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A fresh look at bank risk: Too integrated to fail?

Finance Blogger: Anthony Harrington Anthony Harrington

Blessed with a laser-like eye for the weaknesses in the US economy and a neat, dismissive way with the sophisms, empty sound-bites and hollow rhetoric of US politicians, Yves Smith, the founder and author of the Naked Capitalism blog, is often thought provoking. Her latest idea is that “too-big-to-fail” is the wrong notion. We should be focusing on the “too-integrated-to-fail” problem.

In a recent rumination on the theme of too-big-to-fail banks, Smith derides a recent amendment to the US Dodd-Frank Finance Bill which seeks to add new anti-trust powers to the Bill. These powers would allow regulators to limit the scope of big banks and to break them up if it appears necessary. Smith argues that simply approaching the big banks with a cleaver to hack bits off them is meaningless. In her words:

The problem is not merely the size of these firms, but the fact that they control infrastructure that is deemed critical to modern commerce… in some cases the firm owns critical plumbing outright; in other cases, it is so tightly networked to other firms that mucking with it very much runs the risk of taking down the rest of the grid…. in a tightly coupled system, efforts to mitigate risk typically make matters worse. You need to reduce the degree of integration first, then more direct efforts to lower risk are less likely to produce unexpected perturbations.

She points out that the businesses that are easiest to force a big bank to sell in order to downsize it, such as retail banking and asset management, pose no systemic risk, and do not address the integration issue at all. Actually, integration is a misleading term here since although rival organisations may merge or do joint ventures, this is not what we are talking about. They certainly don’t “integrate” in the sense that a vertically integrated business integrates its parts.  Interconnectedness is a less misleading term.

Just what constitutes “interconnectedness” though is much more difficult to define. Smith focuses on clearing functions and cash management, as examples of the tight coupling between banks and also gestures towards custody and administration. These are all very different things. Citibank’s Global Transaction Services, as she points out, is a global treasury or cash management system that allows a multinational company to have its Singapore branch make a local deposit which will then show up instantly on the head office account.

The problem with GTS, she suggests, is simply its scale. Here she quotes from an article in the Wall Street Journal:

Executives told officials with the Treasury Department and the Fed that GTS’s technology and presence in more than 100 countries made it too dangerous for the U.S. to let Citigroup collapse. The Treasury gave the bank a second big helping of $20 billion just six weeks after an initial $25 billion infusion from the Troubled Asset Relief Program, partly in recognition of GTS’s importance to the financial system, according to government and company officials…

"While Citigroup is primarily known for its retail banking and credit-card businesses, the GTS unit is increasingly integral to the parent company’s functioning. Clients that move funds through GTS leave a lot of cash on deposit at the unit, which funnels the money to other parts of Citigroup for lending or other uses. GTS’s deposit-gathering muscle has grown more important since the financial crisis began, now providing about 40% of Citigroup’s $800 billion of deposits."

The suggestion then is that GTS could and should be hived off in an IPO, thus ending this line of too-important-to-fail argument. Actually, Citi is far from the only bank to have built up a global cash liquidity function, sweeping multiple bank accounts into a single balance for the benefit of multi national clients. It is an essential corporate service provided by corporate banking and it seems odd to try to wrestle this function out of the hands of banks.

After all, these are corporate bank accounts and standard corporate banking practices that we are talking about here. If the bank lobbyists could head off a re-run of Glass-Steagal you can take it as read that they would have little trouble killing off an attack on their global treasury management functions.

Then we come to clearing. Smith quotes Chris Whalen, founder of the Institutional Risk Analytics (IRA), who calls JP Morgan a $1.3 trillion bank attached to a $75 trillion clearing operation. Again, the theme here is that the bank is one thing, the clearing operation is another. However, it is not at all obvious that the Treasuries clearing function adds materially to systemic risk in the US financial system. There is an oddity in having it reside with JP Morgan and Citi, but that is simply a historic fact and it is not clear that we gain much by dragging it into the fray.

The “monopoly” given to Citi and JP Morgan to clear US Treasuries goes back decades. Its origins lie in a decision by the US government to give the Fedwire Treasuries clearing function to two US banks. Smith is not making an argument for dismantling the Fedwire operation. The huge bulk of clearing in the US is done by the Depository Trust and Clearing Corporation and no one is trying to hammer the DTCC. It is absolutely essential plumbing and is not proprietary to any bank.

If there is something in the “too-interconnected to fail” argument it will require more analysis than we have seen so far to tease it out. One to watch, perhaps…

Further reading on systemic risk and too-big-to-fail

Tags: banking , Citibank , Dodd-Frank Act , Glass-Steagall Act , JP Morgan , regulation , systemic risk
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  1. bionicturtle says:
    Sat Jul 31 18:30:30 BST 2010

    Yves is a she (Chris Walen is a he, so you got that right, even though you may live under a rock)

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