Yesterday, Treasury Secretary Geithner presented an outline of his approach to regulating the financial system. The four pillars of that approach seem to be:
- Increased power and regulatory centralization to deal with the problem of systemic risk
- Increased protections for consumers and investors buying financial products
- Closing regulatory gaps by shifting that organizes regulation based on financial functions, not types of financial institutions
- International coordination among regulators
This all sounds good to me, and an improvement over where we are today. But reading Geithner’s discussion of systemic risk – the topic he focused on yesterday – I kept thinking it had been too long since he read Frog and Toad to his children.
The section on systemic risk reads like this (emphasis added, feel free to skim):
To ensure appropriate focus and accountability for financial stability we need to establish a single entity with responsibility for consolidated supervision of systemically important firms and for systemically important payment and settlement systems and activities.
. . . [W]e must create higher standards for all systemically important financial firms regardless of whether they own a depository institution, to account for the risk that the distress or failure of such a firm could impose on the financial system and the economy. We will work with Congress to enact legislation that defines the characteristics of covered firms, sets objectives and principles for their oversight, and assigns responsibility for regulating these firms.
In identifying systemically important firms, we believe that the characteristics to be considered should include: the financial system’s interdependence with the firm, the firm’s size, leverage (including off-balance sheet exposures), and degree of reliance on short-term funding, and the importance of the firm as a source of credit for households, businesses, and governments and as a source of liquidity for the financial system.
Given the existence of “systemically important firms,” I agree they need careful regulation. But why does Geithner assume that they have to exist at all?
There are a few main things that made companies like AIG and Citigroup systematically important. One was interconnectedness: they did business with lots of counterparties. One was complexity: when push came to shove, the regulators were not able to assess the potential damage a failure could cause, and therefore erred on the side of bailing them out. But the big one was size, and this is why we call it Too Big To Fail. The companies in question were so big, and had so many liabilities, that they could cause a lot of damage if they suddenly defaulted on those liabilities.
Interconnectedness is not going to go away. Complexity may not go away completely, but increased supervision could give regulators a better grasp on complexity. For example, all firms could be required to provide detailed information about their positions to regulators, in a standardized format, so that it could be imported into aggregate computer models; data about positions would be kept only by the regulator and not made public. Complexity could also be reduced by limiting the number of businesses an institution is allowed to engage in (like under Glass-Steagall, but updated for today’s world). But size can definitely go away, simply by setting a cap on the volume of assets any institution is allowed to hold (and doing something about off-balance sheet entities). And if a highly interconnected, highly complex but small financial institution fails, the system as a whole would be fine.
What would such a world look like? There would be a lot of small- and medium-sized banks that collected deposits and lent money to households and businesses. There would be brokerage and asset management firms that you used to invest your savings. There would be hedge funds and private equity firms that rich people and other institutional investors used to invest their money. There would be investment banks that helped companies issue equity and debt securities. There would be boutique firms that did research and other boutiques that M&A advising. For any financial service anyone wanted, there would be a company that provided that service; it just wouldn’t necessarily provide every other service, and it wouldn’t have $2 trillion in assets. It would look something like the 1970s.
What’s wrong with this picture? Some people would argue that it would limit financial innovation. But there is no correlation (or a negative one) between the size of a firm and its degree of innovation. Nor do you need to operate a financial supermarket to innovate: mortgage-backed securities were pioneered by Salomon Brothers, an investment bank under the old definition. Finally, perhaps we could use a little less innovation.
Some would argue that costs would be higher, because smaller firms would be less able to capture economies of scale and scope. First, casual empiricism debunks this theory immediately. When I got my mortgage on my house, I got a much lower rate at a small community bank (which holds onto its mortgages rather than reselling them) than at any national bank. National banks also typically offer the lowest rates to savings customers, except when they are about to fail and desperately need cash from depositors. Second, even if this were the case, perhaps slightly higher costs are a price worth paying for reduced systemic risk.
Basically, this is the issue that Ronald Coase discussed in “The Nature of the Firm” (Wikipedia summary; paper). A firm’s optimal size is reached when the transaction costs of doing business in the market equal the administrative costs of managing the firm; the bigger the firm, the higher the administrative costs. Clearly some financial institutions reached a level of scale and complexity where they simply could not even understand what they were doing, let alone manage their risks appropriately; they were too big, looked at just from their own perspective (and excluding the implicit Too Big To Fail subsidy). To this equation, we now need to add the social costs (negative externalities) of being Too Big To Fail: moral hazard, socialized losses, and so on.
To some people, the idea of size caps will seem anti-capitalist (or even un-American). However, that viewpoint is based on a misunderstanding of what the modern large corporation actually looks like. In the United States, supposedly the most dynamic capitalist economy in the world, our corporations are run almost exclusively as giant bureaucracies with a rigidly hierarchical decision-making structure. When I was in the business world, I saw several of these entities from the inside or up close, and they are identical: there’s barely a trace of the free market to be found. Even in the technology industry, the biggest companies, like Cisco and Oracle, expand by buying innovation from startup companies where the innovating actually happens. (Some large technology companies expand by copying innovations made by startup companies, but that’s another subject.)
Geithner’s testimony yesterday did contain at least one important insight:
In general, the design and degree of conservatism of the prudential requirements applicable to such firms should take into account the inherent inability of regulators to predict future outcomes.
When you are designing regulation, you have to bear in mind that the world will change. But this is another reason why simpler is better, and the simplest solution is simply to prevent firms from becoming Too Big To Fail in the first place. First, you have to expect that no matter how clever your regulatory scheme, some firms will be even more clever in finding ways to evade the system and blow themselves up. You are far better off if they are small when they blow up than if they are big.
Second, one of the “future outcomes” you have to protect against is that the firms being regulated will try to change the regulations. So one prerequisite to a successful regulatory structure is limiting the political power of the firms being regulated. This is, ultimately, the most important reason why smaller is better.
Update: Paul Krugman says something similar in his op-ed today:
America emerged from the Great Depression with a tightly regulated banking system, which made finance a staid, even boring business. Banks attracted depositors by providing convenient branch locations and maybe a free toaster or two; they used the money thus attracted to make loans, and that was that.
And the financial system wasn’t just boring. It was also, by today’s standards, small. Even during the “go-go years,” the bull market of the 1960s, finance and insurance together accounted for less than 4 percent of G.D.P. The relative unimportance of finance was reflected in the list of stocks making up the Dow Jones Industrial Average, which until 1982 contained not a single financial company.
It all sounds primitive by today’s standards. Yet that boring, primitive financial system serviced an economy that doubled living standards over the course of a generation.
Update 2: Calculated Risk has this gem which I meant to include in my original post but forgot:
Imagine if the Federal Reserve had been the “systemic-risk regulator” during the bubble.
According to Greenspan in 2005 “we don’t perceive that there is a national bubble”, just “a little froth”, and even in March 2007 Bernanke said “the impact on the broader economy and financial markets of the problems in the subprime market seems likely to be contained”.
How would a systemic-risk regulator help if they miss the problem?
So it’s good to have a systemic risk regulator, but it’s best to minimize the chances of systemic risk getting big in the first place.
61 thoughts on “Big and Small”
Business innovation scholar Clayton Christensen:
“[Industry] regulations ultimately change *in reaction to* the innovators’ success in those markets”.
Enter NYC’s $3M for funding next-gen banks:
New York City, invest your $3 million “angel fund” in start-ups that, en route to becoming a bank, provide individuals with new and improved ways to customize education, and to showcase and earn money from expertise (i.e., ways to become (more) creditworthy)
There is another factor which enables small banks to compete better in today’s world and that is the internet. Internet lending sites enable smaller banks to extend the reach of their lending if they choose to do so. It also makes banks more competitive. About 8 years ago I went online to get a home equity line of credit. The best offer I found happened to come from my own bank, Well Fargo, but it was from a group out of state from where I lived. When I told my local banker about this, he said there was no way that he could give me, a 20 year customer, the rate that I was able to achieve online as a complete stranger to the bank.
Bigger institutions bring economies of scale and increased profits by reduced overhead. However the only time they bring improved innovation is when innovation is tied to large fixed cost or long expensive research cycles. I can’t think of any financial innovation (outside of the ATM maybe) where this applies. And as we’ve learned the hard way, firms that are too large imply increased externality risks for society that are not priced into their enhanced profits gained by size.
I think it’s really nice that America’s oligarchs have agreed to meet with the people’s figurehead today. In his own office, even.
it’s not obvious to me that big firm = systemic risk.
yes, i think that big firms carry a form of systemic risk.
i think that the mechanics of debt deflation carry a form of systemic risk.
i think the main problem was that as a society half of us just became complacent and half of us were rolling dice. the dynamics of the housing bubble were obvious in retrospect. households en masse should not be leveraging themselves for profit — that just can’t work, because eventually the aggregate is going to receive the results of the productive work of the aggregate.
so if we had been paying attention, could we have shut this down a bit earlier? imagine not having to deal with 2006 or 2007 vintage debt — we would have big losses to bank equity and a moderate recession, but that’s all.
in short, i think that i have met the systemic risk regulator, and he is us.
I agree with your “Frog and Toad” point that we should dismantle the ability of the financial sector to capture the political class. Unfortunately, almost everyone in the political class will oppose it; they fear losing a large source of campaign contributions.
Here are some reasons for not declaring things we don’t like as being, ipso facto, “illegal”:
1. Systemically important financial firms exist and unless the PPIP somehow is completely successful regulators are going to have to confront them. Best to have the tools with which to dismantle them when the time comes. Surely those firms in existence today have a right to due process under the legal system in which they exist without having the rules changed.
2. As we go forward the temptation for small, systemically un-important financial firms to become important (in the shadows) will always be there. Better to regulate their effects than to declare their existence illegal. The latter requires policing the shadows looking for something that may or may not be there. How would you propose to do that, discretionary wire-taps?
3. To declare systemically important financial firms summarily illegal is ham-fisted. The world will not respect us or our financial system the more for doing so. As it stands we have a great opportunity to introduce regulation and have it tested in our courts. If we don’t allow ends to justify means we will end up with a strong and reliable financial system to serve once again as the global standard.
4. Once an iron-clad definition of systemically important exists for financial firms there be a temptation to expand this to non-financial firms, those who dominate, say, the internet for example. At a point where we find ourselves blocking access to web sites such as this we will then need to ask ourselves how we differ from the PRC.
But…we do not live in a walled garden. This might make sense in a world without global competition. I do not understand how this proposal would not set up one of our most successful industries (albeit one with some serious problems!) – to get crushed by global competitors? As we all know, there is nothing more fungible then people and capital. I fear what you propose would lead to nothing short of the loss of our competitive advantage in global finance. Thoughts?
Isn’t the problem that the regulator(s) were/are captured, as Simon mentioned in his post on tunnels?
This meltdown has largely taken place in the regulated sector, NOT the unregulated world. It was one thing in 1998 to wonder how LTCM got to be so important. But today the problem children are Citigroup, Bank of America, and AIG – regulated entities all, whose licenses could have been revoked at will.
I agree on the notion of size caps, but I fear that the two solutions (off balance sheet activities and offshore activities) are so easy that we will end up back where we started. If there are not declining average total costs in finance, it’s pretty close.
If our regulators were more willing to enforce the rules they have currently, I would be more confident they would make use of additional tools. As things stand, I am not holding my breath. The threshold of political importance to gain immunity from business consequences is pretty low – look at Chrysler – and a complex, “trust” based business such as finance has an easy time to claiming this importance.
Rick Bookstaber has some good ideas on regulating risk:
What’s wrong with the picture is that small and medium sized banks don’t pay multi-million bonuses or hire out of work politicians to do very little at six and seven figure salaries. Insufficient incentives for the regulators.
I wonder if Steve types “one of our most successful industries” with a straight face (one can opnly assume he’s talking about finace and banking). Boring Canadian banks, hamstrung by govt. banking regulators, mostly stayed out of the financial foolishness of the last decade (and yes, got “crushed by global competitors”) during that time. Who’s better off now? The only problem is that shipping the human capital of finance overseas, where they can destroy other poeple’s financial systems, might be viewed as an act of war.
Also, WTF exactly is “financial innovation”? Are we talking about securitization and derivatives? I’ve heard people refer to venture capital as a type of FI but that doesn’t smell right. Is there anything else?
I’m not sure where it says that larger firms can out-compete smaller firms. Today, larger firms tend to buy smaller firms, but that is something else. After all, if larger firms had such an advantage over smaller firms, why are small banks healthier today than large banks, despite the huge economies of scale available to the latter? The one-stop shop model doesn’t really work when it comes to consumers, and it’s even weaker when it comes to companies, which are pretty sophisticated consumers of financial services. One advantage you have if you offer multiple services is supposedly that you can cross-sell, but if you do it by subsidizing one line of business with another, you’re not really helping yourself.
Large corporations (financial or not) will capture the political class as long as their voices are louder than those who once were called citizens but have since been demoted to “consumer”. As long as corporations are considered persons with all of the rights thereof they will be able to overpower the interests of people simply because they have so much more money to throw around.
While corporations have the rights of people they are not held to account as people are. When a person is convicted of a crime he or she is imprisoned. A corporation is not. It is assessed a fine that too often is worth paying to maximize shareholder value.
As long as corporations are considered persons, laws and regulations will be warped to the benefit of short-term profits at the expense of all other values.
part of the reason that small banks are healthier than large ones is just survivor bias, no? lots of small banks have been closed.
Given that my kid is going to be paying off our competitive advantage in global finance, I say let the other countries have it.
The Calculated Risk cite makes a great point:
Government is part of the system, therefore government is also a factor in systemic risk.
“one of our most successful industries (albeit one with some serious problems!) ”
Sort of like driving your car so fast that the wheels come off. “Of course it has some serious problems; but it’s a really fast car!”
While they have made more than their share of mistakes, the larger banks provide corporations with more sophisticated and less expensive products, and have a much greater grasp of intricate global issues. So while I accept all the arguments as the apply to the U.S. consumer, I don’t think they apply to the international consumer, and certainly do not apply to multinational corporations.
It may be a bit of a leap, but I think if you follow this path, it will also lead you to increased protectionism as the competitiveness of our banking system falls.
Hey, I fessed up that there are issues!
Personally I think that from the ’33/’34 act until recently the U.S. banking system has functioned quite well and on a global basis has been one of our most competitive industries. I acknowledge that we are encountering serious crises with increasing frequency and that regulatory improvements need to happen. But lets not get into a baby/bath water thing.
Ahh…the continued demonization of the financial services sector – no value added and the wizards of wall st. have a special circle in hell reserved for them….
You guys admit that at a oligarchy is calling the shots. The oligarchy is basically made up of Goldman Sachs, JP Morgan and some other friends of high finance. They used to the government to give JP Morgan a big competitor(Bear Stearns). They bailed out AIG becasue AIG owed billions of CDS money to JPMorgan and AIG(the 165 million diversions is a sideshow diversion)
In the words of Carrol Quigley who studied these guys carefully … “The argument that the two parties should represent opposed ideals and policies, one, perhaps, of the Right and the other of the Left, is a foolish idea acceptable only to the doctrinaire and academic thinkers. Instead, the two parties should be almost identical, so that the American people can “throw the rascals out” at any election without leading to any profound or extreme shifts in policy.
– Carrol Quigley, Tragedy and Hope
Yet you seem ridiculously naive in your view that this powerful group will be hurt if Obama merely has the courage to regulate this oligarch! This oligarch you speak of USED the IMF you worked for to make themselves big dollars.
If you really want to go after the oligarch then you have to promote HR 1207 to give congress authority to audit the Federal Reserve Bank. The FRB takes tax dollars and doles it out to it’s member banks every year…the primary dealers get huge adgantages to squeeze profit out of the populace. The inside knowledge of what the fed will do next is worth the entire GDP of this country….are you really naive enough to presume the oligarch you speak of does not use this knowledge for it’s own personal benefit??!!
Especially when there is so much evidence of the problems with many small banks: “…The U.S. system continues to support the creation of numerous small banks through both government-sponsored institutions like the Federal Home Loan Banks and similar non-government entities like Bankers’ bank, that do not exist in markets like Canada. This has led to a more competitive but less stable system, with many thousands of banks having collapsed during U.S. history…” http://en.wikipedia.org/wiki/Canadian_and_American_economies_compared
I still believe that focusing on size alone is the wrong target. It’s just as bad if 10,000 smaller institutions fail rather than just 100 big ones. If we’re trying to deal with systemic risk, we need to make sure that the institutions, no matter their size, are not all taking the kind of risks which expose them to systemic risk.
There seems to be an illusion that reducing the size of the players can be a substitute for smart and effective regulation. It helps, because it increases the number of players you need to be subject to a systemic risk, but it doesn’t eliminate the possibility. If everyone’s making the same bets, you’ll still have a systemic problem.
As for limiting the political power of regulated firms, there’s a reason why there are industry associations – so they can pool their resources so as to influence their common interest. It’s a drag on their ability to influence regulation, but it won’t eliminate it.
folks, no substantively new regs can be expected w/o new banks pushing for them.
think netcos neutralizing telcos…
getting new regs is an exercise in constrained optimization. misrepresent the relevant constraints, or ignore them, and you’ll get nowhere…
Business innovation scholar Clayton Christensen:
“[Industry] regulations ultimately change *in reaction to* the innovators’ success in those markets.”
Enter NYC’s $3M for funding next-gen banks, and this facebook group:
New York City, invest your $3 million “angel fund” in start-ups that, en route to becoming a bank, provide individuals with new and improved ways to customize education, and to showcase and earn money from expertise (i.e., ways to become (more) creditworthy)
Overhead is a significant cost driver of a financial institution, and the entire back office is fairly scalable. Any large regional bank needs a robust IT/accounting system that could probably service a massive institution. So on comparable products (eg treasury services) the larger bank can generally offer lower prices.
Capital markets services (eg debt underwriting) have a large minimum efficient scale and are often more profitable than traditional banking.
Bundling can be economically attractive even if, in some sense, you are cross-subsidizing (eg equity research in 1990s investment banks). http://www.rh.edu/~stodder/BE/PricTheo.htm
Larger firms have gotten into more trouble than smaller firms because larger have focused more on volatile activities and this is a downturn for which they were horrendously ill-prepared.
In addition, accounting favors the small firm in the current situation. Community banks were often shut out of the securitization markets and ended up holding whole mortgages. These instruments are not marked to market, so the balance sheets LOOK healthier than a massive bank with ultimate exposure to the same underlying assets through traded securities.
“I’m not sure where it says that larger firms can out-compete smaller firms”.
I’m not conversant with US data, but in Australia there is some evidence to show that small/medium firms in many (not all) sectors are less efficient (value-added per hour worked) than larger firms.
Aren’t special laws for big institutions just another instance of “one law for the rich, another for the poor”? Has everybody given up on the idea that large and small institutions should be subject to the same laws?
People interested in the growth of the oligarchs’ power and their Govt. links should read “Sold Out” by Weissman and Donahue at wallstreetwatch.org. Among other interesting facts: “In 2007, the financial
sector employed a staggering 2,996 separate
lobbyists to influence federal policy making,
more than five for each Member of Congress”.
So, the people making all these new, and wonderful regulations….aren’t they pretty much the same group of Masters Of The Universe that brought us sub-prime, ALT-A, credit enhancements issued by completely over-leveraged insurance carriers, 40:1 balance sheet leverage is OK by us, bribing the Ratings Agencies is also OK with us, SEC people who were very clearly accepting bribes from Mr. Madoff, and if they weren’t we’re really in trouble if they actually missed the madoff disaster, CDS/O’s are great, selling completely bogus debt portfolios to the entire planet is OK, 23A exemptions are OK, and on and on and on. You Americans caused this mess and it’s about to get bigger. Why don’t all of you pathetic American Titans Of Finance try and figure out what I should tell my wife and kids now that we have been wiped out after 30-years of saving and living honest lives? We loaned you our savings for years, and you sold our pension funds over here all these toxic portfolios that your rating agencies said were investment grade, and now our pensions have evaporated. You lied to us….so you could go buy a bigger house and some more shit from Walmart. Well, here’s a message to all of you pathetic American thieves: STOP LYING, STOP STEALING, AND STOP EXPORTING YOUR NONSENSE TO US. My kids can’t take your bull shit anymore, and neither can I. You’ve bankrupted us over here. Thanks. WE’LL NEVER FORGET WHAT YOU ALL DID……..NEVER. Nor will our children. And why? So you could buy a bigger house. Amazing. Do us all a favor…..go up to the tenth floor,and jump. The sooner the better.
ALL THE GODS MEET! How glorious!
The pursuit of risk reduction by centralizing derivative and CDS contracts was:
1) A force for monopolization.
2) Exploited to actually increase systemic risk.
The opacity and “complexity” of these glorius financial innovations were a cover.
Am I wrong?
It’s not clear to me why we couldn’t get similar levels of systemic risk from many small financial institutions failing at the same time versus relatively fewer but larger failures. It’s not like the current failures are a result of some random process.
So is it time to apply the ‘open source’ model to banking? Seems like all the calls come back to a combination of transparency, smaller and regulated. Since all regulated organizations work night and day to complicate life for regulators (in other words – work around the limits) can transparency be forced in a way that allows honest evaluation of deal risk be done not only by regulators – but by other interested parties, including competitors. It appears that AIG became the poster boy in part because so much of what they did was hidden from the light of day – allowing them to underprice and overcommit in ways that even customers could not figure out.
how do these small to medium companies compete with the behemoths in Europe & Asia? That was part of teh argument to dissolve the Glass-Seagal barriers, and that drove the strategies to get so big.
Are we going to keep foreign institutions out?
Wasn’t the real problem allowing the assets to be over-leveraged? Does it matter how big the institution is if the assets are leveraged at a lower risk ratio?
what’s the value add?
mortgage broker origination fees?
corporate deals that create debt and fees?
Wall Street has been systematically looting US industry since the 1980s. Classic example is Schwartzman’s first big deal: pulling a couple of billion out of US steel to enrich managers, bankers, and dealmakers.
oligarch = person
oligarchy = system of governance
There is no way to eliminate personal benefit; the “invisible hand” and any democratic/republican/capitalist/free market system depend on countervailing interests. The problem is to keep any one or organized cabal of a few from winning the game, and fixing the result in place. Which, of course, is exactly what they will try to do. While “trust busting” and other such programs and pogroms are artificial fixes, blocking use of financially innovated products that fudge information and conceal risk by treating them as fraudulent is also helpful in keeping “the fix” from being put in.
Reality has a nice way of shifting the gains around if allowed into the game. And a non-nice way of breaking the game if not allowed to play.
If lawmaking is already incorporated into the control systems the oligarchy has put in place, then “bad law” (favoring the existing large firms) is already in place. The law creating the Fed is considered by many a shining example.
Well, for one thing, it’s easier to get at the information buried in the records and proceedings of a sample of small firms than in those of a large one. See “system audits” or “analytic audits”, for example. These consist of charting the nominal internal controls of a firm’s accounting system and seeing if it works on (a comparative few) sample real and hypothetical transactions. The underlying presumption is that the management is NOT attempting to deceive unless proven otherwise. A large firm has far more skilled obfuscators with far more resources to keep appearances sweet while getting away with major fraud and deception.
Always remember the accountant’s response to the question, “What was my/our income this year?”
“What do you want it to be?”
In all of this discussion about size and risk, one subject seems to have been ignored. Virtually all of the anti-trust legislation and most of the regulatory agencies were established at the behest of the regulated industries to keep smaller, more agile, firms from competing effectively with larger (dominent) firms. In truth, there is no competitive advantage of scale once a fulcrum point is passed. The tricky part is identifying that point. There is, however, little doubt that Citicorp and AIG were well on the wrong side of the equation.
Part of the point of the article is that the regulators and lawmakers are for sale. If not through crass direct monetary bribes (though those work, too), through status and influence in the cabal.
The tradeoff between having people with “experience” in the ranks of the regulators, and risking the kind of revolving door career paths with unresolveable conflicts of interest, is a tough one. Putting a pure industry/business-naive person in charge of regulation risks the kind of Gong Show now on display with Geithner. Letting CFOs and regulators switch places every few years risks having the Department of JP Morgan.
Face reality: your a deeply corrupt country. Sometimes the truth hurts, but it’s still the truth. You know what happened to you America? The advertising people on Madison Avenue convinced all of your parents (who then convinced you) that if you don’t have a big house and a German car…..your a loser. And you will literally do anything to achieve that baseline goal…..anyting. Wife with huge fake boobs, big (100% loan-to-value) McMansion, big (leased) BMW, SAVINGS IN THE BANK: ZERO. We’re all very proud of you…..and your values. It amazes me that you all know what Britney Spears is doing, but you have no clue who your Congressman is. YOUR DOOMED.
The social pressures are very strong. Simple money bribes would, in theory, work for a lonely misanthrope, but for most people it’s the participating, the acceptance, the joining, the clubbiness which is just as important. Being invited to join the right clubs, playing golf with the right people, getting the right invitations, and so on. The money is part of that, but only part.
That’s why the idea that paying eg. judges a lot of money and giving them job security in the hope of making them incorruptible is never going to be wholly successful. The threat of social isolation remains, and is more than most people can stand. And the threat of isolation extends also to family – can their wives stand it? Can their children?
There is room for a more in-depth study of how pressure is actually exerted on policy-makers, and their vulnerabilities. I think there’s a lot to be learned.
It appears that the very notion of interconnectedness is often misunderstood and exaggerated. The AIG case is used as the quintessential case in point as to the dangers of interconnectedness. I believe the larger danger is the policy response to the misunderstanding of interconnectedness. The real problem with AIG was a lack of understanding of precedent as well as the nature of the crisis by Paulson et.al. Conflict of interest was not helpful either.
What, ultimately, was the nature of the AIG debacle? Entities which either owned mortgages, or wished merely to short them, “sold” or “shorted” them to AIG. They did this this through so called credit default swaps. In a securities based world, the standard way to sell is to sell outright for cash, or more often, to sell by financing the sale through the repo market. The typical “repo” requires a “haircut”, or a partial cash down payment; has a maintenance provision, which means more cash must be posted if prices go down; and is immediately callable, which means the seller can simply unwind the trade at any time for any reason.
There is certainly no reason CDS trades cannot operate in a similar manner. In fact, CDS trades among “dealers” and between dealers and other entities, are structured, for all practical purposes, in a comparable way. However, this is not how the AIG deals were structured.
They were really 100% financed (no haircut); they had no maintenance provision as long as AIG remained AAA; and they were term contracts which could not be unwound by the “sellers” accept under certain conditions. Why did the street do this? Sellers either were looking to hedge their longs, or were looking for capital relief, or were looking to short the market. When the final tally was made, AIG “owned” about $600 billion of mortgage related credit instruments through this method. When their credit rating declined, and market prices declined, then certain “maintenance” or “cash calls” were triggered in massive amounts. Of course, by then they could not come up with the cash.
Those are approximately the details. What does this mean system wide, and what does it mean to the concept of interconnectedness? I will stipulate it as obvious that a dollar of investment can only be lost once. If these CDS represented, for example, mortgages on defaulting houses in California, then the decline in the value of those houses is the true loss the financial system experiences. The financial world believed it had “resold”, or shorted, these mortgages to AIG. What is the systemic impact of AIG’s inability to post collateral?
The bottom line, of course, is that other institutions never really did sell these mortgages. They thought they did, but did not. For all intents and purposes the losses from the decline in mortgage values now reverted back to the original sellers. Of the two types of “sales”, “reselling” and “shorting”, naked shorting is the least disruptive to the financial system. The trade effectively disappears as if nothing happened. They thought they made a bet with a guy who could pay it, but did not. Of course, believing you made money probably effected your behavior in other ways, but that is what happens some times. Still, no money was lost—money was just not made.
Firms who thought they were hedging discovered they did not. Would they have gone “long” mortgages had they not been able to resell them? No. Many used AIG to free up regulatory capital–so by definition they could not have bought as much without someone like them to lower the capital requirement. This, of course, is not an “interconnectedness” problem, but a judgment problem based on their belief in AIG’s ability to pay if there were a problem. Other hedgers were likely hedging inventory so they would not have held as much, presumably.
This is speculation of course. They may have viewed AIG’s guarantees as so cheap that they entered into those trades opportunistically. They might have bought just as much as they would have otherwise. Still, all the losses, which the sellers thought would be AIG’s are now reverting back to the sellers.
When AIG failed, what should the regulators have done? First, they should have taken their damn time and thought about it. AIG’s failure was like a giant “long squeeze”. To replace the now failed company, there was likely enormous short selling in the CDS market—creating widening spreads and declining mortgage values. The sizes were large enough to have caused the rapid decline in mortgage values we saw. The Lucy study (UVA professor William Lucy) demonstrates this decline in values was not based on fundamentals, but panic long covering. Does this remind anyone of something similar? Long Term Capital of course.
What happened with LTCM? Greenspan, in a famous move which was criticized as encouraging moral hazard–how innocent that view seems today—met with LTCM’s counterparties and basically said “it is in your interest not to force these guys to post collateral”. Why? Because that would have set in motion an even larger wave of unwinding thus driving down prices further. One might call this “collateral posting forbearance”.
Paulson and Bernanke should have called a big “timeout” and required the sellers to look at the true underlying value of these instruments What is true? Pontius Pilate once asked a similar question. What is true is one’s judgment as to what is true. That may not have been mark to market values. If the underlying instruments were still paying, an orderly process of unwinding could have occurred—without cash being put up by the government—and without forcing a long squeeze.
Some losses would have been taken just like 1998, and more so. AIG should have been broken up, resold, and gradually the rest of the financial system would have had to assume their positions—not the Government. But Paulson is a creature of Wall Street and is a “hopelessly talented” individual. Talented, because he can see the trees—hopeless because he cannot see the forest. In 1998, Greenspan lead. In 2008, Lloyd Blankfein lead. Goldman had money owed to it and it wanted it now. So Paulson gave it to them
Here’s a simple plan for limiting the danger of leverage in the banking industry in the future: require 10% hard cash tangible equity (none of this silly Tier One and Tier Two Capital monkey business) for any financial institution that takes deposits from consumers and business. Also apply this requirement to any institution that enters into any kind of a financial arrangement with an institution that takes deposits. You can also ratchet up the requirement to 11%, 12%, etc. for gradually larger insitutions to adapt to your concept of limiting the size of institutions. Of course the Frogs and Toads of the future will dismantle any such plan when it suits them (and when the populace regains its complaceny a generation or two from now), but it should work in its simplicity.
It’s worth remember why so much banking consolidation happened in the 1970s and 80s. The driving force was the rise of institutional investing from the 1950s forward (see Drucker’s THE UNSEEN REVOLUTION: PENSION FUND SOCIALISM, 1976), which suddenly presented banks with something they’d never experienced before: clients who were bigger than them, and who could therefore beat them down on price — especially after the early-70s deregulation that for the first time since the 30s allowed stock brokers to compete on price.
The response of the banking industry to the rise of these huge clients was scale up, first by consolidating heavily, and then by making huge investments in information technology that would allow them to essentially bet against their institutional investing counterparties using complicated mathematics backed by the latest computing technology. The need for more and more capital, both to invest in infrastructure and to use in betting against counterparties, also explains why all the now-consolidated investment banks eventually went public.
If you were to break down Wall Street into a bunch of small and medium sized firms, the institutional investors would have them over a barrel again, shifting the center of financial policymaking gravity from the banks back to the institutional investors. Whether you think that would be a good thing or not is another matter; your mileage may vary.
This all sounds a lot like Gosplan (USSR Central Planning Commitee), trying to figure out how to make an unworkable economic planning philosophy work. In my opinion, the unacknowledged elephant in the room is, that just maybe free market capitalism is actually working. Free market capitalism, in the presence of market distorting government interventions, is what is punishing bad actors the way it is. From firms “to big to fail” to consumer credit contracts lawyers have trouble understaning, to a post-republican government daily acruing centralized powers, this has all been facilited by government intervention, not by free market capitalism. Markets have not failed, they are in fact doing what they are suppose to do, i.e. punish poor risk assessment and bad resource allocation. What has dramtically failed, yet again, is government and the propeller heads in it that think that there’s no such thing as “economic laws” arising from nature akin to the laws of physics, that it’s all perfectly maleable to their ends if only they’re smart enough. Surprise, surprise! I’ll make this prediction: More regulatory bodies and procedures will accomplish nothing but creating a new set of market distortions, which will set the stage for the next debacle as very smart people quickly learn how to leveage and/or cicumvent.
In short, more US based corruption, greed and theft. I wonder when we, the rest of the world, are REALLY going to get fed up? Probably in my lifetime, I’m sure. I’ll try to be first in line to sign up to fight these crooks over there. Sometimes a little revolution is a good thing I guess.
Control theory classifies systems as underdamped, overdamped or unstable. An underdamped system responds slowly and smoothly to an input by moving form one set point to another without overshoot or ringing. An underdamped system responds quickly but overshoots the desired destination and then rings (oscillates around the desired destination). Over time the ringing dies out and the system stays at its destination until it receives a new input. When damping is further reduced or gain is increased in an underdamped system, it can become unstable. An input can then lead to oscillations that build over time leading to effects such as those sometimes heard from a poorly operated public address system.In mechanical systems this is typically stopped by something breaking. The Tacoma Narrows Bridge is a classic example see http://encarta.msn.com/media_461550807_0_-1_1_BB/media.html).
Markets tend to resemble underdamped control systems. They respond quickly to news and other inputs, overshoot and ring. Viewed from this perspective recent events make sense.
In the search for bigger profits, especially in the short term, the leverage in the system was increased. This is analogous to turning up the gain. At the same time regulation (damping) was in many areas reduced either through deregulation or regulatory neglect. The stability of the system was thus compromised and a downside input sent it out of control.
One can argue that markets will be most efficient if allowed to behave in this way. By running them at the edge of stability they will respond faster than if they are damped by regulation and leverage is reduced. The downside is periodic crashes. It would be an easy decision if the crashes didn’t hurt people. Since they do, we must find a balance that provides acceptable risks while not giving up too much of the benefits of markets.
In my view gain has been turned up too high and too little damping has been applied in recent decades. Your mileage may vary.
No SPV all assets liability transparent
limit transaction volume and number .. thereby limiting the damage
reduce asset type
get a good risk manager at the regulator not guys like Ben bernanke who felt that the housing crisis has been contained even in 2008, who can’t access the extent of risks in the system, who cannot ask the right question before the event and so on..
But Steve has an interesting point; it may be true that smaller financial firms are quicker and nimbler than larger ones, but larger ones (especially if government backed) also have deeper pockets. And the fact that they may buy smaller firms must also be considered… I think that you are right in being concerned with the size of financial firms and I’m sympathetic to your idea, but it may have some unintended consequences.
First, it may not be effective if the same approach is not followed by other countries. For example, it would be possible to imagine the acquisition of these scaled-down, overspecialized financial firms by Sovereign Wealth Funds, government-owned banks, and/or large international financial firms – I know that there are complications, and such deals could be blocked on many grounds. In effect, the end result of your plan could be further consolidation and concentration, but now at the global level;
Second, I’m not sure if reducing the size of financial firms and limiting the scope of their activities to certain niches would be effective in eliminating systemic risk. Although smaller, financial firms would still be highly interconnected, and some “systemically-important firms” in specific markets would still have the capacity of knocking-out markets and initiating a chain reaction – with the difference that now we would not be talking about one big financial firm or bank but maybe a handful of smaller firms systemically important in their respective markets;
Third, decreasing the size of a financial firms does not necessarily eliminate the influence they may have on regulators – although, of course, it helps. However, on of the problems is that people can shift very easily from positions in the industry to positions in the regulators. This symbiosis may or may not be desirable – I do think that it is problematic and may give rise to serious conflicts of interest – but it will continue even if financial institutions become smaller. It is thus also important to think about ways to limit the appointment of individuals with ties to the financial industry to official positions;
Finally, limiting the size and scope of financial firms may have some impact on international liquidity – although there is nothing preventing smaller financial institutions occupying the space left by the bigger ones. Here the problem may be one of exposure – and smaller sizes may mean less appetite for risk and less exposure to potentially good but generally riskier assets such as those issued by emerging market companies and states.
You might like to consider 2 issues:
1) there have been long periods of significant economic growth without the “assistance” of exotic risk instruments;
2) Canada’s major banks are a fraction of the size of the big American and global banks, partly as a result of being prohibited from exceeding basic capital ratios, etc. And right now they are sitting pretty. Nary a one has required a cent of gov’t money.
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