By James Kwak
Jon Macey is no friend of regulation. In 1994, he wrote a paper titled “Administrative Agency Obsolescence and Interest Group Formation: A Case Study of the SEC at Sixty” arguing, in no uncertain terms, that the SEC was obsolete: “the market forces and exogenous technological changes catalogued in this Article* have obviated any public interest justification for the SEC that may have existed” (p. 949). This diagnosis was not confined to the SEC, either.
“The behavior of regulators in [the financial services] industry is due to exogenous economic pressures that, left alone, would result both in major changes in the structure of the financial services industry and in the need for regulation. However, these economic pressures threaten the interests of bureaucrats in administrative agencies and other interest groups by causing a diminution in demand for their services and products. In response to these threats, pressure is brought to bear for ‘reforms’ that will eliminate the ‘disruption’ caused by these market forces.
“The net result of this dynamic is as clear as it is depressing. One observes continued government intervention in the financial markets long after the need for such intervention has ceased. Such intervention stifles the incentives of entrepreneurs to devote the resources and human capital necessary to develop new financial products and to de- velop strategies that assist the capital formation process by helping markets operate more efficiently.”
So what does Jon Macey think of big banks?
In a new Feature** in the Yale Law Journal, Macey, along with James P. Holdcroft, Jr., argues that banks should be broken up into pieces no bigger than $3 billion. According to Macey and Holdcroft, the basic problem is that the government cannot credibly commit not to bail out too-big-to-fail banks in a crisis. Or, more precisely, the only way it can commit not to bail out TBTF banks is to break those banks up before the crisis hits. Their proposed limit is 5 percent of the FDIC Deposit Insurance Fund, which itself is 1.15 percent of total insured deposits, so the limit would work out to $3 billion as of 2010. (Actually, that limit would apply to bank liabilities, so you could have a bank of any size you wanted, as long as the rest of its capital was equity.)
So, according to Macey and Holdcroft, the most notorious proposal of 13 Bankers — limiting banks to 4 percent or 2 percent of GDP (about $540 billion or $270 billion), depending on their function — was far too timid. While we would have broken up six banks, the Macey-Holdcroft proposal would break up over two hundred.
There is no inconsistency between this proposal and Macey’s general skepticism about regulation. What he is skeptical about is the government’s ability to precisely engineer desired market outcomes. Instead, what he prefers is a simple rule that makes possible free market competition without the distorting effect of implicit government subsidies: “Our proposed approach does not require any restrictions on activities of banks or on the location of those activities of any kind. Our only restriction is on the size of financial institutions.”
Of course, the chances that the government will break big banks into $3 billion pieces is no greater than the chances of those banks being broken into $270 billion pieces. What Macey and Holdcroft really demonstrate is the logical outcome of a free-market approach to the financial system. What is strange, by comparison, is the bizarre alliance of pseudo-technocratic centrists and anti-government conservatives supporting today’s behemoth banks.
* I have no idea why every law review article refers to itself as an Article. As I learned it, capitalization was only for the names of unique things, not for any old referent to a unique thing. Obviously “this Article” refers to a unique article, but so does “this cupcake” in the sentence, “Do you want to eat this cupcake?” and we don’t capitalize “cupcake.”
** Don’t ask.
The Baseline Scenario 
RETHINKING THE ENTIRE SYSTEM APPEARS TO BE A GLOBAL CONCERN THAT MAY BE CATCHING ON. THE IDEA THAT ECONOMIES ARE TBTF AND NOT THE BANKING UNITS THAT SERVE THEM IS, PERHAPS, THE NEW PARADIGM:
http://rwer.wordpress.com/2011/04/26/imfs-welcome-rethink-on-capital-controls/
IMF’s Welcome Rethink on Capital Controls
April 26, 2011 Kevin P. Gallagher
“In February 2010 the IMF changed its stance on capital controls because IMF economists’ own analyses found that, over and again, when developing countries used capital controls, they worked. Indeed, the IMF found that those nations that used capital controls were among the least hard-hit during the crisis.
In a nutshell, the newest IMF report on controls does three things. First, it shows how post crisis capital flows to developing nations have been dominated by volatile portfolio flows and have therefore been destabilising, and that some nations resorted to capital controls to cope with those flows, with some success. Second, it importantly proposes a new nomenclature for capital controls, referring to them as capital flow management measures (CFMs). Third, it puts forth a set of guidelines for when nations should (and should not) deploy such measures and what form CFMs should take.”
FULL ARTICLE :
http://rwer.wordpress.com/2011/04/26/imfs-welcome-rethink-on-capital-controls/
How bout we break up every bank in the world into no more than $100M chunks, make sure they have at least 20% reserves, keep them away from the stock and other filthy markets, and watch them carefully to be sure they’re not colluding and up to no good. If we need banks at all, that is. Which we don’t.
The distinction between regulation and breaking up is precisely the difference that divided Progressives at the beginning of the last century. Teddy Roosevelt favored regulated monopolies while Taft and Wilson wanted to bust the trusts. (I realize that’s a gross oversimplification, but, hey, its what we teach undergraduates!)
@Bruce:
This is the unstated point of Per Kerkowski’s recent video on this website. Banks’ purpose is to support stable economies; but our current financial regulatory system only promotes the continued existence of banks and banking power. But to reduce the potential for mischief by banks, we not only have to have Solomonic regulators but have to reduce the size of the world economy to wean ourselves off of the debt-based system we have allowed ourselves to create in the pursuit of growth.
Before I read their article, I have to ask if they think $3B is really a practical size for our largest banks? We have had the FDIC resolve some very large banks (WaMu, Colonial – you might even put Wachovia in that). Those resolutions, however, required a larger bank to take over the operations. So while $30B banks are not systemically risky, or even $300B banks not systemically risky, that hinges on the existence of larger banks to take over their operations. Indymac was resolved without an explicit buyer at the time of FDIC action.
If you limit banks to $3B, how do you resolve a failure? Another $3B bank can’t immediately absorb it (the preferred FDIC resolution mechanism).
Is $3B a practical size? How many $100k depositors can be served by a $3B bank? 30k. How large a network could that bank support? So you travel from FL to NY. What would the odds be that you’d have one of your bank atm’s there? That could be solved by more universal, utility-like and less bank-owned atms.
It they’re only talking liabilities, it sounds like they just want better capital ratios, which in the laissez-faire world are unnecessary and intrusive regulations.
Governments can resolve any size bank. However, as their size increases the cost and collateral damage increase exponentially. Bank resolution, FDIC included, is a form of insurance. The riskier and more costly the fix, the more insurance should cost. So you set FDIC fees progressively. The larger banks pay a higher % of deposits as the insurance fee. At some point the cost of insurance would reduce the size of banks. This doesn’t address non-banks (AIG) or non-depository institutions (Lehman), but there should be similar ways to address them.
Blame it on the Bluebook, or law reviews’ internal citation guides. One explanation is that “articles” and “notes” (student-written articles are termed “notes” and follow the same capitalization rules) are legal documents that authors might write about, so distinguishing them from a self-referential use of “article” or “note” can be helpful.
Ex.: The note bore a usurious interest rate. This Note argues against allowing such an injustice.
Mmm, I would favor a scheme where the more a bank was worth, the more it would have to pay to a federal agency as insurance…or as a tax. if the fee grew exponentially with a bank’s balance sheet, then this would be a serious drag on bank size and tend to “push” towards smaller banks that didn’t have to carry such an insurance “load”.
The rate could be tweaked to give a “soft” ceiling to bank size. This would probably be simpler than enforcing any given “hard” limit…and it could pay for itself.
Why don’t Libertarian/Laissez Faire zealots realize the obvious: that their ideology leads invariably and unavoidably to monopoly and plutocracy? Or perhaps they do…
Libertarian/Laissez Faire assume that *any* government intervention, even breaking up banks or applying hard size limits, is worse then *any* “free market” solution. There is an implicit assumption that the markets will correct themselves. But then “free market” to them assumes zero government intervention at all.
One assumes that white collar crime would still be illegal, but one wonders.
There doesn’t seam to be a realization that in that market correction process people who had nothing to do with the banks and did nothing illegal or even unethical get hurt the most. aka, the bottom ~90% of income earners.
Had all the banks been left to fail on their own, which is what Libertarian/Laissez Faire zealots wanted a few years ago, we’d be in the Greatest Depression right now….
Frankly, I like the idea. Hard limits make it difficult to lobby your way around it. Though I can see there would need to be some tightening of accounting rules and audit practices to ensure there isn’t a brand new re-definition of “equity” though. Don’t want a Enron/Worldcom fiasco in the banking sector (though that may have been what happened – re: the recent Goldman report last week….)
We have a government that is too weak and conflicted to force the recall of bad hamburger let alone save capitalism from itself.
Two comments:
1. In this day and age, why are there necessarily economies of scale with big banks? Why not have all the banks make their systems largely interoperable, so customers can do business with their banks anywhere and any time over the internet. There’s already a lot of interoperability because of the Fed wire systems and ACH. The computer systems and the internet ought to be able to reduce transaction costs substantially (isn’t that in part what the fight about credit card merchant charges is about?). Then small banks would be able to compete in a lot of areas worldwide.
2. I don’t know if $3B or $300B is the right size. But instead of imposing capital controls, why not control the amount willing to be provided for bail-out purposes and let the market control the capital levels. For example, suppose FDIC or whatever foreign equivalent regulator determines that it will only insure deposit accounts up to $x00K per account/person and $yB aggregate per institution, and there are no other explicit or implicit guaranties. Informed investors will then determine how much they are willing to deposit, lend or otherwise invest in a financial institutions based on how they evaluate the risk. Lenders and equity investors will demand a rate of return commensurate with the perceived risk. Leverage will become more expensive and financial institutions will have to increase equity capital to keep the interest rates they pay down. The biggest institutions will have to break themselves up if they want to attract sufficient investment for whatever they want to do.
LMB – did lenders & equity investors evaluate risk very well prior to 2008? What makes you think they will do better this time?
LMB,
“why not control the amount willing to be provided for bail-out purposes and let the market control the capital levels.”
Because what you suggest is impossible. When financial and other commercial institutions become over-large–whether it’s WalMart or Goldman Sachs–they wield tremendous political and economic power. The only way to control monies made available for bailouts (or corporate welfare, tax “incentives,” transfers of public lands, exercises of imminent domain for private profit, etc.) is to limit the size of the players.
LMB –
I can’t see how relying upon “informed investors” assessment of risk would solve the problem, either. Particularly when you ask retail customers to acquire a level of sophistication in finance that they would be hard pressed to reach and would not have the time to acquire in any case. Applying this expectation to individuals in all areas of their endeavor would leave little time for productive work.
Ian, “There doesn’t seam to be a realization that in that market correction process people who had nothing to do with the banks and did nothing illegal or even unethical get hurt the most. aka, the bottom ~90% of income earners.”
There is absolutely no proof to the contrary, and tons of proof that that was exactly the “plan” all along – get everything from the bottom 90%!!!!
There is no proof to the contrary – none.
I said what’s below to regulators during a workshop in the World Bank, in May 2003, when Basel II was being discussed. This should lend me some credibility when I tell you that much more important than to break up banks is to get rid of the hormones that make them grow so much, so that we do not break up one unsolvable piece into hundreds insolvable pieces.
“There is a thesis that holds that the old agricultural traditions of burning a little each year, thereby getting rid of some of the combustible materials, was much wiser than today’s no burning at all, that only allows for the buildup of more incendiary materials, thereby guaranteeing disaster and scorched earth, when fire finally breaks out, as it does, sooner or later.
Therefore a regulation that regulates less, but is more active and trigger-happy, and treats a bank failure as something normal, as it should be, could be a much more effective regulation. The avoidance of a crisis, by any means, might strangely lead us to the one and only bank, therefore setting us up for the mother of all moral hazards—just to proceed later to the mother of all bank crises.
Knowing that “the larger they are, the harder they fall,” if I were regulator, I would be thinking about a progressive tax on size. But, then again, I am not a regulator, I am just a developer.
Conspiracy? When we observe that large banks will benefit the most with Basel II, through many risk-mitigation methods not available to the smaller banks which will need to live on with Basel I, and that even the World Bank’s “Global Development Finance 2003” speaks about an “unleveling” of the playing field for domestic banks in favor of international banks active in developing countries, I believe we have the right to ask ourselves about who were the real negotiators in Basel?”
@ Per Kurowski
Absolutely Brilliant! :-))
@earle.florida Many thanks, though it is a yes and no.
After that I was never ever invited back to speak about financial regulations, during or after my term as an Executive Director of the World Bank… while other who said absolutely nothing, when they should have, are now regularly invited as famous Monday morning quarterbacks.
Bad information leads to flawed price discovery that creates “vapor assets”. Recall the S&L meltdown, where the indeterminate “asset” on the books of many insolvent S&Ls was “regulatory goodwill” – the regulator’s reward for acquiring an even more insolvent thrift. Who could have foreseen the Resolution Trust Corporation’s (RTC) liquidations that occurred when minimum reserve requirements became illusory in a setting where capital consisted of vapor assets?
Collateralized debt obligations (CDOs) and credit derivative swaps were the subprime boom’s vapor assets where no-money down, NINJA mortgagors were given property rights in order to enable questionable securitizations at even more questionable AAA-ratings prices to take place. But when the bubble burst, “questionable” became “improbable” as deterministic metrics lacked robustness to manage indeterminate investments.
Complexity begets uncertainty. How do you govern uncertainty with one-size-fits-all deterministic metrics? Unless and until the legacy governance regime is segmented into predictable, risky, and uncertain domains, the undesirable trend of larger and more frequent economic boom-busts will continue.
If you want change, you must be prepared for real change by addressing effectiveness issues. Trying to make a broke system more efficient merely exacerbates the process. The so-called banksters will win the definitional war as to what vapor assets define capital.
Sorry omitted last line from above comment.
It is not TBTF accounting scale but TRTR (too-random-to regulate) operational scale that is the independent variable.
Thanks for the grammatical clarification, cupcake.
Eh?
I find this whole ‘it’s impossible to regulate financial markets’ thing ridiculous. It seemed to be working pretty well between the Great Depression and the 80s…
The idea that financial markets should be unregulated is bad economics. Financial markets are simply places where people trade property rights on goods from which they hope to extract rent. They aren’t the same as ‘normal’ markets where people consume things; price signals mean nothing. Allowing rentiers a free for all is no sort of solution at all.
@ Cahal “Allowing rentiers a free for all is no sort of solution at all.” AGREED! The lack of governance begets anarchy. But you need to differentiate regulation from rule-writing.
Rules are codified best-practice procedures that define operational efficiency. Where were the best practices in SOX or Dodd-Frank? Rule-writing is the proscriptive description of an undesirable situation. It does not necessarily produce a net benefit but has become conflated as the same as governance. Rule-writing is ad hoc policymaking that Band-Aids over the current problem. It expects buy-in from society by describing the undesirable situation and prefacing it by saying “don’t do this.” Former SEC Secretary Jonathan G. Katz commented, that when “the SEC adopts a rule, it believes it has solved whatever problem it is addressing. … The solution is to rethink the rulemaking process. Instead of assuming, as lawyers do, that rules are self-effectuating, the SEC should adopt a scientific approach.”
@ Cahal: “I find this whole ‘it’s impossible to regulate financial markets’ thing ridiculous”
You are absolutely right. The problem was that the regulators instead of regulating, among other for the risks that are NOT perceived, arrogantly assumed the role of risk-managers and started to throw their risk-weights around.
I made a reference to a risk-management workshop for regulators above. Well, on that occasion I also told them:
“We can already begin to see how Basel II is forcing bank regulators to make a real professional quantum leap. As I see it, you will have a lot of homework in the next years, brushing up on your calculus—almost a career change. But, my friends, there is so much more to banking than reducing its vulnerability…”
All I know is that nearly three years after the crash that tore down our economy, our financial sector is as rickety and as systemically risky as before – if not even more risky due to all the consolidation we saw in 2008. Should any one bank fail (Citbank, BoA?) today, it will likely be bailed out.
I have no idea what the solution is. But allowing banks to remain under-regulated and over-leveraged is a recipe for another disaster.
[And just what do we gain by having all of our investment banks classified as bank holding companies?]
@Main Street Muse: “All I know is that nearly three years after the crash that tore down our economy, our financial sector is as rickety and as systemically risky as before.”
You wish! It is even more rickety and systemically risky as before. How could it not be that way when regulators have not even acknowledged the mistake of giving double considerations of the credit ratings and building Basel III correcting for that mistake instead of correcting the mistake.
@Main Street Muse: “I have no idea what the solution is”
Well I know for sure that they, as any sensible regulator would need to do, have to start by defining what is the purpose of our financial system, and only when they and we have agreed on that, proceed to regulate… meanwhile it is pure regulator lunacy.
@ Cahal
“It seemed to be working pretty well between the Great Depression and the 80’s…”
Let’s see…(1938 – mid 80’s is the nearest time line, post Great Depression I would dare split quatrains, without checking my history books) post WWII brought prosperity for twenty years plus, bankrolled by Europe and Japan’s Reconstruction. The next twenty years plus were bankrolled by the Korean, and Viet Nam wars. How can that be, and why? Unlike today where War’s become an eventual drag on the economy, an lower GDP. Remember, back then our fledgling “Military Complex Machine” was just beginning to find its sealegs, while flapping a tailfeather? These (years) basically were the renaissance years for unprecedented ‘adulthood’ growth in all defense industries, and it was good!
Along comes “StarWar’s Ronny” and initiates, “Let Freedom Ring” taking down all barriers {and walls[?]} of entry for free market capitalism and the eventuality of slip sliding away, had begun. Indeed history and timely circumstances added to the mystique of that time period, but people back then had seen the world turned literally upside down because of the advent of the “Nuclear Family” which for a period made the “collective all” to rationale the inane capability of policing responsibility their own future.
What has happened since is pure laziness, complacency, and arrogantly dangerous, the contracting out of our patriotic rights and duties as a society once made up of a conscientious, think-alone and stand-on-your-own, proud individuals!
And I would phrase it this way:
In the land of the brave and the home of the free, the banks were tricked by the Basel Committee to cowardly head for mostly unproductive triple-A rated land, and forget what they were all about… like to forget lending to the rugged risk taking individual who are behind any “risky” small businesses and entrepreneurship.
http://www.theaaa-bomb.blogspot.com/
@ Main Street Muse “I have no idea what the solution is. But allowing banks to remain under-regulated and over-leveraged is a recipe for another disaster.”
The answer is to segment one-size-fits-all deterministic governance into predictable, risk, and uncertain domains for better informational management
To illustrate, there were three corruptive information errors that were causal to the subprime crash and required a greater regulatory effort:
1. Mischaracterization of no-money down, NINJA—an acronym for “No Income, No Job or Assets,” mortgage-backed securities (MBS) that conflated risk and uncertainty to misprice subprime debt as AAA.
2. Misuse of wrong tool (e.g., using hammer to drive a screw) where owners gave property rights to renters that created perverse foreclosure incentives.
3. Misapplication of correct tool (e.g., using hammer handle to drive a nail) where uncertain (lack cash flow and mark-to-market valuations) MBS portfolio tranches improperly used the standard deviation as a measure of variability. Attempting to hedge noncorrelative assets minimizes the value of both resources as the reliability of price information is corrupted.
Conflating risk and uncertainty creates informational anomalies that exacerbate diversions from fundamental value.
@ Per Kurowski “ like to forget lending to the rugged risk taking individual who are behind any “risky” small businesses and entrepreneurship.”
Entrepreneurs face “uncertainty” in terms of unknown cash flow and unknown product demand (see The Engine of Economic Growth, http://t.co/f1bISzK ).
@Stephen A. Boyko “The answer is to segment one-size-fits-all deterministic governance into predictable, risk, and uncertain domains for better informational management.”
And who is going to do that? You? Are you sure the boundaries between predictable, risk and uncertain domains are so clear that you will be able to do that?
And even if we could do that why would we want to discriminate based on risk when in fact the least risky could be the least productive and the more risky the most productive for the society?
@ Per Kurowski
It is easy to do with “uncertain” brightlines differentiators of lack of cash flow and lack of mark-to-market valuations. You either have or have not cash flow and a market valuation. To do otherwise, by conflating risk and uncertainty, enables no-money down, NINJA—an acronym for “No Income, No Job or Assets,” subprime mortgage-backed securities (MBS) to be mispriced as AAA debt.
If, as you say, both ” small businesses and entrepreneurs” are risky, then why can small businesses get a cash flow loan in debt while entrepreneurs have to raise equity via private placements?
If you advocate change, then provide real change; not more or less of the existing system. If there is complexity, there is uncertainty. Why do you advocate regulating disparate items as the same?
@Stephen A. Boyko “If you advocate change, then provide real change; not more or less of the existing system. If there is complexity, there is uncertainty.”
I do argue for a lot of change, nothing less than the total scrapping of the main pillar of Basel Regulations.
For more than a decade now I have argued that regulators are not there to be risk-managers, and so that we should have one single capital requirement for all bank lending. Sincerely I cannot think what could be less complex than that!
Yours segmenting that into “predictable, risk, and uncertain domains” does sure not sound like something less complex.
@ Per Kurowski “Yours segmenting that into “predictable, risk, and uncertain domains” does sure not sound like something less complex.”
It is reality, why do you insist on trying to regulate indeterminateness with a one-size-fits-all deterministic system?
How has that been working as the size and frequency of economic crashes has become greater?
By conflating risk and uncertainty you are pouring gasoline on governance fires!
@Stephen A. Boyko “why do you insist on trying to regulate indeterminateness with a one-size-fits-all deterministic system?
You want the truth?
Because I do not trust Stephen A. Boyko or anyone else for that matter to tell me what is predictable, what is risky and what is uncertain, in a world where I know that all those ingredients are present, in different degrees shape and forms, in whatever we do. Not an ounce more than I would trust the credit rating agencies to tell me what is risky or not.
You are an honest person Per Kurowski.
But you would bound the capital market governance to your personal experience? Is this your model for success? How do you manage change?
Furthermore you never answer the question of how do you govern uncertainty with OSFA deterministic system. How do you manage to change the existing legacy system?
@Stephen A. Boyko “But you would bound the capital market governance to your personal experience? Is this your model for success?”
Success, of course I cannot guarantee but let me assure you that what I propose is as far as it can be from binding the capital market to my personal experiences. What I am proposing is setting up some simple and not confusing prudential limits, and then let all of the markets billions of personal experiences play out.
From what I see, what sets us apart is not so much disagreement about what happened but on the way forward. In this respect I at least have no interest in looking for my turn to scheme and meddle with the market… I do not feel duly equipped to do that and neither do I believe others are.
Correction: “innate capability” (*not inane)
No excuses other than I was working on my first cup of morning tea:-))
@Per “What I am proposing is setting up some simple and not confusing prudential limits, and then let all of the markets billions of personal experiences play out.”
Agree.
Sort of like how oxygen and hydrogen combined their “ism” and “ist” to make water (greatest good for the greatest number)
Maybe one day banksters won’t be dumber than a molecule….?
@ Per Kurowski
“Beyond Rumsfeld” (see: http://taffywilliams.blogspot.com/2011/04/beyond-rumsfeld-by-stephen-boyko-and.html ) provides a primer to differentiate “risk” from “uncertainty.” These points will be amplified in a forthcoming blog entitled “Change” that differentiates risk from uncertainty in the real goods and service sector and the financial sector. Many of the issues that we discussed will be explained in greater detail in this blog. Stay Tuned!
@Stephen A. Boyko “blog entitled “Change” that differentiates risk from uncertainty”
For the umpteenth time we know what the difference is. What we do not know is how you can predict the difference… and how to use those predictions.
For instance if they are predictable, who is going to use them the banks, the market or the regulators? I mean so that you do not repeat the current mistake of having both banks and regulators use the information in the credit ratings… so that these are considered excessively, which of course leads us down the wrong path.
By the way was the fact that credit ratings were fallible, something predictable, just a risk, or something uncertain? To me that was just a fact!
@ Per Kurowski “What we do not know is how you can predict the difference… and how to use those predictions.”
The Pugh decision-making matrix (see: http://en.wikipedia.org/wiki/Decision_Matrix) references your question. The conceptual construct for the real goods and service sector is cash flow and product demand as explained in “The Engine of Economic Growth” http://taffywilliams.blogspot.com/2011/04/engine-of-economic-growth.html. The matrix illustrates that the entrepreneur faces “uncertainty” unknown cash flow and unknown product demand, whereas the small business faces risk.
The forthcoming “Change” blog will add matrix for financial sector of the economy that is germane to the subprime crash. Both were contained in “We’re All Screwed! (see http://w-apublishing.com/Shop/BookDetail.aspx?ID=D6575146-0B97-40A1-BFF7-1CD340424361)!”