Breaking up the banks

In the last recent period we have been told that Goldman’s is doing “god’s work”, that they are “sorry” for the “things” they have done wrong, and that their operations are essential to the well-being of the economy. Conversely, there have also been (influential) calls to “break up the banks” so that retail banking would be separated from the investment (risk-taking) activities. During the neo-liberal period, these two distinct roles became blurred and banks increasingly behaved as hedge funds. Legislation that supported the separation was abandoned under intense lobbying from vested financial market interests. The mess that these developments has created is now for all too see. Modern monetary theory (MMT) provides some simple rules for assessing whether the break-up plan is sensible and necessary. That is what this blog is about.

In a Conversation with Lloyd Blankfein the CEO from Goldman’s apologised for his company’s role in the current financial crisis.

As part of the “apology” the company has provided $US500 million to invest in small businesses damaged by the crisis. In terms of the reported bonuses that the Goldman traders are receiving at the end of this year ($US20 billion) the goodwill fund amounts to 2.5 per cent.

These were the words Blankfein used:

… there’s also people who feel – and are right – that there’s some meaningful things where we may have – not may have, certainly our industry is responsible for things. And we’re a leader in our industry, and we participated in things that were clearly wrong, and we have reasons to regret and apologize for.

Blankfein also recently told British journalists that Goldman was engaged doing god’s work and as such should be cut some slack in the growing campaign against them.

I liked the way the Rolling Stone magazine described Goldman:

… a great vampire squid wrapped around the face of humanity, relentlessly jamming its blood funnel into anything that smells like money.

You might like to read that article which ties together the senior Obama administration, regulators and past and present Goldman employees.

In Saturday’s New York Times editorial – Goldman’s Non-Apology – we read that:

On some level, he seems to understand that an apology is in order. But his remarks do not come close to an apology. Even if he had said, “we’re sorry,” it would have been hollow since he never actually said what he was sorry for … or to whom he was apologizing.

Outside Wall Street, those blanks are not so hard to fill in. It is widely and correctly understood that Wall Street, with Goldman as a leader and with regulators in thrall, helped to inflate and profited from a credit bubble that burst and cost tens of millions of Americans their jobs, incomes, savings and home equity. American taxpayers continue to stand behind the bailouts and other government interventions that have stabilized the financial system, including Goldman, enabling the firm to post blowout profits in 2009 and to set aside $16.7 billion for bonuses so far this year.

Apart from the glitch in reasoning (American taxpayers are not funding the bailouts – the US Government is) we can sympathise with intent. I covered the issue of Goldman’s denial that they had received many billions of US dollars from the US Government and generous guarantees to underwrite their credit raising in this blog – Friend of the state, Friend of the people award.

The Editorial also homes in on the claim they didn’t receive public bailout money:

That is absurd. Goldman has repaid its initial $10 billion bailout allotment, but that is only a sliver of its taxpayer support. The firm was paid $12.9 billion, for example, in the bailout of American International Group, and a report by the bailout’s inspector general refutes Goldman’s claim that it did not need the money. Perhaps the biggest continuing prop is that the government clearly considers Goldman too big to fail, which means that taxpayers are on the hook if Goldman faces the abyss again.

Putting the “apology” in context, I recalled reading this Article, which documented how the Goldman Sachs Group:

… peddled more than $40 billion in securities backed by at least 200,000 risky home mortgages, but never told the buyers it was secretly betting that a sharp drop in U.S. housing prices would send the value of those securities plummeting … Lloyd Blankfein … declined to be interviewed for this article.

The article showed that Goldman and other Wall Street bankers created a huge “secondary market for subprime mortgages, converting them to securities and selling many of those securities offshore to circumvent federal tax laws and securities regulations.”

The pension and union funds that bought the assets to provide on-going benefits to their members were not told of the risks which were hidden by top tier ratings by the corrupt credit rating agencies. The latter were paid by the bankers to give their dodgy products high quality ratings. See this blog – Ratings agencies and higher interest rates – for more on the role that the credit rating agencies played.

Anyway, all these stunts are really as sideshow. There is now a growing awareness that something much bigger has to happen by way of reform to reduce the chances that the Goldman “crimes” can occur again.

For example, in a speech on October 20, 2009 to the Scottish business organisations, Bank of England governor, Mervyn King said that:

… the incentives to manage risk and to increase leverage were distorted by the implicit support or guarantee provided by government to creditors of banks that were seen as “too important to fail”. Such banks could raise funding more cheaply and expand faster than other institutions. They had less incentive than others to guard against tail risk. Banks and their creditors knew that if they were sufficiently important to the economy or the rest of the financial system, and things went wrong, the government would always stand behind them. And they were right …

It is hard to see how the existence of institutions that are “too important to fail” is consistent with their being in the private sector. Encouraging banks to take risks that result in large dividend and remuneration payouts when things go well, and losses for taxpayers when they don’t, distorts the allocation of resources and management of risk …

There are only two ways in which the problem can – in logic – be solved. One is to accept that some institutions are “too important to fail” and try to ensure that the probability of those institutions failing, and hence of the need for taxpayer support, is extremely low. The other is to find a way that institutions can fail without imposing unacceptable costs on the rest of society. Any solution must fall into one of those two categories. What does this mean in practice?

He then distinguished between the different activities that banks currently perform – the so-called “utility aspects of banking” (facilitating payments and intermediation) and “riskier financial activities that banks undertake, such as proprietary trading.”

He then said that in other industries cases the two functions utility provision and risk-taking are separated – the former subject to strict regulation and the latter “left to the discipline of the market”.

There have been various proposals put forward about how this separation might be accomplished and I will leave it to you to search them out if you are interested. But all approaches aim to only provide government guarantees to the utility aspects of banking.

Former US Federal Reserve Chairman Paul Volcker has also signalled a need to “break up the banks”. Volcker who at 82 years of age is still the head of Obama’s Economic Recovery Advisory Board has been arguing that it should be illegal for banks to trade in risky financial assets on their own behalf.

Volcker has been reported as saying that (Source):

The banks are there to serve the public … and that is what they should concentrate on. These other activities create conflicts of interest. They create risks, and if you try to control the risks with supervision, that just creates friction and difficulties and ultimately fails.

In the US setting this would see the return of the 1933 Glass-Steagall Act. The Glass-Steagall Act 1933 or the Banking Act 1933 was in fact two separate pieces of legislation – the first in 1932 which allowed the Federal Reserve to offer the discount window and the second in 1933 created the Federal Deposit Insurance Corporation (FDIC) and separated the banks into commercial and investment and prevented “bank holding companies” from owning other financial companies.

The vital changes occurred in 1999 by dint of the Gramm-Leach-Bliley Act which freed a bank holding company from owning other financial companies.

According to Volcker, banks should only be deposit takers, participate in the payments system (clearing house) and create loans. He would also allow them to trade financial assets but only for customers.

Government guarantees would be restricted to these financial institutions and the rest of the investment industry would stand or fall on the market.

Unfortunately, the politicians on both sides of the Atlantic are against this type of remedy. The response of the English politicians was particularly vehement at the time.

The UK PM told the British Parliament that:

Northern Rock was effectively a retail bank and it collapsed. Lehman was effectively an investment bank without a retail bank and it collapsed. So the difference between having a retail and investment bank is not the cause of the problem.

Both points are true but totally miss the point. The issue is about limiting public guarantees to those banks that are too important to fail. Had the retail and speculative spheres of the banking sector not been so intertwined the collapse of Lehman’s may not have been such an issue.

The US government is also not enamoured with the plan and claims that it can regulate Wall Street despite the latter returning to their old ways in recent months. Of-course there is a significant blurring between the Obama Adminstration and Wall Street given the backgrounds of many of the key players in the Administration.

From a modern monetary theory (MMT) perspective the matter comes down to what is required to maintain financial stability and advance public purpose. The main aim of the financial system should be to promote real economic activity and generate employment.

In the blog – Let’s just focus on inflation – I defined the essential elements of financial stability.

What you will gain from the elements of that definition is an understanding that the legitimate role of banks (according to our major goals – enhancing real activity and public purpose) is more akin to that conceived by the Glass-Steagall Act than the role that they have been allowed to play today.

It is not just about the control that Wall Street has on the US political process. The same arguments apply to all financial markets in all sovereign nations.

Clearly from a US standpoint they need some drastic action to break the Wall Street ideology. I read a story today where Goldman was saying that things are better than they seem because the financial conditions index is telling them that. If you explore the composition of that index you will see it measures nothing that matters.

The stark divergence of their priorities and those that support welfare and social meaning requires that the policy influence they have should be eliminated.

First, there is no reason for have a raft of financial products available that are so complicated that it is impossible for the informed purchaser to assess their characteristics properly (for example, risk).

Second, banks should not levy onerous fees for supplying a deposit-taking, loan origination service.

Third, national governments should never undermine the saving intentions of the citizens by forcing budget surpluses. There may be a time when a budget surplus is required to take the heat out of the economy (for example, when net exports are booming) but this will rarely be the case.

Fourth, it is not a credible growth strategy to rely on private spending financed by increasing private indebtedness. This requires a realignment of pay outcomes so that real wages grow in line with labour productivity and workers do not have to take on increasing levels of debt to maintain consumption growth. So the banking reforms also have to be accompanied by reforms to the distribution system.

Fifth, all banking regulations should satisfy a simple rule: do they advance the public purpose goals of the financial sector as above. Similarly, all banking behaviour should also satisfy this rule. If bank conduct doesn’t fit the purpose then it should be declared illegal.

So all pressures from lobby groups, of the type that saw the Glass-Steagall Act abandoned and the 80-20 rule watered down, should be resisted and ignored.

Policy must be focused on enhancing the operations of the real economy and inasmuch as the games played in the financial casino (capital markets) undermine the functioning of the production system they should be declared illegal.

There is no solid evidence to support the claim that the financial innovations that boomed over the last 10 years or so actually enhanced growth. The big financial players would have you believe that but the evidence is non-existant.

In an interesting piece – Too big to regulate, the banks need to be broken up – David Moberg writes:

Indeed, for every high-tech or Internet startup that blossomed (often owing more to small venture capital firms than to big banks), there were an equal number of disastrous bank-promoted corporate takeovers that plundered and destroyed firms … As executives tried to turn every business into a financial play, the booming financial sector led to bubbles that misallocated resources and to debt burdens that squeezed workers. Traders routinely made millions of dollars a year, fueling a salary arms race among managers and professionals. As factory workers lost their jobs and trade deficits rose, neo-liberal apologists argued that America did not need to make things. It could simply export financial services.

So we need to rethink what a bank is and institute reforms to ensure that the actual practice fits that conception of public purpose. Moberg says that an “industry that should resemble a public utility has become a casino”.

In that sense, I agree with the separation agenda discussed above except that I would take it further.

Moberg suggests:

Beyond fighting for tougher regulation, including higher capital requirements, simplification or banning of many derivatives, consumer protection, provisions for resolving bank holding company failures, and many other provisions being debated in Congress, Obama and Democratic legislators should break up the biggest banks and limit their size … The banking system needs to be treated as a public utility, with limits on both pay and bonuses, and higher top income-tax rates. Government needs to steer the economy toward ecologically sustainable growth and shared prosperity, heading off another, potentially even worse, finance-driven boom and bust.

In the blog – Asset bubbles and the conduct of banks – I noted that the only useful thing a bank should do is to facilitate a payments system and provide loans to credit-worthy customers. Attention should always be focused on what is a reasonable credit risk. In that regard, the banks:

  • should only be permitted to lend directly to borrowers. All loans would have to be shown and kept on their balance sheets. This would stop all third-party commission deals which might involve banks acting as “brokers” and on-selling loans or other financial assets for profit.
  • should not be allowed to accept any financial asset as collateral to support loans. The collateral should be the estimated value of the income stream on the asset for which the loan is being advanced. This will force banks to appraise the credit risk more fully.
  • should be prevented from having “off-balance sheet” assets, such as finance company arms which can evade regulation.
  • should never be allowed to trade in credit default insurance. This is related to whom should price risk.
  • should be restricted to the facilitation of loans and not engage in any other commercial activity.

It is true that the meagre separation of banks from investment funds does not eliminate the problem that the Wall Street firms would still be “too big to fail”.

The issue then is to examine what risk-taking behaviour is worth keeping as legal activity. We ban all sort of risk-taking behaviour (most of which I would allow) so governments around the world are not averse to taking drastic action.

The thing that should be foremost in our minds is what public purpose do these Wall Street capital market monoliths serve? If the answer is very little then they are akin to cars driving too fast on the crowded roads. Fun for the driver – for a while – until a massive pileup is caused. There is no public purpose in allowing the cars to drive fast in the first place. We clearly regulate that severely.

While it is unlikely to happen, I would legislate against derivatives trading other than that which can be shown to be beneficial to the stability of the real economy. While there is a lot of unwinding that has to be done to accomplish this end, it is the only way to address the “too important to fail” problem noted by Mervyn King.

We will not hold our breath waiting for any of this though.

CofFEE Conference 2009

Each year CofFEE holds our annual conference – the 2009 edition starts next week in Newcastle – being the Path to Full Employment Conference/16th National Unemployment Conference. It will be held on Thursday, December 3 and Friday, December 4, 2009.

You can visit the Conference Home Page for details. The final program is now released and you will see several MMT themes including a special MMT workshop.

It is a large annual gathering of MMT types from all over the World and several billy blog commentators have registered which will give us all a chance to meet face to face. There is also a big party on the Wednesday night prior to the Conference and a MMT blues band will be playing (well at least the guitar player!).

So if you are interested it is not too late to register. Hope to see some of you there. The weather is beautiful at this time of year and the main hotel is right on the ocean beach.

MMT videos

The following links provide access to the Modern Monetary Theory interviews with Randy Wray and myself which were recorded on May 29, 2009 at Newcastle, Australia. The interviewer was Victor Quirk. They are in standard video mp4 format.

More videos are coming soon.

Spread the word ...
    This entry was posted in Economics. Bookmark the permalink.

    9 Responses to Breaking up the banks

    1. RSJ says:

      Nice post!

      How would you have responded to this crisis, starting about a week before Bear failed?

    2. bill says:

      Dear RSJ

      I might write a blog on that question. I will have to recall all the events though. Maybe in a few days.

      best wishes

    3. Ramanan says:

      Hi Bill,

      should be prevented from having “off-balance sheet” assets, such as finance company arms which can evade regulation.

      I have a related question. This paper The Federal Reserve’s Primary Dealer Credit Facility describes the whole thing as a Repo Run. I like the story but I can’t figure out some numbers. The primary dealer repo financing was itself $4.5T and there are numbers in various places for the whole market, maybe including ROW, but in dollar contracts such as $12T. The only way banks can lend money for collateral is by creating deposits but in deposit liabilities of banks in the Flow of Funds, these don’t seem to show up. Are some deposits off-balance sheet as well ?

    4. Michael says:

      “So all pressures from lobby groups…should be resisted and ignored.” Where on earth does that happen? If we could convert all our wishes for ethical behavior on the part of politicians (and financiers, while we’re at it) into actual behavior, we would all come out better no matter what economic theory we used.

    5. JKH says:


      Just noticed your comment here.

      From the article:

      “The buyer—often a pension fund, money market mutual fund, or bank—is making a collateralized investment, and the trade terms are structured to compensate the buyer for use of its funds.”

      I haven’t looked into the numbers, but you may find that a fair chunk of the repo financing comes from non-banks, including money market funds and pension funds. Of course, their corresponding liabilities won’t be deposits.

    6. Ramanan says:


      Yes yes. But $12T seems to be a big number. In the end it should show up as deposits. One way of asking this is that at any point in time someone is long cash and where is it showing up ? Most deposit owners are households. The numbers quoted could involve doubling counting so $12T may actually be $6T which itself is huge. This is more believable because according to the article I linked the primary dealers repo financing was $4.5T and its official. Even this can be explained. Let us say A takes collateral and lends $1m to B for a period of 6m (term repo). B lends the $1m less haircut to C for 3m … C to D for 1m … D to E for overnight. So some sort of multiplier here, though this effect may not be very efficient. So around $1-4T needs to be explained instead of $12T. There is also some netting (repos and reverse repos simultaneously). Another thing is that the Fed H.6 and Z.1 don’t measure M3 which involves the Eurodollar market. Want to do the math.

    7. JKH says:


      I haven’t looked at the data closely, but:

      “In the end it should show up as deposits.”

      Not necessarily.

      Consider a pension fund with a “steady state” liquid asset portfolio of $ 100 million in reverse repos. This means it is providing repo financing to dealers continuously in the amount of $ 100 million. It’s just rolling over and repricing those repos at some frequency.

      So assuming the portfolio size is steady state. This is a “stock” situation without any net flow aspect to the analysis.

      Consider the balance sheet entries:

      Asset = collateral
      Liability = repo

      Pension Fund
      Asset = reverse repo
      Liability = pension fund liability

      There’s no deposit associated with this arrangement.

      You raise some other points which may be worth considering, but I think this is the general point about deposit liabilities.

    8. Ramanan says:

      Hi JKH,

      Sydneying so slow in reply.

      Yeah there is no deposit liability in the example you gave. So the pension fund and the dealer agree to roll either overnight or on the end of the term. Whatever cash transfer had to happen would have happened at the start when the dealer and the pension fund contacted each other. Right? The cash transfer could have been used by the dealer to purchase some security which goes to someone else. Though a lot else can happen, I am worried about this and to get a bird’s eye view of these repos and the run (with some numbers). I am basically interested in both the flow and the stock.

      The paper I posted has interesting things about the Fed’s operations. The Fed had been asking for an interest paying power on reserves and finally the situation was so bad that it had to push it. It wanted to target both the overnight rate and deposits. The paper says that it was targeting M0 but I think it wanted to increase M2-M0 as well. (In normal cases the Fed can just target the overnight rate) In WCI you noted the difference between a bank buying treasuries and non-banks buying them. I think MS and GS were converted to banks so that the Fed can lend them and they use it to buy Treasuries. In other words make it possible that there is a lot of “money” around – both M0 and M1-M0 and/or M2-M0. The downfall happened IMO, not really because the market thought that the corporates’s likelihood of default increased (they didnt expect the recession) but because of change in preferences to liquid forms. Subprimes’ fall happened because of fall in house prices etc but also because they kept getting dumped by holders and once the price fell to some level, it refuses to increase. And the Fed wanted to provide the support. Hogde-podge thoughts.

    9. JKH says:


      Good quality hodgepodge.


    Leave a Reply

    Your email address will not be published. Required fields are marked *

    To prove you're a person (not a spam script), type the answer to the math equation shown in the picture.
    Anti-spam equation