Off with their heads

WASHINGTON, DC – Just over a year ago, the world experienced the worst international financial crisis since World War II. In September 2008, Lehman Brothers failed and AIG was rescued in a way that fanned the flames of panic around the world. Most major banks turned out to have been, at best, incautious – with some of the largest displaying a complete breakdown of sensible risk management. Almost all giant financial institutions, both in the United States and in Western Europe, were saved only through great exertions by governments and central banks – including considerable commitment of taxpayer resources. Ordinarily, if an industry plunges into crisis, you expect a serious shake-up. Even if there was some bad luck mixed in with manifest incompetence, the presumption generally is: if your firm requires a government rescue, top management needs to be replaced. The US Treasury has for many years consistently advocated such principles – both directly and through its influence with the International Monetary Fund – when other countries have gotten into trouble. This is sensible economic management and plain common sense. But that is not what happened in the US. Most of the pre-crisis executives in big banks remain in place, and very little has changed since the fall of 2008 in terms of other top personnel, risk-control practices, and attitudes towards risk. How is this possible and what are the likely consequences? The main reason that the largest US banks are back to business as usual is simple: at the critical moment of crisis and rescue – from September 2008 to early 2009 – the Bush and Obama administrations blinked. There was no serious thought of deposing the largest bankers, who had helped bring on the crisis, or of breaking up their banks as part of the price of providing a rescue. Why this path was avoided remains somewhat mysterious. Presumably, both fear of the consequences and affection for firms such as Goldman Sachs and Citigroup played a role. But once the window of opportunity was missed and the banks began to bounce back, the political dynamic changed completely. As the measures taken to stabilize the economy began to work, the banks started to make money again. And, given the departure of some competitors – including Bear Stearns and Lehman Brothers – larger market share meant higher profits. This money helped rebuild the big banks’ cachet and fund renewed lobbying on Capitol Hill; within a few months, the banks had regained their previous pinnacle of political access and power. The government was no longer able to dictate terms to their desperate bosses. The Obama administration launched a modest regulatory-reform initiative in summer 2009, but it has been a struggle every inch of the way. The big banks naturally want to keep their existing business model – in which they take the upside when they win and hand over the downside, when they lose, to the taxpayers. This is a very dangerous system that encourages repeated cycles of boom-bust-bailout. Indeed, Andrew Haldane, head of financial stability at the Bank of England, calls this our “doom loop.” The battle between responsible advocates of reasonable public policy and big banks run amok is not yet over, but the bankers are still winning, and their future looks bright. For example, the bankers profess to be unhappy about the new US bank tax that aims to raise about $90 billion, but it won’t hurt them much. If that is the most the Obama administration can muster, then the big bankers have basically won. The essence of the problem is that our largest banks are “too big to fail,” and they know it. It is thus entirely in the interest of these banks, and the people who run them, to take on an excessive degree of risk. Back-to-back major international financial crises are rare, but the continued presence of such perverse incentives always leads to trouble – more than 50 years of IMF experience is very clear on this point. Why should the US be any different? What we really need is for the Obama administration to get tough with the six largest US banks – which now have total assets worth more than 60% of GDP. This is an unprecedented degree of financial concentration for the modern US. As Teddy Roosevelt pointed out more than 100 years ago, the main problem with concentrated economic power is that it tends to take over political power, which runs directly counter to the democratic tradition. Will the administration seize upon this theme, pushing to reduce the banks’ market power and rein in their political clout? A potentially appealing political theme lies ready to develop, and perhaps that could yet swing the mid-term elections to be held later this year towards the Democrats. But the Obama administration would have to change its narrative, to make it clear that much more responsibility for the crisis rests with the banks. This is possible – the administration can say that new facts have come to light, and that it is changing its approach as the potential for global panic recedes. But don’t hold your breath. The grip of the world’s biggest bankers on US politics and financial regulatory policy seems as strong as ever. A political leadership willing to tackle this issue is, sadly, not yet on the horizon. Simon Johnson, a former chief economist at the International Monetary Fund, is a professor at MIT’s Sloan School of Business, a senior fellow at the Peterson Institute, and the co-author of the forthcoming book 13 Bankers. Copyright: Project Syndicate, 2010. www.project-syndicate.org