Karen Petrou memorandum to Federal Financial Analytics Clients on the world’s biggest activist investor, the Fed.
TO: Federal Financial Analytics Clients
FROM: Karen Shaw Petrou
DATE: July 24, 2015
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With the stroke of its G-SIB pen, the Federal Reserve Board sealed its fate as the greatest activist investor the globe has ever seen. Going far beyond its traditional prudential-regulatory role, the Board now has demanded that the largest U.S. banks hold capital formulated to ensure that the cost of a G-SIB’s failure is fully offset by its capital buffer. In essence, the FRB has done what an activist investor would demand: it gets all the upside reward, and current shareholders—complaining all the way—pay for it.
To be sure, the FRB isn’t in it for a bit of share-price appreciation. Its goals are far loftier: making U.S. G-SIBs bear the freight for their failure due to the Board’s now-outed presumption that each of them remains TBTF. With this cost, the FRB believes, would come the G-SIB’s just fate: raising lots more capital—unlikely—or dramatically shrinking—the FRB’s clear goal. Using its clout as the dominant de facto owner of each G-SIB, the Board has flexed its muscles and will get what it wants.
Or will it? The goal is to make the U.S. financial system safer—so we are told in the final rule and the methodology backing it up. However, I see the bottom-line impact of the G-SIB surcharge very differently. Each G-SIB may well be safer, minimizing both risk to the FRB’s liquidity windows and its political reputation, insulated as it would be from more big-bank embarrassments. But, the sum total of the changes across all of the G-SIBs could well be a less efficient and innovative financial system that relies ever more on non-banks far outside the FRB’s clutches.
As I’ve said in the context of recent private-sector activist investors, breaking up big banks looks better on paper than in market reality. If one splits the G-SIBs apart due to regulatory—not market—incentives, then pieces that are not truly sustainable on their own without hard infrastructure will get a brief stock-price pop and then languish.
Only if big-bank debris is picked up by voracious shadow banks with the capacity to handle complex, low-margin and infrastructure-dependent businesses will the market proceed as before, albeit likely at still greater long-term risk. If shadow banks don’t want or can’t handle the pieces, then market efficiency would truly suffer.
The real bottom-line impact of the G-SIB rule as we see it in our proprietary-advisory practice is the non-economic pressure it puts on low-margin activities. For all the regulatory pain they share, each of the G-SIBs is very different from most of the others and some are thus far more dependent on these low-margin activities than others. Still, most of the G-SIBs are a major fixture in activities like securities financing, custody, prime brokerage, and payment, settlement, and clearing.
Many of these activities are critical to market infrastructure—that’s why they are also sanctioned under the calculation methodology for the G-SIB surcharge and in big-bank living wills. Banks make money at them—mostly—but often largely in the context of selling other, higher-margin products or because a package of low-margin services generates so much volume that real dollars nonetheless result. None of these activities is suitable for a six percent leverage charge because none assume anything like that level of credit risk. There’s real risk in each of these activities—operational, market, legal, and reputational top my list—but none of these is captured by the G-SIB surcharge.
Thus like a lot of activist investors, the FRB’s objectives could actually make its targets riskier. With regulatory demands cooking the books—admittedly for altruistic, policy-driven purposes which might even be right and reasonable—big banks will run their businesses the way the FRB demands, not the way the market requires. Some will shrink, but maybe not in the way the FRB wants— G-SIBs may well shutter low-margin, critical market infrastructure in favor of anything higher risk they still can do that more or less makes sense in the new, credit-risk focused capital regime. They could, for example, search for yield by hiking market and operational risk—rules might someday catch them at this too, but when and how well? Other G-SIBs will drive still more cost efficiencies through their overall structures—sensible to a point, but dangerous when vulnerabilities to risks like cyber-attack go unaddressed since there simply isn’t enough money to go around. Read the Comptroller’s recent speeches here as a guide to how badly things could go if operational costs are cut too far.
These non-credit risks to which G-SIBs are heir also tell us one other thing about financial markets: not everything risky in them is a big bank’s fault. Systemic risk of course comes from all the missteps and malfeasance at big banks before the crisis, but history shows us it can also be the result of forces beyond any bank’s risk-management capacity or even that of its sovereign masters, the Fed very much included. I know no cyber-expert who believes that more diligence by big banks will bullet-proof them—it will make them more resilient, but no one can promise total immunity. The Japanese banking system barely escaped catastrophic risk from the Fukushima earthquake—but next time? Another 9/11-style hit at the heart of global financial-market infrastructure? New rules—although not necessarily the G-SIB surcharge—aid resilience, but none is the perfect cure to natural disaster, geopolitical risk, or the other systemic forces that can topple financial markets. Worse, the more capital banks must store for credit risk, the less they have to mitigate all the others.
The Board’s fundamental premise—that big banks must pay all of the costs of their own demise—sounds right, especially in these days of damning all things TBTF. But, it’s as unreasonable to expect an operating company to pay for every risk it might someday, somehow run as it is to expect each of us to pay for all of our possible, eventual health-care costs. We use insurance for that. The Fed should too.