Should Big Banks Split Up?

A recent article by the New York Times detailed a report by Michael Mayo, an analyst with Credit Agricole Securities and author of “Exile on Wall Street,” which argued that JPMorgan should split up into several different businesses rather than one big bank.  In Mr. Mayo’s opinion, JPMorgan split up into numerous businesses would flourish and be worth more than the sum of its parts.  Moreover, the separate businesses would have to hurdle fewer regulatory loopholes and would be subject to less stringent capital requirements and quantitative limits.  Michael Mayo’s take on JPMorgan led me to think back on a paper I wrote on the Dodd-Frank Act lat year.  Specifically, a portion of my paper dealt with the Volcker Rule.  With the proposed Volcker Rule currently published and open for comment, I wanted to take a look at the Volcker Rule and provide my own insight on the matter.

According to MIT professor and former International Monetary Fund economist Simon Johnson, the prohibition of proprietary trading by banking entities is not the most efficient method of regulation.  The ultimate goal of the Volcker Rule is not to put a ban on proprietary trading, but to prevent banks from becoming too big to fail and decrease risk to both depositors and taxpayers.  If the Volcker Rule would allow banking entities to engage in proprietary trading with a set capital requirements and quantitative limits in place, banking entities would be unable to circumvent the ultimate goal of the Volcker Rule by pursuing alternate revenue streams to make a profit.  The majority of banking profits and losses derived from their credit, lending, and securitization activities, mostly with regard to real estate.  Approximately 80% of the credit losses incurred during the financial crisis were tied to such activities.  Under Simon Johnson’s scheme, such capital requirements would include a minimum amount of 20-25% in capital held in reserves, the percent level at which banks had to hold capital before the creation of the Federal Reserve in 1913, which would decrease the risk of a bank operating with inadequate capital.  Simon Johnson has also suggested a limit of the size (in both assets and liabilities) of systemically significant banks in the form of quantitative limits.  “Under Johnson’s approach…commercial banks would be prohibited from growing to larger than 4 percent of the [United States] gross domestic product (GDP), and investment banks would be limited to 2 percent of GDP – which translates to $570 billion and $285 billion, respectively, in assets as of 2009.” (David Skeel, The New Financial Deal: Understanding the Dodd-Frank Act and Its (Unintended) Consequences 86 (2011)).  As proposed by Simon Johnson in his testimony submitted to the Senate Banking Committee, a bank like Goldman Sachs, worth over $1 trillion, could be reorganized into ten independent companies, ameliorating the effect of a single bank or company failure to the U.S. financial system.  Moreover, the Federal government would be much more likely to let such a company fail, avoiding a taxpayer bailout.

As banking entities and nonbanking financial companies supervised by the Board of Governors (of the Federal Reserve System) operate differently, the capital requirements and quantitative limits would vary between the two categories created by the Act.  This broad rule would close the loophole created by the prohibition of proprietary trading – upon such a prohibition, banking entities would find other methods of risk-taking and profit generating activities.  Moreover, some of the biggest and most exposed banks make most of their profits through proprietary trading.  Accordingly, the banks at issue should consider the divestiture of their depository accounts.  By “de-banking,” institutions that engage in proprietary trading would be subject to less regulation and could actually compound the problem of too big to fail.  “The regulatory and supervisory system is much better able to deal with controlling the risky activity of regulated banks than of unregulated investment banks, insurance companies, hedge funds, or commercial companies with large financial operations.” (S. Comm. on Banking, Housing and Urban Affairs 6 (2010) Prepared written testimony of Hal S. Scott, Nomura Professor of International Financial Systems at Harvard law School and Director of the Committee on Capital Markets Regulation).  As Mr. Scott noted, “none of the most prominent failures of the financial crisis—Fannie Mae, Freddie Mac, AIG, Bear Stearns, or Lehman Brothers—were deposit-taking banks.”

The main source of the financial crisis was not the practice of proprietary trading on the part of banks.  In fact, “of the approximately $1.67 trillion of cumulative credit losses reported by U.S. banks, losses taken on trading activities and derivatives accounted for less than $33 billion, or 2%, of this total.” (Scott).  While proprietary trading was not the primary source of the financial crisis, it certainly contributed to the size of banks.  Accordingly, an enforcement of a 20-25% capital requirement and quantitative limits would contain the size of banks and safeguard both the U.S. financial system and American public from the effects of a bank failure.

Obama’s New Tax Plan: A Private Equity Killer?

Obama’s proposed tax plan, however unlikely to be passed, would shatter the investment strategies employed by Private Equity firms today.  PE firms invest in and acquire companies through a process known as a Leveraged Buy-Out, or LBO.  In essence, a PE firm will finance the purchase of a company mostly through debt instruments, usually at a debt-equity ratio of 4:1.  The acquired company then assumes the very debt that was used to purchase it by the PE firm.  This process provides for tax deductions on the interest payments made on such debt.  These deductions later off-set the company’s taxable income, thus juicing the PE firm’s returns on its investment.

Obama’s tax plan proposes to reduce corporate income tax rates from 35% to 28%.  While PE firms would enjoy such a reduction, the plan also aims to eliminate certain tax loopholes and deductions.  One deduction that this tax plan aims to eliminate is that which PE firms employ.  In the unlikely event that Obama’s tax plan is passed as is, PE firms will drastically have to adjust their models.  No longer would they be able to offset their portfolio companies’ taxable income with deductible interest payments.  Even considering the income tax rate reduction to 28%, their profit would be minimal without deductions.  This could cause a significant drop in PE activity, which many have accepted is a net benefit for the US economy.  As I stated before, whether or not this will actually pass is up in the air.  The Republicans are probably willing to spite themselves and their desire for lower corporate tax rates for the sake of saying “no” to Obama.  But should this pass, I suspect we would see drastic changes in the way PE firms go about their business.

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