Financial pain in the behemoth assets

Under Covid, the world’s financial system has become even more distorted and bloated.

US Federal Reserve Board building in Washington. Picture: AFP

Before COVID-19 so drastically reconfigured the world’s public policy priorities, what to do about banks in the wake of the global financial crisis probably was the No 1 generator of reports, inquiries and thoughtful commentary.

In the meantime the world’s financial system has become even more distorted and bloated, almost guaranteeing bank nationalisation in the event of another financial crisis.

In the early 1970s the biggest bank in the US was Bank of America with about $US25bn in assets. JPMorgan, the biggest US bank today, has assets of more than $US3 trillion.

Following the GFC, when policymakers set to work to put an end to the principle of “too big to fail”, the number of US banks with assets greater than $US250bn has doubled from six to 13.

“Are banks too big to fail? Of course they are, as much as ever and probably even more so,” says Alex Pollock, who was deputy director of financial research at the US Treasury until February.

These mega banks now make up 55 per cent of the US’s $US21.3 trillion in banking assets, up from 18 per cent in 2000 and 45 per cent just before the GFC.

The situation is analogous in Australia, where the big four banks’ share of banking assets has jumped from 65 per cent in mid-2008 to 73 per cent today.

Banks, whose assets have grown twice as fast as nominal gross domestic product since 2000, tower over the real economies they are meant to serve.

The response to the pandemic has accelerated trends towards three extremes: concentration, dependence on government and exposure to real estate in the US banking system, which all increase inefficiency and, in the event of another crisis, make a collapse more damaging.

“You wouldn’t have a sense there’s anything wrong in the banking system or anything strange about it, which is a great disservice to the country,” says Charles Calomiris, a banking professor at Columbia University, speaking alongside other financial experts at a recent American Enterprise Institute seminar.

With greater size comes less market discipline, greater monopoly power and closer ties to government and regulators: the hallmarks of crony capitalism.

Size isn’t the only problem. Banks increasingly have become giant building societies, directing their lending and money creation powers at residential real estate rather than lending to real businesses. Political pressure and regulations that favour lending to households for real estate, combined with ever lower official interest rates that push up dwelling prices that in turn require bigger loans, have made the entire financial system vulnerable to any slump in house prices.

“Bankers of 100 years ago would have a heart attack if they looked at balance sheets of commercial banks and realised around 50 per cent of their loans were collateralised by real estate; then it wouldn’t be more than 10 per cent because real estate is very illiquid, and very correlated with the business cycle,” Calomiris says.

The 13 biggest US banks look like extensions of the state: 80 per cent of their liabilities guaranteed by the US government, while the share of their assets invested in government bonds or on deposit at the Federal Reserve has soared from under 7 per cent in 2007 to more than 30 per cent.

Banks aren’t doing anything nefarious but, rather, following the incentives regulators and government have set for them.

The Fed is creating new money by the trillion and stuffing it into big banks’ reserve accounts to buy US federal government debt. More than $US5 trillion of US government debt, about 20 per cent of the total, is now held directly by the Federal Reserve.

On a much smaller scale, our Reserve Bank has started doing the same to ensure Canberra can borrow cheaply. Lending to businesses has become a second order nuisance compared with easier, more lucrative home lending.

The US Federal Reserve banks have become the biggest player in the commercial banking system. “They are now huge home lenders; their $US2.2 trillion of mortgage loans is bigger on an inflation-adjusted basis than the entire savings and loans industry before its collapse in the 1980s,” Pollock says.

Governments and regulators quite like a big, concentrated financial system, which explains why little real reform was achieved in the wake of the financial crisis. What did happen was a huge increase in complexity that benefits large incumbents and regulators themselves. Regulators can “manage the system” more easily and treasurers can enjoy lower interest rates. And activist central banks can ensure governments enjoy much lower borrowing costs than otherwise.

“Banking everywhere has been, is and will be a deal between bankers and politicians,” Pollock says.

A handful of academics, such as Anat Admati at Stanford University, and former central bankers, including Mervyn King in Britain, rightly have called for much more equity, which would have forced banks’ shareholders and bankers themselves to shoulder more of the risk. Of course, they were ignored; the financial sector remains the most powerful vested interest in the world.

“You see in history when assets rise in value, they become collateral for larger loans, so people can extract more value, this is how financial systems can get into trouble,” New York University emeritus professor of finance Richard Sylla says.

“We’re in a kind of trap where low rates encourage more debt and higher debt levels require keeping rates low.”

History suggests another financial crisis is inevitable. Until then we’re stuck with a bloated banking system that suits no one except government, bankers and bank shareholders.

It could be far more efficient and competitive. But for all the heat and light surrounding the scope for digital fintech, the fact is that regulations prevent them from competing on a level playing field with the major banks in their core businesses of investment banking, borrowing, lending, money creation and payments.