Finance and Democracy

By James Kwak

Roger Myerson, he of the 2007 Nobel Prize, wrote a glowing review of The Banker’s New Clothes, by Admati and Hellwig, for the Journal of Economic Perspectives a while back. Considering the reviewer, the journal, and the content of the review (which describes the book as “worthy of such global attention as Keynes’s General Theory received in 1936″), it’s about the highest endorsement you can imagine.

Myerson succinctly summarizes Admati and Hellwig’s key arguments, so if you haven’t read the book it’s a decent place to start. To recap, the central argument is that under Modigliani-Miller, the debt-to-equity ratio doesn’t affect the cost of capital and therefore doesn’t affect banks’ willingness to extend credit; the real-world factors that make Modigliani-Miller untrue (deposit insurance, taxes, etc.) rely on a transfer of value from another party that makes society no better off.

Myerson’s main point, accepting Admati and Hellwig’s position, has to do with the politics of bank regulation. Financial crises can have huge costs for society, as we know, and fundamentally they are about a failure of trust—trust that the banks are solvent, or that the bankers know what they are doing. As capital regulation has become more technical and complex, we have been increasingly asked to simply rely on the expertise of the regulators, since we cannot rely directly on the disclosures provided by the banks.

In 2008, we learned that relying on the regulators was a catastrophic error. Six years later, however, we have no better solution. Politicians, regulators, and bankers have engaged in a great deal of ritual display to try to make us believe we should trust them (resolution authority! living wills! clearinghouses! Volcker Rule! contingent convertible bonds!). But the basic nature of Dodd-Frank was more complexity, more rulemakings, more back-alley rulemaking, and less transparency. Dodd-Frank has probably helped in several ways, but it hasn’t given us any reason in general to have more confidence either in banks or in regulators. Instead, I think most people throw up their hands and move on because they have no other option.

As Myerson writes:

“With so much money in the banking system, our hope that regulators and officials will not be induced to falsely certify unsafe banks must depend on confidence that a failure of appropriate regulation could be discovered, reported in the press, and understood by voters well enough to cause a ruinous scandal for the responsible officials. . . .

“If there are abstruse financial transactions that generate risks which cannot be adequately represented in standard public accounting statements, then perhaps such transactions should be off limits for banks that are in the business of issuing reliably safe deposits.”

In other words, it’s not just that complexity can cause banks to blow up. It’s also that complexity makes it impossible for regulators to monitor banks, which is a critical ingredient in the financial crises that we all supposedly want to avoid.

Besides the primary reason for higher capital requirements—safer banks—this is the political reason for higher capital requirements (and other simple, structural fixes like smaller banks). More equity, based on standards that cannot be gamed by banks, is crucial to ensuring that the safety of the financial system does not depend on a secretive cadre of technocrats whose personal interests (whether or not they act on those interests) are decidedly aligned with those of the banks they regulate. Otherwise, as Myerson warns, “if nobody outside of the elite circles of finance can recognize a failure of appropriate regulation, then such failures should be considered inevitable.”

15 thoughts on “Finance and Democracy

  1. “I think most people throw up their hands and move on because they have no other option.” I do think people throw up their hands or, more likely, think nothing about the unseen risk as they go about their lives. But they do have another option.

    While it is true that people cannot rely upon regulators (because banks will game, because it’s too complex, and/or because they are captured in some way (see 13 Bankers)), people can simply remove their deposits and investment accounts and loans and credit cards from the largest 6 (or whatever number banks makes sense) until they longer pose a systemic risk. It would be, in one sense, better and easier if the government would truly represent and protect the people, but they can, so motivated, undertake what their own government (in name only on this matter, at least) will not.

    In the meantime, we should pursue Richard Fisher’s (President of the Dallas Federal Reserve Bank) proposal to: 1) allow only deposit-taking commercial banks to have access to the Fed’s discount window and FDIC insurance (not their parent company or SIVs or other entities); and, 2) having all customers, creditors and counter-partys for any non-commercial bank entities sign a new covenant, a simple disclosure statement as follows: “Warning: Conducting business with this affiliate of XYZ bank holding company carries no FDIC insurance or other federal government protections or guarantees. I, counter-party, fully understand that in conducting business with XYZ banking affiliate, that I have no FDIC insurance or other Federal government protections or guarantees and that my investment is totally at risk.”

    The problem with the latter is that it will never be implemented because, in fact, too big to fail does still exist.

    That leaves only the people to take matters into their own hands. A daunting prospect but it’s that or face almost certain higher debt (and therefore taxes) at the next, and possibly, worse crisis.

  2. Until Commercial banks are no longer allowed to create money electronically no amount of regulation or moving money from deposit to other banks will make a blind bit of difference to these too big to fail banks. The process used by C.b.’s to create this electronic money has no bearing on who has lent to the banks or how much they have on deposit see here ————-> for the Bank of England telling you what I say is true and here for a transcript explanation that banks create money (deposits when the create loans) how money is created in the modern world

    Click to access qb14q1prereleasemoneycreation.pdf

    This in effect means any sub part of any bank can create money for any other bank. You can say what you like and regulate what you want , but until this ends we are in the same boat heading for more of the same.

  3. THE BIG CHATTER: too large to ignore…between finance and democracy is from and around Pikitty.
    One example:
    “Why a Book on Growing Inequality Is Taking America by Storm and Scaring the Corporate Right
    The translator of Piketty’s ‘Capital In the 21st Century’ discusses inequality and the book’s huge success.

    Lynn Stuart Parramore, AlterNet

    Piketty’s book has touched the nerve of America’s growing alarm over inequality. READ MORE»

  4. [excerpted from review}
    Questions about the long-term evolution of inequality, the concentration of wealth, and the prospects for economic growth lie at the heart of political economy….
    …The main driver of inequality–the tendency of returns on capital to exceed the rate of economic growth–today threatens to generate extreme inequalities that stir discontent and undermine democratic values.”
    “Piketty ends his book with a ringing call for the global taxation of capital.”
    Capital in the Twenty-First Century
    by Thomas Piketty (Author), Arthur Goldhammer (Translator)

  5. Hoenig: Wall Street Banks “Excessively Leveraged” at 22 to 1 Ratios
    By Pam Martens: May 9, 2014
    “…take the time to read Hoenig’s full remarks, printed in their entirety…”
    Can We End Financial Bailouts?
    By Thomas M. Hoenig
    May 7, 2014
    Hoenig: Wall Street Banks “Excessively Leveraged” at 22 to 1 Ratios

  6. Well said. Too big to regulate equals too big to tolerate. Complexity promotes capture, for there is only one place to sell the skills the regulator develops. Don’t attack complexity with more complexity (as any good litigator would tell you). Attack it with simplicity. Break them up into manageable units that don’t threaten our economy but can deliver needed (as distinguished from…) services and be done with it.

    This is from a former 26+ years (pre 2007) securities enforcement professional.

  7. As some time bank investor, I am very interested in the highly leveraged bank because it offers higher option value. I little bit of good news or a little extra local market growth rate can really pay off.

    I would assume that managements interested in more than pedestrian compensation would also be highly interested in similar situations. If their schemes work out, they win big. If they don’t work out, move on to another bank.

  8. Today’s central bank leaders are modern day Nephilim, that is giants amongst us, who rebuilt the economy after the GFC. Trust in their Liberal schemes of Quantitative Easing has produced great gains for the speculative leveraged investment community, and has produced a fantastic moral risk induced prosperity supporting a huge amount of disposable wealth existing in savings accounts as evidenced by the awesome rise in the chart of M2 Money (adjusted monthly) to 11,158.7.

    Beginning with the Liberal scheme of QE1, where money good US Treasuries were traded out for the most toxic of debt, such as that traded in Fidelity Mutual Fund, FAGIX, and the ongoing process of Global ZIRP, banks were regenerated to become the financial engine of economic endeavors. The genius of the Greenspan Put, was that there was no capital investment in banks rather; rather banks were reestablished and now exist one with the state through the awesome rise in Excess Reserves.

    Up until October 23, 2013, when the Interest Rate on the US Ten Year Note, ^TNX, rose from 2.48%, the debt-to-equity ratio did not affect the cost of capital, and therefore hasn’t affected banks’ willingness to extend credit.

    With the failure of trust in the world central banks’ monetary authority to stimulate investment gains, the bond vigilantes are exercising ever greater control over the Benchmark Interest Rate, and this has started derisking out of debt trades and delveraging out of currency carry trades, pivoting the world out of the age of credit and into the age of debt servitude, with the result that the investor is no longer the centerpiece of economic activity, but rather the debt serf is the lynchpin of all things economic.
    Out of soon coming Financial Armageddon, that is a global credit bust and financial system breakdown, people will come to trust in a cadre of regional fascist leaders to establish regional security, stability, and security.


    Steve Kornacki could have done a little more homework and presented his last comment (given after the taped interview), first: He speculated that Warren (64) could perhaps re-consider higher office if Hillary (66) decides not to run for the 2016 presidency. Certainly there are enough reasons to oppose a Hillary run (her Senate record, paid speeches by Wall Street, deference to corporate lobbies, her questionable role in selecting UN members to “spy” on foreign delegates), her hawkish stance on Military action, lack of personal self-respect vis-à-vis Bill Clinton’s womanizing – just to name a few, issues Republicans don’t publically emphasis either since it would self-incriminate their own record/personal foibles).

    In the taped interview, Senator Warren naturally evaded the question for the “Nth” number of times but managed to mention the 1933 Banking Act Glass-Steagall without mentioning the repeal of the Modoeratiozation Act of 1999 under Bill Clinton’s tenure. If Hillary does not run in 2016 (which I believe, will be the case, and Hillary herself saying, she would be announcing her intention to run or not to run later this year (my guess, probably after the 2014 mid-terms)). Senator Warren’s political calculus is apparent: she would need the Democratic Party support if Hillary declines. But regardless of Hillary’s decision, Senator Warren would need the Democratic Party to help advance her own Senate legislation and good will. I would also think that Senator Warren probably views herself “working within the system” more so now rather than what her observations might have been in her earlier critique of Hillary’s Senate record.

  10. Elizabeth Warren: (riveting presentation and foresight)
    The coming Collapse of the Middle Class.

  11. What would it take to make the insured part of banking activities sufficiently transparent that the taxpaying public could effectively supplement the regulators?

    What information could be made available for review by experts and others (the way the Sunlight Foundation and OpenSecrets now reviews political donations)?

    How could we make this information available while preserving enough privacy to still allow competitive, creative business from both lenders and borrowers?

    I’m thinking of aggregated, semi-anonymized information (track to the lender, not to the borrower), possibly a standards body for normalizing the data (this may cut down opportunities for creative finance, for better and for worse), and then regulators who focus on verifying the accuracy of the information disclosed.

  12. Overheard in a NJ Diner, “…..if it’s Bush vs. Clinton, I’m going to gouge out my own eyes…..”

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