You are invited to read this commentary from the Free Enterprise Foundation. It will make you think!

Too Big to Fail

“Our company, J.P. Morgan Chase, employs more than 220,000 people, serves well over 100 million customers, lends hundreds of millions of dollars each day and has operations in nearly 100 countries. And if some unforeseen circumstance should put this firm at risk of collapse, I believe we should be allowed to fail.” Jamie Dimon, Chairman, J.P. Morgan Chase

In 1913 as the nation contemplated the need to amend the antitrust laws to reach combinations not envisioned by the framers of the Sherman Antitrust Act, Louis Brandeis writing in Other Peoples Money: And How the Bankers Use it, noted that although size is not a crime, it may become “noxious” by the means of its accumulation or the uses to which it is put.

Dealing with the veracity of that comment has been at the heart of a national debate regarding financial capitalism and the level of regulation that is appropriate in light of the almost complete collapse in 2008 of the world’s liquidity following the loss of confidence in the underlying value for trillions of dollars of debt. Values that previously were thought to be unassailable became the Achilles heel of legendary financial houses in New York and around the globe.

Jamie Dimon, Chairman of what must be regarded as the prevailing giant of financial supermarkets, says “Let us fail,” but it is not as simple as that. It should be, but it is not and that is where our failure to enforce the existing rules of the road gives me pause to fear that the various proposals for a super financial regulatory agency in Washington will not be the panacea Senator Dodd and others make it out to be.

I doubt if Mr. Dimon is under any illusion that the American public so loves its banks that they acted with charity in mind in pouring hundreds of billions of dollars into the banking system and into the capital of particular banks because they just wanted to. Nor does he think that the public is patting him on the back for making a sweetheart deal to save Bear Stearns from collapse with the support of the U.S. Treasury. The Treasury Department and central banks here and abroad were forced to act by what others have described as a “perfect storm” of long neglected economic truth by regulators and legislators and by the irresponsibility of bankers who should have known better.

The financial sector is the glue that binds together all sectors of our economy. The government acted to save our economy from crashing and destroying the lives of millions of Americans and others around the world that are dependent on its products in their daily life and the safekeeping of their life savings. Only action by government could prevail because it was the only sector with the power and the tools to pull off the miracle which prevented a complete destruction of the trust for the financial system required to regain its stability.

In truth the financial sector is more of a public utility than a normal sector of the free enterprise system. At the time, I said that our collapse was not so much a failure of our manufacturing and service industries but of the financial matrix that kept what were otherwise prudently run, successful enterprises humming. Our failure was a failure to properly regard what was different about finance and to respect the critical roll of financial liquidity in the operation of our economy.

As Lehman Brothers rushed towards oblivion, Dimon is pictured by Andrew Sorkin in his terrific book, Too Big To Fail as calling together a phone conference of his key lieutenants and instructing them, “Here is the drill. We need to prepare right now for Lehman Brothers filing, and for Merrill Lynch filing…and for AIG filing…and for Morgan Stanley filing…and potentially for Goldman Sachs filing.” Although only half right, if the chips had fallen even a little differently, he would have been completely right in his doomsday scenario.

“Let us fail” is fine as a goal and a principle to believe in, but only so long as the financial structure is sufficiently strong to permit the failure of one bank not to drag down its inter connected business relationships which in turn would threaten a large percentage of economy. The interconnection through syndication, guarantees, and cross dealing that characterizes our current financial structure does not permit letting them go their own way, but creating ever closer regulation by Washington will remove the healthy willingness to take risks and build an interlocked relationship between regulator and regulated in which political considerations prevail rather than the commercial needs of a dynamic economy.

So what’s to do? Are we lost if we do and lost if we don’t? No. This nation, as Winston Churchill liked to josh, “always does the right thing, eventually.” We are equal to the challenge and must begin now before we set ourselves up for even bigger disappointment by believing we can “domesticate” big finance, steer them and all will be fine.

Already the cushy relationship between New York financiers and The Treasury Department is too close for effective regulation. It creates favoritism in the development of financial policy alternatives and a two tier system for the top half dozen firms and everybody else. The concept seems to be let’s go into partnership with those really large money center banks and by controlling more than half the nation’s deposits, we can guide finance to avoid future breakdowns. That is neither fair to the broader financial market nor will it provide the financial alternatives for the business sector to be internationally competitive.

A system which is not self enforcing and which relies on consistent regulatory oversight always becomes ineffective over time. I would argue that, with one exception, there are plenty of regulations on the books now to have prevented this current morass from happening, but it did happen and that should tell us a few things about systems that are abused by human error and hubris.

Regulatory schemes which allow too much power to reside in the hands of a few are easily corruptible and subject to political manipulation that does not reflect economic reality. You only have to see some of the You-tube videos of honest regulators arguing for restraint in marketing of NINJA loans and digital products being belittled by Congressional leaders to be suspicious of any “solution” that expands an opportunity for this mischief to be institutionalized.

Prior to 1999, Glass Steagall, adopted by Congress in the Depression to separate our nation’s deposit base from investment banking kept our nation’s bank deposits safe more than 60 years. While we don’t have to go all the way back to its 1933 form, separation of investment banking from the nation’s deposit base must be the first priority for action. I will agree that interstate banking is here to stay, but it makes absolutely no sense to allow investment banks to play lotto with tax payer insured deposit funds in the nation’s banks.

If the next major financial downturn is not going to destroy our economy, the distinction between savings and risk capital that was assured by Glass Steagall must by reinstituted. Investment banks must be spun off from the financial supermarkets to which they are now attached, or… if they would prefer, spin off the deposit institutions, but separate they must be. That one action would go a long way to permit us to respond positively to Mr. Dimon’s wish to be allowed to fail.

Other requirements being debated such as higher capitalization requirements for banks should be adopted as well, and the anti trust and fair practice considerations of financial practices should be heightened. The Courts have looked to the SEC to do this, but its concerns have been more directed to the transparency and adequacy of disclosure not to trade practices. The SEC at the least should be required to respond to concerns of the Federal Trade Commission in approving complex offerings with restrictive trading arrangements.

_._ Copyright © 2009 by Robert E. Freer, Jr. All rights reserved

About the author: Robert E. Freer, Jr., is president of the Free Enterprise Foundation. He is also a professor at The Citadel and was selected in 2005 to be their first John S. Grinalds Leader in Residence and in 2009 to be their first BB&T Visiting Professor in Ethics and Free Enterprise Leadership. A regular contributor to the Mercury, Prof. Freer may be reached at Robert.freer@citadel.edu. If you would like him to appear before your group or organization to speak on any of the subjects about which he writes, please contact him at The Citadel. Copies of his earlier columns may be found at www.FreeEnterpriseFoundation.org