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The Washington Chainsaw Massacre


Merely cutting the banks apart won't avoid another financial crisis.


If you listen closely, you can almost hear "Gentlemen, start your chainsaws," as regulators and politicians in Washington begin to contemplate the fate of our "too big to fail" banks like Bank of America (BAC), Wells Fargo (WFC) and Goldman Sachs (GS).

Some want to cut up the banks according to the rules of Glass Steagall, separating banks from brokers and investment banks, while others are focused on splitting banks from insurance. Some want American banks to keep their US operations, but shed everything abroad. And still others want to bifurcate risk, putting "the casino" in one enterprise and "the utility" in another.

(And some just want to be seen putting a knife in the back of the banking system.)

But no matter how you slice it (pardon the pun), "shrink and separate" -- to use Treasury Secretary Geithner's term -- is now clearly upon us.

But in the midst of all of the ranting and raving, I can't help but think of the quote from Albert Einstein "We cannot solve our problems with the same thinking we used when we created them." And with all due respect to those involved, not only are we using the same thinking, but it's largely the same team of regulators and politicians who were charged with preventing a crisis in our financial institution in the first place, that's doing that thinking

Recently, James Fuchs and Timothy Bosch of the Federal Reserve Bank of St. Louis put together a short paper entitled "Why Are Banks Failing?" and I love their answer:

Although today's challenges are great, the four underlying reasons for bank failures have not changed from those of years' past, which are:

  • an imbalance of risk versus return;
  • failure to diversify;
  • offering products and services that management doesn't fully understand; and
  • poor management of risks.

Pretty simple stuff isn't it?

The media would like us all to blame derivatives, or "too big to fail," or oversized employee compensation and other emotional and/or confusing "flashpoints." But to me, those are all symptoms, not causes. As Messers Fuchs and Bosch suggest, the root was (and would argue, still is) a fundamental failure of basic risk management.

I've long believed that judgment isn't scalable. And when you couple this with the kind of innovation we've experienced in the financial-services space over the past 20 years (not to mention Wall Street's inherent profit motive), it's not hard to see how this crisis came about, particularly given the laissez-faire attitude of both regulators and politicians during this time period.

Many financial institutions took on risks they simply didn't understand, and unfortunately, their regulators didn't understand them either. This crisis was a collective failure.

But as I look at all of the proposals coming out of Washington these days, they're focused on how best to mitigate the consequences of failure. Nothing that I see is aimed at preventing failure from happening in the first place.

This is essentially the same policy response as the 1930s, when we "solved" that banking crisis by separating banks from brokers, launching deposit insurance through the FDIC, and raising the capital and liquidity requirements of all banks.

As I see it, from a regulatory perspective, we've reopened a tool box that's been closed for 75 years and taken out the same hammers and saws.

And now we're going to hammer the banks and cut them apart. And rather than tell the banks what risks they can or cannot take, we're going to hope that we've put in place enough levees that when the dam breaks again, the next flood won't be as big.

Don't get me wrong -- this approach will probably be sufficient to prevent another US banking crisis in the remainder of my life. But let's not fool ourselves: There will be more financial crises, particularly when we "solve our problems with the same thinking we used when we created them."

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Positions in SPY and JPM.
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