Post-Lehman: The Banking Oligopoly Reigns Supreme

Today marks the one-year anniversary of the Lehman Brothers failure, which led to the subsequent rescue actions by the Fed and the Treasury.  Many look at the rescue of AIG, the forced marriage of Merrill Lynch and Bank of America, the TARP, the conversion of Goldman and Morgan Stanley to bank holding companies and the massive increase in the Fed's balance sheet and think that the financial system was utterly transformed.  My view is that the crisis only served to accelerate trends that were already in place, and have been for the last 40 years.  Ironically, the reforms proposed by the Obama administration will mark the final destruction of the old New Deal financial framework and will lock in place a large-scale financial oligopoly.

The battle over the very banking and money is as old as the Republic.  The traditional battle lines are between the Hamiltonians that favored a banking oligopoly to control the money supply and rein in speculation, and the Jacksonians that were suspicious of power being concentrated among an East Coast banking elite and instead favored a "free banking" model of small banks spread throughout the country.  Between the Civil War and the Great Depression, the Hamiltonians (mostly Northeastern Republicans) held sway and banking power was concentrated among the big New York banks led by JP Morgan.  During the New Deal, FDR smashed the New York "Money Trust" and created a fragmented banking system that (1) spread banking power throughout the country by prohibiting interstate banking and even restricting bank branching and (2) separated the types of banks into thrifts, savings & loans, commercial banks and investment banks.

The diffuse nature of the banks limited large scale banking and resulted in the development of the securities market, which is why the US securities markets are much more robust than those of other countries such as Japan and in Europe that have traditionally relied more on bank financing.  It also meant that the US didn't have any global-scale banks as the world economy was becoming more globalized.

Starting in the 1970s, the US government embarked on a piece-by-piece dismantling of the New Deal regulatory framework.  As the commercial banks grew very large and were permitted to enter the securities business in the late 1990s, the investment banks, who traditionally had much smaller capital bases than commercial banks, felt the need to expand their balance sheet to compete, which meant taking on more leverage.  Couple the high leverage with over-confidence in financial innovations such as modern portfolio theory, derivatives math and value at risk measures, the investment banks got overextended and finally succumed to a classic run-on-the-bank.

The result was the forced merger of the investment banking system into the money-center commercial banks.  We now have sitting atop our national financial system an oligopoly of six massive firms: JP Morgan, Bank of America, Citigroup, Wells Fargo, Goldman Sachs and Morgan Stanley.  These six firms together dominate the market for securities underwriting, syndicated loans, derivatives trading, prime brokerage, non-agency mortgage securities underwriting and credit cards.  The federal government now effectively controls the mortgage market and is in the process of pushing private lenders out of the student loan business.  Oh, and at least temporarily it now has a huge chunk the market for US auto loans through its ownership of GMAC and Chrysler Financial.

Given the trends that were in place, this turn of events was unavoidable, unfortunately.  The reforms proposed by the Obama administration are the logical culmination of this system.  Creating a unified regulator, bolstering capital levels, limiting risk-taking, even the proposed consumer protection agency all have the effect of locking-in a conservative financial oligopoly.  Viola, you have the re-creation of the concept behind Alexander Hamilton's Bank of the United States.

Personally, given the choices on the table, I favor this outcome.  The current system of privatized profits and socialized losses is preposterous and literally threatens our democracy by turning the public against the business community.  The banking system, as long as it operates under a fractional reserve model (i.e. with leverage) is intertwined with the money supply in such a way that we can't pretend that it can exist as a truly free market.  The size of the banking system's liabilities relative to its assets is so large, that unless the government is willing to risk the aftermath of a massive debt deflation it will always be forced to step in to bail out the banks when they run into trouble, which they periodically will do.  So Obama's Hamiltonian vision should be supported by centrists as the least extreme potential outcome.

The Republicans, now the naturally the party of the South, the Mountain West and Sunbelt, will likely migrate into the Jacksonian camp.  There is just no upside for the Republican Party to continue to support the current system, as the financial industry is clearly trending Democratic and is based in the super-blue states of New York, Connecticut, New Jersey and Illinois.  You see glimmers of this trend with the (at the time irresponsible) refusal to support the bank bailout, but we have yet to see a positive reformist vision emerge.  My Jacksonian solution would be to force a downsizing of the big six, not in scope, but in scale.  Jacksonians should favor a the migration away from large scale banking and to the securities market.  Just because the CDO math was wrong for the last ten years doesn't mean that securitization itself is a bad idea.  Perhaps moving to a "covered bond" model, where the bank holds 20% of the securities it underwrites, would strike the right balance.

The debate over the nature of banking and money has been raging in the United States has been for a long time.  Jefferson vs. Hamilton, Jackson vs. the Second Bank of the United States, William Jennings Bryan vs. the Gold Standard, FDR vs. the Money Trust…these great ideological battles over banks and centralized financial power have occurred periodically throughout our history.  Ironically, it appears that the parties are switching sides as they have switched their traditional North-South alignment.  While the battle lines between left and right are still blurry, they are clearly being redrawn with the Democrats slowly embracing the vision of their ancient enemy, Alexander Hamilton.

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