Too Big to Regulate?

This guest post was submitted by Peter Fox-Penner, a leading expert on regulation at The Brattle Group.  The views expressed herein are those of the author alone. 

At present, the debate among economists over whether our financial regulations should protect institutions on the basis that they are “too big to fail” (TBTF) still rages.  Like many other economists, I distrust the reasoning behind the TBTF justification and rue the fact that the measures taken to prop up the U.S. financial system have made the largest banks even larger, while small banks are failing at record levels.  In my first guest post I argued patchwork attempts to strengthen financial regulation without a “clean sheet” review were likely to be inadequate.

In this second post I look past short term bailouts and address the broader issue of establishing regulation of TBTF firms.  Policymakers are faced with challenge of establishing a large regulator that retains the specialized expertise needed to manage complex markets – specialization more often found in a network of smaller agencies.  To do so they will need to address the size and complexity of the financial sector itself.  As before,  I turn to examples from the utility industry, specifically the establishment and repeal of the Public Utility Holding Company Act of 1935 (PUHCA), that provide lessons for crafting regulation of complex industries.

There should be no question that any firm considered too big to fail must be regulated thoroughly and effectively.  This is unquestionably the $64 trillion question.  We cannot give an explicit or implicit government guarantee to rescue a private firm without whatever control is necessary to prevent moral hazard.  But what if the need to impose appropriate regulation itself becomes a limit on the allowable size or complexity of firms?  In short, can a firm be too big to regulate? 

In any such discussion it is important first to distinguish between several dimensions of big.  The first dimension is the multiplicity of products and markets in which a company is involved.  In context, this means companies that operate in commercial and investment banking, trading, insurance, and dozens of other product lines that are all “financial,” but which have different attributes, externalities, and regulatory requirements.  Call this “firm complexity”.

“Organizational complexity”, the second dimension, tends to follow firm complexity, but it isn’t the same.  This dimension has to do with the number and diversity of business structures owned by a single parent company.  The larger and more varied the number of corporate entities owned or controlled by a single parent, the more layers of vertical ownership; and the more complex the cross-ownership claims, the more complicated the structure.   

The third and final dimension is “structural bigness”.  This is about having a large market share in a well-defined product and geographic market.  This is the traditional meaning of big in the industrial organization field of economics.  It is bigness within a market, or market dominance.

For most financial (as well as non-financial) products, structural bigness is policed by competition (antitrust) laws.  (The insurance industry has enjoyed an antitrust exemption that Congress is now reconsidering.)  Because I assume these laws will continue to be enforced, I assume structural bigness is not a factor in making a firm too big to regulate.

For the other two dimensions of bigness, product and organizational complexity, it’s a different story.  In a nutshell, when the range of one firm’s market and organizational activities grows too large, it often becomes politically or administratively impossible to do a good job regulating it, whatever the particular tools and processes regulators use.

Firm complexity challenges regulation because it requires regulatory agencies with enormous resources to understand the linkages between extremely different financial product markets.  To regulate a firm engaged in insurance, banking, investment banking, trading, and other products, a single regulatory agency will have to possess an unbelievably broad range of skills, tools, and resources.  This is not to deny that there is a careful balance to be struck between too much and too little regulatory overlap, acknowledging sometimes conflicting problems such as regulatory capture and forum shopping.

It is politically unimaginable that the U.S. would ever establish a single financial sector super-regulator (an outcome far beyond the Fed getting the job of policing systematic risk).  However, if we will rely on multiple specialized agencies to police one market at a time, then we have the current patchwork quilt that never allows narrowly specialized regulators to see the linkages between markets.  It also encourages firms to create products that fall in the cracks between agency jurisdictions and that no agency understands well enough to monitor.  Placing limits on the number of markets a firm can operate in may reduce synergies and scale economies, but there should be no argument that it makes regulation far more likely to succeed.

For purely practical reasons, organizational complexity also makes regulation ineffective.  As businesses get successively more complex and varied business structures, the ability of regulatory agencies to understand the company’s financial position simply fades away.  It is well-documented, for example, that Enron built a financial structure so complex that regulators could never understand what it was up to, even following its downfall.  To cite one example, when the investigative staff of the U.S. Federal Energy Regulatory Commission (FERC) was directed to look into Enron’s electricity trading practices, here’s what they had to contend with:

The complexity of the issues confronting Staff and the agencies cooperating with the Commission is such that more time would be required to fully understand Enron’s and other market participants’ activities in the energy markets.  For example, we spent a considerable amount of time analyzing Enron’s massive information technology (IT) systems that were used to harness information and use such information for Enron’s advantage.  In short, the IT systems were functionally equivalent to the IT systems of a national trading exchange, e.g., a stock exchange, coupled with the credit and risk systems of a large national bank, and linked to a large telecom company.  The IT systems were designed to keep transactional data, such as a telecom IT system much do with telephone service customers such as customer service, billing, scheduling, and provisioning, but also link it to a sophisticated, on-line trading platform, and calculate the credit and risk exposure of each transaction.  Because Enron traded 1700 different products on-line around the world, the trading had to be linked together in a secure manner.

Although Staff has focused its energies on relevant data, the size of the task is enormous.  For example, as described herein, Staff is now reviewing approximately 1.8 terabytes (TB) of data, which is equivalent to the amount of data produced by a large telecom company.  In addition, because the data had to be easily accessible to Enron employees, we are also reviewing nearly 1,000 spreadsheets that were populated with data from the IT systems.  The spreadsheets were approximately 40 megabytes (MB) each and dozens were created daily.[i]

Fortunately for the FERC, its objectives in the investigations were confined to Enron’s role in the Western power crisis of 2000-2001.  No full accounting of Enron’s actions was sought, and none has yet been produced. 

The question of the size and institutional division of the analytic resources needed to properly regulate financial markets was the subject of my prior guest post.  In this area, it is interesting that a National Institute of Finance has been proposed to create an independent body of expertise usable by regulators.  Other regulated industries have this, such as the National Regulatory Research Institute, the Institute of Public Utilities at Michigan State University (MSU), and the Regulatory Assistance Project for energy regulators.

Structural Limits in the Utility Industry

The energy utility industry has struggled to find the right balance between enabling effective regulation and allowing market and organizational complexity.  Starting in the late 1880s, municipalities and small industrial firms began installing electric systems that were seldom larger than a handful of plants and lines.  In the first part of the 20th century, industrial titans like J.P. Morgan and Samuel Insull did what we would now call a roll-up:  they purchased dozens of small systems and assembled them into massive holding companies.

Although most of the local subsidiaries of these utilities had rates set by state or local regulators, these agencies could not understand or control enormous multistate holding companies.  With massive, complicated holding companies, regulators could not determine the true cost of serving customers and therefore could not determine the true cost of serving customers and therefore could not set good cost-based rates.  Complexity gave holding companies the tools to overleverage their companies, mislead investors and regulators, overcharge regulated, captive customers and subsidize unregulated lines of business. 

Following the ’29 crash, Congress asked the U.S. Federal Trade Commission (FTC) to investigate the financial practices of utility holding companies.  The 101-volume FTC report found 19 categories of financial misdeeds, including:

. . . the issuance of securities to the public that were based on unsound asset values or on paper profits from intercompany transactions; the extension of holding company ownership to disparate, nonintegrated operating utilities throughout the country without regard to economic efficiency or coordination of management; the mismanagement and exploitation of operating subsidiaries of holding companies through excessive service charges, excessive common stock dividends, upstream loads and an excessive proportion of senior securities; and the use of the holding company to evade state regulation.[ii]

In what one historian called “the most bitter legislative battle of Roosevelt’s first term,” Congress passed the Public Utility Holding Company Act of 1935, known as PUHCA.  PUHCA essentially banned complex financial holding company structures for utilities, gave the new Securities and Exchange Commission (SEC) authority to approve utility mergers and security issuances, and made it extremely hard for utilities to buy or engage in non-utility lines of business.  Drawing on the notion that utilities had large scale efficiencies, but only if systems were physically connected, it also required that all mergers between utilities created integrated systems.

These strong restrictions were based on a consensus that it was simply not realistic to try and regulate the rates and securities of extremely complicated holding company structures.  It was “the very heart of the title,” said the Senate Report accompanying PUHCA, to “simply…provide a mechanism to create conditions under which effective Federal and State regulation will be possible.”[iii]  Over the next 11 years, under federal supervision, the large holding companies were slowly divided and sold.

Although it is likely that the utility industry lost some efficiencies from the bright-line prohibitions introduced by PUHCA, there is little question that increases in efficiency continued.  Over the fifty years following the passage of the Act, the industry grew by a factor of 100, the average power plant grew more efficient by a factor of five, and pollutant emissions (other than CO2) declined by a factor of 10,000.  Real electricity rates dropped nearly continuously throughout the period.  And if the industry was missing scale economies, this was surely more the case in the third of the industry that was publicly owned or a cooperative, where are still nearly 3,000 separate systems, as opposed to only about 140 investor-owned firms.

Many a utility CEO loathed the shackles PUHCA put in place.  Utilities with interstate operations could rarely get permission to diversify into non-utility businesses, thus hampering shareholder growth.  Utilities that did not cross state lines were exempt from PUHCA, and these intrastate firms often dabbled in insurance, real estate development, fuel production, and other non-utility lines of business.

From this experience, we have something of a laboratory comparing utilities allowed to diversify and utilities that were not.  I think it is a fair to say that the utility economics literature has not found large gains in new product synergies where PUHCA was not binding.  Utilities inside a single state went through a wave of diversification in the 1970s, were largely unsuccessful, and have since primarily abandoned non-utility businesses.  It could not have been costless, but PUHCA appeared to have its intended effect, making regulation relatively simple, practical and effective until the late 1970s.

PUHCA Repeal

As deregulation of utilities (along with financial markets) gained currency in the 1980s, the industry pushed to repeal what it felt was an aging and unnecessary statute.  The arguments for repeal were good.  Financial regulation was far more comprehensive and seasoned by the 1990s than it was in 1935, with almost no one seeing the decay in its effectiveness now so apparent.  Federal and state utility regulation was also now far more accomplished.  Most of all, the requirement for physical integration made no sense in an industry that was intentionally de-integrating in order to introduce competition in parts of the sector.  The economic structure of the industry was at odds with the Act.

PUHCA was repealed in the 1992 energy bill, but many of its provisions, meant to protect against excessively complex utilities, were essentially transferred to the FERC and state regulators from the SEC.  Federal and state regulators were guaranteed access to utility holding companies’ books and records, and the FERC cannot allow a merger that impairs the effectiveness of state regulation.  Many state regulators discourage their regulated utilities from engaging in non-utility lines of business, and nearly all of them require a separation between non-utility and utility assets so that losses in unregulated lines of business don’t affect the financial viability or rates of the regulated part of the firm.  For a recent example, see this press release regarding the recent EDF-Constellation deal.

Technically, the removal of the physical integration requirement and other industry changes have enabled mergers and acquisitions.  Between 1993 and 2007[iv] there was a wave of utility mergers, with 84 U.S. to U.S. combinations completed and a handful of acquisition of U.S. utilities by foreign companies.  Warren Buffet’s holding company has purchased one utility, the Texas Pacific private equity firm recently purchased the former Texas Utilities Company, and several foreign utility holding companies now own state-regulated U.S. firms.  Ownership of deregulated power generators is even more diverse.

Nonetheless, there are still strong limits on trades between utilities and non-regulated subsidiaries in a single holding company.  State and federal regulators require that the regulated entity.  And lately, the pace of utility mergers and acquisitions has slowed to a crawl.  Many in the industry believe that this is because state regulators are starting to once again feel that utilities were becoming too big to regulate.

Relevance to Financial Regulation

Regulation of the financial sector is a vastly more complex problem than regulating electric or gas utilities.  There are dozens of products deeply interconnected in several different ways in a geographically global system.  It is clear this complex, interconnected system needs far better regulation than it has today.

Many of the financial regulatory reforms under discussion involve limits on “bigness” as I have defined it.  The Baseline Scenario has long been a strong voice for limiting bank size based roughly on overall systemic risk; more recently, the idea seems to have been embraced by Mssrs. Volker, Greenspan, and Soros; (Two of my Brattle Group colleagues, George Oldfield and Michael Cragg, have also voiced this view.  See “Life Boats for the Banks–Let the Holding Companies Swim,” in The Economists’ Voice.).  Still others call for no absolute size limits, but rather higher capital requirements the larger and riskier the institution.  Chairman Bernanke, for example, calls for an approach that preserves “the economic benefit of multi-function, international [financial] firms.”  

Among these bigness policies, Mervyn King’s (and others’) proposal to separate commercial and investment banking (so-called utility and non-utility banks), comes closest to the policies that guide energy utility regulation today.  Under King’s proposal, commercial banks would be limited in the amount of risk they could take on and would receive protection against failure, while investment banks would have fewer constraints on risk but would receive no survival guarantee  

While this is analogous to energy utility regulation, and may be a good idea for financial regulatory reform, it cannot be a complete solution.  Even with good separation of “boring” and “non-boring” banks, (somewhat different) regulation will be necessary for both types of firms, and close coordination will be necessary for all financial regulators.  In addition to limits on “boring” banks, it may be necessary to limit, or at least oversee, the riskiness or size of “non-boring” financial entities, however they are defined.  Vexing questions regarding the need for transparency, common clearing platforms, and position limits, in all financial product markets, remain. (See these comments from David Brooks, Sophia Grene, Brooke Masters, and Gillian Tett.

The interconnections between disparate financial products and markets and the need for overall prudential regulation creates an extremely complex tradeoff between multiple regulators who have the resources to specialize — and can serve as checks on each other — and the danger of missing the big picture or letting new markets and risks develop in the cracks between their jurisdictions.  In this context, limits on firm size and complexity help by lowering the difficulty of assessing risks and policing activities within a single sprawling firm, in addition to reducing systematic risk.  One has to wonder at passages like this in the Financial Times:

Then there is the idea of obliging the biggest, most complex banks to draw up “living wills” – certificates that would lay out a blueprint for how a bank should be wound up in the event it should fail, perhaps forcing it to ring-fence certain operations, such as its retail and investment banking, in separate subsidiaries.  Regulators are determined the chaos that followed the collapse of Lehman Brothers a year ago should not be repeated.  It has yet to be decided what form a living will should take, but the very notion has many banks up in arms that they will have to spend months, even years, untangling the complex corporate structures they have evolved both to comply with local regulations and to maximize the tax efficiencies.[v]

If the banks that have complete self-knowledge and control will take years to simplify their own structures, how will regulators do it during a crisis?     

In short, limits on the complexity and product offerings of commercial banks may well be an essential part of the solution, but it is nowhere near the entire solution.  

By Peter Fox-Penner


[i]               See “Initial Report on Company-Specific Separate Proceedings and General Reevaluations; Published Natural Gas Price Data; and Enron Trading Strategies.” Docket No. PA02-2-000, Federal Energy Regulatory Commission, August 2002, p. 9.

[ii]               “The Regulation of Public-Utilities Holding Companies.” Division of Investment Management, U.S. Securities and Exchange Commission, June 1995, p. 3.

[iii]              Ibid, p. 9.

[iv]            “EEI 2008 Financial Review,” The Edison Electric Foundation, 2008, p. 45.

[v]               See Patrick Jenkins, “Banking on the Future,” The Financial Times, Future of Finance Section, October 19, 2009.

47 thoughts on “Too Big to Regulate?

  1. It looks like the problem boils down to two issues.

    1. People really, desperately, want to believe that these big banks can somehow find a way to provide infinite “growth” and debt, and that’s why we need to keep them around; and/or

    2. they recognize the uselessness and complete parasitism of these structures, but despair of our ever being completely free of them, so they engage in the anodyne fantasy that we can have them but “regulate” them.

    Both of these are false.

    To focus on “regulation”, the fact is that so long as the rackets exist they will not be regulatable, and even the best-intentioned misdirection from that can still only prolong the agony.

    If it could be politically possible to regulate, it would be possible to eradicate.

    To unilaterally lower one’s demands, where one is up against a veritably totalitarian opponent, in the name of some delusional self-defined “pragmatism”, is absolutely doomed to failure.

    It’s neither principled nor pragmatic. Relinquishing the demand for freedom, and instead begging for some wretched state of only semi-slavery, in the vain hope of appeasing an enemy who will never stop short of your complete enslavement, not only dooms one to failure, but dooms one to the kind of craven failure which sets a demoralizing example for every freedom activist, everywhere, at all times. Health racket “reform” was only the latest such debacle.

    Isn’t it really about time that we learned this lesson once and for all? Isn’t the real nature of the bank rackets clear by now?

  2. Big Banks Accused of Short Sale Fraud by Diana Olick at CNBC.

    Short sale fraud allegedly by big banks.

    “They are pretty clear and pretty upfront about the fact that if the first lender knows they are getting paid, the first lender will kill the short sale,” says Brandt. “So these second lenders are asking for the payments off the closing documents, off the HUD statement, usually in a cashiers check prior to closing. Once they receive that payment, they will allow the short sale to go through, which according to RESPA laws and the lawyers that we have spoken to on the topic is not legal.”

    It is clear that we must have consumer protection for financial transactions. Absent strong regulation you have predation. Please stand up for the consumer. Protecting the consumer is protecting the entire economy.

    We have all seen the fruits of deregulation.


    The more time you waste thinking about this, well, the more time you waste! But academics must do something to keep themselves busy.
    Meanwhile, the danger of a second Great Depression has not gone away at all.
    The Malcolm Gladwell-esque moment in all this, is:

    “Financial regulation…not complicated!”

    We need to restore the regulatory regime that existed prior to 1980. At a minimum, this means bringing back Glass-Steagall, and banning financial products THAT NO ONE UNDERSTANDS, and that nearly and may still destroy us all! I’m referring to CDOs, CDSs, etc.
    But you academics have to keep yourselves busy….

  4. “There are dozens of products deeply interconnected in several different ways in a geographically global system”.

    Get rid of the derivatives, these ‘deeply-interconnected products’, then regulation is much simpler!

    Was LTCM too big to fail? The problem is the financial products that allowed LTCM to leverage itself at 30 to 1!

    “strong voice for limiting bank size based roughly on overall systemic risk”


    That is why the so-called sociology, and economics are pseudo-sciences when thought of in this way!
    I refer you to Nassem Talib and any number of others.

  5. Err…I meant to write:

    “That is why sociology, and economics are pseudo-sciences when thought of in this way!”

  6. Like minds, think alike… (or,

    Will President Obama vigorously defend the financial “reforms” being proposed in Congress or will he drop the ball again, and put himself and the administration in another no-win situation of continued bailouts.

  7. I am still waiting for an explanation of what these giant banks do which makes them a necessity. I suspect it boils down to making markets in derivative products which should not exist. People need to see a bank charter for what it is: a priviledge conditioned upon the creation of public benefits, in which private profit is limited and incidental.

    We need a death sentence for giant banks, which probably means we need a new Congress, a new Executive, a new political system. Why not merge with Great Britain, sell titles of nobility, replace the Supreme Court with a House of Lords? At least we could then have a Parliamentary System and throw out the next Obama when he proves himself a complete sellout?

  8. None of the three definitions of “bigness” suggested above really accommodate the one used by the Fed/Treasury in making its decision to execute bailouts – big enough to threaten macroeconomic consequences due to a singular failure, either due to interconnectedness or simple magnitude.

    This was the argument made by Paulson to Congress, and even earlier, by Geithner following Bear Sterns. (June 08 – Tim Geithner)

    Nor does your definition accommodate the definition in the Atlantic article (big enough to wield direct political influence).

    You do note – quite accurately – that “while small banks are failing at record levels”. Which raises the question:

    “Without intervention, would the macroeconomic consequences of massive small failures have demanded intervention anyway?”

    This is precisely what happened as the Great Depression dragged on. Arguably, the only reason we haven’t been forced to intervene massively to save small banks is because saving the big banks has proven sufficient to prevent the worst macroeconomic consequences (at the cost of increasing sectoral concentration).

    In terms of macro consequences, all of those stem from the strong dependence on banks for the maintenance of the money supply, and the dependence (in general) on credit (instead of currency or non-credit money) to support investment decisions (arguably OK) and consumption decisions (disastrous) in the broader economy.

    Perhaps a more direct, sustainable, and easier response to TBTF would be to make the entire financial system less dependent on banks (and unstable leverage) to provide the money needed to keep price levels stable.

  9. Ed, I agree that we need to restore our old financial regulations, especially Glass-Steagall. Unfortunately, it’s wishful thinking that we can outlaw dangerous financial products. We could, but then they’d just move offshore. Ultimately, derivatives are dangerous because of the inability of traders to predict the volatility in the underlying assets. The answer is to simplify and take the volatility out of the business activities that the derivatives are essentially betting on. For example, curing conditions that result in asset bubbles, like easy government money, lack of regulation of loan securitizations, and permitting banks to easily sell-off their risks rather than having to live with them. In short, we need to rely on natural checks and balances that come about when you don’t have do-gooder government subsidies and guarantees in place, like those provided by Fannie. People say the free market caused all of our problems, but the market was not free. We had too much intervention in the system by a government with a social agenda, and an unfair playing field as evidenced by uneven financial regulation, which was a result of heavy industry lobbying by Wall Street.

    The answer is to promote financial conservatism and responsibility; e.g., 20% down payments for home buyers, banks carrying their own loans, regulation of non-bank mortgage lending and loan securitizations, etc. Once you do that, the need for risk management via derivatives will evaporate, and traders’ ability to use those derivatives for gambling purposes will also dry up.

  10. Getting rid of economic and politically offending derivatives would require a co-ordinated effort by the first world states and others. Domestic taxation could be used to phase out derivatives relatively quickly. Put an excise tax on the proceeds of a contract and a simaltaneous similar excise tax on the payment of the fee. The offshore angle can be made onerous too by deeming foreign trades as domrestic for purposes of taxation. This could be done directly and as an adjunct of the taxation of Controlled Foreign Corporations that hasong existed.

    Start at 30 % on both sides and increase it by 15 % a year.

    Deemed transactions have a very long history in US taxation. The new taxation would tax ongoing transactions of existing contracts since most have annual payments.

    Similar problems existed many years ago that were solved by the Personal Holding Company and Accumulated Earnings Tax.

    As I see it , there is no political will to solve the problem.

  11. I would encourage others to read ella’s link. I caught that article earlier, and am glad others are picking up on it – if the allegations are true (and the response from the large banks was opaque at best) – the implications are serious.

  12. “make the entire financial system less dependent on banks”…is this a reference to your earlier advice to increase real savings rates so as to not depend upon credit for financing growth?

  13. Tippy,

    I’m disturbed by the way the media and gov’t use the word “bank” to describe both commercial banks and Wall Street firms (i.e., “investment banks). They’re quite different, and should be even more different, if we can get Glass-Steagall back in place.

    The purpose of commercial banks is pretty well known: to provide loans to businesses and consumers, and to provide a place for the public to safely deposit its cash. In effect, the banks are a conduit to bring together those who have excess cash and those who need that cash for consumption and business investment.

    The original intent of investment banks was also to be a conduit, but with more of a long-term investment objective. They raised investment capital from the public and facilitated the issuance of securities (stocks and bonds) from corporations and even governments. The investment banks need very little capital themselves to provide this function.

    Both of these conduit roles are essential, and not inherently risky for the banks (provided they have good lending standards) and Wall Street firms (provided they well-manage their equity exposure when serving as a market maker).

    The problem is when either type of institution starts trading for its own account; i.e., trading in securities and contracts just as any individual might. This has gotten wildly out of control, and risks have become magnified due to derivatives, which provide enormous leverage. Importantly, trading can involve anything, from currencies to energy futures to stocks, etc., and banks were able to trade in some of these things even when Glass-Steagall was in place, so re-implementing G-S is not a complete solution to our current problems.

    In my opinion, no useful purpose is served by allowing these institutions to trade for their own accounts. Commercial banks, which take the public’s deposits, should not be taking that kind of risk at all — PERIOD. If investment banks want to do it, then they shouldn’t be allowed to have bank charters (and thus could not take insured deposits), and they should have to do it in separately-capitalized legal entities that can not put the rest of the company at risk. Such entities should then be heavily regulated to ensure that we stay out of the too-big-to-fail trap by not allowing them to create excessive systemic risk.

  14. I understand Jerry’s perspective, but I’d prefer to keep the solutions so straightforward that a layman could tell when laws are being broken. Call me a cynic as well when it comes to having faith in our government being able to write and pass complex legislation, and us being able to keep that legislation in place without it being corrupted after heavy lobbying. Who ever thought Glass-Steagall would be repealed? Who ever heard of a tax for which someone didn’t find a loophole? When it comes to taxes, if the money is big enough, people will simply change their citizenship and open up shop overseas. They’re untouchable at that point.

    Casino activity is only interesting and is only conducted when uncertainty exists. There was a huge market in credit default swaps because of the imperfect information resulting from the complexity of the underlying securities that were being created. In simple terms, some people thought they were AAA credits, while others knew they were toilet paper. It was also a problem that the derivatives (CDS) were poorly controlled, but what really made them dangerous was the mysteriousness of the underlying assets. Keep the underlying assets simple and understandable, and make the status of their credit quality obvious, and then the need for derivatives evaporates. When everyone has the same information and the same opinion about that information, then there’s nothing to bet on.

  15. Lovely explanation Pat Fleck. Absolutely, banks should not trade for their own account. My main gripe about the financial system travesties of the last decade is that banks as a going concern must lend long to collect the interest and repayment of the loan. Banks cannot be merchants of loans and be banks at the same time. The same is true of investment banks. Their function as far as white shoe firms goes was to gather many investors to loan to a single borrower. Their product was underwriting and watching over the loan on behalf of the bondholder’s. Their reputation demanded it.

    All that changed though since investment banks were permitted to be organized in forms other than general partnerships. Similarly for accounting firms. In both cases, the partner’s put their fortunes and honor on the line.

    Vulgarly, the public apparently wanted huckster’s and they certainly are now inundated with grifters.

    The real problem though is that the political system must make a decision about how the citizenry permits the financial system to operate on their turf. This is an area of political life where necessity dictates a tyranny of consensus. I see no real possibility of a national decision being made for the long term. One methodology of accomodation must eventually prevail . The issue must be settled politically or the financial and political system will implode, then simplify until a political consensus is reached. That would be as catastrophic as the fall of the Soviet Union was for the components of the USSR. All survived but at great cost. The components of the USSR were forced into political simplification and are now apparently reaching a simpler consensus where stabilization is achieved.

    I keep trying to find data that will indicate just how long we have to rationalize a system that rids us of excessive speculation. I do not think we have very long before the next acute attack on the system as it exists tonight.

    If your physician were both a corporate physician and undertaker with a monoply on both would you go to the doctor?

    It will be up to the Obama administration to shepherd in a consensus. If not, we fail politically and economically until a consensus is reached.

  16. I disagree. Sociology and economics are in fact real sciences. However, as practiced today they are incomplete because they lack the real-time physical model that double entry book-keeping traditionally supplied, prior to present day software versions of these disciplines. Today, nothing is being measured correctly. It is the pseudo scientist that is running fast and loose with half baked facts.

  17. Jerry,

    Nice post, but you’re scaring the heck out of me! :) I’m kidding, but I must confess that I have had a growing sense of futility about all of this lately. Our government is perhaps dysfunctional beyond repair. This op ed piece by Tom Friedman makes the case:

    As did this discussion on Bill Moyers’ Journal:

    The problem with implementing a fix in this particular situation, when taking into account that we have a corrupt and dysfunctional government, is that we can’t rely on a unified push from the public to provide direction, as the general public doesn’t really understand the problem. It’s too technical. Our politicians don’t understand it either, but where do they turn for the “inside scoop”? Their advisory panels made up of guys from Goldman Sachs! It’s like asking the fox how to guard the hen house.

    Like you, I believe we are in far more trouble than the layperson knows. Not only are we trapped in a cycle of asset bubbles and subsequent busts, but as a practical matter, where are we going to go as a nation when we can’t rely on investing in the capitalist system as a way to grow our wealth? Americans are notoriously poor savers anyway, but now that most Amercans are no longer covered by pension plans, not only are we not contributing enough to retirement, but what has been contributed isn’t growing. I want someone to explain to me how the baby boom generation is going to live when it’s too old to work and short on retirement savings. Moreover, because baby boomers will have to work longer, there will be less opportunity for the young. In addition, development of new businesses will have to slow due to a lack of investment capital. These booms and busts are simply going to kill this country. I fear we are entering a very dark age.

  18. Partly, yes. Tim Geithner may have done some very bad things, but he’s worth reading:

    “The underpinnings of this particular boom include a large increase in savings relative to real investment opportunities, a long period of low real interest rates around the world, the greater ease with which capital was able to flow across countries, and the perception of lower real and inflation risk produced by the greater apparent moderation in output growth and inflation over the preceding two decades.

    This combination of factors put upward pressure on asset prices and narrowed credit spreads and risk premia, and this in turn encouraged an increase in leverage across the financial system.”

    He’s partly right – unfortunately, the savings were concentrated outside the US, and the “investment” was concentrated in the US, and the investment turned out to actually be consumption (e.g. housing that should not have been built). Moreoover, all of this was accompanied by a decrease in the relative growth of base money (as compared to credit), as leverage made up the difference.

  19. Later on, Geithner writes:

    “The scale of long-term risky and relatively illiquid assets financed by very short-term liabilities made many of the vehicles and institutions in this parallel financial system vulnerable to a classic type of run, but without the protections such as deposit insurance that the banking system has in place to reduce such risks. Once the investors in these financing arrangements—many conservatively managed money funds—withdrew or threatened to withdraw their funds from these markets, the system became vulnerable to a self-reinforcing cycle of forced liquidation of assets, which further increased volatility and lowered prices across a variety of asset classes. In response, margin requirements were increased, or financing was withdrawn altogether from some customers, forcing more de-leveraging. Capital cushions eroded as assets were sold into distressed markets. The force of this dynamic was exacerbated by the poor quality of assets—particularly mortgage-related assets—that had been spread across the system. This helps explain how a relatively small quantity of risky assets was able to undermine the confidence of investors and other market participants across a much broader range of assets and markets.

    Banks could not fully absorb and offset the effects of the pullback in investor participation—or the “run”—on this non-bank system, in part because they themselves had sponsored many of these off-balance-sheet vehicles. They had written very large contingent commitments to provide liquidity support to many of the funding vehicles that were under pressure. They had retained substantial economic exposure to the risk of a deterioration in house prices and to a broader economic downturn, and as a result, many suffered a sharp increase in their cost of borrowing.

    The funding and balance sheet pressures on banks were intensified by the rapid breakdown of securitization and structured finance markets. Banks lost the capacity to move riskier assets off their balance sheets, at the same time they had to fund, or to prepare to fund, a range of contingent commitments over an uncertain time horizon.

    The combined effect of these factors was a financial system vulnerable to self-reinforcing asset price and credit cycles. The system appeared to be more stable across a broader range of circumstances and better able to withstand the effects of moderate stress, but it had become more vulnerable to more extreme events. And the change in the structure of the system made the crisis more difficult to manage with the traditional mix of instruments available to central banks and governments.”

  20. In particular, I repeat one line:

    “The combined effect of these factors was a financial system vulnerable to self-reinforcing asset price and credit cycles.”

    He wrote this in June 08, when I was blithely and ignorantly assuming that that Fed would follow through on its promise to maintain price trends. Stupid me.

    What can we take away from this?

    1) The line between asset prices and money supply is blurred

    2) Since money supply helps determine real prices, the line between asset prices and real prices is blurred

    2) More leverage and smaller capital cushions make everything much much worse, and it’s all really hard to measure anyway

    3) Short term debt is really bad – low short term rates encourage leverage, and then when rates spike, access to credit is effectively cut off (and maturities are short)

    4) It wasn’t just the big banks – it was everyone (shadow banks and hedge funds included) – but only the big banks were bailed out

    5) If the big banks hadn’t been bailed out, Treasury/Fed would have been forced to figure out other ways to bail out the financial system to prevent monetary implosion.

    6) Given the speed of implosion and the relatively low existing interest rates (liming further the stimulus of downward moves), the Fed would need ways to massively and rapidly inject money into the system to compensate for the contractionary effect of a massive deleveraging wave caused by a self-reinforcing cycle of “forced liquidation” of assets at depressed prices. (Big banks just happen to be a fast way to do just that… Thus, we got “recapitalization”.)

    So by all means break up the banks, but this won’t fix all of the problem (or even most of them).

    Perhaps we need to spend a little more time figuring out how to insulate the money supply from dependence on bank credit (and thus leverage and asset values)?

    That way, banks won’t be able to hold us hostage by forcing us to endure extreme hardship in order to punish them…

    Remember this?



    “There may well be short-run costs (i.e., in ways that really hurt: lower growth, more unemployment) to properly cleaning-up and restructuring the banking system. The exact size of these costs is hard to know…”

    Unemployment is at 10.2% (under employment at 17%) WITHOUT those extra “short run” costs… Exactly what sort of costs are the electorate supposed to be willing to endure so that we can carry through on our threat to punish banks?

  21. To sum up the argument:

    We’ve willing let banks tie a rope around our necks. We might want to cut the rope _before_ we jump off the bridge.

  22. This is such typical Geithner gobbledygook. It’s absolutely painful to read. He’s a master of slathering a patina of techno-financial mumbo-jumbo over his words in order to give them an air of credibility, but invariably, he misses the critical issues.

    When you break it all down, the straw that broke the camel’s back — what really overheated housing values and extended the bubble — was Wall Street’s ability to securitize mortgages with virtually no control. This created a ready buyer (the Wall Street firms) for virtually any piece of trash mortgage that any unscrupulous (and also unregulated) mortgage broker could originate. This is where all the sub-prime came from. By making loans available to sub-prime borrowers, massive additional demand was introduced into the market, and all of those people were coached that a home was a no-lose investment. Naturally, home demand and prices went through the roof.

    At least Fannie and Freddie — the traditional liquidity channel — had lending standards. The trouble, though, is that even though they required appraisals and income verifications, there loans ended up being vulnerable too, thanks to the fact that all property values had become inflated, thanks to the excessive demand caused by flooding the market with sub-prime borrowers. Hence, a house of cards was created.

    What we need are tough lending standards and tight regulation all the way through the mortgage channel, from the point of loan origination to liquifying the mortgage. The process needs to be sealed like a drum so that no one can circumvent the regulations.

  23. “I suspect it boils down to making markets in derivative products which should not exist.”

    No, banks create money, and price levels are dependent on this money. Ideally, they create money to fund good investments. Recently, not so. But when bad assets collapse, money is still money, and bad money being destroyed drops price levels just as much as good money being destroyed.

    In regulatory terms, this crisis resulted because we outsourced our money supply to private contractors (banks) without proper oversight.

    Fox-Penner’s reco is to deploy better oversight, which is going to require smaller banks. Absolutely. Let’s do that. But let’s _also_ figure out a way to protect the money supply so that we are not forced into a dependency relationship with banks.

  24. You do realize many people blame Freddie/Fannie (and lowering of underwriting standards for minorities) for the mess – I’ve argued against this, but I’m curious what you think.

    Here’s my suggestion for sealing it “like a drum”:

    – Limit loan values (including refis) for housing to 80% of the 15 year regional moving average trend value of the house. No 20% down, no loan. The 15 year trend value will stabilize prices against speculative action, at the economic cost of “limiting investment” in new housing in high priced areas.

  25. In _Too Big to Fail_, it is evident that organizationally complex entities (I am thinking of AIG here) could not even understand their own positions.

    A scene in the book has the AIG exec committee reviewing their books to figure out how much cahs they had on hand, while an onlooker from JP Morgan calls them “amateurs” and “clueless”.

  26. Yes, I do realize that. They didn’t initiate the lowered standards, though. That was Congress and the Fed. The Fed provided specific guidance to banks and Fannie and Freddie about how to evaluate the credit of subprime borrows. (They couldn’t specifically say minority borrowers, but everyone knew that most subprime borrowers were minorities.) Although they were all asked to lower their standards, that didn’t mean no standards. The subprime loans that went through the Wall Street securitization channel, in fact, were subjected to no standards. I haven’t seen any data on this, but I would bet that Fannie and Freddie’s subprime is defaulting less than Wall Street’s. It’s hard to say, though, given that prices have dropped SO much. At this point, even high quality credits are defaulting.

    To answer your question, I don’t know for a fact one way or the other about whether Fannie and Freddie’s reduced standards added to the problem. Logically, I would guess that they did, though, given that they would have created incremental demand, and that would have had to have added to price inflation. Bringing new buyers into a market — people who couldn’t otherwise participate — shifts the entire demand curve, which means that prices, by necessity, go up.

  27. TBTF is misleading, implying these institutions are necessary for the economy and cannot be allowed to fail. The truth is their myopic interest and that of their enablers in government created oan economic failure. They did fail, Main Street is littered with shuttered businesses.
    They and their enablers then spun this tale to further load the economy. So what if they pay back their resurrection fund, the economy is still loaded with debt and Main Street is still shut down.
    Now they’re ready to start the music again. If only they didn’t have reserved seating in this game.

  28. If an entity is too big to fail thus to regulate isn’t it by definition too big to manage? If it can’t be managed why is anyone in the TBTF organization’s executive being paid – salary or bonuses?

  29. Dan,

    We’ll have to disagree.
    If economics were a real science then arguments that have been going on for a couple of hundred years would be resolved one way or t’other. Robert Skidelsky spends some time discussing this in his recent speech to the CED which is on youtube.
    By the way, I highly recommend Mr. Skidelsky’s biography of Keynes and also his new book, “Keynes, the return of the master”. I’m reading through the second volume of the biography now. Who thought that economics could be so fascinating!

  30. “If investment banks want to do it (casino banking)..then they shouldn’t be allowed to have bank charters (and thus could not take insured deposits)”

    All very sensible.

    It’s like American healthcare. The decent, sensible thing would be to adopt some form or universal health care (rather than playing insurance casino).

  31. Too Big To Fail is the wrong perspective. The issue is too inter-connected to fail. Banks and investment firms got caught in this massive game of musical chairs simply lending money to each other. To get the leverage even higher, they turned to America’s piggy bank, money market funds (via repurchase agreements). In this high stakes game, where everybody lends to each other (or bets on each others securities), when one bank fails, the others fall like dominoes. At the center of all this was every bank’s favorite bookie, AIG, which did a terrible job of balancing the bets. When the music finally stopped, the Fed stepped in and paid off all the bets.

    The solution is simple: Casino banks can do what they please, but commercial banks must not lend to or borrow from other banks.

  32. “No, banks create money, and price levels are dependent on this money.”

    I wish Tom Hickey were here to address this comment because I’m just beginning to wrap my head around some of the modern monetary theory ideas I’ve been looking into for the past four weeks or so. From what I’ve read so far though, I think that someone writing from a MMT perspective would consider the above statement to be inaccurate. MMT would hold that banks loaning out currency to each other or to consumers of financial products are only shifting money that the central bank created around, not actually creating money themselves. These are horizontal transactions, and as a matter of national accounting, the “credit money,” issued by private institutions must sum to zero. That is, no net financial assets have been created. It is only the central bank that can create net financial assets through vertical transactions. I’m not sure what implications this relationship has for interpreting the causes of last year’s financial crisis are though.

  33. The money multiplier and capital/asset ratios are related, given a fixed base money supply. Asset prices depend on higher order money, which depends on velocity. If banks slow down velocity (that is, they slow down the rate of credit creation) in order to rebuild capital cushions, prices will fall. Indeed, prices will fall _in expectation_ of this happening. The fall in asset prices affects real demand.

    In terms of banks “just shifting around net assets”, by loaning money to each other, this can easily bid up asset prices.

    Imagine bank 1 has 100 in capital. It borrows 900 by issuing bonds, and loans out 1000 to investment bank 2 to buy an Asset. The sellers of the asset then might buy $100 in new bank 1 common stock (added to its capital base) and buy $900 in more bank 1 bonds, allowing bank 1 to keep loaning it out. The limiting factors are the speed of these transactions and the original money base.

    By perpetuating this trend, the financial sector can inflate any asset in value, allowing new credit/money to enter the economy (and they have use of that credit at the cost of whatever they can issue bonds for). As this money leaks out of the financial sector, it can be used to buy other things.

    But here’s the terrible part: to keep price levels stable, the monetary authority must decrease its own creation of new money (base money).

    The technological improvements have allowed banks to increase velocity, which effectively means that they are appropriating the right of seignorage from the Federal government.

    Is it any wonder they are immensely profitable?

    But very worst part is that, because Demand is dependent on price levels and price levels are dependent on bank credit (and asset prices), the entire economy is dependent on banks UNLESS the monetary authority (Fed) has the ability to rapidly inject new money into the system WITHOUT GOING THROUGH BANKS.

    And we do – The Fed buying MBS directly, or buying US govt. debt (without increasing taxes) – is an easy way to achieve this. And one that the Fed has avoided, because it WANTS the money supply to be dependent on banks.

    And there are very good reasons for a decentralized system of credit creation (the private sector is often better at allocating investments than government), but there is such as thing as TOO MUCH.

  34. StatsGuy, thank you for your response and explanation. Your discussion of the government’s increasing reliance on private sector institutions to control the money supply is especially interesting in light a graph I recently saw at this website:

    Figure 2: “Historical Behavior of Private Sector Surplus and Government Sector Deficit as a percent of GDP,” depicts an almost perfect dollar for dollar inverse relationship between public and private sector spending. It seems that as the government takes money out of the economy the private sector is forced to react by increasing its debt load. I didn’t really understand why the government would be taking money out of the economy until your explanation here of how the monetary authority must decrease its own creation of base money to keep asset price levels stable. I’ll have to think more about this. Thanks again for the explanation.

  35. That’s the problem with mortgage lending, as is with the business model of selling healthcare insurance (besides the obvious misnomer of “insurance”) – the whole premise is based on a profit motive. The FDIC has included another layer of regulations that is suppose to keep the parties “honest” – along with Regulation Z, is Regulation X:

    Regulation X is fully disclosing the cost of credit (the mortgage + fees) if the interest rate increases beyond .125 and disclosing within three days to the borrower. The front-end loan officer should be obligated to put the consumer’s best interest first but that’s not required nor included in any mortgage contract that I am aware of. Since mortgages tend to be the biggest consumer expense, there should also be some kind of consumer education required prior to signing on the dotted line of any mortgage contract. [When the closed loan gets packaged and sold off to Wall Street, the top layer is “A” rated portfolio, followed underneath by Alt A’s and Subprime paper.]

  36. I post this annonymous commentary from Zero Hedge in it’s glorious entirety because it perfectly aligns with my most dread concerns and is delivered in far more eloquant terms:

    “by anynonmous
    on Sun, 01/17/2010 – 06:30

    From Jesse’s Café Américain

    “Could it all be a bad dream, or a nightmare? Is it my imagination, or have we lost our minds? It’s surreal; it’s just not believable. A grand absurdity; a great deception, a delusion of momentous proportions; based on preposterous notions; and on ideas whose time should never have come; simplicity grossly distorted and complicated; insanity passed off as logic; grandiose schemes built on falsehoods with the morality of Ponzi and Madoff; evil described as virtue; ignorance pawned off as wisdom; destruction and impoverishment in the name of humanitarianism; violence, the tool of change; preventive wars used as the road to peace; tolerance delivered by government guns; reactionary views in the guise of progress; an empire replacing the Republic; slavery sold as liberty; excellence and virtue traded for mediocracy; socialism to save capitalism; a government out of control, unrestrained by the Constitution, the rule of law, or morality; bickering over petty politics as we collapse into chaos; the philosophy that destroys us is not even defined.

    We have broken from reality–a psychotic Nation. Ignorance with a pretense of knowledge replacing wisdom. Money does not grow on trees, nor does prosperity come from a government printing press or escalating deficits.

    We’re now in the midst of unlimited spending of the people’s money, exorbitant taxation, deficits of trillions of dollars–spent on a failed welfare/warfare state; an epidemic of cronyism; unlimited supplies of paper money equated with wealth.

    A central bank that deliberately destroys the value of the currency in secrecy, without restraint, without nary a whimper. Yet, cheered on by the pseudo-capitalists of Wall Street, the military industrial complex, and Detroit.

    We police our world empire with troops on 700 bases and in 130 countries around the world. A dangerous war now spreads throughout the Middle East and Central Asia. Thousands of innocent people being killed, as we become known as the torturers of the 21st century.

    We assume that by keeping the already-known torture pictures from the public’s eye, we will be remembered only as a generous and good people. If our enemies want to attack us only because we are free and rich, proof of torture would be irrelevant.

    The sad part of all this is that we have forgotten what made America great, good, and prosperous. We need to quickly refresh our memories and once again reinvigorate our love, understanding, and confidence in liberty. The status quo cannot be maintained, considering the current conditions. Violence and lost liberty will result without some revolutionary thinking.

    We must escape from the madness of crowds now gathering. The good news is the reversal is achievable through peaceful and intellectual means and, fortunately, the number of those who care are growing exponentially.

    Of course, it could all be a bad dream, a nightmare, and that I’m seriously mistaken, overreacting, and that my worries are unfounded. I hope so. But just in case, we ought to prepare ourselves for revolutionary changes in the not-too-distant future.”

    Beautiful isn’t it?

  37. Yeah, good stuff. But add the expodential growth of the ‘gravy train’ of govt. money-banks, health insurers, military contractors, state pensions, prisons, education, etc.
    We need to de-centralize, re-regulate, and nurture American business.

  38. I concur…. We are witnessing The End of The American Century…. most don’t realize it, few are prepared for what it means, and our children will ask why we let it happen on our watch.

  39. Actually, the first thing we need to do is increase the power and efficacy of all regulators, and then give them the necessary tools to stop the bilking of the taxpayer. That means that the real first step is to overthrow the current government in favor of actual democracy. What we have now is a PLUTOCRACY, with our elected officials acting as the hand maidens to the economic controllers (i.e. big finance, big media, big energy, the military-industrial complex, the food industry, et al) who are gradually eroding the incomes, lives and futures of all other Americans. I am, as the country stands now, an American who loves this country, and deeply and viscerally hates what it has become. Congress and the White House do not lack courage or will, they have simply and succinctly been bought, and will not enact meaningful reform of anything.

  40. Right you are, Bayard. Although I love America with all my being, or at least my concept of what America could be, the question that I’ve been asking myself more and more is, when is my country no longer my country? When does it simply make more sense to find another country, where the beliefs are more compatible with my own?

    My ideals have stayed the same, but the country has moved out from underneath me. We have a corrupt and dysfunctional government, and most of our countrymen have more interest in playing video games than they do in their long-term well being or that of their country. At some point, the rational thing to do will be to jump ship, as our forefathers did.

Comments are closed.