Those who love the tough capital language in the Dodd-Frank bill like to argue that it is warranted by sins of the past. They also suggest that the new law will naturally break up the biggest banks because investors will flee and put equity into smaller insured depositories. We won’t dispute the fact that the largest banks were ill-prepared to meet the market crisis that befell them in 2008, although we won’t back off our view that one reason for this was the failure of the leverage rule to capture high-risk investments like subprime mortgages. But, that was then. Now, we expect that the U.S. capital regime wrought by the new language will drive capital from big banks not to little ones, but rather into the shadow banking system that largely escaped the new law’s harsh glare.
Nothing the legislation does, nor what regulators want, can rewrite the rules of efficient markets. Yes, we know they aren’t anywhere near as efficient as advocates trumpet nor as clean as clients would like. Still, there’s an immutable fact in financial markets: complex banking organizations engage in tasks simple ones can’t, and many of these are critical to an efficient financial-market infrastructure and a robust economy.
In statistics released today, the OCC said that the top twenty-five U.S. banks control 100 percent of U.S. derivatives – surely a tribute not just to their financial muscle, but also to the operational complexity and complex risks inherent in this business. Some of this will be ripped from the market under the new OTC-derivatives reforms, but much of it remains, making this business still ill-suited for small banks.
Someone has to do huge corporate loans, handle billion-dollar trades, mitigate multi-million dollar risk positions and otherwise keep the home fires burning. That some of these types of transactions went very badly awry doesn’t mean that all of them can be dispensed with. The debate over whether some are speculative and inappropriate for entities with deposit insurance and a federal safety net is settled by new law in favor of industry critics. What’s left for big banks now is largely what they need to do for an economy that still relies upon financial colossi. If investors depart big banks, their profits will suffer and their capacity shrink, but the winners won’t be small banks.
Who will be left to do the business that still needs to happen? That’s the multi-trillion dollar question remaining to be settled as the consequences of the new law shake out. But, don’t count the shadow-banking system out. Any player in it that evades systemic regulation – and there will be many – will prove formidable competitors for big banks buckling under their new, heavy load. Of course, these shadow successors to systemic banks will get bigger and bigger and bigger, starting a whole new cycle of systemic risk all over again.