Eugene Fama: “Too Big To Fail” Perverts Activities and Incentives

By Simon Johnson, co-author of 13 Bankers

In our continuing financial debate, one of the central myths – put about by big banks and also not seriously disputed by the administration – is that reining in “too big to fail” banks is in some sense an “anti-market” approach.

Speaking on CNBC at the end last week, Gene Fama – probably one of the most pro-market economists left standing – pointed out that this view is nonsense. (The clip is here, and also on Greg Mankiw’s blog; TBTF is the focus from about the 5:50 minute mark.)

Having banks that are Too Big To Fail, according to Fama, is “perverting activities and incentives” in financial markets – giving big financial firms,

“a license to increase risk; where the taxpayers will bear the downside and firms will bear the upside.”

Fama is not backing down from any of his previous strong pro-market views – as explained by John Cassidy in the New Yorker recently (the full article on the Chicago school is also good, but requires a subscription) – and we can argue about his views on the functioning of financial markets or capitalism more broadly.  When everyone is opportunistic and the “rules of the game” themselves are up for grabs – for example through lobbying based on existing and expected future super-profits (e.g., from being allowed to exercise any form of monopoly) – then bizarre and bad things can happen.

But, in any case, Fama is completely correct that,

 “[Too Big To Fail] is not capitalism.  Capitalism says – you perform poorly, you fail.”

He is also correct that “complicated regulation may be a nice idea in principle but in practice it never works”.  Regulators get captured by the people they are supposed to be regulating (as now illustrated in the oil and gas industry); this is “not unusual; it happens all the time”.

Fama has obviously considered just letting big banks fail (“I would have been for that all along”), but he recognizes that this cannot work in our political realities – governments will step in and make bail for banks when there is serious trouble.  And, as Senator Ted Kaufman pointed out in his exchange with Senator Mitch McConnell, allowing the collapse of huge banks is a recipe for turning crisis into catastrophe.

Fama argues “the only solution is to raise capital requirements of these firms dramatically,” maybe up to 40-50 percent, which is an idea we have also advanced.  It’s an interesting question whether this by itself would take the failure of mega-banks completely off the table – that would probably depend on the extent to which they were allowed to game the system, for example with risk taken through derivative positions against which they hold too little capital.

Still, Fama is thinking along exactly the right lines – and this is further confirmation that the consensus on big banks is shifting.

If implemented properly, capital requirements of the kind he proposes would essentially force the largest six or so banks today to become much smaller.  Given that capital requirements are set by regulators, who claim to be pro-market, they should take careful note of Fama’s views – and look for ways to implement a tough version of this approach.

82 thoughts on “Eugene Fama: “Too Big To Fail” Perverts Activities and Incentives

  1. That’s “reining in” not “reigning in.” Has to do with controlling a horse — or bull and bear . .

  2. Are you implying that we should “tow the line” when it comes to homonyms

  3. A capital requirement that adjusts upward with size and risk is essentially a tax – but one administered by regulators. If high enough to be effective it would make the big institutions uncompetitive and lead to their break up. But they will resist this mightily and there is no evidence the Fed would effectively enforce this requirement. Witness the Fed’s abrogagtion of the 10% deposit rule and failure to regulate fraudulent mortgage lending. Fama himself admits that regulators will get captured. If this is so, why does he advocate what is essentially a regulatory solution? So in the end such a “tax” is not a real solution. If you want to break them up, you must simply break them up, relying on the “market” to do so won’t work.

  4. No amount of regulatory reform – whether consumer protection, limits on leverage, or abolishing certain derivatives and forcing others to trade on exchanges – will fix the current banking problem or prevent future problems.

    As long as five banks make 85% the market there will continue to be market dysfunctionalities and distortions, and serious fraud and abuse.

    The solution is simple:

    1. BREAK UP THE BIG BANKS. They’re too big to fail. They’re too big too indicting. They’re too big to regulate effectively. They wield far too much power in the market and in Washington.

    2. BRING BACK GLASS-STEAGALL. There’s absolutely no reason big commercial banks, which carry explicit and implicit government (i.e., taxpayers) guarantees and borrow from the Fed at rates not available to others, should be speculating in any market.

    These two steps will fix 95% of the problem.

    There is no pro-market or economic case to preserving the current commercial/ investment bank oligopoly. It stifles competition, innovation and growth, and it concentrates wealth, power and risk – and ultimately distort free markets beyond recognition to the unfair advantage of a few.

  5. Higher capital requirements are not ‘essentially a tax’. A higher capital requirement is not at all a tax.
    Taxes are revenues collected by the government as a percentage of economic activity in order to create/maintain the hospitable economic environment in which the activity can happen.
    A rule which says you can only pretend to have 2-3 times as much money as you actually do instead of 10 or 15 or 30 times as much is not in any way a tax.

    I’m not advocating higher capital requirements as THE solution, but we should at least be fair and accurate with the subjects we debate. There are facets of the idea that demand attention, like the reduction in liquidity that would result from reduced leverage. However, a lot of the liquidity in the system is not contributing to productive or useful activity – and the question becomes: how do you get rid of the speculation and gambling instead of the investment and lending?

  6. Breaking up the five largest institutions should be the first place to go because it is the simplest solution. There is no way that the Justice Department would have allowed the consolidating mergers to go through in the first place unless there was a crisis. JP Morgan, B of A and Wells Fargo became the beneficiaries of the political reality that the government could not take over Wachovia, Bear Stearns, Washington Mutual, Merrill Lynch et al directly.

    Where I disagree is that JP Morgan with a 30% capital requirement would not be uncompetitive, it would just have much lower shareholder returns and trade at much lower multiples of earnings – more like a regulated utility with ROE caps. This would make future acquisitions for stock out of the question but they are too big already so that doesn’t matter.

  7. Pro-market economists want it both ways. The imposition of any capital requirements by the government is by definition not a free market initiative. It’s a bit like the irony of Alan Greenspan having been named to head the Federal Reserve. How could any supporter of Ayn Rand (like Greenspan was) have accepted the job that almost defines government intervention into markets?

  8. When there are fewer than a dozen (and 20 is a healthier number) roughly equal largest players constitute more than 50% of buyers or sellers in a market, it becomes dysfunctional. Those players, singly and through collusion can distort transactions and survive at the expense of the others in spite of poor management; in fact poor managers’ best strategy is to do just this since it makes a behemoth easier to control.

    The Financial behemoths should be broken up, by function (Glass-Steagal separation) and by region until no single institution constitutes more than 2% of the market. Any financial institution that reaches 1% of the market should be automatically prohibited from growing through acquisitions and mergers… the usual way behemoths are created.

    Using biological metaphors: markets provide homeostatic (distributed) decision making, which is their primary benefit. Too few roughly equal players destroys this feature and decision making becomes hierarchical and controlled for one side of the market at the expense of the less cohesive counter-parties. (Credit card companies vs individuals who use them is one example.)

    Corporations are living organisms which accumulate parasitic loads over their lifetimes: unsustainable contracts, bloated salaries and benefits, bureaucratic cultures, etc. Nature limits the average parasitc load in species by building in term limits. We need to put term limits on large, public corporations: about 70 years, with an apoptosis process for selling off assets and paying off investors in the last decade. I know that sounds like a wild idea, but consider that “size” is a space-time characteristic, not just spatial in an instant of time. Corporations were first limited to 21 years, it took several hundred years to move to our unlimited lifetime norm….. it was a mistake.

  9. Couple of comments, mostly rhetorical.
    That half of your entire plan is regulatory reform kind of contradicts ‘no amount of regulatory reform…will fix the current banking probem’; Glass-Steagall was a regulation. Unless what you mean is that rules should be clear and simple and have the power of law, instead of being obtuse and complex with ambiguous authority – then I get what you’re saying, but your initial statement sounds a lot like ‘there’s no use trying to regulate the financial system’.

    And your claim that these two steps will fix 95% of the problem makes it sound like the problem is much smaller and simpler than it is. Breaking up the megabanks now doesn’t prevent them (or other banks) from becoming megabanks in the future. There’s also the issue of how you break them up (regionally? functionally?), and under what authority (Anti trust?). I’m not decrying the steps you advocate, but there would still be much fixing to do even after them. There’s an entire opaque lending and investment market that’s larger (in paper values) than the real economy. Hedge funds, derivatives, commercial paper, and many insurance and investment banking instruments perform banking functions without being subject to banking rules.

  10. He is also correct that “complicated regulation may be a nice idea in principle but in practice it never works”. Regulators get captured by the people they are supposed to be regulating (as now illustrated in the oil and gas industry); this is “not unusual; it happens all the time”.

    Fama has obviously considered just letting big banks fail (“I would have been for that all along”), but he recognizes that this cannot work in our political realities – governments will step in and make bail for banks when there is serious trouble.

    So he’s breaking ranks with the Republican liars, while also at least implicitly calling “resolution authority” the scam and lie it is?

    Good – once one rejects those lies, while still acknowledging that TBTF is odious and must be purged, we reach the realm of possible solutions, since all that’s left is various ways of attacking size as such, pre-emptively.

    (Of course, reserve requirements can still be gamed as well, as we’ve seen with various waivers. The EU showed us how what’s supposed to be a similar kind of firm rule, no deficit above 3% of GDP, was flouted by everyone including allegedly “responsible” Germany and France.)

  11. But surely if capitalism was working properly, corporations that accumulated those parasitic loads (great phrase, by the way) would fail.

  12. David Cassidy: “I Think I Love You” etc.

    John Cassidy: New Yorker economics/finance writer.

  13. Paul Handover wrote:

    “But surely if capitalism was working properly,”

    The lunatics still the asylum.

    Moody’s CEO Says Investors Shouldn’t Rely On Ratings

    1hr ago

    NEW YORK — (AP) “The chief executive of ratings agency Moody’s says his company’s inaccurate ratings of mortgage-related investments were “deeply disappointing” but investors shouldn’t rely on ratings to buy or sell securities.

    “Moody’s is certainly not satisfied with the performance of these ratings” and is taking steps to improve its rating process, CEO Raymond McDaniel says in testimony prepared for the Financial Crisis Inquiry Commission.

    McDaniel will testify Wednesday alongside billionaire investor Warren Buffett before the Financial Crisis Inquiry Commission (FCIC). Berkshire Hathaway, which Buffett leads as chairman and CEO, is Moody’s largest shareholder.

    To tackle the conflict of interest problem, the Senate’s version of the financial overhaul would end banks’ ability to choose the agencies that rate their investments. An independent board, appointed by regulators, would choose the rating firms.

    But critics of that plan point out that the agencies would still be paid by the banks whose products they rate. That means the ratings could be influenced by those banks.” – excerpts

  14. The solution is simple

    If only that were true. The financial industry has trumped your solution with a political solution.

    Consider a Politicians point of view. If you support the banks point of view you get rewards:
    – campaign contributions
    – hiring preferences for family/friends/associates
    – invitations to cool parties and events with big shots
    – personal connections to big shots (“hey, guess who I played golf with last week?”)
    – possibility of future speaking fees
    – possibility of becoming an industry lobbyist or consultant

    If you don’t, you get only downside:
    – your opponent in the next election will be better funded
    – your colleagues will see you as a threat to the perks (as above) that they get

    The industry has hundreds of lobbyists drilling home the benefits of remaining in the fold, and the Fed and Treasury doing everything they can to right the ship so that the financial crisis becomes a thing of the past.

    So it becomes easy for politicians to be led into doubts about breaking up the big banks: maybe the problem really was the government (lax regulation, low interest rates, and home affordability), maybe some US banks do need to be big so that they compete against big banks from other countries and can be used as an arm of US policy. Maybe we can fix most of the problems with weaker reforms that don’t upend the whole system.

    Now it doesn’t sound so simple, does it.

  15. Not at all…size and increased control of market transactions compensates for parasitic loads. A weakened behemoth can still compete with an uncohesive host of smaller, healthier players. Besides, we see that “too big to fail” means that government will rescue and put the behemoths on life-support; even though they are brain dead!

    Also, what does it mean to have “capitalism” working properly? I suggest that capitalism is merely distributed power (decision making and implementation)and distributed resources to a degree that the average result of a host of individual decisions is a homeostatic balance between buyers and sellers and it is simultaneously a growing and winnowing process that continually develops and relentlessly tests present and future leaders under fire (with a great deal of uncertainty thrown in) The alternative is hierarchical, cohesive, centralized power (decision making) concentrated in the hands of a few. (The default condition of all economies prior to the Industrial Revolution) Centralized power provides tactical benefits, quick big decisions and cohesive implementation, but over time tends to degenerate; in part because it has no training and winnowing mechanisms for testing and purging weak leaders or for providing the next generation of competent decision makers. Survival and eventual leadership in an effective hierarchy comes from avoiding all risks. China recognized it had too few risk takers in the 1980’s and set up SEZ’s (special economic zones modeled on Hong Kong) as laboratories to develop them. (When I first worked in China in the 1980s, we ended meetings with memorandums of understanding…which were kicked way upstairs for decisions.. and I worked with some high level government/business officials.) Russia faced the same problem, didn’t deal with it so crooks (the only successful risk takers in a bureaucratic society)took over most of their major industries.

    I believe that one of our difficulties in evaluating the structure of the economic system is a religious belief in the wisdom of market forces as opposed to a hard headed analysis of what their benefits and limitations are. As an engineer I’ve learned one thing: all systems are the result of tradeoffs. Homeostatic and hierarchical systems (or combinations thereof) provide relative benefits and weaknesses. There is no “best system.”

  16. A question from Europe: “capital requirements are set by regulators” Can anyone explain as I had the idea
    that the top U.S banks do not apply Basel II ?
    The ECB just published its Financial Stability Report
    and claims that credit is likely to contract further
    as European banks get ready for Basel III in 2012…
    Since credit to private sector grew 0.1% y/o/y and credit to non-financial businesses declined in Europe
    as reported by the WSJ, it is thus likely to get worse..

  17. Consider an industry with exactly two participants, call them D, Inc, and R, Inc. This industry has the ability to make its own rules, to administer them and to enforce them. D and R have nearly unlimited capital – limited only from their ability to borrow from their customers – as well as the capacity to set prices through a process of overt collusion.

    Now, there is a group of observers, call them the “Justice System”, who are tasked with enforcing the rules and determining whether new rules are consistent with the original Rules of the Game as specified in the Game Instructions. These observers are chosen and approved or rejected by the employees of D and R, jointly, by a voting process specified in the original Instructions. Of course, the members of the Justice System are also D and R customers, and they have their own set of rules for membership in their club, called Rules of Conduct for Lawyers, which are administered by themselves (or, at least, by members they elect for this purpose).

    What do Game Theory, the Economics of Oligopoly and Cognitive Psychology suggest about the properties of this industry and outcomes of the behavior of its participants? Let’s ask some questions. First, which customers are most likely to be served in ways that they want to be served, i. e., which customers will walk away from the store satisfied? Second, what and how high are the barriers to entry, and what is the relationship between such barriers and the Rules of the Game? Third, who are the rules probably designed to protect? Fourth, how strong is external enforcement likely to be? Fifth, how likely are D and R to enforce the rules against themselves? Sixth, which model of human motivation governs their behavior? Seventh and eighth, how likely are such rules to change, and how likely is the structure of this industry likely to evolve and adapt to a changing environment? Ninth, to what extent will it act to protect its current structure, i. e., how many resources will be allocated to protecting its incumbent employees and institutions? Tenth and eleventh (should be farther up the list…), what constitutes equilibrium and what are the forces that drive behavior to it? Finally, what are the very-long-term survival prospects of this industry in its present form?

    In Kenya, elections are essentially tribal contests for the right to allocate goods, money, jobs and services preferentially to the members of one’s tribe. They have an expression the sums this situation up. The winning party – read “tribe”or “tribal coalition” – says, “It is our turn to eat at the table.” Are we different?

  18. “Fama argues “the only solution is to raise capital requirements of these firms dramatically,” maybe up to 40-50 percent, which is an idea we have also advanced.”

    In the same breath, if Fama were serious, he would mention that such a dramatic increase would need to be accompanied by truly epic increases in base money (well beyond what we’re at right now) to avoid a crushing dive in the price level (e.g., depression far beyond what we had in the 1930s).
    That means future increases in the money supply would be created by federal money printing, rather than bank credit creation.

    Fama would also need to address international financing issues – e.g., foreign bank lending inside the US (good luck with that one – it’s impossible, which is why everyone tries to pretend that foreign bank competition won’t matter).

    BTW, the derivatives question is not as complex to regulate as one might think. A simple rule that indicates that no bank may own a security with potential liability greater than the cost of the asset – and that even if the bank owns it, the bank is not required to pay out more than the purchase value of the asset no matter the outcome (which means no one would buy a CDS from AIG even if AIG was dumb and corrupt enough to illegaly sell one).

  19. This is the big catch-22 of the current situation; price levels now are constructs of debt finance flows. Reducing volatility and rent-seeking in the economy at one go would require massive deflation. Thus we are relegated to attempting to slowly de-Q the system without causing a sudden collapse. Talk to any engineer about trying to tune the resonance of a high-Q tank circuit and you’ll hear how exacting a process that is. Attempting to do this in a highly complex economy is probably little better than a crap shoot.

  20. I have a question from a somewhat uninformed mind.

    Would requiring drastically high capital requirement (40-50%) also have a severe negative impact on the economy?

    The costs of a “bailout” would now be on the banks instead of the tax payers, in its place we would now have to deal with all of the negative factors of higher capital requirements for banks.

    With banks now being unable to lend, would the effect on the system be close to (and possibly worse) than the economic crisis? Over time is it possible that the costs of imposing high capital (reducing of the money multiplier effect, a lack of available credit, etc) would actually be greater than the costs of the most recent crisis?

    I know that may be somewhat irrational, but considering that we’ve gone through 2 “system failures” in the past 100 years, I feel that is not too far of a stretch.

    I could be totally wrong here, so please correct me accordingly, but it was just something that always comes to my mind when too big to fail and raising of the capital requirements comes up.

  21. “Don’t rely on the ratings”…then why bother to have them?

    I’ll rate stuff, for a lot less money than Moody’s. If no one’s going to rely on my ratings, then I don’t have to work too hard on them, or back them up with any actual data…

  22. Fama says that “complicated” regulation won’t work. The question is whether calculation of capital requirements will be complicated or not. The statement “assets over $100 billion require retention of 50% capital backstop” sounds simple (at least, to frequent readers of this blog), but in reality it may not be if banks can disguise assets through creative accounting.

  23. Doesn’t rent-seeking constitute a sort of resistive loss anyway? Why doesn’t that de-Q the tank?

    I would propose more of a control systems analogy, with lots of non-linear positive feedback nodes that preclude any stable equilibrium state. But that’s a model that is a bit harder to analyze effectively.

  24. StatsGuy: What do you think about requiring holders of derivative assets to mark them at their notional value? If banks had to hold capital against that much larger value it would certainly help.

  25. Laissez-faire capitalism leads to monopoly, oligopoly, and trusts, and eventually to corporate statism, which is where the US now is. This is an existential crisis for democracy, and Americans are at the point of losing their government. Bought-off politicians are papering over the rot instead of addressing it forcefully. What we need is accountability, and people need to be prosecuted for their crimes, not rewarded with government largesse.

  26. for many of these big banks and corporations the money they spend to buy political influence probably tops the taxes they pay to the treasury

  27. Not sure I understand your simple rule. Are you suggesting that the liability assumed when selling a CDS should not exceed the amount paid by the buyer for it, i. e., that Bank A could insure a bond owned by Bank B for, say, $1 for a payment of $1 and that, should the default result in a loss of $2, that Bank A would pay out only $1 under that claim? Would Bank A profit from a default of less than $1 or no default at all whereas Bank B would recoup losses up to and including $1, or, if the default were greater than $1 bear the incremental loss, then?

    In a way, I like it. The cost of insurance would be so high that bond buyers would be more likely to invest more in improving their abilities to evaluate the quality of and monitor the debt that they acquire. After all, who would buy those CDSs and who wouldn’t sell them? Why would Bank B just set aside the $1 as a reserve? Or isn’t there already an accounting mechanism for this (reserves against bad debt/loan losses)?

    I may have misunderstood (wouldn’t be the first time)…

  28. Re: @ Charles B____Nice read – regarding Kenya, I’d like to reference a quote from Joseph Campbell (3/1904-10/1987)…”Is the system going to flatten you out and deny your humanity, or are you going to be able to make use of the system to the attainment of Human purposes?” end quote. Now getting back to the “TBTF” (Five Sister’s) that lend (note:give only?) too organization that ship american jobs overseas eg.) Apple ,Dell, Nokia, Motorola,Microsoft,,etc.,etc,! What does america get from it – but an increased deficit, and a endless army of unemployed for decades (someone prove me wrong?) too come! I ask you this? Is America going to become the next, “Foxconn Technology Group” of the (Major Manufacture/Industrial Parks – sound familar?) west? That is – will we too surround our buildings with “Suicide Nets” as they now do in Hong Kong for the subcontractors doing work for the likes mentioned above? ie.)slavelabor is how these American Companies are now percieved in the east, and its not painting a pretty picture regarding our self image. Glass- Steagall is so easy, but this government loves ambiguity?

  29. All right, stop it. It’s obvious that financial power trumps democracy. Get our kids out of the danger zone.

  30. Off topic—I was just watching Brooksley Born speaking to Warren Buffet on C-Span 2. I guess she was questioning him, although it seemed more like a casual conversation (casual but somewhat informative, I just caught the tail end of it). Then they went to questions from Peter Wallison. I just want to say that has to be one of the most dramatic drops in IQ level in the history of television camera framing.

  31. To paraphrase Bogart said in Casablanca, This could be the start of a beautiful friendship.

  32. Exactly, I agree the affect on the business cycle would be the same. Hank Paulson told Bush and Cheney he had to have the TARP or everyone in America would have been stiffed on their next paycheck because everyone providing retail and corporate banking service was effectively insolvent. No liquidity, no paycheck for Ma and Pa Kettle. The devotion to Libertarian theology quickly evaporates when the politicians see the image of Herbert Hoover rapidly approaching as their legacy.

    I would like to propose a wild and crazy idea. Let the Federal Reserve create a sliding scale for lending money at the discount window. The bigger you get the higher the interest rate you pay. Most if not all of the bubble was caused by letting the big players borrow at near zero real interest rates to play carry trade and other assorted bond schemes. I also suggest we shut down access to US financial institutions from offshore one horse towns where the sheriff is owned by the tax dodgers.

  33. This is so true, and the TBTF’s have worked their asses off to distort this very point.

    Bankruptcy, receivership, and failure are NECESSARY for the market to function:

    Flushes out bad leaders.
    Allows good leaders to arise.
    Realigns resources to productive ends.
    Prices “goods” at true value.

    So far “pretend and extend” has worked to suppress the corrections required for the market to function. The bad leaders that created and caused the economic implosion have essentially held the rest of the world hostage, demanding that they be allowed to continue to rule, or they will break the world’s financial system.

    The US will not function as a free market until the TBTF banks are broken up, the government regulators are flushed and replaced, and the deregulation that turned the market into a giant cesspool of criminal fraud is repaired.

  34. More suspicious trading and maneuvers involving the banksters and their allies at the Fed.

    In order to understand the current economic and financial conditions, one must understand the massive collusion and corruption going on. Fortunately for the bankster gang and their allies in government and at the Fed, the situation is well hidden and very complex. Thus they will get away with the pillaging until they are satiated, or the system collapses.

  35. The really interesting items get buried in dealing with consolidated numbers. In this case, look at the individual Maiden Lane LLC audited statements for 2009. Maiden lane took in cash flows from all sources of $11,394,052,000. Mostly , proceeds of sale of assets, proceeds from principal paydowns and collections of interest.

    Maiden Lane LLC BOUGHT new assets of $11,285,778,000! From whom? Maiden Lane LLC was formed to take over Bear Stearns assets that JPM would not touch. On top of that, the Fed guaranteed to intervene in assets that JPM took in that , shall we say, became impaired in various ways.

    Maiden Lane started 2009 with $30,922,347,000 of Investments, at cost, and ended the year with Investments, at cost, of $31,683,912,000. During the year ML took in payoff proceeds,proceeds of sale and proceeds of swap contracts totaling $10,326,628,000. All to buy more investments from some entity which is whom? JPM? One most conclude that the puchases were acquired from JPM because the special purpose of Maiden Lane, LLC is to sort out the Bear Stearns / JPM deal. The ” Jamie Deal”.

    The CDS contracts owned by Maiden Lane LLC yielded loss settlements for 2008 and 2009 totaling $2,489,024,000.

  36. “What we need is accountability, and people need to be prosecuted for their crimes…”

    There will be no accountability such as you describe until there are first massive public demonstrations and economy paralysing strikes, something along the lines of Budapest, 1956, perhaps. An authentic “Peoples’ Moment” such as this can then lead to the arrest, interrogation and public trial of these swine. Imagine for a moment bought-and-paid-for bacteria like Bohner or Pelosi blubbering out confessions in some huge sports stadium environment. Why there wouldn’t be an unfilled seat in the house.

  37. Fama: ” “[Too Big To Fail] is not capitalism. Capitalism says – you perform poorly, you fail.”

    Showing that Fama is not an empiricist. TBTF is capitalism is it is practiced. The heyday of capitalism was the heyday of the Robber Barons, monopolists who bought legislatures.

  38. Tom Hickey: “people need to be prosecuted for their crimes, not rewarded with government largesse.”

    I don’t know, Tom. I would be willing to supply room and board. ;)

  39. oregano: “This is the big catch-22 of the current situation; price levels now are constructs of debt finance flows. Reducing volatility and rent-seeking in the economy at one go would require massive deflation.”

    Isn’t that one reason that the gov’t has to continue deficit spending?

    BTW, wasn’t it clear from the history of financial crises that the economy would probably require continuing stimulus for at least a couple of years? If so, why didn’t people say so?

  40. StatsGuy: “That means future increases in the money supply would be created by federal money printing, rather than bank credit creation.”

    And about time, too. Why should we pay interest just to have money?

  41. Warren Buffett on Who’s at Fault for the Financial Crisis: Everyone

    06/02/10 – Daily Finance

    “Billionaire Warren Buffett on Wednesday delivered a pretty demoralizing explanation of the origins of the financial crisis before a panel that’s investigating that very issue. The proceedings’ intent was to examine the role Moody’s (MCO) — in which Buffett is a major shareholder — and the other ratings agencies played in the housing bubble. And in that plain-spoken, affable, avuncular style that he has, The World’s Greatest Investor essentially said this: We are all of us, himself included, a bunch of junkies — and history shows that markets will always oblige us with a fix…

    The FCIC is trying to figure out how the entire financial system blew up — they have a report due by the end of the year — and Buffett gave them a history lesson on market psychosis. The rating agencies — Moody’s and McGraw Hill’s (MHP) Standard & Poor’s — were no more tragically myopic than anyone else. Their analytical models had the same horrendous flaw, one shared by the entire American public, which said residential house prices can’t take a dive, and they won’t take a dive all over the country all at the same time.

    “They made the wrong call,” Buffett said. “I was wrong on it, too.

    That is the nature of bubbles. They become mass delusions of sorts.”

  42. “No man is happy without a delusion of some kind. Delusions are as necessary to our happiness as realities.”

    Christian Nestell Bovee

  43. Raising capital requirements is fine and useful, but without changes in accounting, especially with regards to derivatives, as well as the use of repos to monthly cleanse their balance sheets, the bigs will just go on as usual. After all, they can, at very minimal rates, bolster their capital whenever necessary by grazing at the FED.

    As Fama, I too wish, with all my heart, that the bigs had been allowed to collapse. Yes, it could have sunk the global banks, but then the G20, enhanced, would have stepped up and cooperated to get a worldwide recovery without banks in control of literallly the entire globe (at least all of the largest countries).

    Keep talking, Simon, someday, they will hear us.

  44. Mr. Johnson,
    the consensus on too big to fail has been there all along. Except for those bought and paid for. The only end game of this entire fiasco will be violent. it is the french revolution in the making.

  45. It seems to me that if you change the incentives, by capital requirements or taxation (or other methods) in a truly meaningful way, the big banks will break themselves up. And quickly, too.

  46. It did look kind of funny trying to get Warren Buffet to say something objective about Moodys. Why was he even there…..

  47. Re: @ Anonymous____”Who’s at Fault for the Financial Crisis: Everyone?” This is the biggest crock of “BS” I’ve ever heard, period! He’s definitely in a conflict-of-interest situation up to his gill’s, but its OK`, because he’s part-owner of our government now? This here is a classic atrophic cross-dressing phoney, a faux`naif brahma – he’s done nothing with his money since 1990 except status-quo investments. Every penny that Berkshire Hathaway invest now is in “China”, and “His” Rail-Road System, “Burlington Northern – Santa Fe” (largest in United States) in which he purchased Nov./09 for $44Bn. will run his Chinese imported goods throughout our once great country – shore-to-shore. Get this – parlay that with the “Eminent Domain Law” changes of 1998 et.el. New London,Ct.,etc. – will open up the country for his “neo-Robber-Barron Rail Road”, absolutely unimpeded by Gov’t regulation. Here’s a Quote, Buffett: “When it’s raining gold reach for a bucket, and not a thimble!” – ironically spoken at the height of the financial crisis, late 2008? He buys $5bn. warrants from GS, and $3bn warrants from GE 2008, and supposedly will make $3bn. profit. Why does he love Goldman Sachs, and GE , whose Financial (GE) Business is near collapse? Simple – their in bed with the “Fed, period! Note: Buffett’s financial fortunes jump $10bn, to $47bn. in 2009, amazing, simply amazing. Don’t let this guy fool ya, he’s a wolf in sheep’s clothing. PS. Did you notice how many times he referenced Nebraska today – the guys a bonifide charlatan. Yes, if you can’t tell by now , this guys words don’t hold water – kinda like our now defunct President?

  48. Having lost the debate on financial reform, Prof. Johnson first played Cassandra and now plays pollster, citing E. Fama to the effect that “the consensus on big banks is shifting” to a vaguely reference reformist view. If Johnson would sharpen his reference–What sorts of reform will now come true?–and give us a time line–When will the new dispensation be realized?–he could give us a valuable empirical test of his position. I would take the opposite side of this crucial experiment first by pointing out the untenable character of Johnson’s governing concept: quoting Fama, Johnson seconds the claim, “[Too Big To Fail] is not capitalism. Capitalism says – you perform poorly, you fail.” But this apothegm, handed out as self evident, broadcasts the ideological blindness shared by Fama and Johnson alike, namely, the inability or unwillingness to acknowledge that the “free market” capitalism of atomistic competition has long been superseded by the oligopolistic market of giant firms so systemically significant that their nexus with the political state (legislators, regulators, central bank, etc.) follows as a matter of course. Bailouts now must be directed to individual firms because under oligopolistic capitalism the biggest individual firms are of systemic importance. (Barry Ritholtz devoted an entire book to describing, albeit not explaining, this fact.) And “performing poorly” means playing the oligopoly game poorly, including the political end of the systemic nexus. Judging by the recent “victory lap” of Wall St. (Johnson’s bitter expression of a few days back), our oligopolistic masters have played the game well indeed. Eugene Fama built his reputation by extolling a fictional market–rational, free, transparent and omniscient–which the real oligopolists use as textbook PR when it suits their purposes. It is a pity to see Johnson falling for the PR instead of trying to understand the reality that so frustrates him and his fellow reformists.

  49. Dear Simon, James & Peter (I feel like I’m addressing the Apostles…)

    First, I agree with much of what you write.

    Second, the idea of limiting financial institutions by a % of US GDP size, or any other quantitative measure, is arbitrary and unlikely to be well-structured by policy or enforceable–especially by captured regulators.

    Third, how about simply guiding the US government do the following:

    a. Forget goading the administration to impose capital limits;
    b. Let financial institutions grow as big as they can; but,


    Institutions themselves are the best arbiter of exposure to risk and loss of corporate profits, operating capital, mystery funds, off balance sheet shenanigans and all other tangible and intangible assets these public and private institutions put at risk to grow their fiefdoms and paychecks. Let them continue to do so, but without any implicit or explicit guarantees.

    By so doing the US government will be hailed a popular hero (for those wealthy enough to be customers) by guaranteeing customer accounts; the guarantees will further ensure financial institution solvency remains in line with fiduciary responsibility and realign and refocus board stewardship and shareholder advocacy on managing and restricting corporate operating risks and upside gambits–precisely where the onus should be.

    “Well, then they should make themselves smaller!” as Nixon was reputed to have said about a bailout of “too big to fail”. And in this light the entire management class of financial institutions will be forced to self-regulate or simply fail and be swept away while customer accounts stay solvent, simply transferred to the next firm with a readiness and capacity to absorb any greater risks of managing more capital under prudent man oversight.

    PS I wish this was my idea, but it’s one of my clients; he deserves credit if you so choose to incorporate any of this thinking into your own exceptional views.

  50. Which then brings the question: why the hell isn’t that creative accounting so illegal as to make accountants lose their license and companies using them suffer massive monetary penalties?

  51. First, it’s important to keep in mind the distinction between buying protection from risk, and selling protection from risk. Derivatives cover both, and it turns out it was the selling of protection from risk that killed AIG and others.

    (Of course, AIG is in the business of selling protection from risk, so the question becomes, why is this risk not OK to sell, and other risk (life, car, etc.) is OK to sell? The answer has to do with _changes_ in volatility and cross-asset correlation.)

    If we require sellers of protection from risk to post collateral on the notional value of the derivative, then we’re basically getting rid of those types of contracts. Buffett, for example, refused to sell any more CDS-like contracts when the market started demanding this ~2006/2007. Estimates of the notional value of the OTC derivatives contracts globally vary, but some were on the order of 500 trillion dollars in 2007. (TRILLION) Many positions, supposedly, cancel each other out – but we don’t know because there is no public exchange. In any case, there isn’t enough capital in the world to cover the notional value of these contracts.

    I’m not sure what the “middle ground” looks like here. Essentially, we may need to decide whether these contracts really add value to the global economy, or do not add enough value to cover the cost of the problems they create. Right now, Geithner/Summers have come down firmly on the side of OTC derivatives adding value.

    We also need to decide whether if an agency buys protection, this protection should be able to increase the quality of the protected asset for purposes of regulatory capital quality (re Basel II). If so, we need to figure out how to deal with counterparty risk from a regulatory perspective. The simple solution is to say that protection does not affect asset quality , but have no fear, there are ways to arbitrage the regulations here (holding companies, etc.).

    So while I would favor requiring sellers of risk protection to hold collateral equal to the notional value, I can’t see this happening. It would limit sellers of protection to relatively simple contracts (like selling covered calls). And from wall street’s perspective, simple = less profit.

  52. Yes, that’s basically it, which means that the selling of protection from risk by federally insured (TBTF) banks would be greatly diminished or wiped out. Engineer27 may be right to allow risk sellers to (instead) hold collateral/capital equal to the notional value, which would limit sellers of risk protection to things like covered calls. This would eliminate “naked” contracts. We’d still need to resolve whether a purchased protection could count as collateral (neutralizing contracts), which gets back to counterparty risk on the purchased protection. Should AIG be allowed to buy protection from small Bermudan holding company, and sell higher quality protection (at a higher price), keeping the difference, when effectively the counterparty is worthless and AIG knows it?

    Honestly, it may be than any one of 4 or 5 reforms would prevent the problem: put it on an exchange (transparency), get rid of TBTF and restrict insured banks to narrow banking (moral hazard), higher capital ratios (skin in game), better ratings agencies (limiting regulatory arbitrage), etc. OR, we could implement ALL OF THEM, since any single barrier is likely to be town down in a decade. If we implement all of them, we might have another good 60 years before society suffers from collective amnesia again.

  53. About your line, “the “free market” capitalism of atomistic competition has long been superseded by the oligopolistic market of giant firms so systemically significant that their nexus with the political state (legislators, regulators, central bank, etc.) follows as a matter of course”: Well said.

    I have resisted this position as simply unlikely due to the checks and balances of competitive markets and the institutional environment that has existed since the end of WWII until now and the challenges that cartel members face when deciding how actually to cooperate among themselves (“gang that couldn’t shoot straight” assessment). The narrative of U. S. History from reconstruction until the depression of the 1930s describes the march toward the consolidation of industries and usurping of political power by the resulting oligopolies. The underlying economic principles haven’t changed. So, what has changed? The conceptual model and verbal narrative of good governance have changed. Not only are “free markets” a convenient fiction (not necessarily a bad thing for theory formation generally), but, in fact, most markets are rigged to benefit a specific group.

  54. “Higher capital requirements are not ‘essentially a tax’. A higher capital requirement is not at all a tax.”

    They are an operational tax (mandated, not necessarily best-practice)that serve as a barrier to entry and subsidize oligopolistic TBTF governance.

    “how do you get rid of the speculation and gambling instead of the investment and lending?”

    By segmenting one-size-fits-all deterministic regulation into predictable (money market), probabilistic (positive cash flow) and uncertain (negative cash flow and/or mark-to-model) regimes.

    Otherwise, Too-random-to-regulate (what proposals are trying to fix in the intermediation process) and TBTF (what is being proposed as a solution through regulation of investment products i.e. derivatives or prop trading) work in destructive opposition to each other.

    Stephen A. Boyko

    Author of “We’re All Screwed: How Toxic Regulation Will Crush the Free Market System” and a series of articles on capital market governance.

  55. Simplicity you say. Try reading part of the definition for the principle of “liquidity.” It is the Net Capital Rule’s undue concentration haircut provision SEC rule 15c3-1, subparagraph (c)(2)(vi)(M(1). The provision states that in case of:

    “money market instruments, or securities of a single class or series of an issuer, including any option written, endorsed, or held to purchase or sell securities of such a single class or series of an issuer (other than “exempted securities and redeemable securities of and of an investment company registered pursuant to the investment Company act of 1940), and securities underwritten (in which case the deduction provided for herein shall be applied after 11 business days), which are long or short in the proprietary or other accounts of the broker or dealer, including securities that are collateral to secured demand notes defined in Appendix D, 240.15c3-1d, and that have a market value of more than 10 percent of the “net capital” of the broker or dealer before the application of paragraph (c)(2)(vi) of this section or Appendix A, 240.15c3-1a, there shall be an additional deduction from net worth and/or the Collateral Value for the securities collateralizing a secured demand note defined in Appendix D, equal to 50 percent of the percentage deduction otherwise provided by this paragraph (c)(2)(vi) of this section or appendix A., on that portion of the securities position in excess of 10 percent of the net capital of the broker or dealer before the application of paragraph (c)(2)(vi) of this section and Appendix A. In the case of the securities described in paragraph (c)(2)(vi)(J) the additional deduction required by this paragraph shall be 15 percent.”

    Note over 200 words for one sentence. What is even worse is that as a junior research analyst in the NASD’s (now part of the Financial Industry Regulatory Authority “FINRA”) Department of Regulatory Policy and Procedures, I worked on the proposal that brought forth this piece of financial Shakespeare. The people who were party to the discussion were very knowledgeable regulators. They were smart and experienced, but we spoke a language unto ourselves. Translating industry jargon into Readers’ Digest simplicity is a monumental task. The “licensed” have a vested interest in preserving the status quo.

    Whenever there is complexity, there exist “uncertainty” (as differentiated from “risk””. To prevent complexity, Fama would would have to severly bound financial innovation (offshore subsidy).

  56. You have to address the investment process by segmenting one-size-fits-all deterministic regulation into predictable (money market), probabilistic (positive cash flow) and uncertain (negative cash flow and/or mark-to-model) regimes.

    Otherwise, Too-random-to-regulate (what proposals are trying to fix in the intermediation process) and TBTF (what is being proposed as a solution through regulation of investment products i.e. derivatives or prop trading) work in destructive opposition to each other.

    Stephen A. Boyko

    Author of “We’re All Screwed: How Toxic Regulation Will Crush the Free Market System” and a series of articles on capital market governance.

  57. Min,

    The federal government doesn’t print money literally, any more, except to satisfy the need to carry cash for transactions, which is a tiny part of the money supply. It’s too slow and expensive (more than interest). “Printing money” really means issuing treasury bills and notes, i. e., borrowing money from the private sector and other governments (China holds $billions of T-bills and notes, for example) and paying interest on those bills and notes. If the government issues you $1B in T-bills, no cash changes hands. An accounting entry on the government’s books is made: debit cash, credit liability; and, a corresponding entry is made in your books: debit asset-T-bills, credit cash. Money is not created with this transaction, but it is created when the government issues more T-bills to get money to repay you in 90 days, when your T-bills have matured or when they roll over the T-bills you bought by exchanging new ones for ones you bought, initially. You forked over $1B, which the government spent to operate, then, instead of paying you back, they simply extended the loan maturity (issued new bills). Of course, they do this regularly to fund themselves. If you wanted your cash, instead, they would simply get it from me the same way they got it from you. Either way, the federal government pays interest.

    To create money via credit creation, the federal reserve has three ways: reduce bank capital requirements, reduce bank deposit ratio requirements or lend banks money (make more credit available from the Federal Reserve Bank – most banks borrow daily from each other or the Fed to satisfy capital and deposit requirements).

    If the capital requirement were reduced from 15% of risk assets to 10% of risk assets, a bank with $100M in capital could increase outstanding loans (risk assets) from $667M to $1,000M, an increase of 50% by lending more money to consumers, businesses or governments (by buying T-bills, for example), who take that money and spend it or save it, thereby increasing the amount of money in circulation by the amount they spend.

    This increase is multiplied when you deposit your money in your account. Here is where the deposit requirements play a role. Your bank, then, lends, say, 90% of it to me. I deposit it in my account and my bank lends 90% of that money to someone else and on an on until the banks have loaned out your deposit 10 times (90% + 81% + 72.9% + … =10, i. e., the limit of the series equals 10). If the Fed reduces the deposit requirement to 5%, then, your bank can lend 95% of your deposit to me, 95% of my deposit to someone else, etc until your original deposit has been loaned out 20 times. From the original $1B deposit you made, the Federal Reserve Bank used the capital requirement rules and/or the deposit ratio requirement to multiply the money supply by 20 times the increase in lending capacity due to the reduction of the capital requirement, i. e., by 1.666… x 20 or about 33 2/3 times. No matter what, the taxpayers pay interest, unless we print the money, which is even more expensive and takes incredibly longer to circulate (via credit creation and direct government expenditures).

    If nobody wants to borrow your money from your bank, then no money is created. If the capital requirements are reduced and nobody borrows more money from the banks, then no money is created. Or, if I borrow the 95% of your deposit that I can borrow, I could simply leave it in my account as a reserve (not likely!) or buy stocks or bonds (or CDs or T-bills), none of which results in the creation of new money. Credit creation is not a sure fire way to increase the money supply. Since there always (or appears to be always) a market for securities issued by the US, issuing debt is a sure fire way to increase the money supply.

  58. Thanks. I agree that “all of them” is more likely to form a stronger bulwark against erosion. It’s kind of like preserving a beach by erecting sea walls and jetties, planting or encouraging and protecting vegetation and dunes, regulating usage by number and activity kind (with enforcement) and limiting construction along the waterfront. It’s costly, but it’s safer and the beach will last a lot longer.

    As I see this entire mess, derivatives originated as risk mitigation tools and structured asset pools (securitized loans) originated as liquidity management tools. To reduce risk, one must sacrifice expected return (no free lunch or any meal, for that matter). Economic return is easy to understand and the theory of economic return is mostly settled. Risk assessment, however, remains an unsolved problem (maybe a “mystery” in the Chomskyan sense). Investment bankers have turned this unsolved problem into a casino game in which the vast majority of transactions are motivated by goals that are completely independent of the original purpose of the securities themselves. Similarly for securitized loan pools, where the casino-like nature of derivatives

  59. Yes. Money trumps policy. The belief that “what’s good for me is good for all” drives the dominant narrative, which is a naive, self-serving and inaccurate representation of the ideas of Adam Smith. The “invisible hand” doesn’t always produce the optimal outcome. In certain kinds of markets this belief actually results in wasteful investment and suboptimal allocation of resources.

  60. I agree with your analysis and think it would lead to financial instution LBOs by offshore competitors.

    On the other hand it would provide the anti-capitalists with a new target to rail against that was regulatorily enabled by the unintended consequences of their regulation.

  61. StatsGuy – good comment.

    You state; “Of course, AIG is in the business of selling protection from risk, so the question becomes, why is this risk not OK to sell, and other risk (life, car, etc.) is OK to sell?”

    Consider: was this risk or uncertainty that was being sold. If “uncertainty,” how do you govern indeterminate investments with one-size-fits-all deterministic metrics?

    “The answer has to do with _changes_ in volatility and cross-asset correlation.)


    Cross regulating with non-correlative information results in a dysfunctional, discontinuous function. If Citigroup’s one-size-fits-all financial supermarket was a flawed model, can SEC govern with a one-size-fits-all regime? If you can’t cross-sell, you can’t cross-regulate with non-correlative information (discontinuous function.

  62. Capital requirements would seem to be a way to avoid the bigger issue – that is, how to wind down non-bank financial institutions or TBTF quasi-banks in an orderly fashion, something akin to normal bankruptcy. The capital cushion seems more like a way to try and ensure against insolvency, so that no big bank would EVER fail. But that is a massive distortion in itself, and also defies logic that these companies could be run in perpetuity without ever encroaching upon failure.

    In the event that a single one of these TBTF institutions still figures out a way to blow itself up – even with higher capital requirements (less leverage) – the problem then begins again: How do we handle disorganized failures without a restructuring policy akin to bankruptcy?

    I know Bernanke has discussed resolution authority, but it seems to be on the backburner at best.

  63. Edwin wrote, “Russia faced the same problem, didn’t deal with it so crooks (the only successful risk takers in a bureaucratic society)took over most of their major industries.”

    Which takeover in Russia by “crooks” are you talking about – killing the Czar, or Putin throwing a cocky, privatizing OILgarch into jail…?!

    Kinda like in the USA – when there are only “bad guys” doing it all, doesn’t that mean that the “bad guys” are actually the “good guys” by “default”…?

  64. Edwin wrote, “Russia faced the same problem, didn’t deal with it so crooks (the only successful risk takers in a bureaucratic society)took over most of their major industries.”

    Which take-over in Russia are you referring to? The killing of the Czar, or, Putin throwing a cocky “private-i-czar” of oil into jail?

    By default, when everyone is a bad-guy, that means they’re also the good-guy.

  65. HI, Charles.

    I am aware that “printing money” is a metaphor. :)

    Charles: ““Printing money” really means issuing treasury bills and notes, i. e., borrowing money from the private sector and other governments (China holds $billions of T-bills and notes, for example) and paying interest on those bills and notes.”

    But I don’t think that is the metaphor. I think they mean when the Fed buys treasuries, AKA “monetizing the debt”.

  66. There are other ways of “printing money”, which are not in use now. Doing so would not add to the national debt. We would not have to pay interest on it, and people would not worry so much about the debt and deficit.

  67. From Friday’s FT:

    “Interacting with concerns over the pace of reform is the fact that Europe’s banks still have huge capital requirements. Their core “tier one” capital ratios – essentially shareholders’ equity plus retained earnings – vary from country to country. But they are generally well below what the market is likely to demand after the Basel Committee on Banking Supervision – which formulates supervisory standards and guidelines for the global banking industry – finalises tough new requirements designed to head off another crisis.

    In addition, the Basel proposals on liquidity include a new “net stable funding ratio” that requires banks to keep a minimum level of long-term funding relative to their assets. Analysts at Barclays Capital recently estimated that this would leave Europe’s banks with a funding shortfall of as much as €3,000bn. Adding to concerns is the hundreds of billions of euros in bank debt that will fall due by 2012 and will not be nearly as easy to refinance, as the ECB pointed out in its stability review…

    The general consensus is that, while several of the individual proposals might be a step in the right direction, taken in concert they threaten to choke off a still fragile economic recovery, sharply curtailing banks’ ability to lend to struggling corporates and limiting their profits to unsustainably low levels.

    For example, analysts at Barclays Capital recently observed that under the draft proposals for bank capital requirements put forward by the Basel committee, Crédit Agricole’s “core” capital ratio – based on its level of shareholders’ equity and retained earnings – would fall from about 8 per cent to zero.”

  68. Only if Greenspan’s purpose was to de-regulate as much as possible.

    de-regulation = no laws = anarchy

    there were other Reagan and Bush Jr. appointees who were avowed anarchists (i.e. de-regulators)

  69. Governance is not an on-off proposition. It balances shareholder rights:

    Capital market commands
    1. Principles (Fairness, Liquidity, Integration, Transparency, and Efficiency, and
    2. Rules (codified best-practices) in support of principles e.g. the net capital rule codifies the liquidity principle

    with shareholder responsibilities (incentives for pricing and practices).

    Otherwise, you subsidize either public sector rent-seeking or private sector free-riding.


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