More on Managing Systemic Risk

David Moss wrote a good article in Harvard Magazine about systemic risk and regulation; it’s based on an earlier working paper of his. The problem statement is not particularly original, but very clearly put: Depression-era regulation brought an end to recurring financial crises because deposit insurance was combined with strict prudential regulation to guard against moral hazard. Half a century of stability, however, was undermined by a philosophy that regulation was not only unnecessary but harmful in financial markets, at precisely the same time that financial institutions were becoming dramatically larger in proportion to the economy as a whole. For example, as Moss points out, “the assets of the nation’s security brokers and dealers increased from $45 billion (1.6 percent of gross domestic product) in 1980 to $262 billion (4.5 percent of GDP) in 1990 to more than $3 trillion (22 percent of GDP) in 2007.”

The problem today, in Moss’s words, is that “implicit guarantees are particularly dangerous because they are typically open-ended, not always tightly linked to careful risk monitoring (regulation), and almost impossible to eliminate once in place.” The solutions he outlines basically boil down to renewing that tradeoff, so that government guarantees are explicit and financial institutions pay for them through more stringent regulation and cash.

On stricter prudential regulation:

“[A]n important advantage of the proposed system is that it would provide financial institutions with a strong incentive to avoid becoming systemically significant. This is exactly the opposite of the existing situation, where financial institutions have a strong incentive to become ‘too big to fail,’ precisely in order to exploit a free implicit guarantee from the federal government.”

On making systemically important institutions pay for their guarantees:

“One option for doing this would be to create an explicit system of federal capital insurance for systemically significant financial institutions. Under such a program, covered institutions would be required to pay regular and appropriate premiums for the coverage; the program would pay out ‘claims’ only in the context of a systemic financial event (determined perhaps by a presidential declaration); and payouts would be limited to pre-specified amounts.”

Moss thinks there needs also needs to be a receivership process in place as a backstop should both prudential regulation and capital insurance fail.

I think this all makes sense in concept, although I still prefer the idea of simply breaking up the large financial institutions and preventing them from reassembling, either through size caps (yes, I know, this is a complicated issue) or new antitrust laws. One problem I see is that better regulation is based on the premise of better regulators, and until that problem is solved (pay them more? inspect them more closely?) nothing else follows. Moss favors a new agency dedicated to systemic risk regulation (read: not the Fed). However, I previously referred to this as the “posit a good regulatory agency” premise. I prefer the idea of just having smaller financial institutions because it doesn’t require this particular can opener.

By James Kwak

21 thoughts on “More on Managing Systemic Risk”

  1. So many people have put forward so many arguments for limiting the size of banks and proposed so many ways to accomplish that (punishing capital requirements, increased regulatory scrutiny, constraints on compensation, forced breakup, etc).

    Problems with having very large banks are clear and many. Is there anyone (other than bank CEOs) who still argues for economic rationale to allow existence of very large banks? Old arguments, such as increased efficiency, better diversification are today plain ridiculous. The argument about the lower cost of capital, which is true given the implicit government guarantees, is too blatant to be made in public.

    One might not like how the health care debate has been progressing, but at least there is a public debate. There is a very lively debate about the virtue and cost of the government stimulus. Where is the financial reform debate? What we have is a series of monologues, all reflecting relatively similar positions.

    The administration apparently wants to remain above the fray, not engage in the debate, and simply proceed down the path it has chosen, public debate be damned.

  2. Just throwing this out there: how about any financial institution which does not wish to be a heavily regulated (i.e., free to innovate et cetera) traditionally boring bank, must be a partnership or in some other way be denied a charter for incorporation.

  3. I wish scholars who keep coming up with the same idea would address the fundamental international “race to the bottom” issues – how do we deal with foreign banks that play by foreign rules but effectively lend domestically? Even if we try to impose those rules on their activities in the US, how do we make this work when ownership chains and over the counter contracts facilitate regulatory arbitrage?

    Imagine the following situation:

    BigUSbank sets up a wholly owned subsidiary in a foreign country with low capital asset ratios. The subsidiary accepts international deposits, and lends money to US or other multinational corporations, and/or buys wads of shaky loan derivatives. The books of BigUSbank look clean, but depending on the liability structure in the subsidiary relationship, it could be carrying significant risk. In any event, the money supply is still affected, and if the subsidiary defaults then deposits and bondholders are still affected with the inevitable blowback to the world economy.

    You can argue that free markets should prevent this, but it just doesn’t – I would argue that even if we fixed moral hazard, we’d STILL get these problems. This, I gather, is why the US and EU are trying to go after money havens and regulate hedge funds/shadow banking. Fixing the US is just not enough. We’ll simply shift the activity outside of US soil, where we have even lower visibility (and less ability to tax) UNLESS we start policing international capital flows and/or controlling both our _physical_ border and our _digital_ border.

    In other words, if international efforts fail (which I think is likely) we should seriously begin to consider a monetary system that facilitates monitoring of offshore money havens and better control of cross-border capital flows. For example, banning banks not meeting US standards from extending loans to US citizens or small businesses at the very least, and banning the repackaging and resale of such loans (or derivatives or contracts based on those loans) to foreign banks. (IMO, you don’t really need a ban; you can simply pass a law saying that our courts will not enforce any contract which is tied to the value of domestic loans and owned, even indirectly, by a non-conforming bank – the market will evaporate without even having to undertake regulatory oversight.)

    Anyway, it’s time to seriously think about what a unilateral strategy would look like – at the very least, start discussing it to light a fire under international negotiators.

  7. As I follow unfolding events and the perspective offered by Johnson and Kwak, I am overcome with an imagery about our situation. This morning I wrote a shot 1 act play in an effort to capture that imagery. It begins…

    The Dawn of Corporate Capitalism
    A play by Marc Hersch

    Scene:

    Village with decrepit buildings that appear to have been wrecked by demolition teams. Two villagers sit around a campfire in BarcaLoungers. A large, flat screen TV flickers next to them. They are eating an unappealing gruel from soup bowls. In the background, several enormous creatures are grazing in and around the wrecked village and a decimated forest landscape, seemingly indifferent to the conversation between the two men.

    To read the play go to http://www.3sigma.com/the-dawn-of-corporate-capitalism-an-play-in-one-act/

  8. The article says “regulatory philosophy … held that private financial institutions not insured by the government could be largely trusted to manage their own risks—to regulate themselves” “several of the least regulated parts of the system (including non-bank mortgage originators and the major broker-dealer Bear Stearns) were among the first to run into trouble”

    And this is so not true!

    The regulators, for the last decade, what they trusted excessively was the effectiveness of their own bank capital requirements based on risk and the credit rating agencies who they had appointed as their trustworthy risk sentries, believing them absolutely incapable of being captured.

    Had it not been for those capital requirements, which started a crazy race after anything that could dress up as an AAA risk, and had the credit rating agencies not been captured, the non-bank mortgage originators and the broker-dealers would have none to peddle their toxic products to and nothing of this would have occurred.

    In other words what the regulators trusted naively was not any financial institution but the quality of the AAAs

  10. I keep on hearing that we can fix the system by putting some old fashioned rules back into effect, but has the financial engine of the economy become too mangled and distorted to set aright on the track? I expect political and economic power has so shifted to the few that reimposing restraints will be impossible.

    Substantially increasing capital requirements may bring stability to the system, but it will not change the allocation of wealth and thus the distribution of political power.

    On the side, the opening of Marc Hersch’s play reminds me of various dystopian movies.

  11. I’m not criticizing looking at all the ideas, and I think it’s good James brings us Mr. Moss’ ideas to look at. BUT…………..

    We already have many ideas that would work. For example “plain vanilla” loans. Which, if I can still read, was sacrificed to the banking gods yesterday so we could get Consumer Financial Protection Agency through Congress. Although why we can’t have BOTH was never legitimately explained.

    The truth is there are many different sets (permutations) of regulations that would work, but Republicans in Congress don’t want to pass them because they hurt Mr. Banker.

    I’ll tell you this. My U.S. Senators (Republicans, who if they got their way would let bank CEOs maraud the streets like rampaging Vikings without so much as a ticket for jaywalking) are not getting my vote, until they learn to pass REAL regulations on bankers. It’s as simple as that folks.

    Trying to find a bank regulation that Republicans like, is like moving into a new house and trying to find that magic place where your wife wants to put the sofa. “Is it ok here dear?? No? How about over here honey?? No? What about this spot babycakes?? No? Hey light of my life, I just thought of ONE place I’d like to shove this sofa!!!”

  12. Do regulators who were not able to visualize they were setting the credit rating agencies up for capture or that the credit rating agencies could just be human fallible, (and also failed to catch a Madoff) have it in them to even start understanding what systemic risk is? Hey they do not even see that they are themselves the biggest producers of it.

  13. I believe the current poorly functioning financial system could be improved greatly by simply removing the corporate shield from liability for negligent errors of judgement. If financial executive’s personal fortunes were at risk from their mistakes, excessive risk taking would vanish overnight. If Dick Fuld’s assets were vulnerable he would probably paid more attention to what his traders were up to at Lehman Brothers.
    This is the system medical professionals have lived with for years. A doctor can buy insurance but his or her personal assets are not protected by a corporate shield. A financial professional’s knowledge that he or she could lose everything
    would do more than any new SEC regulation.

  14. Why can’t the US regulators oversee the capital adequacy at the holding company level?

    The real challenge is to enforce that US regulators do not allow their banks to deal with branches of banks incorporated in tax heavens (such as Grand Cayman). Instead, all transactions above certain notional level (say, $100 Mil) should be with subsidiaries incorporated in the US and hence subject to US regulations.

  15. Systemic risk implies moral hazard and vice versa. In a well-regulated economic order there would be no possibility of systemic risk because regulators would prevent it from arising. There are two ways to prevent systemic risk. One is anti-trust legislation that is strictly enforced. The second is disincentives such as strong penalties and high taxation. Regarding penalties, a lot of the reason for the current crisis was not simply imprudence, e.g., excessive leverage. It was criminal fraud, e.g., predatory lending and falsification of mortgage documentation. There was also an over-cozy relationship between rating agencies and their clients that misrepresented risk. To date, there has been little accountability.

    Finally, there is too close a relationship between finance and government, which James and Simon have documented, among others like Karl Denninger and Zero Hedge. This is also one of the foundations of systemic risk. While there are many factors involved here, certainly intellectual capture and regulatory capture were and are two of the chief ones.

    Underlying all other factors is also the cancer that one might call “legalized bribery” in the from of campaign finance and lobbying. This leads to preferential treatment and lack of accountability, and it is blocking reform. I doubt anything really meaningful can be put in place without getting the money out of politics.

  16. …Maybe they can’t do what you ask because ruling theory does not explain the actual nature of the “race to the bottom” in such a way that the all the institutions and nations desperately profiting from this race have any reason to slow down or stop the process. Isn’t that ‘race to the bottom’ a sort of main driving force in international markets? And, I think it’s a driving force that we will need to be able to depict as a “systemic danger to all” (as I think it likely is) before significant change can happen.

    Although I agree with your approach in principle do you think that ‘cross-border capital flows’ are perhaps already way too far gone? ie. By waiting until current international efforts fail – where will we be landed in the ‘race to the bottom’?

    The ‘race to the bottom’ may have been driven by competition for US consumers’ business in recent decades…but is that what is driving financiers internationally for now and in the near future?

    I also happen to agree with James’ “idea of simply breaking up the large financial institutions and preventing them from reassembling, either through size caps (yes, I know, this is a complicated issue) or new antitrust laws”.

  18. Yes, James, it’s time to control the oligarchs, still and always!!! I like the idea of having the “too big to fail” financial institution provide for their own guarantee fund. Makes incredibly good sense, and would be easier to legislate than having them increase their capital requirements in the present Congressional atmosphere. It probably could be required by the Fed even without Congressional action, or the FDIC could simply make a change in its required contributions engineered to be a larger percentage of deposits for banks with more depository business (this would take care of all of the banks, but not all of the non-banking holding companies, and so might not work as well).

    Once again, rational doesn’t really seem to be realistic for the oligarchs and their power elite friends. Probably just more spit in the wind.

    It’s kind of like the health care debate. Nothing really reformative will happen because of lobbies and campaign laws.

    Let’s face it, we are getting ready for a trip to the abyss of public rebellion. Unless our leadership wakes up to the vast moral hazard confronting them, revolution is probably inevitable. It won’t be pretty, if and when it happens.

  19. 22% of GDP??? Are you kidding me? Please, I beg any one of you erudite economists and analysts to provide the percentage of the US population that encompasses the “nation’s security brokers and dealers”? What percentage of the US population is appreciating this 22%, or 3 Trillion dollars? How is thievery this legal? How is this theivery anythinglike democarcy? How is this thievery morally tolerable?

    What benefit did these fiends provide to society? What measurable, quantifiable utility did these shades and shaitan produce to benefit the larger socieity. We are silent and impotent witnesses to the most extreme (in pure numbers) example of Kleptocracy in the history of the world.

    Why are we silent? How much abuse are we expected to absorb and tolerate?

    Sharpen you pitchforks biiiaaatches and get locked, cocked, and ready to rock, because – the people are being ROBBED, and the day is long past when we must take it upon ourselves to right these monsterous wrongs!!!

  20. Providing any govt guarantee for home loan repayment destroys the system. Once you have that, there is nor more incentive to reduce the risk of a failure to repay the loans. In fact, it becomes a game of increasing the risk, because those loans will be more attractive to borrowers. Govt pricing for the cost of the guarantees will not reflect that risk level nuance accurately, and will fall subject to Congressional meddling that will reduce the charges to less than the cost.

    We have an enormous and highly sophisticated financial market. Why do we need any govt guarantees for home loans?

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