail the Big Banks out again, I don’t buy it.  And neither do the Big Banks’ lenders and investors.  They still believe that when it comes to the size of the institution, the larger it is, the greater the implicit guarantee of survival there is from the U.S. Government.   How can we tell?  Borrowing costs.

Borrowing Costs.  The raison d’être of Big Banks today is to borrow cheap money, especially in the short term.  We saw what happened in 3Q 2007 when credit tightened in the short term unsecured commercial paper market; some investment houses began a slow death spiral, culminating in the 2008 collapse of Bear Stearns and the bankruptcy of Lehman Brothers.

Not surprisingly, as we round the corner on the fifth year of the housing and foreclosure crises – the unintended consequences of three years of profligate lending – there have been calls to reinstate the Depression-era Glass-Steagall Act, which required that deposit-taking banks insured by the government [now known as the FDIC] be separated from investment banks whose business was not tied to customer deposits.  It was one thing for investment houses like Bear Stearns and Lehman Bros. to fail – customer deposits and government insurance were, in theory, not at risk.   But it would be quite another for an institution that was both an investment bank and a depository institution, to fail.  The government’s effort to prevent this from occurring culminated in its plowing $600+ billion into the Troubled Asset Recovery Program (“TARP”) and the emergency loan program known as the Fed’s discount window.[1]

According to the Bloomberg article:

“…Wall Street relies on borrowed money, or leverage, that can be obtained cheaply as long as the traders belong to a conglomerate such as Bank of America Corp.JPMorgan Chase & Co. (JPM) or Citigroup that gets federally insured deposits. Jefferies Group Inc. (JEF), a securities firm that isn’t part of a bank and can’t turn to the Federal Reserve for help, currently is charged more to borrow in the credit markets.

‘If you divorce them from the mother ship, you’d also be divorcing them from the government at the same time, and that’s where the subsidy is,’ Cornelius Hurley, director of the Morin Center for Banking and Financial Law at Boston University, said in a telephone interview. “The funding advantage is the key.”

So with their stock prices at or below book value today, one has to ask, what’s keeping the Big Banks alive anyway?  The answer is the depository side of their business.

Quoting Bloomberg:

“The 2008 collapse of Bear Stearns Cos. and Lehman Brothers Holdings Inc., as well as last year’s bankruptcy of MF Global Holdings Ltd., taught investors that securities firms not attached to banks are riskier than they once acknowledged.  Merrill Lynch & Co. agreed to sell itself to Bank of America the same day Lehman declared bankruptcy. A week later Goldman Sachs Group Inc. (GS) and Morgan Stanley (MS) converted to bank holding companies that are regulated by the Fed.”

Thus, breaking up these behemoths today would be, in the eyes of Big Bank apologists, a step backward, since it would force investment banks to fund their own operations through the use of the bond markets.  The bleached bones of Bear Stearns and Lehman are stark reminders of what happens when funding dries up in those markets.  So today, for example, in order to fund its trading activities and back up their counterparty liability[2] in derivatives contracts, Merrill Lynch can look to Bank of America’s $1.04 trillion of customer deposits.

“The big Wall Street banks are today what government- sponsored enterprises such as Fannie Mae and Freddie Mac used to be, producing profits for employees and shareholders even as taxpayers bear the ultimate risk, according to Simon Johnson, a former chief economist for the International Monetary Fund who’s now a professor at the Massachusetts Institute of Technology’s Sloan School of Management and a contributor to Bloomberg View.”

To put a finer point on the issue, the Bloomberg article gets specific:

  • Bank of America pays about $500 million a quarter in interest for its $1+ trillion of customer deposits; yet it pays about $2.5 billion for its $300 billion/quarter in long-term debt.
  • Goldman Sachs has increased its deposits to $57 billion since 2008 and “…wants to raise more” because the cost of its three-year deposits is about 2.00% “less than issuing three-year debt in the bond market.”
  • About 99 percent of JPMorgan’s $79 trillion derivatives book is on its deposit-taking subsidiary; the figure for Bank of America is 71 percent.

Confidence Game.  According to Bloomberg: “For a lot of the activities that these companies engage in, the confidence of their counterparties is really confidence not in them, but confidence in the government bailing out their affiliated bank,” Boston University’s Hurley said.”

The result is that the Big Banks, Goldman, B of A and JPMorgan, are perceived as safer borrowers in the longer term bond markets than independent investment banks, because of their implicit federal guarantee.  In other words, lenders and investors do believe that size matters and “too big to fail” is as true today as it was in 2008 when the federal government came to the rescue with $600+ billion in TARP funds.

Conclusion.  Back to the bodybuilder’s artifice of caring more about “looking strong” rather than just “being strong.” Big Banks and their apologists believe they need to be investment institutions and depository institutions for two reasons – neither of which have to do with economies of scale.  “Economy of scale” becomes a non sequitur when a bank’s book value on liquidation is greater than the total market value of its outstanding stock.

The real reason banks need to be big is purely smoke and mirrors. Big Banks need access to cheap money – i.e. their depositors’ – to fund their operations on the investment and proprietary trading side of their business.  Free-standing non-depository investment banks do not have this luxury.  Secondly, Big Banks need to be perceived as “too big to fail” so that their cost of long term borrowing is at rates that do not build in a risk of default.

[1] This does not include the estimated total cost of conservatorship, net of dividends, of $121 billion – $193 billion according to

[2] Counterparty exposure to derivative risk cannot be overstated.  So much of what investment banks do involves some form of wagering. A derivative is a contract “…whose value is based on one or more underlying assets. In practice, it is a contract between two parties that specifies conditions (especially the dates, resulting values of the underlying variables, and notional amounts) under which payments are to be made between the parties.”  The “counterparty” is the other side of the contract – whom the bank cannot control. Thus, “counterparty risk” represents the unknown risk that occurs due to the action of the other side of the transaction.  “The most common types of derivatives are: forwards, futures, options, and swaps. The most common underlying assets include: commodities, stocks, bonds, interest rates and currencies.” [] In order to minimize their derivative risk, banks engage in “hedging” which involves the purchase of a market positions in the opposite direction.  In theory, this protects the bank that if it loses on one side, it will gain on the other, thus reducing total exposure.

Posted in Fannie&Freddie, Financial Crisis, GSEs, Legislation - Federal, Lenders, Market Conditions, Miscellany, Subprime Crisis | Tagged , , , ,
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