Too Big To Free Ride

Too Big To Free Ride

The government awards the largest banks all sorts of privileges, working against the public interest.


Since the 2008 financial crisis, there has been a continuing conversation on large banks and the idea of institutions that are “too big to fail” (TBTF). Anat Admati and Martin Hellwig have provided a valuable contribution to the debate in their new book, The Bankers’ New Clothes.

The authors bring formidable credentials to the discussion. Admati is professor of finance and economics at Stanford University and Hellwig is director at the Max Planck Institute on something called “the collective goods.” They offer an informative overview of the issues involved with the TBTF banks, albeit from the perspective of researchers and economists.


Whether all large, “systemically significant” banks should be broken up is not treated at length in The Bankers’ New Clothes, although the authors do recommend “to determine which banks are insolvent and to unwind them even if the immediate costs seem daunting.” This is a fairly radical proposal in Washington terms, and a good bit different from arguments made about merely downsizing the TBTF banks. A key part of the argument made by the authors is that the large banks are too highly leveraged and thus present risks to the entire financial system.

But the recommendations in this book are not pedestrian. Imposing a 1930s-style solvency test would effectively see a restructuring of some of the top ten money-center banks. This would include a parent-level bankruptcy filing by at least one of the top five, the one with the most real-estate exposure. Use your imagination to see the consequences.

It is important to note that the Dodd-Frank legislation specifically discourages a restructuring by the FDIC and instead pushes financial institutions to conduct voluntary restructurings under Chapter 11. The bankruptcy code is not so much about punitive measures as a means to achieve finality with respect to the legacy financials issues that are still eating away at these banks and creating risks for the entire system.

The book's second key recommendation is to ban dividend payouts to investors by solvent institutions until the capital ratios of the large are roughly twice current levels, a proposal that is unlikely to find a broad following among institutional investors on Wall Street. Dividends to shareholders now exceed operating income, making retained earnings negative at the end of 2012. That is, the largest banks are now essentially reducing capital via dividends to private investors, this contrary to all of the talk from Congress and regulators about “raising capital.”

The good news is that Admati and Hellwig properly diagnose the reluctance of the large banks to increase capital levels. The bad news is that current levels of income and revenue at the large banks justify valuations that are roughly half of pre-crisis levels, and equate to a level of return on equity of about 8-10 percent for well-managed banks.

Names like JP Morgan and Wells Fargo, and smaller, well-managed banks, are currently trading around book value. Names like Bank of America and Citigroup are around half that level. If Admati and Hellwig had their way, the position of dividends and retained earnings would be reversed, causing the price for bank equity to fall to perhaps half these valuations levels. But the authors are not sympathetic to such protestations:

The standard objection to this proposal, that a ban on payouts or a request to raise new equity would make banks’ stock prices decline would be due only to the fact that, with more equity, bank shareholders who benefit from the upside of decisions taken on their behalf would also have to bear more of the downside risks. This would merely correct a situation in which they can rely on others to bear some of the downside risks.

The issue of “free riding” on the public by investors in supposedly private banks is a familiar theme for long-time students of the financial-services industry. Since the New Deal reforms of the 1930s, including the now-repealed Glass-Steagall law, financial institutions have effectively become arms of the federal government, with FDIC insurance for their liabilities and various subsidies for assets from housing to small business and student loans. Like the housing government-sponsored enterprises (GSEs) like Fannie Mae and Freddie Mac, the large TBTF banks have been transferring wealth from taxpayers to private investors for decades.

As I noted in a recent post on Zero Hedge, “Question for Liz Warren: How Many Subsidies Does a Zombie Bank Need?,” the public subsidies flowing through the largest banks far exceed their reported income, raising a question as to whether the U.S. banking industry is profitable at all. The $125 billion in operating income reported in 2012 by the entire banking industry is just a quarter of the interest rate subsidy flowing from the Fed thanks to quantitative easing. Other subsidies total into the hundreds of billions of dollars annually. Valued solely on its net current assets, the large banks are arguably net takers of economic resources from the national patrimony, rather than contributing positively to growth. In economic terms, the banks are GSEs, indistinguishable from housing agencies such as Fannie Mae and Freddie Mac.

Higher capital rules and constraints on risk will eventually make all of the GSEs smaller and less problematic. Admati and Hellwig are perhaps not sufficiently critical of the scale of the imbalances between private-investor returns and the public cost of supporting the TBTF banks. Yet the book certainly has impacted public policy. As the Washington Post notes, members of Congress such as Sherrod Brown (D-OH) and David Vitter (R-LA) “want the major banks to increase their own tangible equity so that shareholders, and not just taxpayers, take responsibility for their risky actions. They want the banks to have greater liquidity by holding more assets they can immediately turn into cash in a financial crisis.”

This is a timely and interesting book and one that is squarely in the middle of the debate over the future of the nation’s largest banks. Whether Congress makes real either of the core recommendations in The Bankers’ New Clothes is entirely another matter.

Christopher Whalen is an author and investment banker who lives in New York. His website is