How Big is Too Big To Fail?

Recent reports suggest that both the TARP payouts to big banks as well the government bailout of AIG will be fully repaid. Scott Sumner says this has changed his mind about the supposed moral hazard problem of banks that are too big to fail:

It appears that at the end of the day the biggest banking fiasco in the history of the universe will not result in any long run net taxpayer transfer to big banks. And yet the owners and managers of those banks incurred mind-boggling losses. So how plausible is it that TBTF was the primary cause of excessive risk taking in 2004-07? If even a crisis this big didn’t result in the long-run transfer of one cent of taxpayer money to big banks, does it seem likely that expectations of those transfers were a powerful motivating factor in the MBSs they bought?

I guess I'd look at this differently. I've always been a little skeptical of the pure moral hazard argument. Until the end came, my guess is that no one at any of the big banks expected to fail and therefore none of them expected to need bailing out. Partly this is because they believed in their own risk management strategies and partly it's because the kind of people who make it big on Wall Street are all convinced that they're smart enough to avoid disaster. Sure, good times and bad will always be with us, but they figure they can ride out the bad times even if some of the guys across the street don't.

So in this sense they weren't motivated by the expectation of a government bailout. But there are at least two other problems that are related but not identical to pure moral hazard. For one, big banks are where the big money is, and in a recent paper Vanderbilt's Margaret Blair argues that executives at big banks therefore have an incentive to amass dangerous amounts of leverage even if they know that this can lead to systemically threatening boom and bust cycles:

Bubble and crash cycles [] can be quite lucrative for the financial market participants who help to create them. This is because of the asymmetric nature of the gains and losses — financiers and shareholders of financial firms take home sizeable wages, bonuses, and dividends in good years, but are not required to pay these back in bad years. For this reason, financial markets will not be self-correcting and self-regulating.

....The effect of repeated bubble and crash cycles in the economy has been a steady ratcheting up of compensation in the financial sector, which has exacerbated the trend toward ever widening distribution of wealth and income in the U.S. In fact, the growing wealth of the financier class might be self-perpetuating because their high wages and astronomical bonuses gives them significant political clout.

The issue here isn't that executives expect to be saved by the government, it's that (a) they don't think they'll fail and (b) even if they do, they know that they get to keep all the money they made during the boom. Thus, dangerous behavior is rewarded, and this behavior costs taxpayers a bundle even if most of that cost isn't in the form of direct bailouts to the banks themselves.

Which brings us to the second problem: a banking crisis does cost a tremendous amount of money even if it's not mostly in the form of direct bailouts. The long-term cost of the 2008 crisis has been huge, but it comes largely in the form of lost economic growth, rising unemployment, and staggering additions to the federal deficit. This cost is borne almost entirely by taxpayers, not by players in the financial industry itself — which has recovered quite nicely, thankyouverymuch. And while it's not possible to say for sure how differently the financial crisis would have played out if we'd had lots of small banks failing instead of a few big ones, I think you can make a pretty good case that the systemic damage came mostly from the crash of the big banks and the shadow banking sector, not from failures at smaller FDIC-insured banks. But those big banks didn't have to pay much of the price.

So: the problem isn't that Wall Street bankers knew they might fail and took risks anyway in the knowledge that the feds would bail them out if the worst happened. The problem is a little more subtle: they're incentivized not to care if they're taking dangerous risks because (a) they get to keep all the money they make during the boom years and (b) they know that even a massive financial crisis will cause them only temporary pain, with most of the cost borne by the broad public which suffers from its aftermath. That's a great big dollop of moral hazard even if, technically, the government doesn't lose a dime on any of its direct bailout programs. And the problem is much worse and much bigger at big banks than at small ones.

Second Thoughts on Basel III

So is the new Basel III agreement on bank capital a win for the forces of light? I'd say so, but I confess that news like this gives me second thoughts:

The U.S. banking industry breathed a sigh of relief Monday after international regulators proposed new rules dictating how much capital financial institutions must hold....Financial stocks shot up Monday on word that the new requirements would be phased in over a longer period than expected. An index of 24 bank stocks jumped 3%.

In some sense, it's probably banks themselves that have the best idea of just how effective the new regulations are — they have the biggest incentives to figure it out, after all — and this reaction almost certainly says a whole lot more about what they think than all their reams of special pleading over the past few months put together. I've said before that the acid test for financial regulation is whether or not it reduces industry profits, and so far the reaction to both Dodd-Frank and Basel III suggests that the banks themselves are pretty sure that the good times are going to keep rolling.

Beyond that, there's another big criticism of Basel III. But first, some background: the basic idea of the Basel regulations is that banks need to have a certain amount of money (capital) to cushion potential losses from their loans (assets). So there are two sides to the equation. The first is how good a bank's capital is. Ideally, it should be something that a bank has fast and sure access to, not something that another party might be able to claim when times get bad, or something that can't be quickly converted to cash. On that score, Basel III does a fairly good job of tightening things up.

But assets are the other side of the equation. Suppose you have some ordinary loans that are ordinarily risky. How much capital should you be required to carry to cushion possible losses? Let's say 10% of the value of the loans. But what if you have some A+ rated assets? Those have a more modest risk of defaulting or losing value, so do you really need 10% for those too? Of course not! So let's say you only need half as much. And how about AAA assets? Those are safe as houses.1 There's very little chance of them losing value at all, so how about if we only require you to hold a fifth of the usual cushion for those? This is how the old Basel II requirements worked, and the logic is perfectly sound. In practice, though, it turned out not to be such a great idea because we were too confident of our ability to measure risk. Noah Millman comments on how this plays out in real life:

Precisely because you now feel like you know what your risks are, you’re going to be inclined to hedge them, until you get your risk position down to something de minimis....Everybody still has to make money, though. And since taking any additional measurable risk is now stigmatized, the game becomes how to increase returns without increasing measurable risk. And that, predictably enough, means that more and more money piles into products with risks that either cannot yet be measured or, even worse, that the financial world is not aware exist.

Developments in banking regulation in the last decade, meanwhile, have turbocharged this process, and I’m increasingly convinced contributed mightily to the financial crisis. At the heart of the financial crisis, after all, was banks investing in highly-rated debt backed by lousy mortgages. But why did they hold so much of this debt? In part because they could plausibly argue that it was risk-free or nearly risk-free. Double- and triple-A-rated debt had very low risk-weighting. Similarly, anything hedged with a double- or triple-A-rated financial counterparty had a very low risk-weighting....Basel III retains this basic framework, but increases (somewhat) the amount of capital that banks need to hold generally. Therefore, it should further increase the incentive to avoid measurable risks and to hold positions whose risks are not well-measured.

When I first read the BIS press release on the new capital requirements, I was under the impression that it didn't address the issue of risk-weighting simply because that was scheduled to be addressed later. But I gather that I was wrong about that. It didn't address it because Basel III simply doesn't address it. This means that banks still have a huge incentive to engage in regulatory arbitrage, desperately searching for assets with AA or AAA ratings because they can be levered up far more than ordinary loans. In fact, the higher capital requirements might provide an even bigger incentive to do this than before. After all, reducing your capital requirement from 10% to 2% is a bigger deal than reducing it from 5% to 1%.

Now, as it happens, Basel III does add a simple leverage ratio to complement the new capital requirements: capital has to be at least 3% of total assets with no risk weighting. That's a good addition, but 3% produces leverage of 33:1. That's a lot of leverage, and as Zach Carter points out, it's probably too high to really have any moderating effect. So what's the right leverage number to shoot for? Martin Wolf thinks it should be in the neighborhood of 5:1. That's probably too extreme in the other direction. But ten or fifteen to one? That would do the job nicely.

Bottom line: requiring banks to carry more, and better quality, capital is a good idea. Basel III really does make things better. But I'm beginning to think that, like Dodd-Frank, it only makes things a little bit better. Consider me a bit deflated.

1Irony fully intended.

Quote of the Day: The Power of ACORN

From Dave Weigel, after reading a poll showing that about 20% of the public thinks ACORN "will steal the election to keep Democrats in control of Congress":

We're about to go into the first election since 2004 where the Democrats won't do very well. It is also the first election since the 1970s when ACORN won't really exist. In 2004, 2006 and 2008, when things were either touch-and-go or terrible for Republicans, voters read lots of election-time stories about an organization called ACORN that was filing lots of bogus voter registrations. This year, Republicans will win, and I bet the myth of ACORN only grows — that a stubborn number of Americans will think that Democrats only won the 2006 and 2008 elections because of fraud, and that James O'Keefe saved us from it.

This is terrifyingly plausible.

Yet More Nonsense in the Senate

Pretty much everyone is on board with repealing or modifying the new 1099 reporting requirement that was added to the healthcare reform bill earlier this year in an effort to keep it within budget. The whole thing was sort of ridiculous from the start, since the new requirement would require masses of new paperwork from small businesses and bring in less than $2 billion a year for all their trouble. The easiest thing, frankly, would be to simply delete it now and forget about trying to offset the revenue, but naturally that makes too much sense. Ezra Klein fills us in on the alternatives on offer:

The Senate considered two different proposals to reform that law today. One, from Bill Nelson, would've exempted purchases of less than $5,000 (which is 90 percent of them) and paid for the lost revenue by cutting oil and gas subsidies. Another, by Mike Johanns, would've repealed the provision entirely and paid for it by cutting spending on public health and weakening the individual mandate.

So here you've got Democrats agreeing to modify the requirement and offset the cost by cutting oil and gas subsidies. Who could be against that? I mean, who's actually in favor of oil and gas subsidies? Come on down, Rep. Paul Ryan!

We’re going to single out one sector of our economy, a very important sector of our economy, and say higher tax rates if you produce in the U.S. than any other sector in the economy. This is just ridiculous economics, redistribution, but more importantly, it’s just punitive. It’s punitive and it’s political and it’s not going to help our economy.

So there you go. Republicans all voted against the Nelson proposal, and Democrats, needless to say, voted against the absurd Johanns proposal, which seems to have been deliberately designed to be as offensive as possible. I mean, cutting spending on public health? Seriously?

Anyway, we all know that Republicans think tax cuts are good things that don't need to be paid for with spending cuts, so again: why not just introduce a clean measure that gets rid of the 1099 requirement completely and doesn't bother trying to offset it? Would the GOP caucus really vote against that?

TV Time In Congress

George Mason law student Alex Mitchell takes a look at the guest list for the Sunday chat shows in 2009 and comes up with this:

As usual women and minorities get the short end of the stick. But mainly that seems to be due to an entirely unrelated underlying cause: the overwhelming preference of talk show bookers for senators instead of House members. The people's chamber just doesn't get any respect.

Delaware and the Future of the GOP

I was on the radio yesterday chatting about my piece on the Tea Party movement in the current issue of the magazine, and although I don't think I said anything very interesting, I was at least proud of myself for successfully remembering the names of Mike Castle and Christine O'Donnell, the Republican candidates currently duking it out for a Senate nomination in Delaware. (On the other hand, I unsuccessfully remembered the name of the Koch brothers' father, so you can't win 'em all. It's Fred Koch. Fred Fred Fred.)

Anyway, this came up because the host asked if the tea partiers were nuts for continually dumping centrist candidates who would be easy winners in November and instead nominating true believers who might very well lose. Think Sharron Angle in Nevada, Joe Miller in Alaska, and Rand Paul in Kentucky. As it happens, my guess is that most of these will turn out OK for the tea partiers. Paul and Miller will probably win, and although Angle is certainly the best opponent Harry Reid could have hoped for, even she has a chance.

But Delaware is the real test. Mike Castle would be a shoo-in to win in November, while O'Donnell — Delaware's version of Harold Stassen1 until the Sacramento-based Tea Party Express got involved — is extremely likely to lose even in the current anti-Democrat environment. Nominating her would truly be a case of cutting off your nose to spite your face. E.J. Dionne writes about the Delaware race today:

Few races this year have been more clear-cut on the matter of electability: The polls demonstrate that Castle would be the favorite against a rather strong Democratic candidate, New Castle county executive Chris Coons. By nominating O’Donnell, the Republicans would hand Coons and the Democrats the seat.

Castle, at least, is not in the least bit complacent. “The Tea Party Express, which claims it’s not a political party, is in reality a pretty good political operation,” he said in an interview last night. “This is a more sophisticated political operation than they’ve been given credit for.”

He adds that what’s happening here “goes way beyond this election” — and that’s entirely true. Democrats may be rooting for O’Donnell because they need all the Senate seats they can get this year. But my hunch is that a lot of them would quietly mourn if Castle, a guy of old-fashioned decency, were to lose. If there is no longer any room for him and people like him in the GOP, it will be the clearest sign yet of a party that has decided to go off the edge.

Not me! I'm rooting for O'Donnell with no quiet mourning for Castle at all. I'm not sure at this point why Dionne still wonders "if" there's room in the modern GOP for guys like Castle, since that seems about as clear to me as anything could possibly be. The answer is no, and Castle's fate won't change that one way or the other. The die has been well and truly cast here for some time: the GOP is irrevocably committed to the undiluted Fox/Limbaugh/Drudge party line, and there's no going back. They're either going to stand or fall on that. So I say: let 'em do it. No excuses, no scapegoats. Finish up the Texification of the Republican Party and see how it goes. Only then is there any hope of a return to common sense.

1See Suzy Khimm's report here for more.

Taking Boehner Seriously

Jon Cohn wants us to take Rep. John Boehner more seriously. Here is the CBPP's estimate of what Boehner's proposal for spending cuts means:

Rep. Boehner has proposed limiting total discretionary funding for fiscal year 2011 to $1.029 trillion [...] while setting funding levels for defense, military construction, veterans, and homeland security at the same levels that President Obama’s 2011 budget requests for those areas. According to CBO, the President proposes $673 billion for the defense (other than funding for the wars) and veterans parts of the budget (the “budget function” for those areas) and the Department of Homeland Security. This leaves $356 billion for “non-security” discretionary funding under the Boehner plan.

First things first. What's remarkable here is what Boehner doesn't want to do. Out of a total federal budget of about $3 trillion (not counting temporary stimulus spending), he puts almost all of it off the table immediately. He proposes no cuts to Social Security, Medicare, defense spending, overseas wars, or homeland security, and along with interest on the national debt that accounts for nearly 85% of the total budget.

So what's left? About $450 billion, which accounts for a grand total of 15% of the federal budget. That's not much, so in order to make a splash Boehner has to propose some pretty swinging cuts. But on what? Transportation? Energy? Agriculture? The Department of Justice? The EPA? NASA? Food stamps? He doesn't say.

And since Republicans have been in office before, after all, we know perfectly well what their spending priorities are. And they don't include swinging cuts to transportation or energy or agriculture or the FBI or NASA. This is, in other words, a joke. Boehner isn't just proposing a bit of trimming here and there, he's proposing truly massive cuts to a tiny sliver of the budget. And we all know that neither he nor the rest of his party will even pretend to follow through on this if they're elected.

But $70 billion a year in tax cuts for the rich? That seems like a pretty good bet. In the meantime, Jon is right: the media should treat Boehner like a grownup and ask him exactly how his plan adds up. If he has the guts to tell us, well and good. If not, then it's time to stop taking him seriously.

Republicans and the Rich, Part LXXVII

The unconditional subjugation of the Republican Party to the interests of the rich, the super-rich, and the hyper-rich remains impressively monolithic. That is all.

Making Basel Work

The Financial Times reports that the new Basel III banking standards might get toughened up in a few countries:

Top bankers in the UK, US and Switzerland are braced for their national regulators to impose tougher capital requirements than those required by Sunday’s landmark global agreement, even as investors bid up bank shares on relief that the standards were not more rigorous....Global banks based on Wall Street, in the City and Switzerland fear they will face the toughest rules.

They point to the “Swiss finish” that regulators there have traditionally applied on top of global standards and the UK’s willingness to be tougher on other issues, such as pay. They also said US regulators were likely to consider shorter timetables and may face pressure from Congress to be tougher.

Well, we can hope. And we can hope that these same regulators will toughen up on the risk weighting of assets while they're at it. At this point I think we can all agree that AAA-rated MBS should probably require a wee bit bigger capital cushion than the same amount of United States treasury bonds, right?

Quote of the Day: More Preservatives, Please

From Robert Waldmann, responding to criticism of preservatives in food:

I stress this post is not a joke. I think that BHA and BHT are good for people's health. I even think that use of BHA and BHT are partly responsible for the increase in life expectancy since they were introduced.

You may read his reasoning here.