What Jamie Dimon Won’t Tell You: His Big Bank Would Be Dangerously Leveraged

By Anat Admati, Professor of Finance and Economics at Stanford Graduate School of Business.  To see her explain these issues in person, watch this Bloomberg interview.  This is a long post, about 3,500 words.

The debate is raging about banks and their size, financial regulation, and the international capital standards known as “Basel”.  Jamie Dimon of JP Morgan Chase, in his New York Times magazine profile, expresses admiration for the Basel committee and says,

“… they are asking the questions that, in theory, bankers ask of themselves: how much capital do banks need to withstand the inevitable downturn, and what is an acceptable level of risk?”

There is one problem, however. Basel may have asked the right question, but it did not come up with the right answers, mainly because it allows banks to remain dangerously leveraged, setting equity requirements way too low. This fact is not understood because the debate on capital regulation has been mired with a cloud of confusion, and filled with un-substantiated assertions by bankers and others. As a result, the issues appear much more mysterious and complicated than they actually are.

After a massive and incredibly costly financial crisis, we seem to have financial system that is a more consolidated, more powerful, more profitable and, yes, as fragile and dangerous as we had before the crisis. How did this happen and what can we do?

Here are some questions on which the confusion is staggering.

(i) Is “too big” the same as “too big to fail?”

(ii) Do capital requirements force banks to “set capital aside for a rainy day” and not use it to help the economy grow?

(iii) Are banks different than non-banks in that high leverage is essential to banks’ ability to function?

(iv) Would terrible things happen if capital requirements were to increase dramatically?  

The first order of business is to clear the fog and focus on the right things. I will try to explain. With the basics in place, answers will begin to emerge, or at least the right questions to ask.

By the way, I answer an emphatic NO to each of the above questions.

Let’s start with balance sheets

Take a bank; indeed take any firm. The balance sheet is a snapshot of assets and liabilities. It has two sides, often shown piled on top of one another in financial statements or online data. 

On the left hand side, or the top, of the balance sheet are the firm’s assets, what the firm owns. The numbers come either in the oxymoron called “book value” that accountants produce based on historical costs, or in the more meaningful “market value,” which for illiquid assets might not be readily available, and which can change frequently. More typically, some assets appear at cost and some are “marked to market.” 

On the right hand side, or the bottom, of a balance sheet are the liabilities and “shareholder equity,” a summary of the claims that are held by various parties “against” the assets. There are two basic types of claims here: one called broadly “debt” (or “liabilities”) and the other is “equity.”

There is a huge variety of debt claims. One that we all provide to banks  is called “demand deposits.” Depositors can demand that this debt is paid back at any time. Other debt claims are distinguished by the length of the commitment, the interest rate, the collateral and the “seniority” (the place in the creditors’ queue in a bankruptcy) and other provisions. Depositors are the most senior creditors of a bank; junior, unsecured debt-holders, or holders of certain “hybrid” securities, are the last in this priority line.  If a bankruptcy occurs, however, it can take years to sort all these different debt claims out.

One feature of corporate debt is that the tax code allows interest paid on debt to be called a business expense and it is deductible before corporate taxes are calculated. This is similar to the deductibility of mortgage interest payments for homeowners.

But the main feature of debt that distinguishes all debt claims from equity, is that debt is a hard claim, an “I Owe You.” Creditors have rights to take legal action if they are not paid what they are owed. They can cause a financial failure or bankruptcy. This process can be a terrible thing or not so terrible. Airlines “fail” routinely and they renegotiate some contracts, re-organize, and emerge out of bankruptcy. No stigma is attached, and operations often continue, although of course it is bad news. And debt contracts work well when the bank finances individuals and businesses. Things are different, and much more problematic, when banks use a lot of debt to fund themselves. More on this later.

The final part of the balance sheet is the category of “equity.” Bankers like to call it “capital,” but let’s stick to the standard terminology of equity. (Using a different lingo than for other types of firms is part of the mystique of banking and helps in creating confusion.)

There are a few distinctions within equity too, mostly between “preferred” and “common” equity. Preferred equity, like debt, specifies how much the holder of the preferred will be paid. The lowest-class equity, called “common equity” cannot be paid at all until the preferred equity is paid what it was “promised.” The key difference with debt, however, is that the firm does not “fail” if it does not pay its equity holders, even if they are “preferred.”  

Why does anyone buy this bottom-feeding equity? Because equity gets the upside, the profits of the firm, and if the firm is successful –and banks make a lot of money most of the time — this can be a very good deal. For banks, in fact, the return on equity is very high, often in the order of 25%. This is not something “abnormal.” It is likely the “appropriate” return, because this “leveraged” equity is also quite risky. In financial markets, the higher the risk, the higher the average or required return.

Leverage and funding costs: the basics

Financial leverage is about how much debt relative to equity a firm has. The more debt relative to equity, the higher is the leverage. Does it matter to overall funding costs how much debt vs equity a firm uses? There was a great deal of confusion about this way back in the first half of the 20th century. In 1958, two economists, Franco Modigliani and Merton Miller (who separately won Nobel prizes, partly for this work) considered this issue and showed that, while leverage does typically affect overall funding costs, this is not due to the reasons people were giving at the time, which were based mostly on the fact that equity has a higher required return than debt.

The so-called MM result from 1958 builds on a basic “conservation of value” principle. As leverage changes, so does the riskiness of equity (and sometimes that of debt as well), and thus its required return. If there were no other factors, such as third parties (think governments) taking or injecting cash in taxes or subsidies, and if the funding method did not affect the investment decisions of the firm that determine what is on the assets’ side of the balance sheet, then it would be irrelevant how much debt vs. equity is on the balance sheet. Of course, none of these “ifs” are true in reality, particularly for banks, so capital structure does matter, sometimes a lot. 

MM is a basic “physical law,” taught in every basic corporate finance course, and the starting point of any intelligent discussion of financing decisions. Yet, quite astonishingly, bankers and others, with a straight face, routinely and to this date, make the outrageous claim that “Modigliani and Miller does not apply to banks.” As if banking is so different from the rest of the world that it is exempt from natural laws. This is akin to saying that one can ignore the force of gravity because of air friction.

If there are frictions, we must consider their impact. Do air frictions work against gravity or in the same direction? Do frictions associated with funding favor debt or equity, in the sense that — in their presence — funding costs or the total value that can be created on both sides of the balance sheet favors a particular mix of funding means?  And, importantly in the context of banks, because the funding decisions of any bank may have broader implications, if a bank chooses a certain way to fund itself, does it follow that society is best off under this structure?

Key observations on the effects of leverage

It turns out that the biggest friction in bank funding is not one that is “inherent” in the banking system or in funding more generally, something unavoidable and found “in nature,” like the wind. The main friction is the result of government policies. That would not be so bad if these policies worked to our collective benefits. Unfortunately, these policies go exactly in the wrong direction, favoring leverage that inflicts systemic fragility and extraordinary costs during crisis, precisely because they give bankers strong reasons to choose high leverage.

The fact is that, because of government policies, the funding costs of banks are lower the more debt they have relative to equity, i.e., the higher is their leverage.

Even worse, these same policies, and the resulting excessive leverage, distort the investment decisions of banks. They give incentives for excessive risk taking, which means that banks may overinvest in risky loans (something we witnessed quite clearly in the housing market leading up to the crisis). And it can interfere sometimes with banks’ ability to provide credit and fund valuable investments, because, with a lot of prior debt commitments hanging over them, it may be harder for highly leveraged firms to raise new funds. This so-called “debt overhang” problem contributed to the credit crunch that we experienced in the crisis.

Clearly, the consequences to society of highly leveraged banks are exceedingly negative. Yet, we have a system where we subsidize leverage!

If this sounds crazy to you, this is because it is crazy. The analog would be a government policy that subsidized pollutants, such that the more they pollute, the larger the subsidy. If pollution is bad for health and for the environment, and you required pollutants to limit emissions, they would obviously complain that their cost of production would increase, and this might be true because they lose subsidies. Does this mean we must subsidize pollution? Clearly not, especially if there is an alternative!

Continuing with the analogy, what if there was another process by which to produce the same product, which would actually not increase the cost of production but which is not chosen because of the subsidies given to the polluting technologies? This analogy is key to understanding the battle over bank funding. The way in which subsidies are given to banks makes no sense. If we believe that banks provide important services, and if we want to subsidize them, we must find other ways to do so which do not lead to this perverse situation. We should not effectively penalize equity as a form of financing.

Leverage in banking and elsewhere

The tax code gives an advantage to debt financing not just for banks, of course. (Whether this makes sense is highly debatable. Many economists, including Michael Boskin, advocate abolishing the corporate tax code in part because of this effect.) But despite the tax incentives, many highly productive firms hardly use any debt at all, and no one chooses to fund themselves with anywhere near as much debt as banks.  (The following, for example, are funded virtually only by equity: Apple, Google, Gap, Yahoo, eBay, Bed, Bath and Beyond, Broadcom, and Citrix.) This is because there are other forces that work against leverage, such as constraints lenders put on firms, and the distortions in investment decisions that are due to conflict of interest between equity and debt. An “all equity” firm is the gold standard for making good investment decisions, as it takes into account properly the upside and the downside of its decisions. 

Everything is different for banks. Banks love high leverage. Whenever they make money, which is most of the time, they pay much of it out (to managers and shareholders), and they keep rolling over their huge debt, continuing to borrow more as they pay off what they owe. Equity is always a relatively small fraction of the total balance sheet. High leverage creates fragility because even a small change in the asset value can wipe out the equity and cause insolvency and financial “failure.”

Bankers tell us that they must be allowed to maintain high leverage because this is part of the business of banking. They assert that economies will suffer if they are made to fund more of their investments with equity, there will be credit crunches, terrible things will happen. We clearly must examine these statements carefully before agreeing.

Why banks choose high leverage, and why this has awful consequences

The “safety net” that was created to make sure banks’ operations are not disrupted by economic shocks, i.e., the fact that the FDIC, the Treasury, or the Fed, often stand ready and are expected to back up the banks’ liabilities, plays havoc on banks’ incentives to manage their risk and their leverage prudently and create a gap between what the banks find optimal and what is good for society. This is a very unhealthy situation.

The reason banks strongly prefer debt over equity is because their creditors or debt holders feel reasonably safe about being paid and thus do not require much in average return from the bank. Such creditors don’t have to put restrictions and conditions on banks’ activities. As long as they are confident they will be paid, creditors don’t care what the bank does with its money. When they become nervous, it’s often too late and the system freezes.

Why have we established this safety net for banks? Experience and research has shown that bank runs are very inefficient and disruptive. To prevent inefficient runs, deposit insurance was introduced. The safety net was expanded because the distress or failure of a bank has certain “contagion” effects and can thus be very disruptive and costly to the financial system and to the economy.

Even the suspicion of possible insolvency for a bank can lead creditors to withhold further funding. Banks then may need to engage in massive “fire sale” of their assets to pay their debts, and even that might not be sufficient if they are truly insolvent. This can lead the entire system of credit and payment to freeze. Does this sound familiar?

Allowing the legal process of bank “failure” to work itself out is extraordinarily costly and disruptive, particularly for global banks subject to different legal systems. There are no great options here. The Lehman bankruptcy process, which is still going on for more than two years, has consumed many billions of dollars in direct and indirect costs. And we are still dealing with its fallouts.  

So when Jamie Dimon says that he favors resolution authorities and that JP Morgan “should file for bankruptcy” if the situation arises, we must ask ourselves the following: first, do we believe that the government will actually let JP Morgan go into bankruptcy, and if they did, would this be the right thing? Second, is there an alternative? Can we prevent more of these costly and disruptive failures and the need for bankruptcy and resolution procedures? And if so, how?

Is high leverage necessary for banks?

Here is the good news, and the simple and powerful answer. NO! Quite simply, high leverage is not necessary for banks! We can significantly lower the fragility and the likelihood of needing resolution and bankruptcy in banking by insisting that they use a lot more equity and less debt to fund themselves. And, for society, this will only have positive side effect, despite what the bankers say. Focusing on more equity funding is the simplest and most effective approach to the “too big to fail” problem, because it directly works to reduce the likelihood of “failure.” It does not rely on costly resolution or “bail-in” mechanisms that we are not sure would work or on bankruptcy courts. And it forces banks to “own up” to their investment decisions and alleviates many distortions associated with high leverage.

The business of banking does mean that banks cannot be funded completely with equity as Apple or Gap, because demand deposits and even money market funds and certificates of deposit are part of their business of financial intermediation. Thus, a certain amount of debt is built into banks’ balance sheet. But this does not imply that banks’ leverage must be as high as it is or as they would like it to be or even as high as Basel III would allow.

There is simply nothing that prevents banks from doing everything valuable for society at dramatically lower leverage, say 30% of total balance sheet. (In an interview on CNBC in May, Gene Fama suggested 40% or 50% in equity for banks would be a good thing.) Some of the banks’ debt is not part of their business model and just serves to provide funding. And issuing more equity to support the liability on their own would not increase their funding cost in a way that represents any social cost. (If they lose some subsidies, we save on providing these subsidies!) .

Not only would we have a safer system if equity levels were dramatically higher, it is hard to think of any negatives, from society’s perspective, of doing so.  Back to the pollution analogy, the alternative, clean technology of funding turns out to be cheaper than the polluting one once subsidies are removed!

The fact that so much fog was created to prevent the above from being recognized by decision makers in Basel and in many governments, including US, is maddening.

There are other claims made in this debate, but the bottom line holds up upon closer examination: there does not seem to be any compelling reason that banks must be as highly leveraged as Basel III would allow. Those who say otherwise, and bank executives such as Vikram Pandit of Citi have complained that Basel III is too harsh on banks cannot justify their claims coherently.  The only interpretation is that they are motivated by self interest.  

In a paper I wrote with Stanford colleagues Peter DeMarzo and Paul Pfledierer and with Martin Hellwig from Bonn, we discuss in some detail every argument we are aware of regarding the mantra that “equity (or, as bankers call it, “capital”) is expensive.” We also discuss contingent capital and bailout funds, arguing that the equity-based solution dominates them.  The paper is available here.

Many experts agree with the conclusion of our paper, as is clear in this letter signed by some very prominent academics in finance and banking. For another letter I sent to Financial Times this week as part of this debate, see this link.

Conclusion

The case for much more equity funding for large banks (and possibly other financial institutions) is overwhelming. The main challenges are to define the “regulatory umbrella” appropriately, to understand the “shadow banking” system, and to find effective ways to monitor the true risk and leverage of financial institutions on and off the balance sheets. These challenges can be met if energy is focused appropriately.

Sensible capital regulation does not necessarily involve a hard and fixed “number” for the equity ratio, but rather a flexible system of buffers and adjustments where the balance sheet of the banks is managed with the objective of allowing them to operate without overly endangering themselves and the system. Supervising the payouts and the funding methods of banks so as to keep the system healthy and functional is eminently possible if we take up the challenge.

First, however, we should remove the fog of confusion. Then we must find the political will to insist on prudent regulation before another crisis hits.

Comments on Hoenig, Dimon and banks being “too big”

Many argue that banks that are “too big to fail” are simply “too big.” In an excellent op ed in the New York Times this week, Kansas Fed president Thomas Hoenig identifies the key problems of “too big to fail” banks and argues that we should strive to create smaller banks, none too big to fail. Related proposals were made by Andy Haldane from the Bank of England (see this link), and by Simon Johnson and James Kwak, authors of the important book “13 Bankers.” These proposals, and the so-called Volcker Rule, focus on the total size of the bank and more generally on the “asset” side of the balance sheet. How does this relate to leverage?

If managed properly, breaking up the banks would likely be a step in the right direction. But we cannot ignore leverage. Many small but interconnected banks would still be fragile and subject to systemic risk and possible crises if each of them was highly leveraged. A small drop in the asset value of a leveraged bank leads to distress and possible insolvency, and this can be contagious in such a system. So fragility in the banking system invariably relates to the degree of leverage.  

Jamie Dimon of JP Morgan says large banks are useful and efficient. He wants to be the Walmart of banking. Presumably, he wants to have the size of Walmart but he is not planning to have the type of capital structure that Walmart and firms like it have, with more than twice as much equity as debt on the balance sheet (at least by market value).

Mr. Dimon, how about you start helping the world of banking and the economy by pushing for banks to be much less leveraged, relying more on equity funding than Basel III allows, and for regulators to make sure they are?  If you do that, your growth aspirations might seem a bit less scary.

92 responses to “What Jamie Dimon Won’t Tell You: His Big Bank Would Be Dangerously Leveraged

  1. I would call Modigliani-Miller a “theorem” rather than a “natural law”, but that is a quibble.

    I really like the observation that the only reason “MM does not apply to banks” is because of government policies.

    Excellent piece and great suggestions. Now if only our government represented someone other than Jamie Dimon… Oh, well.

  2. About three years into a crisis, and running a well visited blog on financial regulations, here we have the “expert” again proving he has not the faintest idea of what has happened, and this because he refuses to move outside his agenda cocoon, and believes it is ok to opine about banking regulations without reading up and understanding sufficiently the current regulations. I am of course talking about Simon Johnson.

    For instance, he writes: “They [Basel Committee] give incentives for excessive risk taking, which means that banks may overinvest in risky loans (something we witnessed quite clearly in the housing market leading up to the crisis).

    And that is so absurdly wrong. The regulators give the banks incentives, in terms of ridiculous capital requirements, for lending or investing in what is perceived as having a low risk, and so what happened is that banks overinvested in what was thought ex-ante as non-risky loans… like those triple-A rated securities backed with lousily awarded mortgages to the subprime sector, Greece or Irish banks.

    Banks, as all businesses earn their returns in relation to how much capital they need and so the less the capital the easier to get the higher returns… and that is why banks will not lend to small businesses or entrepreneurs because when doing so they need much more capital.

    Right now, in the USA and in Europe, billions if not trillions of bank liquidity, has painted itself into that corner where it needs 0 to 1.6 percent capital, and cannot move where we need them to move, to the real economy that creates jobs, because that would require 7 to 8 percent of the bank capital they do not have and that is extremely scarce.

    Mr. Simon, how about learning a bit more of what is happening and start asking the regulators to stop using capital requirements that discriminate based on perceived risks, and which are fully layered on top of the risk-premiums the market already applies when clearing for perceived risks of default?

    One of the reasons we have not advanced is that so many amateurs thought their PhD backgrounds were enough to enter the debate… without taking regulations 101.

    Much much worse than whether the current capital requirements are high or low, is the fact that they discriminate… and to top it up, in an arbitrary and erroneous way.

  3. Desi Girl, aka ...SJ reallly Needs an Internship

    i find it quite astounding that Roger Lowenstein would legitimize simon jhonson by quoting the mit prof in his article. Now, the undereducated academics who have never had a real job are leaning on each other to yell more of their lies.

    just for some fun this evening, lets tear apart admati:

    The academics cleverley mix fact and fiction to confuse their followers.

    1) fact: After a massive and incredibly costly financial crisis, we seem to have financial system that is a more consolidated, more powerful, more profitable and, yes,
    Fiction: as fragile and dangerous as we had before the crisis

    There is nothing wrong with being profitable, unless you are living in the former soviet republic.

    2) Fact: The fact is that, because of government policies,…. their leverage.

    Fiction: Even worse, these same policies, and the resulting excessive leverage, …. Yet, we have a system where we subsidize leverage!

    Very key point but misrepresented by admati…oh my, how i love breaking the arguments of these apparently smart geniuses: The government wants to make credit for MAIN STREET and the PEOPLE of the us of a cheap. Banks are only the transmission mechanism. if a bank borrows at 25 bp overnight from the fed, they can lend the money to GE, Intel, local municipalities, and homeowners at a lower rate so that companies can grow and hire people and so that MAIN STREET can refinance their mortgages at lower rates and go out and spend more money to buy stuff to help GE grow.

    Interest rates are low because the fed wants to revive the economy NOT because it wants banks to over-lever.

    3) Fact: High leverage… and financial “failure.”
    Fiction: Banks love high leverage.

    4) Fact: Whenever they make money, which is most of the time, they pay much of it out (to managers and shareholders), and they keep rolling over their huge debt,
    Fiction: ..continuing to borrow more as they pay off what they owe.

    Again the prof implies that making money is a bad thing and then implies that there there should be other recipients of profits apart from managers and shareholders? The prof would make chairman mao very proud.

    5) Fact: Bankers tell us that they must be allowed to maintain high leverage because this is part of the business of banking. ..clearly must examine these statements carefully before agreeing.

    Fiction: We can significantly lower the fragility and the likelihood of needing resolution and bankruptcy in banking by insisting that they use a lot more equity and less debt to fund themselves.

    First the prof quotes the MM theorem that is not applicable in real life and then ignores the other finance 101 class that teaches us that debt is cheaper than equity?

    There are so many more fictional arguments presented in the article that are easy to see through

    Johnson’s and Admati’s comments are quite laughable.

  4. Since the collapse of Continental Bank in 1982 I have been professionally involved and/or interested in discussions on the topic of how to strike a better balance between the interests of taxpayers, financial system users and financial system operators (those split between various levels of the financial system food-chain, managements and shareholders). Main issues for a “closed” economy would be efficiency (with emphasis on a variety of institutional/information economics issues, which abound in this business: asymmetrical information, agency, moral hazard etc) vs cyclicality risks. One little interesting fact in this regard is that the first graduate textbook on the microeconomics of banking dates from the late 1990s and the work itself is a veritable smorgasboard of unresolved thearetical issues.

    As said, in a closed economy the conflict would be between efficiency and contingent taxpayer costs (a “banking” system could be efficient (ie an efficient allocator of funds, or rather an ideal complement to pure market allocation but it would also be highly procyclical. The problems that one finds in the current situation are partially caused by a poorly functioning banking system, partially by the cycle (banks under current rules tend to restrict the supply of credit reactively rather than proactively as a more market mimicking system would). Maybe (maybe) a very safe banking system would also ver very pro-cyclical. During the negotiatiopns over Basle II procyclicality was a recurring issue.

    In an open economy and one with many providers of substitutes from outside the regulatory scope of banking there are two further issues that complicate matters for regulators: (1) avoidance of protectionism (foreign banks should be treated like the locals, at least) and “level playing field” banks should have the minimum of privileges that might cause market distortions and banks should be able to counter competition by vendors of substitutes. The former gave rise to Basle I after japanese banks with very lenient regulation dumped their excess lending capacity in the international markets rather than shrink with the shrinking domestic need for bank funding), the latter led to roughly, the removal of separation between commercial- eand investment banking for diversified financial firms. Basle II was a response to the growing irrelevance of that framework in and environment with innovation (derivatives, securitization) to which the regulators responded not by barring regulated firms (operating under various formal (FDIC) and informal (too big to fail) umbrellas to a defined set of permissible products and practices and leaving the remainder to credibly uninsured firms.

    The current situation between regulators and holders of financial system licences is complex. Big changes in regulation affect the property rights of licence holders. They cannot just make arbitrary changes. For instance, a very safe banking system could consist of a few gvt supervised and backstopped utilities (for instance payments and safekeeping systems) not allowed to pay interest, trade etc and investing their float in gvt securities. Everything else could be made credibly uninsured. That would probably result in your high-equity variant but also probably lead to high levels of specialization (finance companies, money market funds, small payments banks, etc. No one knows if that situation (we would have to return to the 19th century debates about the British and the German approach to banking) would be better (ie politically more able to attract politician and voter support) than the current one.

    Another approach is the alternative to Basle II that was never taken seriously amidst the academic barrages from the ISDA/banking lobby, was to oblige banks (with broad product mandates) to have large amounts of long dated subordinated capital outstanding and actively traded. Vulnerable banks would then show up as quickly as vulnerable EUR members (who issue an inferior form of souvereign debt). It is doubtful how this would work better in a macroeconomic downcycle exogenous to banking (the world had cycles before there were commercial banks, right), but it might be less procyclical than the version where the only regulation for lenders would be consumer protection etc.

    Finally, both these systems would have great trouble to account for a globalized world with a diverstity of large and small economies, open and closed, and a variety of currencies.

    Our best hope -now the ideal moment for change has passed, like it passed after the Continental and S&L crises- is that the tinkering with Basle III and better supervision of non-bank providers will at least lead to something that taxpayers do not have to worry about for a while.

    PS. If one accepts that portfolio diversification by banks can work (as is implied by Basle II, though somewhat discredited since the discovery that a global crisis can wreak havoc with historical patterns), big, internationally diversified (or regionally diversified in the US) banks are to the advantage of the public because the required capital to cover their unexpected losses would be lower, which (if not eaten up by higher coordination costs) should make them more competitive. This, of course in the absence of an well functioning market for securitized assets and an industry that securitizes competently. If banks (again like in the 19th century) would manage the customer interface and “sell their paper” to a market (like the peddlers who sold US commercial paper to City discount houses) but had their reputation at stake), banks could be small and useful. Then the opportunity for predation would shift to fund managers and the intermediaries who service them.

  5. PS: in my PS i omitted to mention (in the penultimate paragraph) that the ideal moment was of course when the market value of banking licences was very low, minimizing the property rights issues.

  6. Not bad!

  7. Its good to see that more prominent academics in the feild of finance are starting to make good suggestions which are not tainted by the interests of business or governement.

  8. Is this post written in English? Pieces of sentences that make no sense, meaningless punctuation, lunatic spelling, irrelevant and ad hominem arguments — what in the world is this writer up to?

  9. Basel II had a basic capital requirement of 8 percent which means that banks could leverage their capital 12.5 to 1… 100 percent divided by 8 percent, for those who do not understand the math.

    Then if a bank believed it could make .5 percent net margin investing in triple-A rated securities backed with lousily awarded mortgages to the subprime sector, or lending to Greece or Irish banks then it should have the expectation of making 6.5 percent in yearly return on its capital, .5 percent times 12.5, for those who do not understand the math.

    But no! Basel II risk-weighted those mentioned investments/loans at only 20%, which meant that the effective capital requirement was only 1.6 percent, which meant they could leverage their capital 62.5 to 1, which meant that they could then expect a yearly return of 31.25 percent when investing/lending to clients who seemed so much less risky than small businesses or entrepreneurs… and I leave to you the math on this.

    And, about what this arbitrary and plain stupid regulatory signaling that discriminates on perceived risks meant to the bank, the “experts” have not yet been capable of seeing and discussing, much less correcting.

    If in the global warming issue, we land in the hands of something like a Basel Committee and “experts” like Simon Johnson… then friends… bye-bye, we are all toast!

  10. DakotabornKansan

    In words are seen the state of mind and character and disposition of the writer. An inverted style of ad-hominem, arrogance? A “language of non-thought?”

    “Ignorant people think it is the noise which fighting cats make that is so aggravating, but it ain’t so; it is the sickening grammar that they use.” – Mark Twain

  11. Ok, my concern with the Basle system is not so much the capital “charged” to exposures (though I agree with increasing the base number for rather complicated reasons), but the measurement of the exposure. There is too much that is hard too measure, and instead of adopting a punitive rule (for instance marking long positions to the bid and short to the offer, and if these are unreliable, with a large haircut. If no market exists, no value for long and a very high requiremant for short. Clearinghouses seem to be able to do conservative marking, why not ban regulators?) . Why do lots of countries have no banks with CDO, CDS or even MBS exposure? because their regulators deem those unsuitable. We have regulators that serve the industry, and an industry that lost its capacity to serve the public interest (the only reason for public privilege) a long time ago, essentially because the money center banks saw their franchise threatened by investment banks who were hungrier, recently deregulated and facing an industry shakeout. They were the natural innovators (moneymarket funds, derivatives, securitization) and they managed to prolong their shakeout. Now there are no pure investment banks left and there is no reason whatsoever for US authorities to not lean towards prudence rather than competitive fairness.

  12. Sorry for a multitude of typos. Maybe it is clear enough.

  13. I enjoyed reading your posts and they raised the question: How do we get banks to invest in the “real economy” vice financially engineered, “triple-A” instruments?

    Possible answers (not an all inclusive list):

    1. Re-enact Glass-Steagall.

    2. Break-up the mega-banks.

    3. Regulate asset side of the balance sheet.

    4. De-regulate the banking system.

    5. Create specialized banks a la farm banks, savings and loans (before they went rogue)and credit unions.

  14. When managing systems, whether financial, social or natural, we typically prefer productivity and stability over resilience–the ability to recover from perturbation, the abiliy to restore or repair themselves; and heirarchy–subsystems organized into larger subsystems, aggregated into still larger subsystems, for example a cell in your liver is a subsystem of you as an organism, etc. The purpose of the upper layers of the heirarchy is to serve the purposes of the lower layer.

    When a body cell breaks free from it hierarchical function and starts multiplying wildly, we call it a cancer.

    The goal of corporations, banks and other financial institutions included, is to grow, to increase market share, to bring the world (customers, suppliers, regulators) more and more under the control of the coprporation, so that its operations become ever more shielded from uncertainty–to engulf everything, like cancer.

    Having laws, rules, regulators, etc. is important, but they have to be aligned with the purpose of the system. Currently the financial system (as well as many other organizations including the health care ‘system’, ‘defense’ industry and government) dominates society at the expense of society’s goals.

    Until we reach a tipping point in our belief that the proper role for the financial industy (and corporations in general) should be to serve society vs the current view, I see little hope for change.

  15. “Measurement of exposure”

    Let us suppose a bank with 1 billion in equity and with a 50 billion exposure to triple-A rated securities or Greece or Irish banks as these two were rated less than a year ago.

    Traditionally that bank would have been regarded with horror as a bank leveraged 50 to 1, but, because that exposure became then risk-weighted at only 20% and counted therefore only a 10 billion exposure, the leverage was reported (and is still is reported) as being a modest and normal 10 to 1.

    In Baseline there are numerous occasions where it is clearly evidenced that the in-house “expert” does not understand the difference between traditional bank leverage and that new Basel invention of a leverage based on risk-weighted assets.

    The amount of books by “experts” that keeps comparing old traditional nominal leverages with modern risk-weighted measures is just unbelievable. In fact I have yet to read the first book making clear that difference. In the future it could be interesting to write a book about how “experts” became so extremely blind.

  16. How do we get banks to invest in the “real economy”?

    At this particular moment when there is an incredible shortage of bank capital that makes it impossible for the banks to move their unreal “risk-free” exposure to the more real and “risky” economy, I cannot think of any other way than temporarily lowering drastically the capital requirements for what is perceived as “risky” and then slowly, over some years, moving up all the risk-weights for risky and not risky alike to 100%… and that includes of course the risk-weight for exposure to triple-A rated governments like USA, UK, Germany, France and others and that are currently risk-weighted at 0% meaning that banks need to hold zero capital against that.

    Now try to suggest reducing the capital requirements for what is perceived as risky in a debate where almost all the experts, because they do not understand what happened, are shouting like wimps for higher capital requirements… cross-the board.

  17. I absolutely agree, but only as long as these comments are not equally biased, and instead tainted by anti-business or pro-government sentiments.

  18. Go back to all that has been written by the Basel Committee on Banking Supervision since the Basel Accord was signed in 1988… and there you will not find one word, and much less a sentence that refers to what should be the purpose of our banks.

    These regulatory Taliban have never had a purpose for the banks in mind, only their simpleminded objective of avoiding bank failures… as if we would all like to live in a world where all but the banks fail.

  19. Per,
    I hope you are realize that you are talking about Basel I, or the “Basel I like” part of Basel II (aka “Standardized Approach”, which by the way is not allowed in the US).
    Basel II does expect banks to assign their own ratings to all exposures, including sovereigns, and in general sovereign exposures are treated similar to corporates. Whether banks will apply these rules correctly or will game them is a separate story, but at least let’s get the facts straights and not confuse the situation more than necessary.

  20. I forgot to mention that the strongest form of resiliance is so called self-organization–the power to add, change or evolve system structure. For example the humane immune system has the power to develop new responses to some kinds of insults it has never before encountered.

    The unpopular course of encouraging variability and experimentation and diversity means “losing control.” Most corporations want to play it safe and decrease market diversity.

    Elizabeth Warren’s new Consumer Financial Protection Board that brings transperancy to the financial system for consumers is a step toward resilience. It allows the financial system to be responsive to consumers, to develop new responses, to experiment.

  21. Two thousand page financial reform bills and subsequent regulations will not accomplish their goals. Glass Steagal and partnership law worked well for many years. Government protected banks should be highly regulated and separated from bank proprietary trading and investment banking. The problem would be easily solved by removing the corporate shield from bankers. Let bank officers, directors and traders be personably liable for their investment decisions. Once their personal wealth is on the line these financial shenanigans will stop. Until recent years Lehman, Goldman Sachs, Morgan Stanley, Bear Stearns operated as partnerships. None were too big to fail because the partners had their personal fortunes on the line every day. Today bank’s proprietary trading is so large, complex and leveraged that senior managers do not understand the complexity of their trader’s risk profiles. The temptation to gamble with other people’s money is too great for most people to resist.

  22. In my exceedlingly uneducated opinion (in finance and economics, anyways), leverage is just a house of cards. Now that our financial system is so highly leveraged, the question is no longer whether we should have, but the more practical how do we extract ourselves with a minimum of damage? I liked the Glass-Steagall of 1933 philosophy of just separating investment banking from depositor-style traditional banking. I would be inclined to separate the two, let the investment side totally collapse, and then pick up the pieces, perhaps even using Keynesian-style government investment in manufacturing to spur growth of the productive economy. Let the extractive side wither and shrink, but this is hard to do with legislative capture, since preventing regulatory capture failed when the finance was deregulated 10-15 years ago in a post-Reagan, ‘small govt is beautiful’ manner.

    Those that firmly believe in the beauty of a bloated extractive sub-economy will surely differ, as giving up skimming the cream from the economy is going to be a tough addiction to conquer. Its just greed. Get over it.

  23. “perceived as having a low risk”

    You must drink Kook-Aid by the Tanker full.

    The banks knew EXACTLY what they were doing and did it deliberately. They were stealing and they knew it.

    Only the puppets and stupid defend the banks.

  24. No MrM. Basel II, approved by the G10 in June 2004, is enacted in the USA… both the Standardized Approach and the Internal Ratings Approach, and that both form part of it. I invite you to read http://www.bis.org/publ/bcbs107b.pdf

    And the above to such an extent that the SEC in their meeting of April 2004, when they allowed for lowered capital requirements for investment banks and brokerage houses explicitly stated that this had to be done according to the principles established by the Basel Committee.

    http://subprimeregulations.blogspot.com/2009/12/day-sec-delegated-to-basel-committee.html

    Right now in the US a bank needs to hold 5 TIMES as much capital when lending to a small business or an entrepreneur that when lending to a triple-A rated client so do not come with comments about me confusing what you obviously do not want know you totally missed.

    And by the way, my name is Per Kurowski, and my email is perkurowski@gmail.com, if you want to present an evidence in private of what you are saying above Mr.MMr.M.

  25. “Jamie Dimon of JP Morgan Chase, in his New York Times magazine profile, expresses admiration for the Basel committee and says, ‘… they are asking the questions that, in theory, bankers ask of themselves: how much capital do banks need to withstand the inevitable downturn, and what is an acceptable level of risk?’ ”

    I wonder what in the world he meant when he added “in theory” to his comment? The comment would have stood just as well – probably better – if he had not added it.

    Does it mean they’re doing thought experiments like Einstein? We all know these bankers are no Einsteins and the results of their thought experiments are there for all to see.

    Perhaps they need to do some applied banking like physicists do applied physics. Construct a balance sheet of 70% liabilities and 30% capital (sorry, equity); it’s not hard to do.

    Would that balance sheet require changes in the dynamic between interest and non-interest income? Would we see the relation between commercial and investment banking in a different light? How does that balance sheet produce revenues? How much does it produce? How would the practice of banking change in order to assure sufficient returns and maintain the bank’s ability to attract sufficient capital (sorry, equity).

    Or maybe “in theory” is a way of saying that the rest of us theorize that bankers ask themselves these questions when in fact they really don’t have a clue.

  26. We could solve the entire problem with one page.

    Just a poster declaring open season on bankers, and a bounty of 5000 dollars a head.

    These sub human parasite life forms called bankers have come to the end of their time.
    Time to pour lots of bleach in the gene pool.

  27. Sorry it is not me who “drink Kook-Aid by the Tanker full” but the regulators who said that if it had a triple-A rating, then the risk-weight was only 20%, and therefore the banks only required 1.6 percent in capital (or less since that capital was not all real capital).

    I, among others in the Financial Times, in February 2003, screamed out against it saying this was setting us up to the “mother of all systemic risks”, as obviously human fallible rating agencies would sooner or later either go wrong or be captured.

    Only the ignorant can believe that the great majority of banks and bankers did not truly believe that the triple-As were not real triple-As.

  28. Over “Two thousand page financial reform bills” and where, surrealistically, the Basel Committee is not mentioned even once.

  29. Just, BTW, the government does subsidize pollution. Consider depletion allowances.

  30. Per,
    The US rules regarding Basel II are defined by US regulators, not by the BIS, which only defines the general framework, which every country than adopts.
    The US implementation is defined by the so-called “US Final Rule” and it is available, for example, here http://edocket.access.gpo.gov/2007/pdf/07-5729.pdf.
    It only applies to the largest and internationally active US banks. All other US banks still follow Basel I.

  31. By the way this post is written by Anat Admati and not by Simon Johnson! When your entire critique is that “he” did not read up, the least you could do was to read who the writer is!!

  32. Unfortunately the accounting is so opaque as to make the real level of leverage an unknown (possibly deliberately). Eg If I go long (ie receive) swaps it just appears in my balance sheet at NPV (initially zero) despite the implicit leverage in the transaction. Once one moves onto 3rd gen derivative it becomes even more obscure (what is my leverage if I have no delta but am massively short gamma). In order to regulate banks it ill be nessessary to ban many of theses products and force proper grossing & reconciliation on the rest

    1)Ban complex derivative with no legitimate real world use – and set a high bar to prove they are legitimate.
    2)All transactions to be grossed. If I recieve in 30yr swaps then I should record the asset & liability PVs separately (NPV is a curse)
    3)Enforce common quarter ends with full reconciliation. My derivative asset equals your derivative liability – no more dodgy accounting driven transactions & window dressing

  33. markets.aurelius

    Desi Girl, aka …SJ reallly Needs an Internship, write much you do not.

    Seems to resemble Yoda’s your first language. From Yoda a thought to you then give I: ““Named must your fear be before banish it you can.”

    Weak in the Force are you, Desi Girl, aka …SJ reallly Needs and Internship. Weak your thought too. But your arguments make more sense than Jamie’s they do. So all good. All good. Keep it up. All good.

  34. Mr.M The document reads “The July 2007 interagency press release stated that the agencies have agreed to issue a proposed rule that would provide non-core banks with the option to adopt an approach consistent with the standardized approach included in the New Accord. This new proposal (the standardized proposal) will replace the earlier proposal to adopt the so-called Basel IA option (Basel 1A proposal). And as you know the Basel 1A proposal included all the risk-weights differentiation based on credit ratings.

    Yes the Fed implements, but the US and the Fed signed up and committed to the Basel II principles in June 2004 and so to say that the US is not bound by it sound not that correct.

    If core banks are the only ones with the right to those low capital requirements that would of course only condemn the other banks to be feeders of loans. Tell me what non-core bank gives a loan to a triple-A rated client and puts up 8 percent of capital to hold it on its books? The proof as they say is in the pudding.

  35. “How do we get banks to invest in the ‘real economy'”

    John, why don’t you take some time to define ‘real economy?’ Don’t you think if that existed we’d see more of it? What is indeed real are the earth’s resources matched to the world’s vital needs–to have an idea for how low that can go, just think of the many millions living on less than $2/day!

    We should realize that the financial sector has packaged smoke for so long that everything resembling reality is obliterated by the mountains of play-money.

    Per argues for relaxing capital requirements, as if that’s cure for our addiction to creating money out of nothing. No, I’m afraid, relaxing it’s not going to cut it unless you have saints handling the whole process. Perhaps war could do it…

    ___________________
    BTW, Per makes a crucial distinction between nominal vs. weighted leverage. He attributes people’s addiction to the latter to myopia; I’d rather suggest we deal with cynical operators of an inert populace. As long as we step over each other for a $200 Chinese TV set rather than protesting against the airport in-security measures, (http://multumnonmulta.blogspot.com/2010/11/black-friday-shopping-vs-protesting.html ), my bet is on the operators!

  36. “Mr. Simon, how about learning a bit more of what is happening and start asking the regulators to stop using capital requirements that discriminate based on perceived risks, and which are fully layered on top of the risk-premiums the market already applies when clearing for perceived risks of default?”

    It’s not Simon who’s authored the main entry.

    Secondly, I think one can see a risk differential between your regular startup and even Greek bonds (‘Greek’ here is generic). The former is indeed riskier. Try to think liability of those who packaged and sold such debt, for a change! As for the housing bonds, a little common sense would have gone a long way, except that we hide behind general purpose formulas, which are easily gamed by all parties involved. Personal liability would again help.

    Now, since we cannot afford to wait until personal liability considerations kick in, why not drastically tax the income of the financial wizards?

  37. Thanks for the response.

    I think we will need more than a reduction in capital requirement to the banks motivated to again make loans to the real and “risky” economy (like this phrasing of what I define as the Main Street economy). To get lending started again, perhaps we need more and smaller banks a la what Thomas Hoenig described in his NY Times op-ed.

    Your suggestion to change the risk-weighting of assets seems to be a step in the right direction. I would add asset-class ratios to ensure diversity among industries and business sectors.

    Your response to RealityBites – “Only the ignorant can believe that the great majority of banks and bankers did not truly believe that the triple-As were not real triple-A.” – captured my theory of the true cause of the current financial and economic calamity.

    Bankers, via exotic “triple-A” financial instruments (CDO, CMO, CDS, etc.), thought they could eliminate their risks; but when the tide ebbed many banks were found to be naked. Would higher capital requirements precluded this type of banking behavior? I doubt it since the bankers thought they were laying off the risk on unsuspecting investors.

  38. Real economy was a place where tangible goods and services (e.g., cars, televisions, refrigerators, steel, roads, accounting, health care, etc.) were produced and provided; that contributed to an increase in the real wealth of nation.

    It seemed that our capital allocators became more interested in investing and re-investing in financially engineered instruments (e.g., CDO, CDO-squared, etc.) that burdened the economy than allocating capital to those economic activities that would increased national economic wealth.

    Also, my post that you referenced was referring to the “real economy” as defined in per Kurowski’s initial post.

  39. LOL! You are funny. Obviously, you aren’t gonna do anything to the “savvy businessman” like break up his megabank. What’s he got to worry about? He’s got the full faith and credit of the U.S. gov’t behind him. Team Obama would never let him eat cake.

  40. “Per argues for relaxing capital requirements, as if that’s cure for our addiction to creating money out of nothing”

    That is not really true. I argue for not having capital requirements that discriminate… and the temporarily lowering of the higher requirements related to what is perceived as high risk is only a consequence of our inability to order the banks to adjust upwards all the low capital requirements, without deepening recession.

    Why is it not ok to allow banks to lend for instance to small businesses with only a 4 percent requirement but it is okay for them to lend to the US government with zero capital so that instead some bureaucrats relend that to small businesses?

  41. Re: @ MrM___”Unraveling the Basel Capital Accord (BCS)” by smithy (~ 2/3 down) is quite enlightening. Illustrates just how Basel came about as a orphaned adopted stepchild of the “Bank of Int’l Settlements (BIS)” Ref:

    http://www.bilderberg.org/bis.htm

    The following article would greatly enhance the read (a somewhat lenghty read at that) ellaborating upon the adoptive parents involved…that being the World Bank (WB), International Monetary Fund (IMF), and last but not least the “Bank of Int’l. Settlements (BIS)” Ref: “Global Banking : “The Bank of International Sttlements”

    http://www.augustreview.com/issues/banking/global_banking:_the_bank_for_international_settlements_200510147/#

    It bemoans me not to include the actual owners of the three rating agencies: Fitch; S&P; and Moody’s but ?
    Finally to connect the dots? “as opposed to Britain the United States returned to the Gold Standard in 1919 (Woodrow Wilson ?) – that, and its increasing importance in global trade, put the United States “Dollar” in a position to replace the British Pound/Sterling as the “World’s Reserve Currency”, not as most presume was after WWII” Ref: ” The Gold Price” *{(arrogant hegemony gone wild?)}

    http://www.silverbearcafe.com/private/gold101.html

  42. In November 1999, in an Op-Ed in the Daily Journal of Caracas I wrote “The possible Big Bang that scares me the most is the one that could happen the day those genius bank regulators in Basel, playing Gods, manage to introduce a systemic error in the financial system, which will cause the collapse, of the only remaining bank in the world”

    And clearly we are on our way there!

  43. Fair distinction, Per, but please follow the line of my argument as well: Greek bonds are less risky than the 15th pizza parlor on the strip mall.

    Unless the government decides to invest itself at x%, in whichever it considers […], I cannot force a bank to lend at fixed rate. Otherwise, think of all agency problems.

    BTW, great call you made in 1999!

  44. “Real economy was a place where tangible goods and services (e.g., cars, televisions, refrigerators, steel, roads, accounting, health care, etc.) were produced and provided; that contributed to an increase in the real wealth of nation. ”

    John, I thought so much, but just wanted to make sure. Now, how many instances of most goods that are tangible the typical western/American family has? Then think, how much more you can produce and sell on top of that?

  45. “Greek bonds are less risky than the 15th pizza parlor on the strip mall.”

    Absolutely! And because lending to pizza parlors on a strip mall is perceived as riskier that is precisely why there has never been a bank crisis because of excessive lending to pizza parlors on a strip mall, nor will they ever be. All bank and financial crisis result exclusively from excessive investments or lending to what ex-ante is perceived as not risky. And that is the main reason why the current bank regulations are so stupid and counterfactual.

    Greek, Irish banks and triple-A rated securities were all perceived as not risky and then on top of it all by requiring so little capital, they seemed such a tremendous opportunity so banks went there, and here we are in this crisis.

  46. Per, the discussion should be about those ratings, the banks that packaged and sold the bonds, and the Greek politicians. We are talking institutions and individuals–hold each of them responsible, while reducing through taxation the incentive to lie/cheat, and you may have a different outcome. Otherwise, there is going to be hardly any investment.

    Now, with the Greek/Irish bailouts, why not let the Franco-German banks sort it out with Goldman Sachs/JP Morgan, the raters, their CEOs (liable per SarbOx?), and former Greek prime-ministers?

    No, I don’t expect an easy/simple answer, while trying to resist too much complexity also.

  47. Stephen A. Boyko

    A rarely identified factor that stands as a constant obstacle to the effective and efficient capital market governance is the relationship of the component parts – predictability, risk, and uncertainty – to the connective concept of randomness.

    Randomness is the range of variability of a complex adaptive system. If there is complexity, there is uncertainty. In determining the degree of randomness the component parameters of predictability and risk can be bounded whereas the component of uncertainty cannot be bounded with any degree of precision. But uncertainty must be considered.

    Ignoring uncertainty is done at one’s own peril. There are roughly 50 trillion cells in the human body. How many of those who believe that the key to capital market governance lies in the deterministic governance of scale (i.e., capital rules) would be willing to implant a single cancer cell in the hope that its spread could be effectively bounded?

    I argue that one-size-fits-all governance metrics are too loose an operational tolerance to be functional because they lack clarity and precision due to non-correlative information such as Too-Big-To-Fail (TBTF) financial institutions that are, in reality, Too-Random-To-Regulate (TRTR).

  48. Stephen, if the top result of googling your name points to your professional page, isn’t your conclusion, “Too-Random-To-Regulate,” self-serving?

  49. Herbert Wetherby

    So what you are saying is that any gold in the U.S. priced in dollars, could be worth far more in another country due to the inflated USD. Then convert the other countrys currencies to dollars and presto chango a quick return on your investment.

  50. @ via fCh___After studying Mr. Boyko’s thesis, it is without a doubt a pragmatic approach to the over-arching one-size-fits-all regulation bandied about today. If ever a mathematical equation can illustrate the parameters of probability, statistics, deterministics ( benign logic algorithm’s) via randomness using authentic empirical data programs of integrity, cross referenced with infinitesimal economy’s of scale, ie., daily “AD” feedback from non-contaminated sources. JMHO

  51. earle, I agree with you, just as much as I did with the premise in Stephen’s posting. It’s the conclusion that I question, especially if coming from a banker.

    If you read further above, you can see Per’s thesis, which I think it’s too simple. On the other hand, Stephen paints a situation so complex that no sensible regulation can be attempted.

    I happen to believe there is a middle ground. The major difficulty I see though is of different nature, read population ecology and life-cycle of our economy.

  52. @ Not complex if diferential (Laplace Transform) equations become applicable, which in of itself will tweak itself rationally. Thanks for the heads up on the read, will check it out:-)

  53. “Per’s thesis, which I think it’s too simple.”

    If you refer to one single capital requirement I propose it is not because I am simplistic but because the market already discriminates for risk by mean of the risk premiums they charge and that go into bank capital. How they get to that is indeed a too complex issue for anyone of us to understand and so what I protest is that the regulators from the Basel Committee have arbitrarily added a new layer to compensate for exactly the same perceived risks… and which therefore makes the banks irrationally risk-adverse of perceived risks.

    If the banks charged all clients the same interest rate, then the Basel Committee’s capital requirements could make some sense, but the banks do not do that as you know.

  54. earle, I’d restrict the scope of whatever equations to science/engineering–where one doesn’t make a fool of oneself or his students by holding the context constant. I hope the text you refer to is Arrighi’s, which kind of put my experience, intuition and thinking on a conceptual path.

    Per, I welcome your clarification, for it shows you go beyond over-simplicity. However, why don’t you explore a bit the situation at either one of the levels I keep suggesting: go after the bad guys and/or think population ecology/lifecycle of the whole economy…

  55. “Go after the bad guys!” You see that is what I would call simplicity. Who are the bad guys, the bankers, the regulators, the politicians, the PhDs like Simon Johnson who said nothing?

    For over a decade (since 1997) I have been asking the bank regulators to define a purpose for the banks but not a word from them and not a word from the rest. In the same vein with respect to the “ecology/lifecycle of the whole economy” I have begged regulators to stop just looking at what happens in the crisis and start looking at what happens over the whole boom bust cycle… as that is what is truly important for humanity.

  56. “Who are the bad guys, the bankers, the regulators, the politicians” YES, YES, YES!

    Have you seen any freaking politician losing the job because of how they did(n’t) regulate? Barney Frank just got reelected…

    Tax progressively the income of the bankers, expropriate ill-gotten wealth, and send some to jail. Other than Madoff, who’s doing time?

    Block the revolving door between politics and industry. Oops, I’m fast entering Disneyland and have no taste for that sort of entertainment!

    No, as I quoted earlier in the thread, if our co-nationals crowd the stores after Thanksgiving instead of signaling/exercising civic mindedness at any level, we are good, as good as wood.

    They know that and act in consequence. For example, government employees are not allowed to access wikileaks even from personal computers at their homes. Long live US of Absurdistan!

  57. Have anyone of those thousands of tenured finance professors who should have spoken out and did not, felt any sort of heat?

  58. “Have anyone of those thousands of tenured finance professors who should have spoken out and did not, felt any sort of heat?”

    Considering the finance professors are social scientists, I wrote about them on this very blog:

    http://baselinescenario.com/2010/11/20/how-are-the-kids-unemployed-underwater-and-sinking/#comment-70756

  59. “As if banking is so different from the rest of the world that it is exempt from natural laws.”

    It is _made_ exempt from natural laws because banking involves the exercise of government issued licenses to create money, via the multiplication of a base. By virtue of maturity mismatch, banks face the potential of a run – other corporations do not. Without a backstop, banks live in an inherently unstable equillibrium. Hence the backstop.

    The MM angle is interesting, but we’ve been debating the capital asset ratio question here for 2 years now. I think the author leaves out an important aspect (notably the impact on the price level of the credit channels). The author ignores the macro endogeneity problems, but at least avoids other problems with the TBTF narrative (e.g. the number of _small_ banks that failed during the great depression).

    I’m not sure where the author falls in the debate between “the problem was too much govt.” vs. “the problem was the elimination of regulation”. Both are true – the problem was too much govt. subsidy with too little oversight. The result was privatizing the benefits of seignorage while keeping costs public.

    A final thought (dug up from earlier posts): if we raise cap/asset ratios, what does this imply for the price level? And, just how much base money needs to be pumped into the system to keep things stable?

    And, that new money, where does it go, eh?

    I’m not sure the Modigliani Miller framework captures all of that… even though I agree with the conclusion.

  60. Read the full paper – the problem remains the macro issues:

    1) govt. subsidizes bank credit ostensibly to force investment and close the savings/investment gap – what macro management mechanisms replace existing mechanisms?

    2) do the authors really think that loans, in _real_ terms, will not become more costly if we shift banks to an alternative capital structure they propose without massive central bank infusion of base money?

    3) authors talk about repos briefly, as if it were a minor point – need to consider the impact of sweeps more broadly

    4) The authors are discussing a micro issue – firm financing structure – in absence of the macro impact. They include no discussion of the supply of equity/credit to banks, which is a function of the demand of other firms/households to own bank equity/credit. We’re talking a LOT of money here. Even if bank stock becomes less volatile, it’s still more volatile than investment grade bonds, and as such what happens when the supply of fixed income assets plummets while the supply of bank stock increases?

    In essence, risk does not automatically vanish – it’s merely distributed differently. Total risk only changes if the capital structure introduces better management incentives (hopefully it would), but when the authors address the social cost of subsidized bank credit they fail to address the social benefit (e.g. subsidies to the macro-level investment).

    Without the subsidies via govt. backstop of bank risk, the question is: WHO CLOSES THE INVESTMENT GAP? How do we actively manage the business cycle? (Or, are the authors abdicating management of the business cycle, per our Austrian friends)?

    The answer would be a much larger role for government discretionary spending funded by printed money. And that, I propose, is precisely the reason why people like Alan Greenspan prefer a privatized credit based system to a less leveraged banking sector.

  61. cold calculating mind

    Is this what you are doing for your banking internship, writing poorly organized attacks? No wonder a banking deck takes so many edits by all levels of bankers to ‘add value.’

  62. How do you find good refinance rates? I like “123 Mortgage Refinance”. They gave me the option of selecting various rates with different problems. I choose the lowest rate of 3.29% BTW Remember to call and verify the loan rate. Search online to find them.

  63. The purpose of a bank is to make money for its owners using a licence granted by the state. The state does this because it deems unlicensed banks problematic. Now, the problem is, what is problematic about unlicensed banks. And the licensing process must of course refer to a public interest served by permitting some firms to operate as banks and others not. Basle XYZ does not have to state a purpose, it simply provide a framework for national regulators that will achieve two things (1) create a level international playing field so that internationally operating banks are not (prudentially) regulated twice, and differently, and (2) hopefully providing a prudential regulatiion template that should be sufficient to avoid bailouts, unless these have exogenous causes (i.e. where the buffers covering the individual firm’s unexpected risk (which is NOT, catastrophe risk as may occur in a depression where asset values and real sector cash flows drop far below levels envisaged by the relevant models, turn out to be insufficient).

    That does not require defining the purpose of banks in Basle (but local regulations may work with concepts like “a proper incident to banking” etc. I really do not see the problem, but that does not mean that I like Basle III as stated earlier.

  64. Thanks for the comments and explanations – it really helped me to better understand of this capital, equity, and Basel stuff.
    If you had to sum it up in one paragraph, what would be the ultimate reason? Herd behavior (everybody believed real estate never goes down), US governmnet mis-regulation, Basel philosophy wrong, or lots of decisions that in total caused a snowball effect?

    I remember when banks were dull, stable, and never in the news. It seems the more financial inovation we have the poorer we get.

  65. The root of the problem is deposit insurance. That is the source of government’s need/desire to “bail out” the banks.

    Milton Friedman recommended two types of banks: One could invest only in US government securities and those who deposited there would have insurance without limit. The other banks would be free to invest in any way, but deposits would have no insurance.

    Friedman’s approach would cause the risk factor to be taken into account and would remove the government subsidy that deposit insurance represents.

  66. DRDJ,

    Pretty good!

  67. If you want to hold on to tenure-ship as a way to guarantee their independency, though in fact it often seems to only guarantee their indifference, then you might at least have a system of impartial drawings by which you fire 20% of them when the economy is tanking so that they feel the heat too.

  68. As a bank regulator, you need of course to define a purpose for the banks you regulate… like acknowledging their role in allocating capital to serve the needs of those small businesses and entrepreneurs who have yet not graduated to use the capital markets.

    If Basel had done so, they would immediately have realized that allowing the lending to others to those who are perceived as having less risk of default to generate lower capital requirements, placed the banks prime objective clients in an unfavorable competitive position.

    Regulations are in their own way the greatest source of systemic risk!

  69. A small group of likeminded bank regulators with only one objective that of avoiding bank defaults, allowed to act isolated in a small mutual admiration club in Basel, came up with what to them sounded like a splendid idea, that of the more risks of default as measured by professionals like the credit rating agencies the higher capital, and the lower risks the lower the capital. They then thought they had solved it forever… and went to bed.

    If they had listened to outsiders like me they would have heard at least three things. First, banks are not really there to avoid risks, but to help the society take the right risks. Second, you do not give so much power to human fallible credit rating agencies which will therefore be excessively targeted for capture. Third… since there never has been a bank crisis caused by excessive lending to what is perceived as being risky and they have all occurred because of excessive lending to what was perceived as not risky… would these capital requirements not be sort of counterfactual?

  70. Herbert Wetherby

    @ Have anyone of those thousands of tenured finance professors who should have spoken out and did not, felt any sort of heat? No snowflake in an avalanche ever feels responsible.

  71. We would need a Wiki-accountability to go through the papers and writings of tenured and non tenured professors of finance to identify those few who might have said anything relevant to warn the world of the impending disaster… and those not on the list should be forced to wear a cone of shame to class for the next five years.

  72. Stephen A. Boyko

    @ Earle

    You are right on the money with Laplace Transform, but that conversation is best had via white paper.

    BTW, how many SEC attorneys have such familiarity?

    @via fCh

    If the top result of googling your name points to your professional page, isn’t your conclusion, “Too-Random-To-Regulate,” self-serving?

    Response: Does self-serving = correct?

    For I have been not only a practitioner, but an educator, regulator, and government capital market consultant.

    Other than my wife’s complaint about not being able to hold a steady job, financial market curiosity has given me an unique perspective.

    Whether I am correct remains to be seen, but the conentional governance is a flawed construct that has produce larger and more frequent economic dislocations.

    When understood, my prescription is the sole of simplicity that can be modeled as a regulatory Rubik’s Cube.

    Regulatory Rubik’s Cube, June 2009 SFO Magazine By Stephen A. Boyko

    http://www.sfomag.com/article.aspx?ID=1353&issueID=c

  73. A bank failure due to excess debt is nowhere near as bad an entire nation defaulting:

    “Russia was – until the latest attack by the bond vigilantes on peripheral eurozone members – the exception.”

    http://www.berfrois.com/2010/12/deja-vu/

  74. Of course not! Bank failures are indispensable so as to avoid accumulating that combustible material that could if igniting burn up a whole country. The need for bank failures is also something that was ignored by the arrogant in Basel.

  75. Re: @ Stephan A. Boyko___Hold your ground my friend…be forever steadfast, for nothing of any value comes handed on a silver platter! The great Noble Prize Laureate “Milton Friedman” was a *Plantain (Basel?) plant, whereas his “Ism” was a myoptic late 19th century,and blasphemous (oh my, such harsh criticism?) early 20th century gibberish tool of a finite closed-end system with little hindsight, period! Applicable only to outdated Econ 101, as are the outdated text book that can’t explain “Freedom of Thought” (abstract thought is the pulse of innate logic)? Ref: “The Monetarist Transmission Mechanism” and his failed mathematical theory of “Time’s Long Past”, “Ism’s”…

    http://homepage.newschool.edu.het//essays/monetarism/monetransmission.htm

    PS. I believe your almost there Stephan if you could equate your paragmatic and timely thesis :-))

  76. Per,

    In interesting angle, but as I said, Basle is focused at leveling various playing fields while defining boundaries for the balance between the various risks (credit, market and operational risk) and capital, using formulae and underlying structures (standard approach, internal models etc) that have some empirical basis but are mainly the result of what political scientists call: path dependency. The original Basle I top capital requirement was 8 and the designers scaled it down for risk classes perceived as less risky. The process by which this happened was a blend of science and horse-trading.

    However if a national regulator wants to restrict its banks to just lending to SMEs or Friends of the Earth or whatever puprpose may be politically profitable for the politicians, there is always the option to have the bank so desinated operate under a purely national charter. Basle applies (in principle, unless the national regulators determines that all banks should comply with Basle) only to banks that are internationally active. In principle, an internationally active bank could be the sole investor in a business that would be a bank under national regulation, as long as no liability for that business was envisaged.

    But you are absolutely right, Basle (and its sister efforts to bring all financial firms (banking securities, insurance and their associated trading and agency specialties) under a single regulatory capital regime, aim at avoiding discrimination between various types kinds of competitors for the same “wallet”, across industries and jurisdictions. Not at the social function of those industries. However the perceived public benefit of a level playing field is to foster competition and innovation. Theoretically, your SMEs should benefit too. Or persih quicker if absence of protection makes them obsolete..

  77. Glass Steagall could have been working well had it been updated to account for innovation. As it stood it was ineffective and dangerous. However, commercial banking and investment banking are very different businesses, depending of course on yr definition. If one perceives CB as balance sheet lending and deposit taking, with a high degree of customer contact and under the protective umbrella of gvt that recognizes the benefits of a service-oriented utility, it would be very different from the stereotypical advising, originatind, distributing model of IB. A CB would deal in the wholesale markets out of necessity (to balance the ersiduals from it customer business). An IB would trade primarily for account of others, unless it saw an opportunity for “proprietary” profit. Ithe IB structure is already riddled by conflicts of interests, but mixing that with CB makes it far worse.

    However, most international competitors (free to operate in the US as US firms are free to operate elsewhere (with many rulles hthat must be complied with) already had integrated models and US commercial banks (pioneered by Walt Wriston’s Citibank) wanted to defend against non-bank competition by acquiring IB functions. Derivatives and highly developed asset markets facilitated that and that created so much pressure on the regulatory model (plus interest group politics) that is was basically scrapped without an adequate replacement. Maybe that has contributed to the economic problems of the past 10 years, but I doubt that those would not have occurred under the old regulatory model. One view of the past 10 years is that a deflationary situation (a liquidity trap) was temporarily avoided by (a) high degrees of (wasteful) deficit spending, combined with loose monetary policy and (b) unsustainable (mainly) residential construction levels facilitated by poorly regulated financial markets. The liquidity trap danger would not have arisen without the protectionist FX strategies of countries like China that led to a very large pool of savings disconnected from the real US/USD economy.

  78. “The original Basle I top capital requirement was 8 and the designers scaled it down for risk classes perceived as less risky. The process by which this happened was a blend of science and horse-trading.”

    I do not know about the horse-trading part, but I assure you that the science part was pure and unabridged mumbo jumbo.

    They ignored completely that the perceived risk of default were already being cleared by the markets by means of risk premiums, nor did they consider how banks would take their decisions after seeing the credit ratings… which would be the only way of calibrating something correctly. As is, they just increased dramatically the returns for the banks on what was perceived as low risk… precisely the only type of lending that has a chance of becoming excessive and pose a systemic risk… like triple-A rated securities and well rated Greece and Irish banks.

    Go to Basel Committee in the BIS site and read the document from 2005 and where they describe how they calibrated the risk-weights… it is to start crying. Make them at least wear cones of shame.

  79. theotherguydidit

    Do I have this correct?

    Exile the Basel crew to Siberia.

    Suspend numerous bankers from lamp posts in no particular order of seniority. Trussed up like a sack of potatoes. And inviting passer’s by to take a wack at them with sturdy staff. They may bring their own or one will be provided free of charge.

    Rating agency heads and regulators like wise.

    An assortment of lawyers so as not to descriminate.

    Provided there is enough audience participation available.

    And lastly, assisting politicans in their efforts to release themselves from shame by waterboarding them in the name of democracy. Folowed by releasing them into Afghanistan as political advisors to the local communities.

    I’m considering pay-4-view for the later.

    U-tube would just be tacky.

  80. by the way, thanks for all the Basel and other links – a truly impressive knowledge of the official documents on the subject! – not to mention what is really worth noting in them.

  81. Thanks for your kind comment. It helps.

    The bank regulations coming out of the Basel Committee represent the accepted principles for the financial regulations of most of the world. It is therefore so frustrating to have to discuss with “financial regulation experts” like Simon Johnson and most others, who feel they are so expert that they do not really have to know what´s in them.

    It is like discussing Christianity with Christians who feel they are so Christian that they are beyond the need for knowing what the Bible says.

  82. crash jp morgan buy silver

    http://maxkeiser.com/

  83. theotherguydidit

    Rick

    It can’t happen fast enough.

  84. The U.S. government will do whatever it can to prevent secrets relating to corporations and banks from ever seeing the light of day. If wikileaks really had secrets about the secret machinations of U.S. government officials (desperate to prevent the kleptocracy from collapsing) with bank and corporate executives, they would have already leaked them. Does anyone doubt such a smoking gun exists?

  85. Per, “It is like discussing Christianity with Christians who feel they are so Christian that they are beyond the need for knowing what the Bible says.”

    Uh, Per, small detail – Joshua ben Joseph, AKA “Jesus Christ” – did not write the Bible. A bunch of his Jewish followers “interpreted”

    Love one another.

    And the Mormons have their man-made “holy book”…

    And you are right, Greenspam was “interpreted” with a religious zeal.

  86. “your comment is awaiting moderation”

    when did that become part of this place…?

  87. @ Barney___Yes! It goes like this:

    The “World Bank (WB)” …why is it when I see the acronyms it reminds me of the “Looney Toons”?
    There job is to screw everything up, period!

    via…The “Bank of International Settlements (BIS)” {shorthand reads “Bull-Incorporated-S***”! This is the most secretive, and opague organization in the known universe with Greenspan, McDonough, Geithner, and others as BOD’s Members (lifetime?) The Central Bank of Central Banks accountable to no one!!!

    Next we go to the “International Monetary Fund (IMF)” which is the back end of the {“Trilateral Commission” founded in 1973 by David Rockefeller, and Zbigniew Brzezinski (NIEO) New Int’l Economic Order)} three step BIS. They smooth things/finances out after the World Bank makes a mess. Thusly the BIS brokers a deal to have the IMF correct the obvious carnage after the soverign has been raped of all resources (sound familar?). Please Note that the BIS makes/brokers both ends of the charade.

    Lastly we have the “Basel Capital Accord” {(BCA)(Basel I; Basel II & Basel III)} which facilitates the rules and (animal deals?) regulations unquestioned for all the Private, and privileged Int’l Banking Members to fix/rig the game so that it’s failsafe from any kind of public scrutiny being under the aupice umbrella of the “Godfather “BIS”! All this in a quaint little town in Basel, Switzerland, that controls every central bank, and gold/silver transaction as a silent mediator for the most nefarious dealing in the known universe with worldwide immunities! Let me reiterate: BIS=WB
    / BIS=IMF /BIS=BCA/ BIS=The World Comptroller, period?
    Yes there is a smoking gun Barney but it has “International Immunity” ?

  88. I am a scientist by training and have very little knowledge of the financial world. However, I have become increasingly interested in the Fed and how the banks are associated with it.

    I have a couple of questions based on this article.

    1. If the Fed keeps pumping money into the banks and the banks do not in turn use that money to provide loans to businesses, etc. how does this equate to the so called leverage? In other words, now they have these large reserves, but they are not putting them to use.

    2. If the Fed is giving away money to the banks and the banks would give it away, we would get inflation?
    Since they are not are we expecting deflation?

    Thanks

  89. Re: @ BrianH___We’re in limbo…that is to say the money the Fed is digitizing is going everywhere but in the United States. The world is currently being flooded (deluged) with our toilet paper. Sooner, rather than later it will all come home to bite us and “Stagflation” will rear its ugly head once again as in the 80’s! Deflation is upon us now, but the public has been insensitized, or better said massaged into complacency. Here’s the bottom line – the banks have tons of dough, but hedge their free (0.25%) money offshore to their cronies…thus when the sovereigns (emerging markets, higher commodity prices, a U.S. shrinking exporting country, etc.,etc.,) are flush, they export it back to the american citizens (not the banks doing the lending mind you?) in inflated cost. What happens next because of their {Banksters, Corporates (?) & Fed} fiscal recklessness is gross inlation that will make your paycheck seem like “FoodStamp Funny Money”! JMHO
    PS. The only leverage you or I will see is in higher taxes, and cuts in social programs – that how leverage is defined by the Fed/Banksters :-(