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HPSinsight.com August 2, 2012

HPSInsight Hoenig's Big Bank Plan Misses the Mark

By Tony Fratto, (202) 822-1205, tfratto@hamiltonps.com

On CNBC's Squawk Box this morning, Thomas Hoenig, former Kansas City Federal Reserve Bank president and current FDIC board member, made the case for his proposal to end the so-called too big to fail problem with large banks. Similar, but not identical to Sandy Weill's comments, Hoenig is pushing for a modified restoration of the Depression era Glass-Steagall Act. I disagree with Hoenigs proposal in total, but here are three specific instances where I believe his responses to key questions miss their mark. This is a fundamentally different global economy than the era Hoenig yearns for Hoenig argues that U.S. banks will not be at a competitive disadvantage if we reduce the size of our banks because in the past, we had a dynamic economy even with smaller banks. I have made this point before, but it bears repeating: the global economy has grown exponentially over the past 25 years and it's only going to get bigger, and much faster. While the banking system of the post-World War II era may have been sufficient for the economy of the immediate post-World War II era, that banking system is certainly not sufficient for today's economy. The volume, diversity, speed, and breadth of both trade and capital flows are breathtaking. Total global financial assets, excluding derivatives, have increased four times the rate of the global economy over the past 20 years. This seems difficult for big bank critics to grasp even ones with Hoenig's deep experience. U.S. currency exchange activity alone is approaching a billion dollars a day in transaction more than a ten-fold increase since 1986. On a global level, foreign exchange activity tops $4 billion a day. I could list dozens of more statistics, but the point is clear: the world is exponentially bigger and more connected than ever before and this process is not slowing down. More germane to the current discussion, it is the global, diversified banks that are the ones providing financial services to companies and individuals so they can participate in the global economy. Yes, our economy grew faster in the immediate post World War II decades, but it wasn't because of our banking system. Correlation is not causation. Portfolio
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investment was neither so large, nor so mobile. And today the global nature of manufacturing -- sourcing commodities and components is enormous. The bottom line is this: If we revert to a model of smaller, domestically-oriented U.S. banks today, the global needs of companies and individuals will not go away. Those needs will simply be met by the larger European and Asian banks. Not only would this be more costly for U.S. firms, it will reduce the influence of our regulators. The false choice between the European model and breaking up the banks After writing off real competitiveness concerns, Hoenig suggests that we should break up the banks because the European universal banking model is broken. He is right; we do not want Europes banking system. And thankfully, we dont have it -- and I don't expect we ever will. U.S. banks have more capital, liquidity and lower loan-to-deposit ratios. Our system is also less concentrated with the top 5 U.S. banks having less bank assets as a percentage of home country GDP than the G20 average. And, despite the hyperbolic fears about big U.S. banks, U.S. banks are smaller than their foreign counterparts. We do not have a single bank in the top eight in the world by asset size. And, based on the measurement of asset size relative to home country GDP, i.e. the most important metric for anyone concerned about taxpayer exposure, we do not have a bank ranked in the top 40. Hoenigs point is moot we do not have Europes banking system, and we never will. Capital levels are the answer to moral hazard concerns Moral hazard is one of the core reasons advocates push to break up the banks. Moral hazard concerns have two dimensions: the banking operations side and the funding side. On the operations side, I agree with Hoenig bankers do not take government guarantees into account when making loans or trades. But Hoenig's greater concern is on the funding side. If bondholders believe banks will be bailed out, big banks can raise debt more cheaply, giving them a funding advantage over smaller banks. I think the evidence of this is far over-estimated, if it exists at all. Regardless, whatever benefit might exist is balanced by higher capital requirements for big banks today. Banks cannot simply leverage up on cheap debt, as they will have to maintain higher capital levels. Therefore, rather than simply focusing on the price of debt, we should also examine the price of equity, which is currently high for big banks.
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With enforced capital requirements, banks will have to choose between facing the high cost of equity or reducing what are deemed risky assets. Either way, we will have a significantly less leveraged banking sector and the size of our banks will be determined by the market, not the government. Moral hazard on the funding side of banks could be a concern, but if it exists, it is being addressed both in the U.S. and globally with Basel III. There is no need to break up U.S. banks. Doing so will raise costs for U.S. businesses and reduce our competitiveness in this industry. Tony Fratto is a Managing Partner at Hamilton Place Strategies, former Assistant Secretary at the U.S. Treasury Department, and a former White House official. He is also an on-air contributor for CNBC.

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