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Banking reforms

I am strongly impressed by the argument, and the facts marshaled to defend the argument, of this Bloomberg column by Anat R. Admati of Stanford.

Confusing language often obscures the discussion of capital regulation and makes it more difficult to evaluate such threats. Banks often are said to “hold in reserve” or “set aside” capital; capital is described as a “rainy day” fund, and we are told “a dollar in capital is a dollar not put into the economy.” These descriptions portray capital as a pile of money sitting idle and not being used productively. This is nonsense.

Capital is simply equity, the value of shareholders’ ownership claims in banks; and it represents a way for banks to fund their investments without undertaking debt commitments that they might not be able to meet and which add to systemic risk. Bankers are fiercely resisting the suggestion that they use more equity and less debt in funding, even though this would reduce their dangerous degree of leverage.

When debt supplants equity, bank holdings “can be easily wiped out by small declines in asset values.”

If 95 percent of a bank’s assets are funded with debt, even a 3 percent decline in the asset value raises concerns about solvency and can lead to disruption, the need to “deleverage” by liquidating inefficiently, and possible contagion through the interconnected system. As we have seen, this can have severe consequences for the economy.

Debt markets, of course, were the stupendously huge benefactors of state intervention to prop up values, quell panics, and sustain liquidity throughout the acute crisis of 2007-09. Even a cursory perusal of the Fed’s extensive documents concerning its lending activities will confirm this. TARP was different because it eventually involved equity purchases. We may even turn a profit on those capital investments. But the real action was in central bank operations in debt securities: that was where the market mechanism was tested and found wanting, whereupon the state’s own financiers intervened, using the credit of the US taxpayer.

Debt, usury and shadow banking are intricately intertwined. Remember in late 2008/early 2009 when General Electric was permitted to issue bonds backed by the FDIC? Doesn’t that sound strange to you? How could a famous American industrial conglomerate find itself in such dire straits as that?

The answer lies in this: over the past several generations, quite a number of big industrial corporations have found it advantageous to convert themselves into gargantuan banks or securities firms, often concentrating in a particular class of security. GE is one of those; its specialization is commercial paper, a short-term debt security. When world banking went south, it sucked all these peripheral lending institutions, these shadow banks, into its death spiral. That’s why the day dawned when the Federal Deposit Insurance Corporation was compelled to help keep General Electric afloat.

Professor Admati continues:

While equity is used extensively to fund productive business, bankers hate to use it. With more equity, banks have to “own” not only the upside but also more of the downside of the risks they take. They have to provide a cushion at their own expense to reduce the risk of default, rather than rely on insurers and eventually taxpayers to protect them and their creditors if things don’t work out.

The obvious next step here is the idea of pushing the investment banks back into private ownership. The experiment of publicly-traded firms at the top of the securities industry has failed. It was an encouragement to ever more exotic innovations, ever more obscure abstractions, built on ever more excessive leverage. Off at the end the structure depended for permanence, in the teeth of panic and collapse, upon the beneficence of the government.

What we need in to restore in finance is an anchor in human reality. Our reforms should have that purpose in mind. I agree with Professor Admati that the preference in finance should be for equity. Furthermore, a regulatory goal of pushing for private i-banks would go some way toward checking the extreme generalization of mathematical finance with the time-honored human intangibles of the wisdom and reputation of particular bankers and particular institutions.

Debt markets proliferate with abstractions and the newest rocket science modeling. (There is plenty of this sort of thing in equity too, of course.) But with the broker-dealers and perhaps some other vital firms in private ownership, the financiers’ enthusiasms are more contained. Self-interest becomes a check on excess, rather than an inducement to it. The bankers’ own personal capital is on the line. There is no cushion of public shareholders to absorb reckless losses: creditors will be coming for your home, your plane, your boat. Thus we incentivize more prudent banking.

Let me add that —

(a) I have no illusions about these reforms performing the work of a panacea. There were panics and crises in abundance in the era of private investment banks. But in my judgment the ameliorative advantage of these ideas is evident.

(b) I do not underrate the difficulties facing us, even should we (the people of this Republic) decide that these reforms must be implemented. How to get from here to there is no inconsequential question.

Comments (5)

Several centuries ago, the common law accepted a rule, which the civil law names the "numerus clausus," stating that there would be no innovations in property rights: if you wanted to claim an interest in property, it had fit into one of the existing, established categories of property rights.

It seems that the numerus clausus should have been imposed on securities some time ago: sell all the stock, futures, and partnership interests that you like, but that's it. Don't come in here trying to securitize derivatives from negotiable instruments. That dog won't hunt. Now it's too late, I suppose.

What, if anything, would the place of micro-banks? Seems to me that (naive as I am) banking would be all the better if most loans were between people who already knew of each other, as they had been members of the same community for years. The "fill out this form and put down every detail that I could ever think of" loan application method seems to be another way of abstracting: from real human relationships. Shadow banking loaned on shadow assets to shadow people.

I also think it's important that bailing out the banks will lead to lower debt costs for the banks. For all intents and purposes, it's now clear that USG won't let banks default. Banks' borrowing costs will therefore be lower due to this implicit guarantee. Lower borrowing costs will entice banks to issue more debt.

@Paul, Signal your turns please. I was following you just fine as you worked through the dangers of excess leverage, but lost you when you abruptly turned to a solution involving a restriction on the nature of equity I-banks should be permitted to use. I suspect that's a wrong turn, but I don't know how you got there, so I'm not sure where you've gone wrong (or even if you have).

Maybe Prof. Admati is correct that bankers consciously count on the bailout, but I suspect a larger driver of their actions is the fact that equity costs more than debt, so that if you fund with more equity your returns are lower or you are less competitive.

@Titus, would you be interested in buying Class A partnership interests in American Mortgages LLP? The class A partnership interests entitle you to a pro rata share with all other class A interests in the first payments that come in on the assets owned by the limited partnership - a bunch of mortgage loans. Rated AAA by S&P it pays a little more than AAA corporate debt. Hunts just fine.

@Foseti, it is important to include the modifier "large" banks. 23 banks have failed this year (so far); 157 last year; 140 in 2009; and 25 in 2008. The largest bank allowed to fail during the crisis was WaMu ($300 billion). Obviously the largest I-bank to be allowed to fail was Lehman ($768 billion in debt/ $639 billion in assets at bankruptcy). Clearly the government won't allow a bank as large as Lehman to fail again. You are of course absolutely correct that the implicit U.S. government guarantee (i.e., you and me) lowers the megabanks' cost of funds, so the real issue is the fact that small medium and merely large banks are at a serious competitive disadvantage, driving them to riskier activity themselves.

At the end of the day, its hard to argue with the observation that too big to fail is too big. Banks with more than $300 million in assets should be required to slim down.

Banking reforms are risky ventures in any economy. They present severe consequences (positively or negatively). I am more concerned with the basis/motive and manner of implementation of any reform effort initiated by either the government or the banks themselves. Wrong implementation may precipitate another financial crisis,reduce investor confidence, lead to job losses, frighten depositors or other stakeholders,and even jeopardize attempts by regulators to stabilize the financial system. The reverse may generate more desirable outcomes. So how do we proactively determine which implementation option is right or wrong?

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