Discretion and financial regulation

An enduring truth about financial regulation is this: Given the discretion to do so, financial regulators will always do the wrong thing.

It’s easy to explain why. In good times, regulators have every incentive to take banks at their optimistic word on asset valuations, and therefore on bank capitalization. It is almost impossible for bank regulators to be “tough” in good times, for the same reason it is almost impossible for mutual fund managers to be bearish through a bubble. A “conservative” bank examiner who lowballs valuation estimates will inevitably face angry pushback from the regulated bank. Moreover, the examiner will be “proven wrong”, again and again, until she loses her job. Her fuddyduddy theories about cash flow and credit analysis will not withstand empirical scrutiny, as crappy credits continually perform while asset prices rise. Valuations can remain irrational much longer than a regulator can remain employed.

Bad times, unfortunately, follow good times, and regulatory incentives are to do the wrong thing yet again. When bad times come, overoptimistic valuations have been widely tolerated. In fact, they will have become very common. Overvaluation of assets leads to overstatement of capital. Overstatement of capital permits banks to increase the scale of their lending, which directly increases reported profitability. Banks that overvalue wildly thrive in good times. Fuddyduddy banks lag and their CEOs are ousted and The Economist runs snarky stories about what schlubs they are. The miracle of competition ensures that many of the most important and successful banks will have balance sheets like helium balloons at the end of a boom. Then, like a pin from outer space, somebody somewhere fails to repay a loan.

When this happens, bankers beg forbearance. They argue that the rain of pins will eventually pass and most of their assets will turn out to be fine. They ask regulators to allow them to write down assets gently, slowly, so that they can let ongoing earnings support or increase their regulatory capital. If that doesn’t work, they suggest that capitalization thresholds be temporarily lowered, since what good is having a buffer against bad times if you can’t actually use it in bad times? Knowing, and they do know, that their assets are crap and that they are on a glide path to visible insolvency, they use any forbearance they extract to “gamble for redemption”, to make speculative investments that will yield returns high enough to save them, if things work out. If they don’t, the bankers were going to lose their banks anyway. The additional losses that fall to taxpayers and creditors needn’t concern them.

Here, wouldn’t regulators draw the line? When the trouble is with just a few small banks, the answer is yes, absolutely. Regulators understand that the costs of closing a troubled bank early are much less than the costs after a delay. If a small bank is in trouble, they swoop in like superheroes and “resolve” it with extreme prejudice.

But when very large banks, or a very large number of banks are in trouble, the incentives change. Resolving banks, under this circumstance, will prove very expensive in terms of taxpayer dollars, political ill-will, and operational complexity. It will reveal regulators to have been asleep at the wheel, anger the public, and alienate nice people whom they’ve worked closely with, whom they like, who might otherwise offer them very nice jobs down the line. When a “systemic” banking crisis occurs, regulators’ incentives are suddenly aligned with bankers: to deny and underplay, to offer forbearance, to allow the troubled banks to try “earn” their way out of the crisis. Regulators, in fact, can go a step further. Bankers can only “gamble for redemption”, but regulators can rig the tables to ensure that banks are likely to win. And they do. A central bank might drop short-term interest rates very low to steepen the yield curve. It might purchase or lend against iffy assets with new money, propping up prices and ratifying balance sheets. It might pay interest to banks on that new money, creating de novo a revenue stream based on no economic activity at all. Regulators might bail out prominent creditors and counterparties of the banks, suddenly transforming bad bank assets into government gold. Directly or via those bailed out firms, regulators might engage in “open market transactions” with banks, entering or unwinding positions without driving hard bargains, leaving taxpayer money on the table as charity for the troubled institutions. They might even redefine the meaning of financial contracts in a subtle ways that increase bank revenues at the expense of consumers.

If all that stuff works out, regulators might be able to claim that they didn’t do such a bad job after all, that the crisis was just a “panic”, that their errors prior to the crisis were moderate and manageable and it was only the irrational skittishness of investors and the taunts of mean bloggers that made things seem so awful for a while. Regulators, like bankers, have everything to gain and little to lose by papering things over. And so they do. Besides, things here weren’t nearly as bad as in Europe.

There was nothing new or different about the recent financial crisis, other than its scale. Yes, the names of the overvalued financial instruments have changed and newfangled derivatives made it all confusing about who owed what to whom and what would explode where. But things have always blown up unaccountably during banking crises. We have seen this movie before, the story I’ve just told you is old hat, and the ending is always the same. We enact “reform”. The last time around, we enacted particularly smart reform, FDICIA, which was painstakingly mindful of regulators’ incentives, and tried to break the cycle. It mandated in very strong terms that FDIC take “prompt corrective action” with respect to potentially troubled banks.

The theory of “prompt corrective action” was and is very sensible. It’s pretty clear that the social costs increase and the likelihood of an equitable resolution to problems decreases the longer banks are permitted to downplay weakness, the more regulatory forbearance banks are granted, or the more public capital banks are given. (An “equitable resolution”, in this context, means giving the shaft to bank managers, shareholders, and unsecured creditors to minimize costs to taxpayers and to sharpen the incentives of bank stakeholders to invest well. “Regulatory forbearance” and “public capital injection” are redundant: Under current banking practice, regulatory forbearance is economically equivalent to an uncompensated injection of public capital, like TARP but without the messy politics and with no upside for taxpayers. Make sure you understand why.)

So FDICIA tried to short-circuit our woeful tale by telling regulators they should have a twitchy trigger finger. If regulators intervene early and aggressively, the costs of the crisis will be moderate, and since the costs of the crisis are moderate, it should actually be plausible for regulators to intervene early and aggressively rather than playing the world’s most expensive game of CYA. It was a great idea. Except it didn’t work.

We’ve already told the story of why it doesn’t work. Bank health and safety is a function of capitalization, capitalization is a function of bank asset valuation, and there is no objective measure of asset valuation. During good times “conservative” valuations are demonstrably mistaken and totally unsupportable as grounds for confiscating the property of respected, connected, and wealthy businesspeople. Regulators simply fail to take prompt corrective action until it is far too late.

As you read through the roughly 1400 pages of currently proposed regulatory reform, ask yourself what, if anything, would interfere with the (uncontroversial and long-understood) dynamic that I’ve described. Giving regulators more power doesn’t help, when regulators have repeatedly failed to use the powers they had. Putting more bank-like institutions and activities under a regulatory umbrella seems sensible, as does eliminating opportunities for firms to choose among several regulators and shop for the most permissive. But even our most vigilant and competent regulator (hi FDIC!) was totally snowed by this and the previous two banking crises. It has become fashionable to suggest that the idea of “systemic risk” is novel, and that just having some sort of high-level, blue ribbon council explicitly charged with worrying about financial catastrophes will change everything. But financial meltdowns are not new, Timothy Geithner was giving smart, widely discussed speeches about systemic risk in 2006, exactly as the current crisis was building.

There is, unfortunately, almost no correlation between the degree to which an institution or sector is supervised by regulators and behavior or misbehavior during a financial crisis. Commercial banks, GSEs, and bond insurers were intimately regulated and are now toast. Mortgage originators, boutique securitizers, ratings agencies, and CDS markets were largely unregulated. They also clearly failed. The one trainwreck that the current round of proposals might have forestalled is AIGFP, whose unhedged, uncollateralized CDS exposure would make even the most lackadaisical regulator blush. But it is not at all plausible, especially in the US, that AIG was the linchpin without which the late troubles would not have occurred. If we had to refight the last war under all the regulations now proposed, we might have won one battle. But we’d very definitely have lost the war. Deregulation won’t solve the problem. But neither will the sort of regulation now proposed by Barney Frank or Chris Dodd.

But what about Bernie Sanders? Is “too big to fail” the problem? Yes and no. Unsustainable bank-funded asset price booms can and do occur even among small banks. But systemic crises are more likely in a world with big banks, as only one or two need totter to take down the world. Chopping up banks reduces the frequency of major crises. Also, “prompt corrective action” does sometimes work for small banks. For big banks, PCA is just a joke — Citibank is and always will be perfectly healthy until it is totally a basket case. But regulators do stage early interventions in smaller banks, even during relatively quiet times, and that does help. Crises among small banks can lead to large fiscal costs (c.f. the S&L bailout). But even during serious crises, many small banks turn out to have been prudent, and small banks tend not to be so interconnected that a cascade of failures leaves us without a financial system. Small-bank-based systems fail gracefully. (See Felix Salmon.) Crises among small banks are less corrosive to incentives for careful capital allocation, and less offensive to distributive justice, than large bank crises, because regulators are willing to force preferred equityholders and unsecured creditors of smaller banks to bear losses while they hesitate to do so for big banks. Also managers of smaller banks can be perfunctorily defenestrated, while managers of megabanks somehow survive (and even when they don’t, they are too wealthy to have to care). Again, one hates to be mean, but treating the managers of trouble-causing banks roughly is important both to get the incentives right and out of regard for justice.

We should insist upon a market structure in which financial institutions are universally small. But smallness cannot be defined by balance-sheet assets alone. We need to manage the degree of interconnectedness and the scale of total exposures (including off-balance sheet exposures arising from derivative market participation). Further, we need to ensure that no market participants are indispensable by virtue of controlling some essential market infrastructure. Clearing and payments systems, securities and derivatives exchanges, etc should be multiple and redundant if privately owned, or publicly managed if efficiency demands a monopoly provider. Essential infrastructure should be held by entities that are bankruptcy remote from firms that bear unrelated risks, although the stakeholders needn’t be bankruptcy remote from the critical infrastructure. (For example, if the owner of a derivative exchange goes under, the exchange must be immune from liability, but if the exchange suffers losses due to insufficient collateral requirements, the owner could still be liable.)

Fundamentally (and a bit radically), for financial reform to be effective, regulators must actively target market structure. Financial systems are public/private partnerships, not purely private enterprises. It is perfectly reasonable for the state as the ultimate provider of funds and bearer of risk to insist on a robust and heterogeneous network of delegates. Regulators needn’t (and really cannot) architect the breakup of today’s destructive behemoths. All they need to do is identify dimensions along which firms become indispensable or threatening to financial stability as they grow, and tax measures of those attributes at progressively steeper rates. The taxes could be slowly phased in over a few years, to give existing firms time to arrange efficient deconglomerations. Importantly, legislators should characterize the target market structure, and empower regulators to define and alter tax schedules as necessary to achieve that target, rather than specifying them in law, to counter gaming by nimble financiers. (For example, a tax on balance sheet assets would lead to rapturous innovation in tricks to keep stuff off-balance-sheet.) Taxes should always be imposed in a nondiscriminatory way across the industry. (If you are not concerned about the role of political influence and favoratism in regulatory action, you haven’t been paying attention.) “Taxes” could take the form of increased regulatory burdens, such as capitalization or reserve requirements (though the effectiveness of the latter is diminished if central banks pay interest on reserves).

Variations of these ideas are actually in both Frank and Dodd’s proposed legislation. Regulators would have a fair amount of discretion, under the new laws, to do the right thing. They could ignore the terrifying shrieks of our banking overlords and force the monsters to break apart. But we come back to the first and most ancient law of banking regulation. Given discretion, banking regulators will always, always do the wrong thing. Only if Congress defines a verifiable target market structure and periodically audits the regulators for compliance will we eliminate “too-big-and-mean-and-rich-and-scary-and-interconnected-and-sexy-to-fail”.

But what about the much vaunted “resolution authority”. Doesn’t that change the deadly dynamic of banking regulation described above? Sure, it will still be true that during booms, banks will make dumb mistakes and regulators will be unable to point out that the Swiss cheese they’re calling assets is chock full of holes. But, you might argue, when the cycle turns, they’ll no longer be helplessly forced to resort to CYA-and-pray! They’ll have the tools to wind down bad banks ASAP!

Maybe. Resolution authority might be helpful. But I’m not optimistic. During the current crisis, there are two accounts of why we guaranteed and bailed existing banks — including creditors, managment, preferred shareholders, and financial counterparties — rather than resolving the banks and forcing losses onto the private parties who made bad bets. One account emphasizes legal constraints: we had laws that foresaw the orderly resolution of commercial banks, but not investment banks or bank-holding conglomerates. According to this view, regulators’ only options were to permit Lehman like uncontrolled liquidations of financial firms or else make whole every creditor to prevent a formal bankruptcy. If this is what you think then, yes, resolution authority might change everything.

But another view — my view — suggests that despite the limitations of preexisting legislation, regulators throughout this crisis have had the capacity to drive much harder bargains, and have chosen not to. Despite having no legal authority to do so, the government “resolved” Bear Stearns over a weekend in almost precisely the same manner that FDIC resolves your average small town bank. Secretary Paulson could at that point have gone to Congress with a proposal for resolution authority to institutionalize the powers he clearly required. Instead, he had Treasury staff prepare the first version of TARP and put it on a shelf until an emergency sufficient to blackmail Congress arose. Whatever the legal prearrangements, regulators have always had sufficient leverage, over firms and firm managers, to push through any structural changes they deemed necessary and to create bargaining power for firms to insist on loss sharing. Finally, earlier this year, when bank nationalization was an active debate, opponents did not because they could not claim that authority would not be found if the administration decided nationalization was the way to go. Harsh measures towards banks would have been extremely popular. What authority the administration did not have by virtue of existing powers and informal leverage they could have achieved by purchasing common shares instead of preferred during “capital injections”, or, in a pinch, by asking Congress for help. In my view, legal niceties were never the issue. Regulators opted to guarantee the banking system and bail out creditors because given the terrifying scale of the problem, the operational complexities and investor uncertainty associated with resolutions or nationalizations, the power of the banks and regulators’ personal connections to them — our leaders simply opted not to pursue more hardball resolutions. If we don’t change the structure of the financial industry, there’s no reason to think that next time around regulators won’t use the proposed resolution authority to do exactly what they opted to do this time. They won’t even need to go to Congress for a new TARP, as Frank’s proposal gives the executive branch carte blanche to provide financial firms unlimited guarantees and support. (I haven’t read the text of Dodd’s bill.)

Yes, I know that “living wills” are supposed to diminish the operational complexity and uncertainty associated with taking a harder line, and that, in theory, might encourage different choices. I also understand that some sort of industry-funded slush fund is supposed to bear future bail-out costs. My sense is that during a gut-wrenching financial crisis, hypothetical funeral plans will provide little comfort to terrified regulators, prepaid slush funds will prove to be laughably inadequate, and commitments to make firms pay for the mess ex post will be waived in order to shore up struggling bank balance sheets. These proposals are about providing the political cover necessary to get legislation passed, but they will prove to be utterly without substance when the next crisis occurs.

I’ll end where I started. The one rule that you can rely on with respect to banking regulation is that whenever regulators have discretion, they do exactly the wrong thing. For very predictable reasons and despite the best of intentions, they screw up. Besides messing around with intragovernmental organization charts, the main proposals before Congress give regulators more power and more discretion. That just won’t work.

Afterthoughts: It is really worth considering this excellent piece by Matt Yglesias, ht Mike Konczal.

I almost always disagree with Economic of Contempt on these issues. But despite being wrong, he is very smart, and a gentleman too. You should read this piece, which gets everything right, within the confines of supervisory regulation. We need structural changes most of all, but supervisory regulation won’t be going away, and there his points are dead on. Also check out his very creative defense of Too Big Too Fail banks. I happen to think liquidity is as often vice as virtue, so I’m not persuaded. (Assets that are difficult to value should be illiquid. Otherwise investors fall prey to delusions of safety and rely upon risk-management by exit, which never works out well.) So EoC is wrong. But he’s wrong in clever ways, and always worth reading.

Go Paul Kanjorski!

Update History:
  • 13-November-2009, 7:45 p.m. EST: Changed “as often virtue as vice” to “as often vice as virtue”.
  • 16-November-2009, 3:15 a.m. EST: Removed an awkward and superfluous space before a period.
  • 16-November-2009, 4:4 a.m. EST: Removed a comma and a repetitious “to banks”. Reworked (still awkward) sentence that used to read incoherentely “It’s pretty clear that both the social costs and the likelihood of an equitable resolution to banking problems increases…” It should have said costs increase, likelihood decreases, and now does. Inserted the word “by” before “asking Congress for help”. Put commas around “in theory”.

31 Responses to “Discretion and financial regulation”

  1. Paul E. Math writes:

    You, sir, have it the nail right on it’s head. If only Frank and Dodd had the attention span to read this.

  2. JKH writes:

    Palley’s idea of increased reserve requirements is profoundly stupid. It’s beyond my own disgust. (Perhaps Winterspeak could bear to comment on it.)

    The public/private partnership idea is fine. But it’s an existing idea; not a new one. The issue is execution.

    The partnership still depends on private capital absorbing the first loss. The fundamental issue remains capital requirements.

    This includes debt capital, with contingency provisions forcing conversion to equity, in order to facilitate safe failure for large institutions.

    And why in God’s name don’t you look at Canada for a capital and regulatory template?

  3. JKH writes:

    Also, the regulatory focus might be improved by regulating the risks relating to product pipeline, in addition to institutional clustering. E.g. try looking at mortgage interest deductibility as a perverse economic incentive out of the blocks.

  4. SW:

    I’ve been saying similar things for years. I remember how the regulators failed to see the 1979-86 S&L crisis until it was too late to do anything useful to minimize the damage.

  5. winterspeak writes:

    Good god.

    I read Palley and almost threw up. If this is the “help” we are getting, then maybe it would be better just to take a “worse is better” approach and drive the entire bus into Hell.

    JKH: With respect, I do not think the “public/private” partnership is a new idea. I think very few people understand exactly why a bank can do what it can do, what mechanisms the Government has extended to it, and why those mechanisms exist. That is why I wrote my post. I really was speaking amongst Chicago economists who claimed that banks had no public purpose and only existed to benefit their shareholders, a position that I am actually, generally, pretty sympathetic to btw. And then they threw out “well, what is a bank” as if that is some kind of philosophical stumper. They are barely comprehending that Govt deficit spending is the only source of net private financial assets, and we have yet to touch on the Truth of reserve requirements. I have no hope, actually.

    I would *love* to know what makes Canada special. Nick Rowe is less than useful here. You and I have spoken about the zero reserve requirement, but in general I do not know how Canada manages capital requirements, span, and recapitalization rules in extremis.

    For example, does the Canadian equivalent of FDIC (I assume it has one) cover all deposits?

  6. Paul — Unfortunately, I don’t think that any of what I’ve written would be a surprise to policymakers. It’s not what they don’t understand, it’s that the incentives and constraints that shape their actions place a much higher value on continuity of incumbents (public and private) than one might hope.

    IA — I am not at all surprised. You might feel like a vicarious sisyphus, cringing as you watch the rock of idiocy crawl up a hill of illusory valuation, screaming as you watch it fall and start its journey all over again.

  7. JKH writes:


    Glad you almost threw up – we’re in synch there at least.

    Sorry, the public/private partnership comment was not directed at your post at all – my miscue. I suppose Mosler is where I first recall seeing the phrase itself, but the phrase is not at all what I’m referring to. The basic idea is pretty factual and simple as I’m concerned – the core of it is deposit insurance as a backstop. The partnership is about sharing of risk and capital allocation. It’s implicit if not explicit. But when I said it wasn’t a new idea, I didn’t mean to imply that it was widely understood! I think you know well where I stand on the ability of the economic elite to comprehend how the system works, and their complete inability to understand the distinction between central bank reserves and bank capital. That is why I join you in retching over the Palley article. Among other things that is why your post is important.

    The Canadian experience speaks for itself. It’s the top ranked banking system in the world. It sprinted through the credit crisis relatively unscathed, with a couple of relatively minor exceptions in which the worst threat to the banks in question was public speculation that they might have to cut their dividends for the first time since the Second World War. They never did, and remain well capitalized. The entire system is better regulated than the US, with an oversight body (Office of the Inspector General) that is independent from the central bank (important I think). The banks as institutions and the mortgage business as a business are highly regulated. The core problem in the US is a putrid, stinking mortgage business. The big Canadian banks keep a massive amount of their originated mortgages on balance sheet. Mortgage securitizers and subprime lenders are present, but relatively speaking are restricted to the profile of smallish boiler room operations that can’t damage the system.

    And the kicker overall in the Canadian case is size and concentration. If the Royal Bank were a US institution, its comparable (economy weighted) size would be 50 per cent bigger than Citigroup and Bank of America combined ($ 6 trillion, using 10 times $ 600 billion). Royal Bank will probably raise its dividend in Q1 or Q2, 2010.

  8. JKH & Winterspeak — You guys are going to have to help me out on why you’re so allergic to Palley’s proposal. I’ll grant in advance one huge problem: his reasoning is undermined when CBs pay interest on reserves, he argues his point from the vantage of a pre-2008 world. But.

    Reserve requirements have lots of different “meanings”. The most common one is something that the three of us will agree is bullshit: under banking practice since at least the middle 1980s, reserve requirements do not serve as an effective constraint on the quantity of bankloans per the ridiculous-but-still-taught money multiplier model. OK.

    A second “meaning” of reserve requirements is that they force individual banks to self-insure against liquidity risk. This meaning, I will grant, is mostly bullshit. In “good” times, nearly any bank can borrow reserves from the interbank market at a negligible to modest spread over the central bank’s policy rate, either directly from the CB (eg at the discount rate) or indirectly via the explicitly manipulated interbank lending market. So traditional bank liquidity risk ought not be a significant constraint on bank behavior, and as long as a bank is “clearly well capitalized”, there should be no reason to insure against it. Thus the trend towards eliminating reserve requirements: let the central bank is provide liquidity insurance, let banks focus on economic value, that is, capitalization.

    That said, in the world as it is, I do think that banks pay some attention to liquidity risk. Sheila Bair’s words (see Felix Salmon) must chill the hearts of bankers who’d grown comfortable with the idea of central-bank provided liquidity insurance:

    WaMu was a liquidity failure. It could not meet its obligations, it didn’t have enough cash on hand to meet the funding obligations it had contractually committed to. That is a basis for closing an institution.

    Many investors (see John Hempton) and vanguard intellectuals have taken the haphazard evolution of banking practice to its logical conclusion that banks needn’t manage liquidity risk. But academic papers are still published about how banks have a comparative advantage at managing liquidity risk, and regulators still have discretion during a run as to whether or not to make good on the insurance policy (when borrowing on the interbank market is not an option). So, in practice, I think banks do put some time and trouble into managing liquidity risk, as silly as it seems when you try to impose a coherent model on the banking system we’ve evolved.

    Related to the above is that reserve requirements impose a fairly arbitrary friction on individual banks. That friction was particular important before banks paid interest on reserves, as it was the lever central banks used to control interest rates. We can argue about magnitudes, but while reserve requirements don’t ultimately constrain even an individual bank from lending if it perceives risk-adjusted return above its expected FF rate time path, they may alter the distribution and timing of loans as banks face costs due to the hassles of reserve management. Banks clearly do work to manage reserves. They do try to attract deposits (entirely superfluous in a reserve-free world), and they incur costs sweeping funds from account to account (and paying interest to accountholders whose funds they sweep). It is too easy to see the big picture and forget small details that may, after all, matter.

    But none of the above have anything to do with Palley’s column. A final “meaning” of reserves is as a means of “taxing” banks. I use the scare quotes, because I hate it when banks complain about this “tax” — reserves are created by central banks, the “opportunity cost” they bear by not paying reserves is means foregoing a potential subsidy enabled by central-bank reserve creation. I don’t think interest should be paid as reserves, and I think we should mock bankers derisively when they complain about being “essentially taxed, since we are forced to make non-interest-bearing loans to the government” (not a specific quotation, but a synthesis a whine I’ve read ad nauseam). Still, for any given bank, the degree to which it is required to hold reserves functions feels like a tax, and each bank has every incentive to minimize its own reserve requirement, whenever there is an opportunity cost to holding reserves (which at least historically there usually has been).

    Palley’s argument, which I think is decent but undermined when CBs pay interest, is asset-based reserve requirements would affect behavior like a “tax” on certain kinds of investment portfolios. It is very much analogous to risk-basef capital schemes, where again a costly constraint is extenuauted or diminished based on bank asset portfolio. However vestigal and nonfunctional reserve requirement might or might be in the banking system we want to move to (I could argue for extreme shifts in either direction), at the moment, reserve requirements exist, they are sometimes costly, and adjusting them could be used to alter bank incentives re scale, interconnectedness, etc. I think this is straightforward, whenever there is a significant opportunity cost to holding reserves (again, paying interest on reserves pretty much kills this plan). Why do you guys hate it so much?

    Now, I’d agree it’s second-best: if we want to tax markers of criticality or risk, I’d rather we do it transparently with a visibly progressive tax schedule rather than through means as arcane and poorly understood as reserve requirements. And I gather, by both of your exaltations of Canada, that you’d like use to move towards a “channel” or (god forbid) “floor” system in which reserve requirements are completely superfluous. (Yes, I know we’re already de facto in a floor system. But I hate that.) I mostly don’t agree. (I was once entranced with the simplicity and elegance of the channel approach, but for political economy reasons, I am now opposed.)

    But regardless, while a channel or floor system has no need of formal reserve requirements, they are not ruled out either. And politically it might well be easier to tax “bigness” (broadly defined) via a grandfathered institution (however superfluous) than to impose a rational and transparent regime. Again, I’d prefer the latter. But I’d settle for the former.

    Re Canada (and Australia) generally, I don’t buy the view that these systems had some secret sauce that made them immune to the crisis. My view is that their genius can be summed up by an old joke:

    Two hikers in the forest trip over the cub of a grizzly bear. From a distance, the enraged momma bear charges. One hiker starts to bolt. The second cries out “There’s no way you’re gonna outrun a grizzly bear!” The first, over his shoulder, responds: “I don’t have to outrun a grizzly bear. I just have to outrun you!”

    I think that Canada and Australia were similar to the US and Britain, just significantly more conservative in straightforward dimensions. That conservatism was diminishing over time, just as it inevitably had diminished in other countries. But they were still towards the rear of the flock. Had there more foolhardy colleagues not crashed and burned first, they would still be slowly creeping towards insolvency, as they clearly were prior to the crisis. (Canada &Australia both had — and continue to have — serious bank-financed real estate bubbles. BMO (bank o’ montreal) got bit by its first forays into US MBS/structured credits, and those forays were ended by the crisis, not some regulatory or institutional genius. The CanadAustralian solution is to keep a step or two behind some patsy (not as an intentional scheme, just an outgrowth of institutional and cultural skepticism towards high finance). I don’t believe they offer a reproducibl
    e model for banking reform in general.

    That said, I’m hardly expert on those banking systems, and if you guys can describe some institutional innovation that cures the ancient cycle of bank-borne tragedy, I would love to know it.

  9. JKH writes:


    I hate Palley’s article because it is incredibly STUPID. We have “asset based reserve requirements” now. THEY’RE CALLED CAPITAL REQUIREMENTS.

    Palley’s ABRR idea has NOTHING to do with liquidity management.

    It’s this inane confusion between central bank reserves and capital that is the all pervasive problem for economists who are disembodied from the actual functioning of the financial system.


    “A similar logic holds for stock market bubbles. If a monetary authority wanted to prevent stock market inflation from generating excessive consumption, it could impose reserve requirements on equity holdings. This would force financial firms to hold some cash to back their equity holdings, lowering the return on equities and discouraging such investments.”

    NEWS FLASH! That’s the same economic impact as an increased capital requirement!

    What Palley is proposing is a method by which a central bank can bootstrap onto an existing capital allocation system by imposing occasional “reserve taxes” on assets. Such “taxes” are economically equivalent to a direct adjustment to required capital ratios.

    Additional reserves reduce ROE by cutting the weighted average return on assets supported by the same amount of capital. Increased capital requirements reduce ROE by increasing the highest cost funding component in the overall liability/equity mix for funding those assets. It amounts to exactly the same thing from a risk management and funding cost perspective.

    So why confuse the whole issue of the distinction between central bank reserves and capital once again? Because that’s what economists do. This is another step back.

    The distinction between central bank reserves and capital falls out from the more comprehensive comparison of liquidity and capital – the most important topic in banking, IMO.

    In other words, the discussion about central bank reserves should be put into the framework of a discussion about bank liquidity.

    Anybody who thinks that banks don’t have to manage liquidity risk now is a fool.

    And anybody who thinks that the elimination of central bank reserves implies banks don’t have to manage liquidity risk is mistaken.

    The question on the table regarding these statements is – what is the role of central bank reserves within bank liquidity management?

    Well, if Canada right, with a zero central bank reserve requirement, it means the role of central bank reserves is nothing – or next to nothing. That’s not quite right either of course, but what does it really mean? What it means precisely is that the role of a positive stock of central bank reserves is – nothing. Conversely, the role of central bank reserves in a flow sense is fundamental to what it means for a central bank to be central – a point some of us tried to make on Nick Rowe’s blog, to no avail.

    First, why is a positive stock requirement unnecessary, as Canada has proven? The answer is that a positive central bank reserve stock can just as easily be replaced by a positive stock of government treasury bills or other highly liquid assets. And that’s exactly what banks do in managing liquidity. Commercial banks devote enormous resources to managing such non-central bank reserves. (Apparently investment bank Bear Stearns didn’t.)

    Banks don’t want to go to the discount window when they have a prospective cash shortfall. So they have treasury bills and other liquid assets to sell. (There is still something called “moral suasion” in normal times. The challenge for the Fed was to reverse the moral suasion imperative with the term auction facility.)

    You may say that a forced holding of treasury bills is the same as a forced holding of reserves. Well, it’s not really. First of all, we’re not talking about a forced holding of bills yet – although we may be at some point. Secondly, treasury bills do have the property of being liquid securities. Required reserves would just sit there until a troubled bank starts to run them down. How does that sort of passive dead man approach to liquidity management help the banking system progress into an improved prudential management mode? Finally, a stock of treasury bills is only the highest quality tier of assets in a more comprehensive and larger liquid asset portfolio.

    The point is that there are substantial mean for attracting the flow of central bank reserves required operationally to settle the central bank account at the required level rather than calling upon a stock inventory of reserves to do so.

    The other point of course is that to the degree central bank reserves are required they constitute no liquidity at all in the sense that banks do not have the option of falling below such a requirement without revealing ineptitude or inadequacy in the operation of their overall liquidity management. Why bother with a stock of central bank reserves when the stigma associated with coming in below one’s required level of reserves is the same as if one borrowed at the window? In fact, it requires borrowing at the window to meet the requirement. What’s the point?

    So a stock of central bank reserves is a red herring insofar as effective reserve management is concerned.

    But Palley’s article has nothing to do with effective reserve management. It is about capital requirements. It’s just that he doesn’t know it.

    Are required reserves a tax? Well, they are in the sense of the opportunity cost of holding zero interest earning assets, if that’s the arrangement. And that tax applies to both the bank and its depositors in some sense, because margin crimp will require some cost sharing on the liability side.

    Alternatively, required reserves are a mode of forced “monetization” of deficits through the banking system. They are simply a piece of the “net financial assets” delivered by government deficits to the non government sector through the Chartalist conduit. The tax in this sense is the reduced non government income from what might be payable on government debt.

    So if the objective is to force deficits through the banking system – sure, why not? But what’s that got to do with improving the efficiency of the banking system or the effectiveness of prudential liquidity management? On the contrary, it’s a dumb way to promote efficiency, because it’s got little to do with effective liquidity management, and everything to do with capital requirements.

  10. JKH writes:


    I think you’re wrong in the Canadian case. Their capital ratios were much higher than US and UK counterparts going into the crisis. Mortgage financing is entirely differently in how risk is managed. Underwriting standards are far higher. Distribution is truncated. Canadian banks have near zero losses on residential mortgages. The BMO gas trading debacle was a small capital hit for that organization. It was an isolated case of rogue trading and inadequate risk management located in a specific Manhattan location. The worst Canadian case was CIBC, who did get caught up in CDO trading. Still, the aggregate capital hit to the Canadian system has been minuscule in proportion to the US and the UK. They certainly weren’t and aren’t heading toward insolvency. And if they were slower as you say to get involved in the suicidal parts of the market – that may have something to do with their risk management culture. Not sure how they can be faulted for that.

  11. winterspeak writes:

    SRW: JKH gets to my core objection with Palley — he confuses reserve requirements and capital requirements. For someone who is talking about banking, this is like confusing a fish with a bicycle. It should simply disqualify you from playing.

    I would add that banks used derivatives and off balance sheet vehicles extensively to game capital requirements prior to last year. This is something that Arnold Kling, for all his ignorance about the banking system in general, gets right. I think it also highlights the problem you’ve put your finger on — regulators will always do the wrong thing.

    Capital requirements put a real, meaningful constraint on private section credit extension. If we don’t know what the difference is between capital and reserves, then we will keep the financial system we have.

    I hope it’s also clear what a bad mechanism the interbank system and discount window is for banking. It has proven itself to be extremely extremely brittle to credit risk, which is why that mechanism should be replaced by something more straightforward. Like… the Fed running an open, unsecured discount window all the time and eliminating the interbank lending market. It can set price by fiat, and let quantity adjust as a new (and more straightforward) mechanism for bond pricing.

    You need a mechanism like this because our system is not reserve constrained UNTIL other banks shun you overnight AND you don’t have the assets the Fed requires at the discount window. Then you switch to being reserve constrained all of a sudden and fail. There is no need to banks to fail catastrophically if they have access to Fed reserves AND have capital requirements waived, and both of these are easy to implement. It is easier to engineer a quiet wind down if banks never need to worry operationally about liquidity or capital issues.

    To push your point even further, SRW, I don’t think that anything can be done about the fact that banks are pro-cyclical. You can dampen the swings by capital requirements, and eliminating securitization; and you can make sure the right people get punished by always having public capital in 2nd loss position behind all private capital.

    JKH: I’d love more details on Canada. This last crises isn’t the first one that the Canadian system has come through unscathed, so I don’t want to put it all down to sensible mortgage policies. Some specific questions:

    1. Does Canada have securitization? If it’s smaller, what keeps it smaller?

    2. How much of Canada’s performance is simply quality regulation? After all, doesn’t canada have “good governance” somewhere in its constitution? Quality management is not part of how the American Govt chooses to run itself (or everyone else).

    3. Are capital requirements just higher? Or harder to get around? Or both?

    4. Does the CBOC lend unsecured to member banks?

    5. How would Canada implement regulatory forebearance on capital requirements, or has it just never come up?

    6. Bank lending needs reserve accounts, but all the other stuff Citi et al. get up to do not. To what degree are entities that have reserve accounts allowed to engage in other activities?

  12. JKH & Winterspeak — I’m going to hold off on the Canada debate, because I have strong priors but insufficient information. Maybe you’re right, but I’m very skeptical. I would point out that losses on residential mortgages in the US were near zero until suddenly they weren’t, that these things break discontinuously. Please do offer what you know and provide pointers, and maybe I’ll argue or agree with you when I learn more.

    Re: Palley & asset-based reserve requirements, a few things.

    1) I think you’re misreading him. Many pundits, including trained economists, do infuriatingly confuse reserve for capitalization. Palley, though I often disagree with him, is a bright guy who has thought and written a lot about banking systems. Banking economists tend not to make this mistake. It’s not like some chartalist heresy. That banks face two distinct constraints is elementary and orthodox, and economists who don’t get it are the ones who don’t do banking. If you read his piece carefully, he never says or even implies that ABRR would make banks in any sense more solvent. He says quite explicitly that they are a lever that could be used to shift bank behavior in whatever direction a regulator pleases. Is he wrong about that?

    2) JKH, you’re right that capitalization requirements could be used for the same purpose. If you want banks to hold fewer CPDOs, you could increase their risk-weighting for capitalization purposes and/or you could force banks that hold them to carry more uncompensated reserves. Which would be more effective? That would depend on banks’ cost of capital, the opportunity cost of reserves, and which of the two constraints are typically binding. I don’t think that Palley is suggesting that the risk-weighting lever be abandoned. He’s offering another tool by which regulators could influence bank behavior. I view the proposal in political terms. It’s hard to regulate banks, they find ways out of straightjackets, transparent “Pigouvian taxes” on undesirable activity are legislative nonstarters. There are two tools grandfathered into place: capitalization and reserve requirements. But capitalization requirements have been painstakingly captured and standardized by the Basel II process, while reserve requirements remain national and heterogenous. So, he wants reserve requirements to become the all-purpose lever that capitalization requirements can no longer be. Reserve requirements have another benefit over capitalization requirements. Capital can be faked, while reserves cannot. Overvaluing book assets makes solvency look good. But overvaluing assets would cause reserve requirements to increase under Palley’s scheme. Asset-based reserve requirements would lean against the terrible dynamic that, via capitalization constraints, the more banks fake their wealth, the more freedom they have to gamble.

    3) Repeating a bit, but since you put it in big letters. Yes, ABRR has NOTHING TO DO WITH LIQUIDITY MANAGEMENT. Neither he nor I care. The point is to hijack reserve requirements and put them to a different purpose. That idea is not some error having to do with delusions of enhancing solvency, but an attempt to constrain and shift bank behavior.

    4) It might be true that the idea would further confuse the general public and most economists about the distinction between capital/solvency and liquidity. Reserving “against assets” sounds like risk-weighting capital, and if thunk about that way makes no sense. But even if it is an idea that tends to increase the confusion of already confused people, the marginal loss of comprehensibility to those who already fail to comprehend may be reasonable if the scheme has sufficient benefits in terms of taming bank misbehavior. Also, there is a way that the idea could be presented that could underline rather than confuse the distinction between liquidity and capital JKH showed the way. It would be perfectly sensible, on liquidity grounds, to have reserve requirements be lower for banks holding liquid assets such as Treasuries. Since these are easily converted to reserves, the liquidity rationale for accepting lower cash holdings is straightforward. Illiquid CDOs cannot be converted to cash, so, again on liquidity grounds, you could argue that banks with a lot of that sort of thing on their balance sheets should hold more reserves. I don’t like pushing this too far. From my perspective it is a pedagogical point. I want a broad toolbox available to regulators to make it uneconomical for banks to be too large or influential, full stop. I wouldn’t want to constrain the use of tools based on a story that reserve requirements are set to ensure liquidity, so I’m glad to keep the relationship abstract. Again, the first-best solution would be to empower regulators to impose taxes fairly arbitrarily, as long as they do so in a nondiscriminatory manner across the industry, in order to target market structure. But if new taxing powers can’t be had, I’m glad to retrofit capital and reserve requirements for the purpose.

    5) I think both of you place too much faith in capital requirements. Capital is theology. It can’t be measured, it can only be asserted. It’s the gappy shiftiness of the capital that creates the procyclicality of banking. ABRR may not be the best alternative, but we do need alternatives, redundant constraints and backstops.

    6) Winterspeak — I’m not with you on perfecting what admittedly would be a more coherent architecture for banking. As you say, banks are never insolvent so long as they are allowed to produce or borrow liabilities that are substitutable for money. If we relaxed capital and reserve constraints to zero, banks could always create deposits to cover any obligation, and there could be no banking crises. We’d just have very crappy allocation of real capital, as heads I win / tails I print became the way of the world. If reserve requirements remain but banks can borrow at the discount window without good collateral, same situation. No banking crises, terrible economic crisis. You probably know that my view is that the financial crisis is just a symptom of a real economy crisis, that we were fortunate to have the signal provided by banking system tremors and are foolish to ignore that signal by taking the monetary-system equivalent of aspirin and continuing basically as we did before. I think we are heading for a motherfucker of a problem, and that apparent successes in “healing” the banking system will before very long feel very ironic. We haven’t fixed real capital allocation, and we’ve created distributional nightmares. I think the problem was not that we had a banking crisis, given the real economic mistakes we were and probably will continue to make. The problem was that the banking crisis came so late, or more optimistically, that the banking system didn’t do its job of creating constraints that would prevent the awful misallocations in the first place. Your suggestion of relying only on the first-loss of largely fictional, often dispersed-ownership financial capital to ensure decent allocation strikes me as way, way too weak. I’ll grant that what we have done during this crisis would have been much more painlessly and efficiently done if the system you suggest had been in place. As you want, we’ve forced (some) private capital to take losses, and then we’ve come in whole hog with liquidity and solvency guarantees, so it’s reasonable to ask, if we were gonna do that anyway, why go through all the angst? My view is that it was an error to do that, that we should have tolerated a great deal more disruption of incumbent financial institutions, that disruption of the real economy should have been calmed not by saving existing intermediaries but by temporarily replacing them (as the Fed has done via TALF and its money market investing program).

    I’m rambling, but the problem was not that banks faced breakdowns in the interbank market and might have faced them at the discount window. The problem is that banks faced those breakdowns so suddenly and so late. We ne
    ed constraints that bite early, and capital constraints will never do that during the exuberance of a boom.

    7) Finally, I agree that we’ll never eliminate procyclicality. That’s why graceful degradation is so important to a banking system. We should have a system with lots of redundancies and no critical nodes, precisely because we understand that there will be cycles, and in times of stress a substantial fraction of those nodes will blink off.

  13. JKH writes:


    I used to like Palley. But the fact that he didn’t even reference capital in this piece makes me suspicious. It’s an obvious association and an obvious question.

    I disagree with you on the importance of capital. Capital is mostly about managing asset risk, and that’s exactly what Palley’s addressing.

    There have been proposals for countercyclical adjustments to capital requirements as well. It’s not necessary to fog up the system by running such adjustments through a central bank reserve account.

    I’m no expert on taxation, but central bank reserves are a tax in disguise. Why not just levy an actual tax, instead of fogging up the tax concept as well? Otherwise, taxes and capital constraints are both disincentives to asset accumulation and risk taking. Central bank reserves are an unnecessary mechanism in either case.

    “But capitalization requirements have been painstakingly captured and standardized by the Basel II process, while reserve requirements remain national and heterogenous.”

    I disagree. National regulators are free to adjust minimum capital requirements up. I believe Canada’s regulators did that in guidelines. In any event, the Canadian banks have always done it as a matter of publically announced policies of self-imposed targets that are measurably higher than minimum regulatory requirements.

    “Capital can be faked, while reserves cannot. Overvaluing book assets makes solvency look good. But overvaluing assets would cause reserve requirements to increase under Palley’s scheme. Asset-based reserve requirements would lean against the terrible dynamic that, via capitalization constraints, the more banks fake their wealth, the more freedom they have to gamble.”

    Capital requirements can be designed with countercyclical adjustment as easily as reserve requirements. The direct source of the fakery is asset values, not capital per se. Fake asset values could deceive a reserve requirement as easily as a capital requirement.

    “The point is to hijack reserve requirements and put them to a different purpose… But even if it is an idea that tends to increase the confusion of already confused people, the marginal loss of comprehensibility to those who already fail to comprehend may be reasonable if the scheme has sufficient benefits in terms of taming bank misbehavior.”

    Wonderful writing, but I disagree. If incentives to asset risk can be managed coherently, why enable the compounding of broad misunderstanding as to how our financial system works? Why irritate this cancer of confusion further between liquidity and capital?

    “Also, there is a way that the idea could be presented that could underline rather than confuse the distinction between liquidity and capital. JKH showed the way … it would be perfectly sensible, on liquidity grounds, to have reserve requirements be lower for banks holding liquid assets such as Treasuries. Since these are easily converted to reserves, the liquidity rationale for accepting lower cash holdings is straightforward.”

    I think there’s a contradiction here. If a bank held $ 1 billion in central bank reserves on a particular day – sure, that’s as good as or better than holding $ 0 billion in central bank reserves and $ 1 billion in treasury bills. That’s an analysis and an argument about liquidity position. But that’s got nothing to do with either ABBR or capital requirements. It’s just a liquidity alternative – not a risk asset based argument. If you’re then comparing either of those alternatives with a third alternative of holding neither type of liquid asset but a risky asset instead – then that’s obviously a risk analysis problem that has nothing to do with the choice between the first two liquid asset alternatives. So the point overall is irrelevant to a preference for capital requirements over ABBR or vice versa. And the “idea presented” remains as confusing if not more so.

    “It’s the gappy shiftiness of the capital that creates the pro cyclicality of banking. ABRR may not be the best alternative, but we do need alternatives, redundant constraints and backstops.”

    It’s not the capital per se that’s gappy. It’s the required risk adjustment. An incremental reserve requirement would be no different economically than an incremental capital requirement – with respect to the challenge of managing and responding to such gapping risk.

    The only reason to choose reserve increases over capital increases is that it’s convenient. That’s not good enough in my view.

    I’ve given an overview of what I think are the important factors about Canadian banking, and I’ll leave it there for now, mostly because of time constraints. If either of you are interested in more detail, I suggest the entire annual report of the Royal Bank of Canada, particularly the risk, capital and liquidity management section; and/or the risk management section of either Scotiabank or TD bank, OSFI (regulation), and CMHC (mortgages including the country’s largest mortgage securitization program). Otherwise, I’m sure lots would pop up under Google, or we can leave the question open, or you can just infer that I’m bullshitting.




    BTW, I haven’t seen too many Canadian Steve Keens out there – can’t think of one off hand (I mean Steve Keen relative to Australian risk, not US risk). No doubt there’s some damage waiting if interest rates rise, but no more proportionately I expect than the US would experience in a second wave. And Canada completely bypassed the first wave. I think US analysts generally are making a mistake in not viewing the mortgage system, including the pipeline in its entirety, as a primary root of the evil. I don’t think too many bad Canadian mortgages landed in Iceland.

    Obviously, I agree with the Dimon view that too big per se is not the problem, although it’s a factor to be taken into balance. Too big Citi is different than too big JPM – bad management.

  14. JKH writes:


    I don’t see the question about whether to waive capital requirements in a wind down. The government waives capital requirements de facto in any wind down. Residual private capital becomes first loss.

    The question is whether or not to inject treasury capital or waive capital requirements as the means for providing public support to an institution that is not yet being wound down.

    The Mosler argument I believe is that injecting capital has been redundant, because FDIC can absorb second losses as easily as can Treasury injected capital.

    But the market won’t treat these approaches equivalently. The market will treat Treasury capital as rescue capital, and FDIC “capital” as contingent second loss absorption in wind down mode.

    The market will view Treasury capital as an additional buffer and additional time to “expected wind down time” – which means additional time to generate capital internally or raise it externally. The trigger for wind down is the exhaustion of both private and Treasury capital, versus the lesser amount of only private capital and shorter remaining time without a Treasury injection.

  15. winterspeak writes:

    SRW: We’ll have to disagree on the merits of Palley. I think he’s spouting garbage because I know how reserves work, and what purpose they serve, and the crap he’s uttering conflicts with that knowledge. He’s calling a wisp of smoke a lever. I have no idea if he actually knows better.

    You are correct in saying that capital can valued in rubbish ways. This is why you need to end securitization as well, and keep all loans on books. There is little sense in lying to yourself. Fundamentally, I think we can both agree that asset valuation is inherently bogus if done by third parties. Ratings agencies are a joke. If you make the loan, you need to do the credit analysis, and bear 100% of the cost of getting it wrong (and reward for getting it right). This is the fundamental purpose of banking, and all suggestions for what to do with the banking industry should be weighed against this simple test. ABRR, apart from being rubbish, is also tangential. Although maybe, at this point, that’s a feature.

    SRW: My point on relaxing capital requirements and lend unsecured at the discount window was merely to point at a mechanism that would operationally protect individual banks while we wound them down.

    Checks would clear, people would get paid, the lights would stay on, and the bank could be dissolved in a controlled fashion. People make a big point of “resolution authority” and avoiding “chaos” — I’m merely pointing out how easy it is to get there. Add in infinite FDIC cover, and we’re done.

    De facto, we are there anyway through TARP (which is regulatory capital forbearance by another, worse, way) and the massive expansion of lending facilities at the Fed. My solution is better.

    We are agreed that the bubble went on for way too long. Maybe we are only kind of agreed on the first-loss for private capital requirement — I think we both believe there hasn’t been nearly enough of it, but I think it, along with banning all secondary market activity, is enough to have banks focused on their public purpose.

    I think I may actually be further along the road of “there is nothing we can do about banks being pro-cyclical” than you may be, title of your post notwithstanding. You are correct, nothing that I have suggested handles that pro-cyclical problem. To deal with that I would actually shift out of the banking sector entirely, as I do not believe there is any solution within the sector. You still seem to hold out some hope for that line of inquiry.

    JKH: Thank you for the pointers. I will check them out.

  16. winterspeak writes:

    JKH @ 11.15.2009 11:26am:

    You are correct. My point was that the market reaction can be managed through lending at the discount window.

    The Treasury action is correctly seen as a bail-out, an attempt to avoid a wind down. It puts public capital in first-loss position before private capital. This is directly contrary to the purpose of banking, and therefore fails by simple test.

    Why did they do this? To avoid a chaotic wind down. Unlimited access to the discount window, plus unlimited Government capital as a backstop, would have achieved the same result and preserved the point of the banking system.

  17. JKH writes:


    If you do happen to look at any of the annual reports, keep in mind they were done as of October 31st, 2008, and lots has happened since then, including the March meltdown. But the banks have done reasonably well through the piece.

  18. One of the most dangerous things about allowing super rich and powerful megabanks is that they can hire armies of lobbyists and bribe congressmen and parties with enormous contributions. This can obviously cause highly sub-optimal policy and legislation to be adopted.

    It would be great if we could pass a law outlawing political contributions and lobbying for banks.

    I’d like to see all corporate political contributions outlawed, as this can cause severely harmful economic distortions of policy to benefit individual corporations and industries – for a particularly ugly example look at the sugar industry – but this would be very hard to pass politically.

    However, with the public, rightly, strongly against the banking industry, and strongly favoring measures to keep them in line and diminish their power, this would have a much better chance of passing than a blanket prohibition on all corporations. And, you could also, quite clearly, add the argument that this industry is special because of its great importance and externalities, that it’s strongly a public good industry.

  19. So, Steve, what is your proposed solution? Should we just bury some gold in the back yard and drink heavily (i.e., more than I have buried and more than I currently drink)?

    Faced with such a Gordian Knot, I think the only valid approach is to start trying to identify all the tangled strands and tease them apart one by one. Surely this is not an insurmountable problem.

    I also note that you suggest empowering regulators with discretion in certain areas, to prevent clever banks from gaming the system. Given the adaptability of sophisticated financial institutions and the pace of change in the global financial system, I cannot see how an effective regulatory regime can forgo a very substantial element of discretion. The challenge becomes, in my view, not how to remove discretion from regulators, but rather how to equip them to handle it in a more effective manner. In many instances, this will probably lead to granting them greater discretion than they currently have. We just need to structure it properly.

    This leads into a suggestion I have been making semi-seriously on my site for quite some time: discretionary regulation of the most complex and clever institutions can only possibly work if it is staffed by regulators who are as clever as their charges. also, one must remove or minimize the potential drivers of regulatory capture like amakudari and massive pay differentials between the public and private sectors, at least at the top.

    I take as my example the military, who have belatedly figured out they need both conventional military forces and highly-trained, specially-equipped elite units to address the full range of threats they face. Why should there not be a special regulatory unit–composed of senior ex-investment and commercial bankers who are paid approximately as well as their peers in industry (with an upper limit, of course) and a 10-year ban on joining the private sector after they leave the government–which has the skills, knowledge, tools, and authority to truly understand and supervise their charges?

    Set up a shadow banking network, with highly skilled, (mostly) incorruptible regulators embedded at or near the highest levels of the most complex and interconnected financial institutions, and give them the budget and the authority to afford state-of-the-art IT and professional support. If Congress has a conniption funding such an outfit, make the regulatees themselves support it through levied fees. Move them around periodically so they don’t identify too strongly with any one bank or institution, pay them really well so they are incentivized to work as hard and smart as their industry counterparts, and let them share each bank’s proprietary information on a completely confidential basis. Give them or their bosses C-suite and Board level access to the firms they regulate, for regular consultation and feedback.

    Congress should periodically audit these guys, and their interactions with the regulated firms should be completely transparent (with a time lag, to preserve timely competitive information) and on the record, so potential regulatory abuse can be identified and punished.

    Even with all their problems, we are probably stuck with lumbering, stupid dinosaurs like the FDIC and the SEC, since the banking and securities industries are huge. We will still need battalions of ground troops, armored divisions, and air support to deal with them. But as far as the most interconnected firms go, like JP Morgan, Goldman Sachs, and perhaps even the biggest hedge funds, we should have some really smart, dangerous, and vicious bastards like the Navy Seals, Delta Force, and the Army Rangers to kick ass and take names.

    I also like Richard Serlin’s idea of banning all political contributions and lobbying of lawmakers by financial institutions, but that probably has just as much chance as my proposal of happening; that is, nil.

    Oh well, back to the bottle.

  20. dave writes:

    I have a friend who is an insurance regulator. If anything getting politicians more involved in the nitty gritty of regulation is bad. If you think regulators sometimes make the wrong decision, politicians ALWAYS make the wrong decision. They are much easier to buy and sell. You have good and bad regulators, but I’ve never seen a good politician. Most of the good regulators get pushed out by politicians who don’t like it when they use discretion to do the right thing. I don’t see how taking away regulators discretion and giving it to corrupt politicians changes things.

  21. fresno dan writes:

    I really enjoyed your analysis.

    The link to the 3% prime actually brought back memories when I cas a child, and saving and loans had neon signs saying that you could earn ?5%? on a savings account.

    Perhaps our financial system does not (per Minsky) incline toward equilibrium. Perhaps the benefit of regulation is merely stability, and tamping down changes in valuations. Maybe when we had to beg and plead and provide our children as collateral, that was the best thing for home ownership.

  22. LawrenceGulotta writes:

    Bank regulators must be insulated from political pressure otherwise there is only a modest liklihood of success. The line troops must be free of political harrassment.

    The valuation of real estate assets is not a mystery. Well educated and trained appraisers and regulators can do a respectable job. MBAs and finance majors basically should not be assigning value to real property. It is not their field.

    Loan underwriters may have a sound background using the Excel and Argus spreadsheets, but they essentially have little or no experience regarding field conditions (the local market place) nor do they have the background to test their underwriting criteria or financial assumptions. The Underwriters do not have a code of professional practice or Standards of Professional Practice. In my not-so-humble-opinion, they are undereducated and poorly advised concerning Professional Ethics. Often, their day-to-day compensation is predicated on looking the other way, checking the boxes, or fudging the numbers.

    Each regulatory agency need SWAT-teams, consisting of the “best and brightest.”

    The business class is as corrupt, perhaps more corrupt, than the political class. Face facts, instead of free market myths. I see more white collar crime today than anytime in my memory or your father’s memory.

    Regulators need to be able to put fear into the hearts of the coddled banking classes.

    I support a return to real estate appraisal basics and underwriting with dispassionate intelligence. Compensation not based on production, but on quality.

    I’ll let the “theorists” tell me about derivitives.

  23. csissoko writes:

    @The Epicurean Dealmaker: So, Steve, what is your proposed solution?

    The solution is simple: recognize that it is not the regulators’ job to keep the banking system sound, it is the bankers’ job to police each other. For two centuries bankers performed this role because nobody imagined the possibility of a government bailout. Only in recent decades — with (i) the passage of legislation exempting financial contracts from the bankruptcy code and (ii) the decision to extend the government’s financial system support beyond liquidity support to the commercial banking system — have respected banking institutions been willing to take on the risk of exposing themselves to poorly managed banks (e.g. Goldman Sachs and AIG).

    The stability of the banking system has always relied on the fact that bankers had first loss exposure to each other — so they were the first ones to cut off liquidity to poorly managed banks. By instituting a policy of protecting the banks from first loss interbank exposure, the job of regulators has been made literally impossible.

    The only question is: How do we terminate the policy that banks which make bad loans get bailed out — and go back to the old-fashioned rule that lenders of last resort wait for a bad bank (of any size) to collapse and then provide ample liquidity support (but no credit support whatsoever) to ensure that the resulting asset price dislocation does not take down banks that were not really exposed to the bad bank? In short, every bank that was heavily exposed to a bad bank must fail — that’s the law of the market. Will a transition to a healthy system be difficult? Yes. Impossible, I hope not.

    (Note in my view this US banking crisis is not comparable to the Depression — because the devastating failures in the US of the ’30s were caused by a collapse in the value of the reserve currency. For obvious reasons US commercial banks nowadays are protected from this type of crisis. In other words there was a solvency crisis in the 30s, but it wasn’t really a bad lending crisis. Thus, I view our current banking system as an entity in the process of self-destructing, whereas the banking system of the 30s was mostly sound but hit by a massive shock.)

  24. Nemo writes:

    Solution is trivial. First, break up the large banks. Second, heavily tax the whole of the financial industry so that smart people are tempted to get real jobs, rather than pursuing useless careers as “bankers”, “dealmakers”, etc.

  25. Taunter writes:

    I would suggest that the problem is not that regulators operate with too many constraints – it is that they do not operate with enough constraints.

    We should certainly break up large financial institutions. But we might as well accept that regardless of the absolute size, the temptation will remain to bail out the largest of the herd. When Goldman ran aground in 1994 as a private partnership, it knew well that no government help would arrive. Had Merrill hit the wall, I am less confident the regulators would have made the affirmative decision to let it go, even though by the standards of universal banks a decade later 1994 ML was a minnow.

    The only way to get regulators to resist the temptation to bend the rules in favor of their favored children is to ban the practice, just as the only way to get regulators to stop taking bribes is to criminalize bribery.

    First, have a clear political decision as to which stakeholders in a financial enterprise are worth government protection. Historically, of course, the answer was only depositors, who accept a return below Treasuries for the security and liquidity. Lately, we have behaved as though bondholders and even shareholders should be protected, which is strange insofar as that allows them to tax the government at will. In the event, we need to decide.

    Given some decision on where in the capital structure we draw the line, the important issue is to bar any government intervention to aid other stakeholders. Citigroup could easily have been resolved in February by implementing the Bulow Plan; that simply would have crushed the bondholders. Goldman could have been allowed to fail in late September 2008; it had inadequate capital to become a depository institution and, as a minor point of trivia, no plans to actually become a bank with its newly minted bank charter. The regulators made the choice to keep it alive; the legislators, in more sober times, should deny them that option.

    More here

  26. Aaron Krowne writes:

    I have not read all the comments but this is a very thoughtful piece and I figured I’d add my two cents.

    I think Steve rightfully disdains the “discretionary” regulatory approach that seems to dominate in the US right now. I can add little to his treatment of that topic.

    However, I also have little confidence for the “structural” regime he seems to be proposing.

    Even if the ideas are noble, there are the ominous “regulatory lag and scope” issues. It looks like some people have already made the key demonstrative points I would make along those lines, from various shrewd schemes to avoid reserve requirements to off-balance-sheet-vehicles to hide liabilities and appear to be better-capitalized relative to risk.

    I would also add as another e.g. that Glass-Steagall, that Depression-era “grand old lady” of structural regulation, seems to have done little of substance: the great wave of post-S&L bank mergers was over BEFORE Gramm-Leach-Bliley was passed. Glass-Steagall was less of a great bulwark and more of a bothersome mosquito for, ultimately, Citigroup to flick from its bosom.

    Perhaps the ultimate answer lies in the apparent a priori assumption that the financial system is a “public/private partnership” — at least, in the sense of the body politic having bureaucratic involvement in that system. I am reminded of how my favorite “public” transportation systems in the world are not public at all. And I might much prefer a financial system that was similarly NOT public.

    But that might prove impossible not to mess with, eh?

  27. Declan writes:

    Re: the Canadian banking system, I think a major difference vs. the U.S. ties back to your earlier discussion with John Hempton and your comment in this post that, “The miracle of competition ensures that many of the most important and successful banks will have balance sheets like helium balloons at the end of a boom.”

    The Canadian banking system is a lot of things, but overly competitive is not one of them.

    There’s some interesting historical charts on the Canadian banking system in a Bank of Canada presentation here. I found page 16, showing how leverage at the banks was brought down by regulatory decree over the last couple of decades interesting, and somewhat (not entirely) counter to your bear analogy above.

    Having said all that, there’s still something to your bear analogy, in my opinion. It was only a couple of years ago the government decided to increase competition in lending to people who couldn’t afford typical down-payments, allowing mortgage insurers to offer 0 down mortgages and 40 year amortizations for the first time (they changed their mind a bit later on, raising the requirements to 5% down and 35 year amortization, still all-time highs (or lows, depending on your perspective).

  28. locrian writes:

    This post is amazing, thank you for taking the time to write it.

    I’m not surprised you often don’t agree with Economics of Contempt on many things. Two very different people with very different blogs. When I want deep insight into the nature of our current system and how a good banking system might run, I can come to interfluidity. EoC, on the other hand, has given me insight into the details of how our system runs, and I feel it is often much more realistic about what changes can actually be made.

    Oil and water, we need you both. I hope you two continue to blog for a long time.

  29. BSG writes:

    Steve, another brilliant way to show how fractional reserve banking, especially combined with fiat money, is a predatory system, by design.

    There is really nothing wrong with the system – it is functioning as intended for the predators that designed it (and their offspring.)

    As long as we accept the rules predators set for us for the basis for a financial system, the rest of us will continue to be prey.

    Elizabeth Warren said recently on PBS NOW that if Congress gets reform wrong (for me not an IF,) the country we know will be gone. I’ve never heard someone so prominent and thoughtful express it so starkly. She also talked about how all of us are just going to be working for the big banks.

    I would welcome your analysis as to how there are any _realistic_ solutions short of eliminating that dastardly duo of fractional reserve banking and fiat money.

  30. Rogier Swierstra writes:

    On the point of “resolution”, compare how the government came down on GM’s CEO Rick Wagoner with the velvet glove for BofA and Citi. Wagoner was fired before the goverment had any legal authority to call for his resignation.

    Banks are different.

  31. Swiestra:

    You hit the nail on the head, “banks are different”. They are part of the Treasury “system” to sell US debt. As long as Uncle Sam sees the current banking system as being useful to sell US debt it will remain. Our supposed banking “regulators” understand this. Uncle Sam’s interests and the Uncle Sam’s creditors’ interests, i.e., US dollar holders are directly opposed. I have said for years, either Uncle Sam kills the banks or the dollar. Banking regulation must be consistent with the latter.