Karen Shaw Petrou’s memorandum to the Federal Financial Analytics clients on TBTF banks, how bankers’ blood will be spilled on the 2016 battleground.

TBTF: How Bankers’ Blood Will Be Spilled On The 2016 Battleground

How will financial firms fare in a Trump-Clinton match? So far, financial-industry policy is subsumed beneath the more potent personality questions that got us to this parlous point. Still questions such as the regulation of the largest banks and the role of hedge funds have played a far larger role in the campaigns so far than one might have thought given challenges ranging from slow growth to Syria. If financial-market conditions remain calm, relative quiet may continue on the future of finance. But with issues like TBTF bubbling barely below the surface, it won’t take much to ignite calls for a 1933-scale rewrite of U.S. regulation. Mr. Trump and Mrs. Clinton would go about this very, very differently, but go about it they will if that’s what it takes to appease an electorate hungry for banker blood.

When I talk to financial-industry folk, most are rattled by the rhetoric, but assured that the storm will largely pass them by. This is, I think, a dangerous bit of political complacency akin to GOP confidence that known candidates with proven governmental experience would win the day. Policy solutions offered by Mr. Trump and Mrs. Clinton will differ in critical details. However, with Mr. Trump’s propensity for what I will politely call big-picture thinking and given that Mrs. Clinton is being pushed hard to her progressive left, radical recommendations are a sure thing.

What would Donald Trump do? He won’t think twice about proposing a TBTF “solution” that redefines banking as we know it. Like most else Mr. Trump says, it’s hard to predict what this ground-breaking demand would be, but I’ll bet it will look a lot like the narrow-banking idea espoused by advocates as far apart as the Bank of England’s former head Mervyn King and Pat Buchanan.

Narrow banking – an idea that got a lot of traction in the 1980s when Brookings Institution scholars and a McKinsey analyst reviewed it – takes the Volcker and Vickers Rules and does them more than one better by restricting any regulated bank to two functions – deposit-taking and lending – backed by dollar-for-dollar capital or, in Mr. King’s new-style narrow bank, high-quality liquid assets. Narrow banks thus are expected to perform traditional financial-intermediation tasks but do so – mirabile dictu – without any taxpayer risk. All that narrow banks cease to do would then be done elsewhere in the financial sector subject, so it is thought, to market discipline and unbridled innovative acumen free of any claim on the FRB if all that seems good suddenly goes bad.

A big problem with narrow banking – and the reason fractional banking was invented several hundred years ago – is that it’s hard to lend much when you have to support each loan dollar-for-dollar with capital and/or reserves. Sure, there’s no risk in a narrow bank, but there’s also no reward for investors who will, at least in what’s left of a free market, take their money elsewhere.

Two recent studies prove the point by showing how capital charges even in fractional-banking regimes affect credit availability. As I noted last week, the IMF’s new macroprudential-impact study finds that economies like the U.S. do not necessarily lose credit availability when bank capital goes up, but that’s only because non-banks substitute for banks. A new FRB paper analyzed yesterday for clients demonstrates further that borrowers who depend on banks – e.g., U.S. manufacturers – get hurt when bank capital rises unless they are large enough to access non-bank funding sources. In short, if regulated banks are skinnied into the narrow-bank straightjacket, credit will suffer badly unless unregulated non-banks step in. They for sure won’t be narrow; indeed, they could well make a very large hole when they blow up as surely they would unless they so quickly get out ahead of the next crisis that they stand apart from the chaos they have helped to create.

I suspect Mr. Trump will be just fine with the narrow-bank solution because he likes debt a lot even if not so much big banks. Mrs. Clinton, however, will not support any solution that favors the “shadow banks” she highlighted in her own foray into recommending financial-sector policy.

This Clinton platform was relatively moderate, with the Democratic candidate eschewing big-bank break-ups and new-style Glass-Steagall in favor of revved up Dodd-Frank style reforms. Like much else she has said that has since been pushed hard to the left, this relatively-moderate approach will not withstand the general-election cauldron. With Bernie Sanders – not Hillary Clinton – beating Donald Trump in many current polls – Mrs. Clinton will I think have to go left and fast.

What then would she propose? I doubt it will be a reversal of her previous stands against forcible big-bank restructuring because that will be quickly ridiculed by the ever-ready Republican candidate. Rather, the Democratic platform will go Bernie Sanders one better and argue that, since big banks can’t be broken up, they will be nationalized. Not by express statutory taking, mind you, but rather through a series of new rules that builds on the FRB’s GSIB standards and adds to them a series of affordable-lending, compensation, and prudential standards. These would, it will be said, ensure that the nation’s largest banks do the nation’s bidding, not their shareholders’, in return for remaining too big to fail.

Before you tell me that the nation’s largest banks are not in fact TBTF, let me quickly assure you that I agree – the new resolution regime and other sanctions make big banks by far the least TBTF of all the SIFI fraternity. But what you and I think doesn’t matter – big banks have been branded as “the TBTF banks” not only in political rhetoric, but even in day-to-day business journalism dealing with mundane matters like quarterly earnings.

Mrs. Clinton may try to populate her financial-market utilities not just with the “TBTF banks,” but also with a few large institutions she has already said should be designated as SIFIs. Maybe she can with her own FSOC, maybe not given the recent MetLife decision. Either way, though, public utilities will redesign U.S. banking as thoroughly and destructively as narrow banking.

Despite all their differences, narrow banking and forced utilization are in fact based on the same premise – that U.S. banks are now irrevocably and irremediably TBTF and, to cure this, they must be structurally reassembled. One solution seemingly favors the private sector while the other is closer to socialist thinking, but each rests on the premise that reasoned, gradual, market-driven change won’t work. That’s surely what voters are proclaiming, and I doubt either party’s political candidate will have the fortitude to withstand calls for radical change even if they privately prefer another, more sensible course.

TFTB Breaking Up the Big Banks
Breaking Up the Big Banks