Richard X. Bove, Vice President Equity Research at Rafferty Capital Markets, discusses Minnesota Federal Reserve’s Symposium on “Too Big To Fail” (TBTF) banks.

Break Up The Big Banks – Minneapolis Fed Symposium

Absurdity Made Large

The Federal Reserve Bank in Minnesota (FRBM) made good on its promise to hold a Symposium on “Too Big To Fail” (TBTF) banks. The national press dutifully reported on the Symposium supporting the contentions being made by the anti-big bank speakers, as expected. The President of the Minneapolis Fed was so pleased with the event that he is promising more Symposiums and recommendations to Congress to stiffen banking laws.

The Minneapolis Fed District President, Neel Kashkari, indicated that there was a need for his efforts because no one is doing the basic work needed to resolve the issue of big banks failing. He is also convinced that the Federal Reserve system, of which he is part, cannot adequately protect the American public from a large bank crisis in the future.

Rather than attempting to debate the points made by the big bank haters at the Symposium, it may make sense to ask a few questions that could merit further study.

Who is the Minneapolis Federal District Bank?

The Federal Bank of Minneapolis is one of the 12 Federal Reserve District banks in the United States. It is owned by the banks that have headquarters in the states of Minnesota, Montana, North and South Dakota, and the northern portions of Wisconsin and Michigan. It is by far the smallest of the nation’s Federal Reserve District banks serving a U.S. population of less than 9 million people. The bank’s assets are believed to be $33 billion or 0.7% of the total aggregate assets in the Federal Reserve District bank system.

While U.S. Bancorp is a member of the Federal Reserve of Minneapolis it is not represented on the Board. The Board is chaired by MayKao Y. Hang the president of a local non-profit organization, who has an unusually impressive resume. Of the other 8 members only one may be designated as coming from a large corporation. The Board fairly represents its constituency of small bankers and business people.

On January 1, 2016, Neel Kashkari was elected by the Board to be the President of the Bank. His election was approved by the Federal Reserve Board in Washington. Mr. Kashkari never lived in the Minneapolis District. He is an Ohioan who worked for Goldman Sachs and in the Treasury Department under Secretary Paulson. For a brief period, he headed TARP, the bank relief program in Treasury. Two years ago he ran for governor of California as the Republican candidate and subsequent to his loss ultimately wound up as President of the Minneapolis Fed.

Given the ownership and structure of this 9th District Federal Reserve Bank, Mr. Kashkari’s function will be to function as an advocate for small banks.

What is the Status of Small Banks?

Small banks in the United States are disappearing at the rate of almost 1 per day. This has been true since 1985. A total of 11,524 banking companies have disappeared. Approximately 3,096 of these companies 26.8% (1 of every 4) have failed. This data was not mentioned in the FRBM Symposium.

Break Up The Big Banks - Minneapolis Fed Symposium

One would have thought that if the FRBM was thinking of its membership, which is virtually composed of only small banks, the question as to why so many small banks disappear would have been of paramount importance. Apparently, it is not.

How Will The Big Banks Be Dismantled?

One speaker at the Symposium indicated that big banks are those whose assets exceed 2% of the United States GDP or $350 billion. The question, therefore, arises as to how the companies with trillions of dollars in assets shrink? A bank like JPMorgan Chase (JPM/$58.61/Buy), for example, would have to eliminate $2 ¼ trillion in assets.

Presumably tens of thousands of loans would have to be called. This would be happening when other banks with more than a trillion in assets were cutting back, also. Assuming this were to be done over a five to ten year period, it is likely that it would create chaos leading to hundreds of thousands, if not millions, of jobs being lost.

What Would Happen to the Money Supply of the Nation?

The money supply of the United States is composed of cash, bank deposits, and investments in retail money market funds. If tens of thousands of loans were called it would shrink bank deposits. Thus as large numbers of companies were being driven out of business the money supply of the country would shrink. How would the Fed deal with this?

What if Big Banks were Split into Many Small Banks?

Assume that JPMorgan were to be split up into 8 smaller banks. How would these small banks meet the needs of large multinational corporations? How would they meet the needs of the United States government?

For example, the United States government has an outstanding debt of $19.2 trillion. It uses special banks designated as primary dealers to raise the funds to roll over the existing debt and fund the new deficits. At present, there are 21 banks designated as primary dealers. Only 7 are U.S. banks. The remaining 15 are foreign banks.

Break Up The Big Banks - Minneapolis Fed Symposium

If the big banks were eliminated in the United States, there would be no institution in this country that would qualify to be a primary dealer. Then 100% of the funding of the United States government would have to be carried out by foreign banks. If this were to be the case for the United States government, consider what it would mean if foreign banks also handled the funding needs of the Fortune 500 companies.

Did the FRBM think of this when it planed its Symposium?

How Does Cost of Capital Play into This Situation?

Perhaps the biggest complaint investors have when analyzing big bank stocks it is that these banks do not earn their cost of capital. It is one of the reasons that virtually every one of the nation’s biggest banks sell at discounts to book value. It is a key reason why they have historic lows to price to earnings ratios in what are good times. It is the reason that they are issuing long-term debt to meet government regulations rather than selling more equity.

At the Symposium it is being suggested that the banks be forced to take their equity to asset ratios up to 40%. There is actually a bill in the United States Senate that would require this. Demanding banks to increase their equity to asset ratios to 40% would roughly be forcing these companies to triple to quadruple their common equity. It would cause their return on capital to plummet. And, it would meaningfully dilute existing holders of these stocks.

The question here is simple: “Which money manager following “prudent, man standards” would put new funds into buying bank equities as they are issued?” Moreover, if they did this how could they defend themselves in the lawsuits that would be sure to follow? The deeper question is where would this new equity come from?

What about Minnesota?

Minnesota has one of the most successful employment records of any state. The biggest employers are the state government, health care companies, and retailers. The two biggest employers after these industries are Wells Fargo (WFC/$47.47/Hold)(20,000 people) and U.S. Bancorp (USB/$40.03/Buy) (12,000 people). In fact, now that Wells (legacy Norwest) has moved its headquarters to San Francisco, U.S. Bancorp is the fourth largest company in Minnesota.

The FRBM has hired a California politician to run the FRBM. His first recommendation is to break up two of the biggest employers in the state presumably causing a few thousand people to lose their jobs. Is this the reason that the Federal District Bank system was created – i.e., to make suggestions that will disrupt employment in the areas where they operate? Maybe so, but possibly not.

Conclusion

A politician is now running a Federal Reserve District Bank. His clear mandate is to attack big banks since his constituency is virtually 100% small banks. The national media has blindly followed him in. Possibly, someone should actually think about what they are saying or writing about here. It is not likely, but it may make sense to do so.