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Leverage
In last week's column, Martin Wolf warned that bushels of new regulations won't save us from another banking crisis. The problem, he said, is that in a highly leveraged business it makes perfect sense for shareholders (and therefore management) to take enormous risks, and nibbling around the regulatory edges won't change that. But what will? He didn't really say, prompting me to comment, "Perhaps this column was a season finale cliffhanger and we have to wait until next week for the mind blowing conclusion?"
I guess it really was, after all, because this week we get Wolf's answer:
If institutions are too big and interconnected to fail, and no neat structural solution can be identified, alternatives must be found: much higher capital requirements and greater attention to liquidity are the obvious ones. At present,
big financial institutions operate with next to no capital: in the US, the median leverage ratio of commercial banks was 35 to 1 in 2007; in Europe, it was 45 to 1 (see chart). As I noted last week, this makes it rational for shareholders to “go for broke”, with the results we have seen. Allowing institutions to be operated in the interests of shareholders, who supply just 3 per cent of their loanable funds, is insane. Trying to align the interests of management with those of shareholders is then even crazier. With their current capital structure, big financial institutions are a licence to gamble taxpayers’ money.
So how much capital makes sense for systemically significant institutions? “Much more than today” is the answer. Moreover, the required capital must also not be risk-weighted on the basis of banks’ models, which are not to be trusted. Shareholders’ funds should make up a minimum of 10 per cent of capital. In the US, it used to be far higher.
....Within a far better capitalised financial system, it would also be relatively easy to operate a “macroprudential” regime, with the required capital rising during booms and falling during busts. Again, the bigger the stake of shareholders, the less one would worry if the rewards of managers were aligned with them.
Well, that turned out to be distinctly non-mind blowing, didn't it? Regulate leverage wherever, whenever, and in whatever form it appears. But though Wolf's answer may have been a bit anticlimactic, at least it has the virtue of being right.
The big remaining question, though, is: how? How do you mandate higher capital requirements in a way that's likely to be robust? As Wolf says earlier in the column, "'Never again' might be too much to ask. But 'not for a generation' is essential." So how do we build a system of stronger capital requirements likely to persist around the globe for at least a generation? I haven't yet heard a really persuasive answer to this, and unfortunately, at this point it's not clear that anyone is even trying very hard to figure it out. There are just too many people who want to believe that the crisis is over and we can go back to business as usual with just a bit of minor deck chair rearranging. Ten years from now we'll pay the price for this.
I don't understand the
I don't understand the question. Regulators can set higher capital ratio standards and punish institutions that don't meet those standards. Seems pretty straight forward to me. I'm pretty thick, so please tell me what I'm missing.
But I agree
The question about capital ratios is purely academic. The Obama people ares only interested in seeing how many bandaids are necessary in order to get back to business to usual. No matter what the cost to taxpayers.
Yes, obviously within ten years we get a replay of the crisis. A variation on the theme, but essentially the same thing where those who caused the problem make out like bandits while everyone else pays.
And these are the guys I voted for.
Sen. Dick Durbin (D-IL) on
Sen. Dick Durbin (D-IL) on the influence of banks: "the banks, hard to believe in a time when we're facing a banking crisis that many of the banks created, are still the most powerful lobby on Capitol Hill. And they frankly own the place."
Ditto for the White House.
Not to argue, but...
I think the Obama approach is this:
bandaids are good til healing can naturally occur
reforms (like surgery or casts) are necessary when the system was broken
Determining which is necessary is debated.
debt to equity
tagged as:- solution
"I don't understand the question. Regulators can set higher capital ratio standards and punish institutions that don't meet those standards. Seems pretty straight forward to me. I'm pretty thick, so please tell me what I'm missing."
I think the argument is that firms like Citi were required to have far higher levels of capital than they did but bypassed this through accounting tricks. Regulators allowed this because they believed banks had become better at managing risk and so did not need to hold so much equity.
The concern is that when we have another bubble the same mind set will take hold and regulators will allow banks to bypass regulations again.
I think a big part of the answer is to require that when banks issue debt it be convertible to equity in the event of a regulatory event that would be triggered by another financial crisis.
In this case debt would become equity when a bubble burst. Banks would have far less actual leverage than they would appear to.
Most importantly, banks would feel no need to sneak around this regulation during a bubble. The main characteristic of a bubble is that people think that nothing is going to fail. In a bubble the possibility that the debt would be converted to equity would be thought of having a 0% chance of happening.
Don't you think the answer
Don't you think the answer is more that you should have regulators actually enforcing the rules, and calling BS when institutions are using tricks to break those rules?
To me, what just happen is no different than drug dealers paying off the cops to look other way. You can have all the rules in the world, but if no one is willing to believe in them or enforce them, they mean nothing.
This debt-equity swap that you mention, which I'm not sure exactly what you mean, seems to me to be just another way to let regulators off the hook.
Then the question is...
whether changing regulators (a bandaid) is enough to solve the problem or
if some other systemic change is required.
Is there another way of forcing the rule, so as to avoid the problem of a weak regulator?
"I don't understand the
"I don't understand the question. Regulators can set higher capital ratio standards and punish institutions that don't meet those standards. Seems pretty straight forward to me. I'm pretty thick, so please tell me what I'm missing."
The issue is "what is defined as reservers, and what is defined as a loan". An old-fashioned loan is legally well-defined. Now suppose that we start writing credit-default swaps on that loan. We've now split the loan (a bundle of distinct things, like a flow of cash into the bank each month, and a risk that that flow of cash will abruptly stop) into two distinct things --- the flow of cash (guaranteed never to stop) and the risk that the flow will stop (borne by some sucker like AIG, and paid for through an insurance-like premium).
When you split your loan up like this, is it still legally a loan, and do the "old-fashioned" rules apply? Obviously the banks will argue no. It may or may not have been stupid for regulators to go along with this logic, but more was going on that simply ignoring the rules. I suspect that when the details are investigated, for example, it will be found that a few regulators WANTED to apply the existing rules more stringently, and were told by Congress and/or the White House to apply the letter of the law and not one damn step more.
A substantial problem (not just in the financial space) is that US society is populated by a substantial number of people (I suspect a majority) who think that operating a legal system based on the exact letter of the law, rather than on intent, is an altogether fine thing, and that when someone is "smart enough" to figure out a loophole and exploit that, good for him. A legal system does not, as far as I know, have to be structured with these as the default assumptions; and from what I have heard, the Scandinavian legal systems, for example, are not --- something that is sometimes a cause of friction when they rub against the more US-like EU system.
Agree with just about
Agree with just about everything you said. My point is that the problem of maintaining capital ratios does not need to be that complicated as long as regulators acknowledge that it is important and are willing to interpret and enforce the rules in order to meet their goals.
Obvioulsy that didn't happen.
First, with all due respect to Wolf (who is an excellent analyst
He's wrong with respect to regulation, for the US in particular, regulatory system weakness clearly contributed to much of the excess risk getting into the system to begin with (and indeed into the global financial system, the US bad asset problem being the most toxic given it came in most exotic structures).
Relative to Drum's question: "haven't yet heard a really persuasive answer to this, and unfortunately, at this point it's not clear that anyone is even trying very hard to figure it out." I am happy to tell him that there are a lot of people looking at this (perhaps not among US Journalists in a literate non-hysteric fashion, nor US Congress, but elsewhere). In particular Bale committees and Central Banks; indeed I just attended a a working sympo of regulators and financial sector folks on just this.
One item is clear: the burnt fingers have taught a lesson to all that the pre-2008 conception of the risk modeling and risk weighting was all bollocks. The Quants fell into Scientism and built Rube Goldberg machines. A more strict regulatory view on risk shedding via CDS and other derivative / insurance schemes (perhaps entirely discounting from a regulatory capital point of view, although the bank can still do it as an Economic Hedge) is clearly in the works, and I will say the more strict the better relative to Regulatory Capital.
As for the opininating supra re what the Regulators wished to do, in my experience the above is bollocks re 'old fashioned' - certainly it appeared however, given a generation of bank stability that the risk dispersion systems created in the 1990s were working. And they did under very plain vanilla circumstances. However, they also showed that under high stress circumstances, they don't work. Regulators pushed for more risk oriented systems as it appeared to be more efficient.
As such, I believe I partially agree with Powell supra, that with certain key rules (and ex USA, this is fairly straight forward given that generally only one regualtor exits for an activity / area - credit versus cap mkts - unlike the American madness of god knows how many different regulators for different flavours of banks, each one taking a supposed standard rule set and ....).
Banks pay insurance premiums
Banks pay insurance premiums to agencies that guarantee deposits. Other institutions pay regulatory fees. Have a sliding scale so that greater leverage brings higher fees.
How indirect can it get and still be safe?
Degrees of safety:
First, having all cash/assets on hand.
Second, required reserves as percentage of cash/assets.
Third, insurance on cash/assets.
Fourth, insurance on required reserves.
How far can this go before someone yells that the emperor has no clothes?
Would you associate smaller thrifts in the pool that insures the more risk-taking large banks? Same for FDIC has already raised questions recently.
No, no, no
Insurance premiums that you refer to are Deposit Insurance. That is plain vanilla, much bank lending (even in a non-exotic world) is not off deposits.
That is why there is Regualtory Capital and additionally why Reg Cap is not linked to Deposit Insurance.
The Lounsbury, What you say
The Lounsbury,
What you say is reassuring, and I hope to Hell you are right about serious, enforced regulations for capital requirements.
I hope you can understand that from my perspective I am a bit skeptical, because in the US to me it looks like the bankers own the government, and the bankers have not yet gotten 'burnt fingers,' so the bankers making the rules are unlikely to change the rules at this time.
Obviously I am going to ignore what they say and instead watch what they do.
Tripp
On burnt fingers:
When the private banks were owner-operated they stayed cautious to avoid the burnt fingers of having skin in the game when one is reaching too far into the flames.
They went corporate (who let that happen?) and burnt a lot of their shareholders' fingers (when Lehman went belly up and others shrank).
A lot of the big corporate banks have lost a lot of value, but because of crazy CEO comp (who let that happen?) they haven't burnt fingers.
Change the rules a bit to ensure CEO fingers are in the game (who's going to do that?) and caution will return.
Reassruing?
Quite the contrary, my comments should be worrisome as I have suggested the problem is a system problem (and Martn Wolf is far more intelligent here, his columns are worth reviewing if one is really following this issue, rather than whanking on).
Re your skepticism, I again reiterate my s obs re USA, a byzantine system is infinitely gameable' there is no way of create a 'virgin birth' operationally; a reason I have hanged on this blog re regulatory simplification is rather simply that i seems o me that there would real operation gains in simplification for all parties, but it is one of those subjcts tha is of to diffuse interest to have champions. Drum, however much he is primitive in his understanding of this subject (nd hy not, except he writes about it in public) has an interesting audience,.But above all, it amuses me.
Reassruing?
Quite the contrary, my comments should be worrisome as I have suggested the problem is a system problem (and Martn Wolf is far more intelligent here, his columns are worth reviewing if one is really following this issue, rather than whanking on).
Re your skepticism, I again reiterate my s obs re USA, a byzantine system is infinitely gameable' there is no way of create a 'virgin birth' operationally; a reason I have hanged on this blog re regulatory simplification is rather simply that i seems o me that there would real operation gains in simplification for all parties, but it is one of those subjcts tha is of to diffuse interest to have champions. Drum, however much he is primitive in his understanding of this subject (nd hy not, except he writes about it in public) has an interesting audience,.But above all, it amuses me.
Ummm, Lounsbury?
You know I respect you, man, but have you been drinking?
I don't have a problem with that, and I think I would thoroughly enjoy tipping a few with you some evening, but I'm just wondering if you are drinking or if you are trying to type on your mobile phone while riding a camel?
Tripp