By Scott Lanman
Jan. 8 (Bloomberg) -- The biggest U.S. banks may face the threat of lower profits or pressure to break up under greater regulation following the financial crisis.
Federal Reserve officials have made tackling the issue of firms that are too big to fail a priority. Options may include banning or restricting activities that could threaten the stability of the financial system, analysts said.
“Rates of return are going to be smaller,” said Vincent Reinhart, a former director of the Fed’s monetary-affairs division who is now resident scholar at the American Enterprise Institute in Washington. “That will be the quid-pro-quo for having the government safety net.”
The goal would be to avoid the type of government rescues mounted last year that have put taxpayers at risk of hundreds of billions of dollars of losses. The interventions have increased the risk of future crises because companies have come to rely on official lifelines, current and former policy makers said.
As the firms most exposed to the mortgage collapse failed during the 17-month crisis, some of the biggest players expanded. Bank of America Corp. acquired home-loan-financer Countrywide Financial Corp. and broker Merrill Lynch & Co., and JPMorgan Chase & Co. took on Bear Stearns Cos. and Washington Mutual Inc. Meanwhile, Citigroup Inc. was forced to absorb off-balance sheet units it had created to invest in complex securities.
‘More Vulnerable’
“We are certainly more vulnerable” because of the size and interconnectedness of today’s banking structure, said Harvey Goldschmid, a former commissioner at the Securities and Exchange Commission.
With the failure of investors “to discipline and hold companies accountable, we’d better figure out what kind of government oversight or other techniques will work,” said Goldschmid, who is now a Columbia Law School professor in New York.
Fed Chairman Ben S. Bernanke favors setting up a “macroprudential” financial supervisor to address systemic risks. While he hasn’t identified which agency should undertake the role, some -- including House Financial Services Committee Chairman Barney Frank and outgoing Treasury Secretary Henry Paulson -- have said the Fed is best-placed for the job.
“Reforming the system to enhance stability and to address the problem of ‘too big to fail’ should be a top priority,” Bernanke said in a Dec. 1 speech in Austin, Texas. “The right way to do this is through regulatory changes, improvements in the financial infrastructure, and other measures that will prevent a situation like this from recurring.”
Subprime Lending
A market-stability regulator might aim at making a small number of major decisions to contain threats. The supervisor could, for example, have targeted the subprime lending boom that triggered the mortgage crisis.
Another option is to levy fees on companies to create a bailout fund in a way that’s analogous to the Federal Deposit Insurance Corp.’s pool for guaranteeing bank deposits, which is funded by bank fees.
The biggest firms “have to be subjected to a higher degree of supervision,” said Edwin Truman, a former Treasury assistant secretary and director of the Fed’s international-finance division. “Not that supervision and regulation can solve all the problems, but it can mitigate them,” said Truman, now a senior fellow at the Peterson Institute for International Economics in Washington.
Pressure to Split
More-stringent supervision could create incentives for Citigroup and other large firms to break up, said Bruce Foerster, president of consultant South Beach Capital Markets Advisory Corp. in Miami and a former Lehman Brothers Holdings Inc. managing director. “I think Citi should have been broken up a while ago.”
Banks may be resigned to additional regulations, especially after receiving funds from the Treasury’s $700 billion financial- rescue program.
“It is entirely defensible” that the institutions whose disorderly failure would pose a threat to the system be “subject to oversight, the comprehensiveness and detail of which is commensurate with that” risk, said John Dearie, executive vice president of the Financial Services Forum. The forum is a group of 17 chief executive officers from financial companies including JPMorgan, Citigroup, Bank of America and Deutsche Bank AG.
JPMorgan spokesman Joe Evangelisti and Scott Silvestri of Bank of America declined to comment. Citigroup’s Stephen Cohen had no immediate comment.
Timing of Change
Officials have said that a regulatory overhaul will need to await the end of the financial crisis, seeking to avoid adding to banks’ burdens amid volatile markets. Lawmakers are also planning to consider legislation for new rules, which could lengthen the process.
Former FDIC Chairman William Isaac also said that “the very large banks are already the subject of a great deal of regulation” and “one might question how effective” it’s been.
“You can’t make the argument that they aren’t subject to an incredible amount of rules and oversight including thousands of examiners that live there on a daily basis,” said Isaac, who is now chairman of consultant Secura Group LLC.
The federal government has increasingly inserted itself in financial markets in the past 1 1/2 years to forestall a deeper credit crunch. By October, U.S. officials joined their Group of Seven counterparts in pledging to prevent the failure of “systematically important financial institutions.”
Federal Interventions
Federal officials took over American International Group Inc.,Fannie Mae and Freddie Mac, averted the collapse of Citigroup and Bear Stearns and encouraged mergers such as the takeover of Merrill by Bank of America.
Minneapolis Fed President Gary Stern said in a November speech that the “too-big-to-fail problem now rests at the very top of the ills elected officials, policy makers and bank supervisors must address.”
Richmond Fed President Jeffrey Lacker and Charles Plosser, his Philadelphia Fed counterpart, also warned last year that the central bank’s emergency lending programs raised the risk of future crises by worsening moral hazard -- where firms take on more risk in anticipation of a government backstop.
“If you’re going to get rid of ‘too big to fail’ then you have to be one of two things: either small enough to fail or too regulated to fail,” said James Ellman, who manages more than $100 million in financial stocks as president of Seacliff Capital in San Francisco and used to work for Merrill Lynch.
To contact the reporter on this story: Scott Lanman in Washington at slanman@bloomberg.net; Robert Schmidt in Washington at rschmidt5@bloomberg.net
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