For a complete list of Beginners articles, see Financial Crisis for Beginners.
Arnold Kling helpfully pointed out a 2000 paper on regulatory capital arbitrage by David Jones, an economist at the Fed. In his post, Kling said, “In retrospect, this is a bit like watching a movie in which a jailer becomes sympathetic to a prisoner, when we know that the prisoner is eventually going to escape and go on a crime spree.” Having finally read the paper, I have little to add in the way of analysis. But I thought it provided a useful basis for a discussion of what regulatory capital arbitrage (RCA) is and why it is a helpful way of thinking about the financial crisis.
In my opinion, one of the biggest contributors to the crisis we know so well was compensation schemes that gave individuals at financial institutions – from junior traders all the way up to CEOs – the incentive to take massive bets. Put people in a situation where the individually rational thing to do is take lots of risk, and they will take lots of risk – especially if they are generally ambitious, money-loving, and predisposed to think that if the market is giving it to them, they must deserve it.
Alan Blinder does a good job explaining the problem in simple terms in the first half of his WSJ op-ed. However, I’m not optimistic about his solution:
It is tempting to conclude that the U.S. (and other) governments should regulate compensation practices to eliminate, or at least greatly reduce, go-for-broke incentives. But the prospects for success in this domain are slim. (I was in the Clinton administration in 1993 when we tried — and failed miserably.) The executives, lawyers and accountants who design compensation systems are imaginative, skilled and definitely not disinterested. Congress and government bureaucrats won’t beat them at this game.
Rather, fixing compensation should be the responsibility of corporate boards of directors and, in particular, of their compensation committees. . . . The unhappy (but common) combination of coziness and drowsiness in corporate boardrooms must end. As one concrete manifestation, boards should abolish go-for-broke incentives and change compensation practices to align the interests of shareholders and employees better. For example, top executives could be paid mainly in restricted stock that vests at a later date, and traders could have their winnings deposited into an account from which subsequent losses would be deducted.
Why am I not optimistic? Disney.
The Washington Post (hat tip Mark Thoma) has a profile of Brooksley Born, who has been credited by dozens of commentators (including us) for unsuccessfully attempting to increase regulation of derivatives in the late 1990s while serving as the head of the Commodity Futures Trading Commission. There’s much to admire, including being the first female president of the Stanford Law Review, making partner while working part-time, and, most importantly, this:
Born keeps informed, but she has other concerns, bird-watching jaunts and trips to Antarctica to plan, mystery novels to read, four grandchildren to dote on. “I’m very happily retired,” she says. “I’ve really enjoyed getting older. You don’t have ambition. You know who you are.”
Then there are the frightening flashbacks to the regulatory battles we are sure to relive this fall:
Greenspan had an unusual take on market fraud, Born recounted: “He explained there wasn’t a need for a law against fraud because if a floor broker was committing fraud, the customer would figure it out and stop doing business with him.”
Translation: Imperfections in free markets are logically impossible.
In the same post I discussed yesterday, Keith Hennessey cites the same NHTSA report – the Final Rule governing CAFE standards for model years 2011-15, issued in January 2008 – to make this point: “The proposal will have a trivial effect on global climate change.” (It’s point 5 in his post, and was also picked up by Alex Tabarrok in his endorsement.) Hennessey cites the NHTSA report accurately, but the report itself is misleading.
What does the report say? Look at Table VII-12 on page 624. There are three scenarios that we are concerned with: No Action (which Hennessey calls, and I will call, “Baseline”); Optimized (“Bush Plan”); and Total Costs Equal Total Benefits (“Obama Plan”). If you want to know why Optimized is Bush and TC = TB is Obama, see my previous post. In the year 2100, the projected carbon dioxide (“CO2″) concentration in the atmosphere, in parts per million, is:
- Baseline: 717.2
- Bush: 716.2
- Obama: 715.6
That’s pretty convincing – or is it?
Note: There are two somewhat significant updates at the bottom, just before the Appendix.
CAFE stands for Corporate Average Fuel Economy – the average fuel efficiency that is calculated annually for every manufacturer that sells cars or light trucks in the U.S. and compared to standards set by the National Highway Traffic Safety Administration, part of the Department of Transportation. (If you want to know more about how CAFE is measured, see the Appendix to this post.) Yesterday, President Obama proposed new, higher CAFE standards for models years up through 2016, by which point aggregate efficiency should reach 35.5 miles per gallon.
The typical conservative response to regulations like this is that they impose costs on the economy. In this case the main argument is that mandating higher fuel efficiency standards makes cars more expensive to produce; so car companies have to charge more for them; so fewer people will buy cars, and fewer people will be employed in the auto industry. I was planning to try to pre-empt this argument, but Keith Hennessey, former head of the National Economic Council under Bush II, beat me to the punch. His post summarizes some findings from a 900-page report produced by NHTSA in January 2008, when the Bush administration released the latest version of the CAFE standards. One of his main points, taken from that report, is that the Obama standards will cost 49,000 jobs. That’s relative to some baseline that I haven’t been able to identify, but it’s 38,000 jobs more than the Bush standards. The table is on page 586 of the long report; the Bush plan is “Optimized” and the Obama plan is “TC = TB.” Hennessey’s post has been picked up by Marginal Revolution (where I found it) and by The New York Times, so I decided I should stay up late and write a response.
This guest post was contributed by Ilya Podolyako, a third-year student (for a few more days) at the Yale Law School and until recently executive editor of the Yale Journal on Regulation and co-chair, with James Kwak, of the Progressive Law and Economics reading group.
Though many economic indicators continue to look grim, the sense of crisis has largely faded from the front pages in the last few weeks. In my opinion, this is shift in demeanor of reporting is due to audience fatigue, not some fundamental change in the underlying dynamics of the economy. As the ever-prescient Onion points out, the American public has only so much tolerance for tragic stories, regardless of their source. For better or worse, however, calls for a drastic restructuring of the regulatory framework have quieted as of late. The Obama Administration has already spent a large amount of political capital on its first round of stimulus, the auto “bailouts,” and the day-to-day management of the financial sector, and will likely have to use up some more for further bank recapitalization and a possible second round of the stimulus. Unsurprisingly, in this environment, blueprints for a brand-new “systemic” financial regulator seem to have been shelved, despite a general consensus that some such entity is necessary to avoid future economic meltdowns.
This development may have some surprising upsides. For one, we have time to scrutinize the wisdom of putting enormous power into the hands of a single agency. The extant regulatory framework is certainly inadequate in many respects. Yet consolidating the exchanges, the SEC, the CFTC, the OCC, the OTS, federal housing agencies, federal consumer protection organs, a macroeconomic policy maker, a new oversight agency for derivatives, and perhaps a dedicated industrial policy manager into one body with wide-ranging authority carries enormous risks that cannot be ameliorated unless we manage to fix certain seemingly intractable underlying problems first. These include the outsize importance of the financial services sector to the U.S. economy, the permeation of government by individuals with a vested interest in preserving this status quo, and basic human fallibility and greed. Of particular concern is the possibility of regulatory capture, which takes place when a regulator begins acting for the benefit of its subjects rather than in accordance with its stated mandate of minimizing systemic risk. While any agency can theoretically be captured by concentrated and powerful individuals, a breach of the “mothership” would carry far more severe repercussions than the loss of one or two “destroyers.” Of course, only the mothership can accomplish certain tasks; in the economic context, it would exist to take on challenges of a scope that smaller bodies simply cannot handle.
Arnold Kling has developed a new form of communication across the Internet: he wrote a blog post entitled “Paging Simon Johnson and James Kwak,” pointing to a 2000 paper by a Federal Reserve economist on the usage of securitization and off-balance sheet entities to effectively lower banks’ capital requirements for the same level of asset exposure. According to Kling, “the article clearly shows that the Fed was aware of regulatory capital arbitrage (RCA)and it paints a largely sympathetic picture of the phenomenon.”
I haven’t sprung for the $31.50 to download the full article yet, but it is going on my reading list.
Kling also said he is “researching the history of capital regulation,” which is something I would also look forward to reading.
Update: One of my friends pointed out that my university has online access to lots of journals, including the one this paper was published in, so I now have a copy.
By James Kwak
One of the curious things about coming to law school was discovering the very high regard that “economics” is held in, at least in some areas like torts and contracts, where “law and economics” has become the primary theoretical construct. In essence, this school of thought holds either that the law has developed in such a way as to promote efficient economic outcomes, or that it should promote efficient economic outcomes. There is now an empirical branch of law and economics, but historically the law and economics approach was largely theoretical. For example, in United States v. Carroll Towing Co., 159 F.2d 169 (2d Cir. 1947), Judge Learned Hand wrote that the whether behavior is negligent should be determined by multiplying the probably of an accident by the cost of the accident and comparing that to the cost of taking precautions. Twenty-five years later, Richard Posner argued that this rule would lead to the optimal level of accident prevention, because it doesn’t make economic sense to pay more for accident prevention than the corresponding reduction in the expected costs of accidents; at that point, the firm would be better off just paying damages to accident victims. (There, now you don’t need to take first-year torts – just apply that principle everywhere.)
The Hand-Posner principle has filtered into the world of public policy and regulation as the argument that the benefits of regulation must exceed their costs. This argument is ascribed to Cass Sunstein, who “cruised through Tuesday’s Senate confirmation hearing” to be the “regulatory czar” in the new administration, which sounds much more powerful than “Administrator of the Office of Information and Regulatory Affairs” in the Office of Management and Budget. Sunstein is a widely respected law professor who specializes in just about everything (constitutional law, administrative law, regulation, and now behavioral economics – he co-authored Nudge - with a brief foray into the death penalty on the side).In principle, he would be able to review new regulations being defined throughout the executive branch. So the cost-benefit model of regulation – already favored by the previous administration – may become more firmly entrenched in the federal government.
The Obama administration is strengthening its antitrust enforcement policy.
That said, this in itself probably wouldn’t have done anything about the “too big to fail” problem. It might have increased scrutiny over large bank mergers – like Nations-Bank of America, Bank of America-Fleet, or JPMorgan Chase-Bank One, but frankly those probably would have gone through anyway; the banking industry is just not that concentrated compared to some others. Too big to fail is a combination of size, interconnectedness, and the critical role of finance for the economy. But the signal that the administration will actually enforce antitrust law is a step in the right direction.
By James Kwak
This guest post was contributed by Lawrence Baxter, a member of the faculty at Duke Law School and formerly a divisional executive in a large banking organization. He takes a look inside the large mergers that created the behemoth financial institutions we know today, and the assumptions that encouraged and allowed those mergers.
A friend recently observed to me that he had maintained zero interest in banks and banking all his life—until the past year. Now everyone is engaged in a swirl of emotions and punditry as we focus as experts, taxpayers or consumers on almost every dimension of the financial crisis, from bailouts to complex executive compensation schemes. Yet throughout the commotion we have not lost our faith in one quintessential American value: bigger is better. How quickly we forget such disasters as Daimler Chrysler and Travelers-Citicorp, even as we hail Chrysler-Fiat.
True, a consequence of great scale has informed the public policy debate on banks: what do we do with a financial institutions that is “too big to fail”? Yet answers to this question have, for the most part, turned on whether a particular company should be allowed to fail, or be propped up by government action. The underlying pathology receives only passing attention. Why do we let these institutions get so large in the first place? Is it not likely that many of the institutions requiring massive injections of public capital and other forms of subsidization and public assistance are, and have been for some time, simply too big to manage?
America’s obsession with bigness has led us to assume glibly that organizational growth, vertical and lateral, is a natural consequence of business success and must be respected, even celebrated. Armies of consultants, lawyers and investment bankers devote their businesses to the science of corporate enlargement, encouraged by economists who celebrate not only economies of scale, but even “economies of super scale.” Ken Thompson, then CEO of one of the most venerated banks in the United States, Wachovia, spoke for an industry when he declared in 2006, at the very moment the company was making its fatal acquisition of Golden West Financial, that ““[c]onsolidation continues to make economic sense. Done right, size enhances competitive power. With economies of scale, a company can better afford the technology and longer branch hours that customers demand.”*
The big news on the banking front this week will be the public release of the stress test results, currently scheduled for Thursday (originally it was supposed to be today). Over at The Hearing, I wrote an overview post recapping the context for the stress tests and the current dilemma the administration faces: whether to keep quiet about the details, and risk undermining the credibility of the exercise, or whether to release signficant bank-specific information, and risk undermining the reputation of certain weak banks.
There is nothing wrong with the concept of the stress tests, and arguably regulators should have been doing them constantly as the crisis worsened, so that this particular iteration would not create such a political challenge. The idea is that not only do you want to know how much capital a bank has right now, but you want to know how much capital it will have left if the economy continues to get worse. If you did this analysis in a way that was credible with the market, it would go a long way toward restoring confidence in the financial system, since the current lack of confidence is based on people’s not trusting the information they are getting.
The great corporations which we have grown to speak of rather loosely as trusts are the creatures of the State, and the State not only has the right to control them, but it is duty bound to control them wherever the need of such control is shown.
Theodore Roosevelt, “Address at Providence,” 1902 (emphasis added)
By “creatures of the State,” Roosevelt meant not that corporations were created by the state, but that their existence and power existed because of and in concert with the state. A few years ago, someone reading this quotation would have probably thought first of Halliburton; today, it evokes the large banks that are too big to fail.
That quotation was pointed out to us by Zephyr Teachout, a law professor at Duke, who has been proposing new antitrust laws aimed at reducing the political power of large firms.
Yesterday I highlighted an op-ed written by Desmond Lachman, a veteran of the IMF and Salomon Smith Barney (and currently at the American Enterprise Institute), comparing the United States and the current crisis to an emerging market crisis.
Saturday evening, Nicholas Brady, Secretary of the Treasury from the end of the Reagan administration through the entire Bush I administration, gave a speech at the Institute of International Finance – comparing the current crisis in the United States to an emerging market crisis, only in that case the banks were in the U.S. and the bad assets were in the emerging markets.
There are uncanny parallels between the situation we find ourselves in today and the one the Bush administration confronted a generation ago. . . . First of all there was a serious LDC [Least Developed Country] debt crisis. It’s easy to forget that in 1988 our banking system was in dire straits because the commercial banks held billions of dollars of loans in countries whose economic prospects had ground to a halt.
The solution, according to Brady, was identifying the fundamental problems and forcing all parties to recognize them.
Among the indisputable points we laid out were that new money commitments had dried up in the past 12 months and that many banks were negotiating private sales of LDC paper at steep discounts while maintaining their claim on the countries that the loans were still worth 100 cents on the dollar. There were more, and they were equally sobering. We used these irrefutable facts as a starting point in all subsequent meetings. Our rule was that no suggestions were permitted to be discussed if they didn’t accept the Truth Serum. They were off the table. Goodbye. Don’t waste time. . . . [W]e persuaded the international commercial banks—at first with great difficulty—to write down the stated value of the loans on their books to something close to market value in exchange for that lesser amount of host-country bonds backed by U.S. zero-coupon Treasuries.
(For a complete list of Beginners articles, see Financial Crisis for Beginners.)
Kevin Drum pointed me to Ryan Avent’s insightful review of Ben Bernanke’s recent speech on financial innovation. (How’s that for the Internets in action?) Bernanke’s brief was simple: to defend financial innovation in general while acknowledging that at the margin it can be counterproductive and may need to be more closely regulated. “I don’t think anyone wants to go back to the 1970s,” he said in a line that was clearly supposed to make his point. Unfortunately for Bernanke, Avent was listening closely. His rejoinder:
neither could Bernanke point to a truly helpful piece of financial innovation developed after that decade. His examples of successful financial products? Credit cards, for one, which date from the 1950s. Policies facilitating the flow of credit to lower income borrowers was another, for which he credited the Community Reinvestment Act of 1977. And, of course, securitization and the secondary mortgage markets developed by Fannie Mae and Freddie Mac in…the 1970s.
With one exception:
Tasked with defending deregulation as a source of financial innovation, Bernanke reached for subprime lending.
This helped at least partially crystallize some thoughts I have had floating around about financial innovation for a while.
Tyler Cowen, co-author of a prominent independent economics blog, has an article in The New York Times explaining “Why Creditors Should Suffer, Too.”
What the banking system needs is creditors who monitor risk and cut their exposure when that risk is too high. Unlike regulators, creditors and counterparties know the details of a deal and have their own money on the line.
But in both the bailouts and in the new proposals [for financial regulation], the government is effectively neutralizing creditors as a force for financial safety.
I couldn’t agree more (except for the bit about the regulatory proposals, and that’s just because I haven’t read them closely). We need creditors who will pull their money or demand tougher terms from financial institutions that are doing things that are either too risky or just plain stupid; that’s theoretically a more efficient and cheaper enforcement mechanism than regulatory bodies.