One of our readers pointed me to a paper by Edward Kane with the unfortunately complicated title “Extracting Nontransparent Safety Net Subsidies by Strategically Expanding and Contracting a Financial Institution’s Accounting Balance Sheet.” The paper is an extended discussion of regulatory arbitrage — not the specific techniques (such as securitization with various kinds of recourse) that banks use to finesse capital requirements, but the larger game played by banks and their regulators. This is how Kane frames the situation:
“Regulation is best understood as a dynamic game of action and response, in which either regulators or regulatees may make a move at any time. In this game, regulatees tend to make more moves than regulators do. Moreover, regulatee moves tend to be faster and less predictable, and to have less-transparent consequences than those that regulators make.
“Thirty years ago, regulatory arbitrage focused on circumventing restrictions on deposit interest rates; bank locations; charter powers; and deposit institutions’ ability to shift risk onto the safety net. Probably because regulatory burdens in the first three areas have largely disappeared, the fourth has become more important than ever. Today, loophole mining by financial organizations of all types focuses on using financial-engineering techniques to exploit defects in government and counterparty supervision.”
Large banks can increase the benefit to them of the government safety net by becoming larger, more complicated (less transparent to regulators), and more politically powerful; yet, as Kane observes, they do not exhibit increasing returns to scale. The implication? “As institutions approach and attain TDFU [too difficult to fail and unwind] or TBDA [too big to adequately discipline] status, value maximization leads them to trade off diseconomies from becoming inefficiently large or complex against the safety net benefits that increments in scale or scope can offer them.” In other words, mega-banks take on the inefficiencies of being complicated, unwieldy, bureaucratic, etc. because they are compensated for by greater safety-net benefits.
In this interpretation, the point of structured finance is not just to reduce capital requirements, but to make it harder for regulators to estimate systemic risk implications and easier for them to ignore what is going on. Unfortunately, regulators do not face incentives that motivate them to take appropriate corrective action. Instead, “history shows that top supervisory officials that respond in a market-mimicking way [that is, the way private creditors would respond] to these signals [of financial deterioration] at TDFU firms must expect to be pilloried rather than praised both in congressional hearings and in the press.” Instead, Kane proposes that heads of regulatory agencies be paid in part through deferred compensation that would potentially be forfeited based on the performance of the institutions they supervised during the subsequent years, including the years after they left office.
One conclusion we can draw is that the bigger and more complex a bank, the harder it will be for regulators to adequately monitor what is going on, and this is one reason that banks make themselves big and complex (it doesn’t just happen by itself). This seems important to bear in mind in assessing the likelihood that current regulatory reform proposals will do the job they are supposed to do.
By James Kwak
The Baseline Scenario 
I have had it with all of the would-be fix-its, end runs and excuses: Repealing Glass-Steagall was a travesty. Fix it.
Regulatory arbitrage is an important concept, thanks for pointing out this paper. It highlights the importance of not just following the rules, but for all participants to remember why they were instantiated in the first place.
Regulatory arbitrage is very important in thinking about systemic designs as the participants (actors in the system) are going to constantly going to be seeking individual gains at the potential expense of systemic safety.
It seems like the ultra-complex banks know exactly what they’re doing, and the government is allowing them to do it. Too Big isn’t as much of a problem if there’s enough regulation to ensure no colossal losses, but it seems like current regulators are content to allow banks to both be Too Big, and far too loosely regulated. It’s a bit unnerving.
Yes, I agree, restore all the controls that were removed during the 1980s and 1990s. My Malcolm Gladwell-esque, counter-intuitive moment a few days ago was:
Financial regulation is not complicated!!!
It’s very simple, so keep writing your papers and blogging while we have our zombie banks, liquidity trap and horrible labor market.
K(eep) I(t) S(imple) S(tupid)
I doubt that banks developed derivatives to assist them in regulatory arbitrage. A far more reasonable explanation is that some bright young kids with more math skills than common sense convinced the relatively staid, but extremely greedy upper-level managers that they could make extraordinary sums of money with little risk.
You don’t need to go around plotting “how can I make myself ‘too big to fail'” in order to circumvent federal regulations. The SEC is not very bright, in case you didn’t notice.
This paper (which I’m printing out as I write) sounds right up my alley. Thanks for alerting us to it.
It seems like people are starting to agree that you can’t regulate entrenched rackets.
No doubt the abysmal performance of Congress this year is helping. Can corruption become more institutionalized, more openly enshrined?
I guess we’ll see what SCOTUS does with Citizens United vs. FEC.
To paraphrase Deng:
Slow cat..if it doesn’t catch mice it’s a bad cat.
Obama missed his chance to take over these rotten banks with stock purchases, fire the top management, fire the bank lobbyists, and have a clear run at getting decent legislation passed while the pay-offs to the Congress were stopped – not to mention breaking them up into smaller more coherent entities.
But, looking on the bright side, when another debacle occurs in 5 or 10 years, there will be another chance to get it done then ;-)).
Of course, the bankers will be thinking ahead to that, and making their plans…. maybe a long term media campaign to get voters to realize bubble and bust cycles are actually a *good* thing, and that we need legislation to prohibit socialist predators trying damage “free” enterprise during cleanup phases… hmmm.
Complex facts leads to complex regulation. Enforcers are facing complexity squared. Make a complex web of different enforcers, and you end up with complexity cubed.
The economists have failed in finding an enforcable solution to sound regulation. The task is too complex.
I suggest we cheat by changing the facts. Eliminate the strict dichotomy of equity and debt for financial institutions that are tbtf. This dichotomy is not a fact given by nature. It is part of the virtual world we have created by our own legislation. It has failed as a useful tool to build our financial world with since enforcing it is too difficult and even destructive.
Solution:
A mandatory convertion of debt to equity in the form of ordinary shares in any financial institution if its debt traded with a spread higher than x bp above government bonds of the same maturity.
Let the olldest debt be first in line for conversion. The chunk of debt converted should be made big enough to eliminate any need for further funding. New debt would be last in line for conversion, so the conversion should not influence the ability to borrow.
The whole point is that instead of letting this virtual creation we call a “company” fail, we let the owners of the company fail by eliminating most of their ownership in the company. We could still protect savers by exempting saving accounts from conversion.
My guess is that the debt market would very soon adapt, and create an orderly line of seniority based on contract. But it will only do so if there is a blunt backstop that ensures that a tbtf never will fail.
We are worried by companies failing – we are not worried of owners failing. Eliminate the ability af tbtf companies to fail – and there will be no tbtf.
The president is too busy bowing down to foreign heads of state to care about this:
http://americaspeaksink.com/2009/11/race-black-president-bows/
As I read all the myriad proposals on how to better regulate the financial system, the posts here bring me back to one basic point: the Fed is the best-positioned institution to regulate the big banks–they have long-standing relationships with the big players, which they use for information-gathering and monitoring. And yet, the Fed is owned by the banks, so any digging by Fed staffers into the workings of the big banks, and any burdensome supervisory actions undertaken by supervisors can be ended with a quick phone call from the big bank to top Fed officials, many of whom owe their jobs to individuals at the latter. The problem is exacerbated by the fact that the primary nexus between big banks and the Fed–i.e. the New York Fed–is situated within the social nexus of Wall Street.
I guess proposals along these lines are being floated now, by why not federalize the Fed, or at least the New York Fed? This may not solve the problem entirely, but as things stand now, bank examiners at the NY Fed work for the big banks; the only thing theoretically keeping them focused on proper regulation is the Fed mandate, which makes vague reference to ensuring financial stability. Fed propaganda (e.g. http://www.dallasfed.org/fed/understand.cfm) states that the people of the US own the Fed due to an act of congress, yet shares of the branch banks are held by banks, and 6 out of 9 board members are appointed by bankers.
I was talking to a structured finance guy the other day and wondered aloud that “it would have been great if the research people at the Fed could have talked to you in 2007” and seen some of the dodgy practices in the area, especially with regards to relationships with ratings agencies. His reply: “if someone from the Fed called me in 2007, I would have asked for a subpoena”. I’m willing to bet that, if the Fed were a government agency, which would place them much closer to the nexus of law enforcement agencies (e.g. the NY Fed wouldn’t be able to deny FOIA requests), the dynamics of information gathering would be much different.
The banks are the ones driving the financial industry, not the regulators. That’s how the system is supposed to work.
With that responsibility the banks have relentlessly driven the financial industry towards greater complexity, because they could and because it represented growth pure and simple. The level of complexity now is simply colossal. It spans nations and even encroaches on adjacent unrelated industries that produce real value. The financial industry in the U.S. as a block is now around 30% of the economic activity. It is impractical to regulate something that complex and sprawling. The financial industry might as well be viewed as a swelling tumor, devouring all surrounding tissues to continue its uncontrolled growth-for-the-sake-of-it.
As such — and for the same reason we would cut out a 30 pound tumor from a 100 pound patient — it needs to be destroyed outright.
It can be a controlled collapse, if possible, but it needs to be cut out and left on the operating room floor.
The economy might end up 30% lighter — or not even that — but the rest of us will be able to go forward at least and figure out what to do with what is left.
“In this interpretation, the point of structured finance is not just to reduce capital requirements, but to make it harder for regulators to estimate systemic risk implications and easier for them to ignore what is going on. Unfortunately, regulators do not face incentives that motivate them to take appropriate corrective action. Instead, “history shows that top supervisory officials that respond in a market-mimicking way [that is, the way private creditors would respond] to these signals [of financial deterioration] at TDFU firms must expect to be pilloried rather than praised both in congressional hearings and in the press.” Instead, Kane proposes that heads of regulatory agencies be paid in part through deferred compensation that would potentially be forfeited based on the performance of the institutions they supervised during the subsequent years, including the years after they left office.”
You mean, the better they do, the worse the regulator does?
Somehow I think that he has the opposite in mind. That’s like paying the FBI based upon the profits of the Mafia. ;)
An ecological analogy suggests that to protect the rest of us from the regulated institutions, the regulators should be predators on the institutions.
Predator-prey population dynamics do tend to be countercyclical, predator numbers rising in response to prey numbers, thus dampening prey numbers, and so on. So if regulator power responded that way…
Off-topic, or maybe not (you never know where adventurous thoughts may lead), predator-prey metaphors made me remember this:
http://www.theoildrum.com/node/4448
joedee1969,
Republicans say President Obama is arrogant, then in the next breath say he apologizes for Bush’s F*#^-ups too much. Go back to watching Glenda Becky before she realizes her 15 minutes of fame already ticked off the clock.
Yeah, let’s face it, repealing Glass-Steagall was a cruel joke. I was once involved in a lobby (in the insurance industry) that argued against such dangerous deregulation. Furthermore, it makes sense to have both positive and negative incentives for regulators, AND to assure that they are assigned blame (including criminal penalties), if they fail to vigorously pursue their regulatory objectives. I’m sick of watching free rides for regulatees. It’s way past time to get overly tough and nasty. Also, the regulations should be enforced under criminal statutes, and substantial rewards offered to whistle blowers.
Of course, none of this is ever happening unless and until we reform our campaign finance and lobbying laws, and the tax code.
I’m reading a paper Volcker helped put together now, so I can’t keep up with the reading. Maybe later I can speak intelligently on it. I just say the same thing I’ve always said. Investment banks and commercial (retail) banks should be kept separate, banks shouldn’t be able to sell their own loans (packaged with bogus ratings or otherwise), and credit default swaps should be illegal. I expect none of those 3 things to occur and I expect none of our problems to end.
The hilarious fallacy of all this conjecture is based on the FICTION that we live in a land of law, or are ruled by or beholden to the ruleoflaw, or that “goddamn piece of paper” we call the Constitution. The predatorclass does not abide by, honor, or hold any respect for the existing laws, the socalled ruleoflaw, or that thing we used to call the Constitution. The predatorclass operates above and beyond the law, is accountable to no one and no thing, and in bent on sucking the blood and the life out the America’s poor and middleclass for profit.
There will never be any regulation, because the predatorclass who owns and controls the socalled government will NEVER allow it. What are you people imagining or talking about?
Good post, and Ed’s paper is important. The larger point, as argued at Finance:Facts and Follies, is that without a change of incentives for regulators as well as for market participants, we will not have addressed the issues that have caused this and earlier crises. Since the regulatees have always had the incentive to hide information, regulators have to be motivated continually to search for a reveal it, rather than keeping it to themselves.
Step 1:
Put the cost of saving the financial industry where it belongs.
Create an after-the-fact insurance pool (ala FDIC) to pay for TBTF bailouts. Tax profits on big banks, insurers, hedge funds etc. until government loses are covered – and build towards a $700 billion pool for the future.
Step 2:
Watch financial leaders demand better protection against TBTF banks that put everyone else’s profits at risk.
Step 3:
Revisit debate on proper form of regulation once financial players have bigger incentives to want regulation to work. In the meantime, cost of future bailouts are carried by financial sector.
P.s. To improve motivation of financial sector leaders, put 50% tax on all pay packages exceeding $1 million at financial firms until cost of last bailout is recovered.
James or editor – please delete this earlier one – I didn’t realize I’d posted it and I can’t figure out how to remove it – my bad!