Boring and Exciting Finance

Taunter has a comprehensive proposal about how to regulate financial services, dividing them into Boring and Exciting.  Boring services are the following:

  • retail deposits
  • loans to retail customers, including mortgages
  • retail insurance, including annuity products
  • any custodial service beyond traditional settlement (i.e., if you hold something after T+3, you’re a custodian)

If you do any of those, then you are a Boring institution, you can do all Boring services, you face some significant regulations, and you get bailed out when necessary. If you do none of those, then you are an Exciting institution, you can do almost anything you want, and there is an ironclad rule preventing the government from bailing you out. Boring institutions cannot offer Exciting services (I think) and Exciting institutions cannot offer Boring services (that’s certain).

It feels like a modern version of Glass-Steagall (although I’m probably not doing it full justice) – create an explicit linkage between tight regulation and a government backstop, and protect the part of the financial system that affects ordinary people.

A key requirement of this system is that you have to be willing to accept the consequences of the collapse of an Exciting institution. I’m not sure that Taunter has sufficiently sealed off the real economy from Exciting firms, however. For example, suppose an Exciting firm offers revolving credit accounts to companies that they dip into to make payroll (to smooth out fluctuations in cash flow over the month). I don’t think this qualifies as Boring in Taunter’s scheme. But if the Exciting firm goes down, suddenly thousands of companies might be unable to make payroll.

I’m not saying this is a fundamental flaw; maybe the lines just need to be drawn differently. Or maybe I’m missing something. In any case, it’s an interesting way to think about the problem, especially for people who want to combine closer regulation of financial services that affect ordinary retail customers with free markets and financial innovation for sophisticated actors.

By James Kwak

31 responses to “Boring and Exciting Finance

  1. That was good. Last winter there were tons of comprehensive ideas like this; these days, not so much.

    But I knew what my comment was going to be the second I read James’ first sentence, and reading the post didn’t change it.

    We only need the Boring services; we don’t need the Exciting stunts at all. So, since we know how dangerous they are, how this is not some bungi-jumper who risks only his own neck, but a drunken pilot risking the lives of hundreds of passengers; and since we know how the Exciting stuff is not innovation but “innovation”, then since it adds no value but only a tax and tremendous risk (and I certainly don’t believe for a second that you can allow this to exist at all and not have it erode and eventually dismantle any wall you set up), we must simply cleanse ourselves of it completely.

    To preserve a free-fire zone for “free markets and financial innovation for sophisticated actors”, i.e. for psychopaths and con men, is not sufficient reason to have this. Indeed, we could do without the existence of such “actors”.

  2. The only excuse for exciting institutions has been their alleged role in managing risk. But, the way they managed risk was to stick the federal government with it. All this took was relatively modest campaign contributions. If their power to tap the Treasury was extinguished these exciting institutions wouldn’t outlive the next bubble. Perhaps not even the current bubble in stocks.

  3. Can they do business together? The services a bank offers are only part of its larger operations. If you are trying to reduce the bank’s exposure to exciting firms, how would you treat things like wholesale banking and participation in the repo market?

  4. There is more to investment banks than credit default swaps and the like. The roads you drive on, the schools your children attend, the plant that treats your drinking water were all likely financed with bonds underwritten by an investment bank.

  5. {Yawn}

    Not going to tackle dark pools, eh? Chickens.

    Hey look at this. These guys had a plan back in 2007 too.

    http://www.nber.org/books_in_progress/econ-reg/kroszner-strahan9-26-07.pdf

  6. That was a taunt, btw. Taunter never taunts. What’s up with that?

  7. To my understanding roads were built far before investment banks started leeching along.

  8. What exactly does it take to get to “underwrite” a bond issue?

  9. In the it security business this is called sandboxing/virtualization, where untrusted code is run in a confined environment where it can’t harm the basic operating environment.

  10. Simon van Norden

    So NYSE market makers can now all collectively go broke (which the Fed took pains to avoid in Oct ’87, didn’t they?) LTCM? The Options Clearing Corporation?

    I guess the big questions are
    1) How to be certain that exciting firms can never pose a systemic risk.
    2) How to credibly commit to not bailing out big firms with powerful lobbies that don’t pose systemic risks (think GM.)

  11. I’d like to think it’s what Glass-Steagall would have done if they had realized the danger of allowing broker-dealers to retain custody of their clients’ securities and understood the similarities between insurance and deposits.

    In the 1930s securities were far less broadly distributed and there was no conception that individuals would plan for their retirements by accumulating vast piles of claims upon distant companies or municipalities. A similar lack of foresight was shown in allowing insurance companies – whose balance sheets need to be able to withstand shocks decades into the future – to merge with firms that were able to offer unregulated products.

    To the direct example of a mainstream firm that fails to meet payroll because it manages working capital through Exciting instruments…why is it doing this, and to what extent is it responsible for the consequences of its decision? Vanilla direct corporate lending would be offered by Boring firms (and the only option for small businesses that are not accredited investors). So the company in distress would be one that chose, in full knowledge, to take the risk of complete counterparty failure in exchange for a few basis points from a bespoke structure.

    I don’t think such a firm – even if it makes things that hurt your feet when dropped – should be protected from the consequences of its actions. If it is solvent, the consequences would likely be needing to unwind and switch to a Boring firm for the duration of the crisis. But if it chooses to live so close to the edge that any disruption in its financial structure will cause it to miss payroll, I think that is a failure that should be punished.

    The example I used in responding to a comment on my blog is from Brazil this year: the largest food company in the country (Sadia) was forced into a distressed sale after massive foreign exchange losses. If that happened here – if a sixty year-old company managed to blow itself up on a financial transaction completely unrelated to its core operations – I hope we would have the courage to let it fail.

  12. Be legally qualified, able to bear the financial risk, and have relationships with investors. It takes a lot.

    I’m starting to understand the failure to communicate here…

  13. Yeah, who needs underwriters?

    Why don’t municipalities sell their bonds directly to the public? Doesn’t look like rocket science to service the monthly payments and all.

    What services provided by the banks are really essential?

    Let’s strip everything down to the barest minimum.

    Nassim Taleb rule 5: “Counter-balance complexity with simplicity”
    http://www.fooledbyrandomness.com/tenprinciples.pdf

  14. Too bad they couldn’t be satisfied with the dough they made just doing that. It worked okay for them up until, when, 1980? But the existence of all this electronic money provided opportunities too good to pass up. All they needed was two or three hundred MBAs out front and a dozen Russian physicists writing equations in the back. They wrapped this package around one hundred year old reputations and voila! Meltdown.

  15. There is more to investment banks than credit default swaps and the like. The roads you drive on, the schools your children attend, the plant that treats your drinking water were all likely financed with bonds underwritten by an investment bank.

    IOW “just because things for the last few seconds of historical time have been done in a particular way means they must continue to be done in that way until the end of time”.

    I’ve never understood that argument, and I completely reject it. Throughout history there have been lots of ways of funding public projects not requiring turning society into a casino.

    So when I say eradicate casino capitalism, I’m of course proposing to finance the building of schools in a different way than through casino bonding.

  16. Yes, the ability to put AAA on a piece of rubbish should count for something, heh Bond Girl??? And thank God we have investment banks that are MORE THAN HAPPY to sell that garbage to municipal governments. And if after the investment banks sell that garbage to the municipal governments the garbage goes bad and they can’t pay for textbooks, educational resources for children, etc…. you’ll have to forgive them for their lack of gratitude “Bond Girl”.

  17. Everyone is born in order to sacrifice their lives for the investment bankers. The sooner you learn this, the sooner you will become well-adjusted.

  18. Yes, the ability to put AAA on a piece of rubbish should count for something, heh Bond Girl??? And thank God we have investment banks that are MORE THAN HAPPY to sell that garbage to municipal governments. And if after the investment banks sell that garbage to the municipal governments the garbage goes bad and they can’t pay for textbooks, educational resources for children, etc…. you’ll have to forgive them for their lack of gratitude “Bond Girl”.

  19. Good grief, there’s a big difference between bonds backed by property taxes or bridge toll revenues and the Rube Goldberg finacial instruments Wall Street came up with, many of which were apparently based on wishful thinging or arithmethic errors. If the bankers had stuck with the former we wouldn’t have had to dump trillions into the black hole to keep the financial system from sinking into the abyss.

  20. That was kind of my point – there is a continuum of activity here. It is pretty silly to say we do not need investment banks at all.

  21. History is full with “boring” banks failures. Who should you put in jail for a longer time the failed boring banker or the failed exciting banker? What do you prefer some exciting boredom or some boring excitement? When you wake up on the side of a wall… how do you know on which side you find yourself… the boring or the exciting? What is so boring and not so exciting with “loans to retail customers if you are going to do it right?

  22. Jake?

    “Russian physicists”

    was there really a cluster of Russians somewhere down the creative line?
    If yes, were they hired straight from the former SU or were they US-burghers of Russian descent?

    because:
    wouldn’t it be ironic to think that the end of the Cold War and thus the vanishing of the job opportunities around the atomic bomb for these people ultimately seeded this blow-up

  23. “Throughout history there have been lots of ways of funding public projects not requiring turning society into a casino.”

    I rather got the impression that whenever governments’ needs exceeded its means gamblers were given free reign – unfortunately history books stay quite mum on how money was dealt with but I remember that the value of Byzantine coins had stayed stable for 700? years relative to the price of bread? – when a time of change/turmoil came they lost in a very short time 25 % of their value -

  24. Per
    just to tell you that your labours have generated a convert
    – I have now my own image/memory of how risk averseness was behind the incredibly dubious stuff that was imposed on us clerks and paralegals starting at around 2000.

    Up till now I have always wondered why “they” all of a sudden wanted to get rid of as much qualified personnel as possible and aimed for the impossibility of replacing the savvy clerk*) by a brain-amputated button pusher (hirnamputierter Knöpfchendrücker) – now I know it was the same risk averseness you keep teaching us about.
    After all if the computer decrees it, the manager may feel safe in the knowledge that his underlings are pushing the right button and are not coming and pestering him with a problem that may be solvable only by taking risky decisions
    When being confronted with such a choice who is the manager to not vote for the robot.
    – and
    … unfortunately bureaucratic meltdowns may take even longer than financial ones and once they happen who is going to think back to the first nail in the coffin.

    also by the time I retired at the beginning of 2004 nobody seemed to have realized that a programmer should have a detailed knowledge of the subject he is transferring into software (they came all from the “technical” crowd) just like a good translator of legal texts should have studied law extensively.

    *) after all courts make procedure influencing decisions every day and that they were of this kind you often realize only when a “Black Swan” case turns up

  25. Yes the financial “Hirnamputierter Knöpfchendrücker” were those monitor glaring investment officers at some banks who when they found one AAA rated instrument offering 3 basis points more than another AAA rated instruments shouted “Hurrah! I found a profitable arbitrage opportunity to push my bonus with”

  26. ““Hurrah! I found a profitable arbitrage opportunity to push my bonus with””

    I’d much rather direct my anger at those who programmed that guy because he did exactly what he was supposed to do what “they” wanted him to do – they didn’t want him to look right or left let alone think anything else than pre-designed thoughts while working (that does not absolve him of his responsibility for what he did though)
    – also this kind of stuff if it comes clad as Zeitgeist works all the way to the top
    – everybody is all of a sudden spouting the same kind of non-sensical stuff
    – during one of our mergers they made the mistake to offer us an anonymous forum site – all of us remained all very civil expressing things as politely as humanely possible, but they shut it down as soon as they could without losing too much face, but by then we knew from all over the place how frighteningly conformist all those creative leaders acted and decided.

    maybe “your” Basel II guys were similarly programmed – if that is feasible, by whom were they sent?

  27. Oh I am not angry at the “Hirnamputierter Knöpfchendrücker”how could I be they are just “Hirnamputierter Knöpfchendrücker” and, of course, I am angry at those who made them “Hirnamputierter Knöpfchendrücker” (As you can see, I love the term)

  28. Hehe, I had the same reaction.

  29. Daniel Habtemariam

    2) How to credibly commit to not bailing out big firms with powerful lobbies that don’t pose systemic risks (think GM.)

    I’d say you do it by taking it out of the hands of elected officials and leaving the decision to appointed officials (who are inherently insulated from such forces, at least theoretically). I’d recommend the Federal Reserve or a newly created Consumer Financial Protection Agency. Like you said, GM was a big firm, but it did not pose the systemic risk that AIG did, and so the public value in bailing them out was merely to mitigate the sharp effects on unemployment its failure would have…though not nearly as sharp as messy AIG failure would have had.

    1) How to be certain that exciting firms can never pose a systemic risk.

    I don’t have a good answer for this. Over time, if any firm grows large enough, I suppose it may pose a certain level of systemic risk. Perhaps the answer lies in the rule barring Exciting firms from engaging in any of the activity that Boring firms are allowed to do and the complement rule that Boring firms are not allowed to invest in anything Exciting. I imagine that it would take a breaking of at least one of these for any firm to become too big to fail.