Remarks made at the St. Louis Banking conference by R. Crosby Kemper
My remarks are going to be somewhat different than George Kaufman's
and Bert Ely's because, though I think George, Bert and I end up
in the same place we end up in love with the market
we see history a little bit differently, and we see the nature of
the current system a little bit differently. As I see it, George
Kaufman thinks that the current system works pretty well, but he
would like to scrap it and let the market work. Bert Ely thinks
the system works pretty well, but he would like to scrap it and
let Bert's cross-insurance system work, which is a market-based
system. I don't think the current system has worked all that well,
and I would like to scrap it and get to a marketbased system. I
think we end up in the same place, but I think we have a little
different vision of history.
I also have a little different vision of the moral hazard that
is out there today. I think it exists, and I think it is very big.
I don't think it will bring the system down, but I think it will
cost you as taxpayers, you as depositors, and you as bank shareholders
(if you should be a bank shareholder) some money. And more importantly,
the moral hazard I'm concerned about does not concern the regulators,
and it does not concern the depositors or the shareholders. Instead,
it is really a moral hazard concerning the discipline of the economy,
and that is where I differ with George and Bert.
Now, let me explain my vision. We are entering a brave new world.
You have heard discussed today in a number of panels what is happening
to the financial system, and it is changing dramatically. It is
a brave new world, and, oh, what creatures there are in it
Citicorp and Travelers! With my vision of moral hazard, I was amused
by the fact that Citicorp and Travelers got their ultimate regulatory
approval on the same day that the Federal Reserve announced the
bailout of Long-Term Capital Management. I happened to be having
breakfast with three Federal Reserve Board Governors on that day,
and we were discussing this coincidence. And one thing that was
clear to me was that the whole notion of off-balance-sheet liability
was one they hadn't thought about a lot. And there is a tremendous
degree of off-balance-sheet liability today in the financial system.
I also note today in the New York Times that a global group of
regulators have gotten together and announced they are going to
regulate derivatives of some of the off-balance-sheet stuff as Long-Term
Capital Management did. An international banking panel proposes
a way to limit risk. There we go. I am not a big fan of what the
regulators are doing with this kind of risk, and I don't think the
regulators can regulate the off-balance-sheet risk of the kind that
Long-Term Capital Management created the derivative risk.
But before I get to that, I will tell you a little more about derivative
risk and the hedge funds. It is interesting they call them hedge
funds, because the last thing that Long-Term Capital Management
was doing, or the folks Bank America had in New York that lost them
a billion or two were doing, was hedging risk. In my case, as my
father likes to say, the only perfect hedge is in a Japanese garden.
My underlying assumption is that the market works. I am libertarian,
and my conclusion will be Hayekian, but you are going to see that
I get there in a different way and so I want you to bear with me.
I do believe that the market will ultimately work, but it is not
working today in part because of the policy known as "Too Big
We have enormous underwriting risk in the system today. One of
the panelists from an earlier panel said that through the Internet
and electronic commerce, we are going to be underwriting small business
loans. That is actually going on right now, and more and more of
this is going to happen. My question would be, is it going to be
You heard John McCoy of Bank One quoted earlier about internet
commerce. Well, this may have not been internet-related, but it
certainly involved electronic commerce Bank One just took
a $90 million hit on a subprime auto lender that it owned, where
they are taking in direct paper from dealers around the country,
and they didn't know what they were doing. And they took this hit
at a time when we have full employment, when we are still in the
Reagan-Volcker-Greenspan-Weidenbaum 17year economic expansion. We
have full employment, we have the finest economy we have had, I
believe, in the history of this country, and Bank One took a $90
million hit on this very simple underwriting challenge of underwriting
subprime auto loans. Here is how it works you have a list
of criteria, usually about a hundred of them. It takes you about
half an hour to read the list, you pick an empirical score, and
you underwrite it. And they can't do it.
This leads me to the preface to my Hayekian conclusion, which is
that nobody knows everything. And the underlying assumption of both
the regulators and some of our larger financial institutions
which are coming together, I think, in a symbiosis of incredible
risk for a financial system is that they do know everything.
We are also underwriting all kinds of new things. Citicorp is now
going to be underwriting insurance. They are not just underwriting
loans any more small business loans, or installment loans
they are underwriting insurance. They are underwriting investments.
They are out there in the capital markets underwriting things that
insurance companies used to underwrite on a longterm basis, and
underwriting more things than they have ever underwritten before.
There is more transaction risk than ever. The internet has come
to us; electronic commerce has come to us. The speed of transactions
is amazing and the potential for mistakes is absolutely enormous.
And I am not just talking about Y2K. I think the banking industry
is pretty much on top of that, although I guarantee you that there
will be some problems in the transactional system on January 1,
2000. In the future, the risk at the transaction level will be magnified
by the speed of what is going on, and I don't think there is anything
that the regulators can do about that. However, I think they think
they can do something about it, which is a moral hazard.
We also have systemic and subliability risk in the marketplace
of kinds that we have never had before. This relates to derivatives,
to the nature of balance sheets, and to the fact that so much of
the earning power of our largest financial institutions is, in fact,
off balance sheet today. If you look at the growth in revenue of
most of the largest banks in the United States over the last five
years, at a time when we have been making more money than we have
ever made before, you will find that the growth in revenue has been
in trading income, in credit card securitization, and in various
forms of fee income and underwriting income that are not traditional
bank businesses and have fluctuations that are very different from
traditional bank businesses. I don't think these differences have
been factored in.
One of the people who invented this brave new world is Frank Newman
at Bankers Trust. When he was Undersecretary of the Treasury, I
was in an American Bankers Association meeting with him where he
explained that he had sent his assistant, a young graduate student
from Harvard, around to the various banking systems in the world.
He visited the English system, which we heard about earlier today,
and the Japanese system and whatnot, and he came to the conclusion
that those systems were much better than ours because they had fewer
banks. Therefore, the United States regulators were going to try
to get ours down to a system where we would have many fewer, much
larger banks, making them much easier to regulate.
And my reaction to that was that maybe one of the strengths of
the Reagan-Volcker-Greenspan-Weidenbaum expansion was the fact that
we have had so many banks, so many financial institutions, so many
different locations for the borrowing of capital and for the use
of capital, whereas other countries have had so few. Relatively
few decision makers making relatively few decisions based on relatively
little knowledge is to me, again, according to my Hayekian bias,
a recipe for huge inefficiency if not disaster. And if that inefficiency
is in the direction of hazard, it could be a much larger hazard.
One of the problems with dealing with regulatory issues today is
that we have had this incredible expansion, and it is hard to tell
what risks are actually out there. There is an old saying
"you don't know who is swimming naked until the tide is out."
But I think we are about to find out. I don't believe the business
cycle has been done away with any more than the tide, and I think
we are going to find some interesting things.
Bert Ely will probably not remember this, but one of the high points
of my media career was a National Public Radio show on banking in
about 1992 or 1993 on which Bert was the featured guest, and he
was talking about what a great deal Citicorp stock was at that time.
But I called in to that show and I said, "Bert, I disagree
with you. What Citicorp is doing is not a good risk today because
they are doing these crazy things (and I brought up Too Big To Fail
in the course of this conversation), and they are making all these
crazy loans." I had recently read that they had made $400 million
in moped loans in India. And I thought, you know, that may be the
definition of moral hazard right there. And Bert disagreed with
me. Of course, Bert was right, Citicorp recovered and they did well.
However, I continue to read the New York Times, and I found an
interesting article on May 25th. Citibank in India used collectors
accused of strong arm tactics. Credit card debtors tell of scares
despite a code of conduct the bank has, et cetera, et cetera. They
threatened to remove their kidneys. My favorite example is they
were using eunuchs to collect loans because there is some shame
attached to being seen with a eunuch. Now, you know, Bert is right,
they are probably collecting the loans right now, but at some point
there is going to be a problem with making consumer loans in India
if you don't understand the culture and you don't know how to get
the money back. The globalization of credit has created moral hazard.
The description you have heard of the international system or the
financial system so far has been mistaken concerning where the moral
hazard has led us and where Too Big To Fail has led us.
I disagree with George Kaufman to a degree on whether or not we
have had failed banks: We have had failed banks. Citicorp was insolvent
in the early 1990s. The Chairman of the FDIC told me that they had
to bail it out. Manufacturers Hanover was broke. Many of the larger
banks survived but were essentially broke and the regulators saved
them one way or another. I don't think J.P. Morgan was going down,
but there were rumors. You could see it on the Bloomburg newswire
in November that J.P. Morgan was broke partly because of their derivative
exposure in Asia, which was absolutely enormous, and the Feds were
lending them money. They had to go to the window.
Now, maybe we shouldn't have let J.P. Morgan go down. Maybe it
was great that we organized a Long-Term Capital Management bailout,
I don't know. But what happens in a bailout is that money is flowing
from efficient places in the economy, from places where some banks
or other financial institutions are making successful loans, to
people who are loaning on empty buildings in Korea. And I don't
take that as a description of a functioning market.
As I said, I am with Bert and George in where I want to end up.
I want to end up with a market. We haven't had a free market; we
haven't had a well priced market. We have used the regulatory agencies
to bail out people doing idiotic things. The Japanese banking system
is a good example of an extreme version of what we have been doing.
They have bailed everybody out, until very recently. They are beginning
to turn around now because they have let some banks go down. They
have let some shareholders take a hit. It is exactly what happened
in the savings and loan crisis here when we finally let some pain
out. We finally took some shareholders' money first and then took
some money from a few depositors. That's right not everybody
was bailed out in the S&L crisis. Most people were, including
those with over $100,000 in most institutions. But a few people
took a hit. It was at that moment that things turned around, when
we allowed some credit discipline not very much but
some credit discipline to hit.
If you think there cannot be a problem that would be systemic,
I would point out the statistics on the notional amount of derivative
contracts in March of 1998. These statistics are fairly old. They
are the most recent ones that I have, and I think the numbers are
actually larger today. This is about the time that Long-Term Capital
Management went down. The notional amount of derivative contracts
that Morgan Guaranty had was $6 trillion on March 31, 1998. Citibank
had $3 trillion; Chase Manhattan had $7 trillion. Now, most of that
they are claiming to do as agent for someone. But there also were
a substantial amount of derivatives that were on their balance sheets
where they were the beneficiary, and I will give you the biggest
one there Morgan Guaranty had $23 billion, which was at that
point somewhat larger than its capital. And that money is essentially
interest rate speculation. What Long-Term Capital Management was
doing was interest rate speculation. It was not a hedge fund. They
were betting on the direction of Russian bonds. They were betting
on the spreads between certain kinds of contracts, various futures
and forwards and swaps. They were betting on things.
And though the Federal Reserve didn't put any money at risk when
they bailed out Long-Term Capital Management, they did put something
else at risk, they put the credibility of the regulatory system
and the financial system on the line behind Long-Term Capital Management.
What they should have done is let Long-Term Capital Management go
down. Fewer stupid things would have been done in the last year
than were done in the previous year if the regulators had done that.
I would like to scrap the regulatory system. As a practical matter,
that won't happen. I would like to go to the perfect market. As
a practical matter, that won't happen. As a practical matter, we
won't get to Bert's crossinsurance, though I would be in favor of
that; I think that is a very good idea. But we can reduce the moral
hazard in the system by telling the regulators that Too Big To Fail
is a bad idea. We can let some of these guys take a loss every once
in a while. If they had let Continental Bank go down, there would
have been an effect in the marketplace and perhaps, I don't say
this is a certainty, but perhaps the S&L crisis wouldn't have
happened to the degree that it happened if they had really let some
people take a hit at Continental.
It is true that most of the correspondent banks, and we were one
of them, had relatively small risk. But, Continental was the largest
funder through certificates of deposit of money market funds in
the United States. And the money market funds would have taken some
hits. We would have broken the buck, as they call it, for the first
time if they had allowed Continental to go down. Would that have
been a good idea or a bad idea? I think it would have been a good
idea, because I think the amount of speculation in the economy would
have been reduced. I think there would have been a flight to quality,
and I think a flight to quality is always a good thing because it
ends up with a more efficient system, a more marketbased system,
prices that reflect reality and economic activity that reflects
So, do I agree with the conclusions that Bert and George reach?
Absolutely. I think the market should work. Do I think the market
has been working? No. Do I think there are problems out there? Yes.
I think we have been floated by the economy for a long time, and
I think in the next business cycle we are going to see the problem
with the kind of regulation we have had, and I think H.R. 10 (now
S. 900), and the various financial modernizations that have gone
on are in fact Trojan horses. There is an enormous amount of regulation
buried in them, and I think there is an enormous amount of regulation
out there coming from the financial regulatory institutions.
We have broken out of GlassSteagall, and we are allowing people
to do a lot of things that they weren't able to do before. But as
soon as we allow them to do derivatives, we will get another Long-Term
Capital Management. As soon as we allowed Bankers Trust to underwrite
the kinds of things that they were underwriting, it was underwriting
that got them into trouble (along with trading and derivatives).
As soon as we allow them to do it, and something goes wrong, we
step in and we re-regulate, or we force a sale.
So it is my belief that what we need to do is undertake a steady
march towards the market. We need to get rid of Too Big To Fail,
or at least modify it as much as we can. FDICIA did modify it to
a great degree. But the market has never really been tried. We will
see how well FDICIA works the next time we have a truly big bank
The other hazard that is out there that almost no one has identified,
and the regulators certainly haven't identified, is the interest
rate problem. Historically, banks are a middle man on interest rates,
and the job of a bank has been to speculate as little as possible.
Lean, obviously, in a direction you think interest rates are going
to go, but do not speculate. Shortterm assets, shortterm liabilities.
We now have financial institutions of all kinds, particularly larger
banks, speculating on interest rates, and the problem with this
is, and the regulatory failure on this is, we have forgotten that
interest rates can rise or fall dramatically. For about ten years
now interest rates have had one or two relatively small blips. In
199394 we had one of those small blips. I think Alan Greenspan brilliantly
managed it, and maybe even deliberately managed some of it. But
we had a lot of those early derivative losses people taking
$100 million losses to the common fund such as Proctor and Gamble.
Bankers Trust was in trouble at that point. If we had let them go
down at that point, maybe we wouldn't have had the subsequent Bankers
But historically, interest rates can rise very dramatically. If
you look at the stress tests that the regulators give banks today,
it is, depending on what is being tested, a 200 basis point or a
300 basis point rise in interest rates. Well, interest rates went
up 300 basis points in a matter of weeks in the early 1980s and
went up much more than that over relatively short periods of time,
and that will happen again. I am not going to tell you it is going
to happen today or next year, but it will happen again, and at that
point the moral hazard of Too Big To Fail is going to hit like a
* Mr. R. Crosby Kemper III, President UMB Bank _ St. Louis Region.