Hoenig describes idea to break up largest banks

In his first public speech since winning Senate confirmation as a director to the Federal Deposit Insurance Corporation, Tom Hoenig once again called for the country's largest banks to be broken up into smaller entities. Speaking at the Iowa Division of Banking's Day with the Superintendent on April 26 in Des Moines, the former president of the Kansas City Federal Reserve Bank said the largest banks should be broken up along business lines.."If you look at the largest institutions, there are six lines of business. There is the traditional commercial bank," he explained. "In addition, there is investment banking, there is managing and advising, there are certain kinds of proprietary trading, and broker/dealer activities, and managing investments in trust services.".Hoenig said the law should segregate these lines of businesses into separate corporations, just as the Glass-Steagall Act separated investment and commercial banking before the Gramm-Leach-Bliley Act was passed in 1999..He said that since 1999, banks have been able to engage in business activities far more risky than traditional lending. "Let me give you one example," he said. "Let's just say you are in proprietary trading. If I set up a hedge fund as an individual and I decide I am going to put a bet on corn and I sell it, and I am convinced the price of corn is going to go down, if the price goes up, I am wiped out. I'm taught a lesson; the market works. Let's say you are under the safety net. You have enormous access to funds. You place the bet, you lose, but guess what? You have this enormous access to funding because the creditors know you are too big to fail. They are going to give you more money. So you cover your margin, and perhaps you double down because you are so convinced you know which way the market is going. You multiply risk.".Hoenig tried to put the level of risk into perspective. "If you think about the size of one of the largest institutions, their broker dealer activities, in the broad sense of the word, when you look at their balance sheet in 2007 prior to the crisis, it was as big, or in some cases, bigger, than their actual whole bank size was in 1999, prior to the repeal of Glass-Steagall. If you break these institutions up you will make them smaller, make them less powerful, and you as the FDIC or the bankruptcy court can resolve that in much more systematic fashion. The interconnectedness, the probabilities of being able to solve that problem, go up dramatically.".Breaking up the largest banks, Hoenig said, is not a matter of "getting even," but a matter of correcting perverse incentives. He said the federal safety net incents the largest institutions to grow and take risks that smaller institutions simply can't take.."In 1913 when the Federal Reserve was formed, we began the concept of the federal safety net… At that time the five largest institutions in this country controlled assets that were about 2.5 percent of the gross domestic product. Today the five largest institutions control and manage assets that are about 60 percent of our national income. Now we have something to worry about. That is a large chunk. And the largest 20 have about 80 percent, leaving the rest to community banks.."In 1913 the equity capital to assets across the industry was about 16 percent. In 1933 it was about 13 percent, a 25 percent reduction but still very high. Today we have individuals talking about capital ratios that are 5 percent, and the reason for that is the safety net. Because you no longer post your call report on your bank window every quarter. You post 'insured by the FDIC' and for the public that is a huge substitute for equity capital. And the largest banks benefit most from that because it is in fact a subsidy that we all benefit from, the larger you are the greater the subsidy. That has allowed these institutions to take on more risk.".Hoenig emphasized the importance of market discipline to the success of the economy. "If you go back and think about the success of the United States over its history, you will note that it has been a system driven by capital and capitalistic philosophy of success of firms of all sizes — large, very large, and small. Among that is a churning of institutions through success and failure based on the decisions that they made. And the benefit and beauty of the market is not the fact that it's smart — it's not any smarter than you or I — but in the harshness of its discipline to correct the errors, bringing back focus.".Heonig said our country's economy has "enabled us to find a way to fund the entrepreneurial vigor of the United States that made us successful." He lamented that new rules in the banking industry will make it more difficult for many banks to finance that entrepreneurial vision. ."Dodd-Frank, for all its intentions, does increase fixed costs to you. Larger fixed costs to the largest institutions but when you distribute that over assets proportionately, in the end, I think there are more costs to community banks. Your efficiency ratio is coming under pressure. You have to manage it. Many of you have said to me personally that instead of hiring a new loan officer you are going to hire a new compliance officer," Hoenig said..Hoenig acknowledged the unpopularity of his opinion about the necessity of breaking up the largest banks. "They will object, saying this will not make us competitive in the global market. My answer to that is … since the Great Depression when Glass-Steagall was passed, [we have] the experience of the value of specialization in the capital markets where commercial banks are separate from investment banks. And our market, our commercial banks, our investment banks, were more innovative, more competitive and more globally influential then than they are today. So you are not necessarily giving up the competitive position. You may in fact be building it. I like to remind people that Adam Smith talked not only about the invisible hand but he talked about the value of specialization. And history would suggest that it remains as valuable today as it did prior to the repeal of Glass-Steagall.."Those are the things we need to think about, not just say it can't be done, which is often said about breaking up the largest institutions," Hoenig concluded. "And again, it's not because they are bad, it's because the incentives are wrong. They are going to invite new problems; they are going to invite new crises, and they are going to be as hard to deal with next time as they were last time because they are larger today than they were prior to the crisis. We need to think of solutions that aren't on our plate today … that is what my agenda is as I have taken on this job. It is clearly on the record. When I was up for confirmation I told every member of that finance committee this is how I think. It is part of my mission."