"Walter Bagehot. “The business of banking,” he wrote, “ought to be simple: if is hard, it is wrong”.

Yesterday, I disputed the notion that Low-Information Assets allow more Trust than High-Information Assets. I said that Trust, which Banks need to survive, is never to be taken for granted, and that investors always need to be aware of a Bank' s financial status. Here's Tony Jackson in the FT:

"What are banks for? In normal times, the question would seem redundant. But, with the banks now drifting rudderless in a sea of popular resentment, the answers are alarmingly vague.

Precisely to whom do banks owe their first duty of care? Is it to their shareholders, their depositors or their borrowers? Or all of those?

The thought was partly prompted by a recent letter to this paper from a retired British banking grandee, Sir Ronald Grierson. “A bank is a bank,” he wrote, “and, if the security of its depositors is not its main concern, it should be required to adopt another name. Members of the public are entitled to take this for granted.”

I do not agree with this. We have just learned that such an attitude is not wise. But, together with this notion of Low-Information assets engendering more Trust, I can already see where many of us went wrong.

"Under UK law as it presently stands, Sir Ronald is, strictly speaking, wrong about that. At present – though this is to change – a UK bank is just another company. As such, its primary duty is to its owners."

Is this a surprise?

"More of that in a moment. First, how has the banks’ duty to shareholders been discharged in practice?

In two words, stunningly badly. UK bank shares are almost all below their level of five years ago, in most cases disastrously so. Many may never recover previous peaks."

Job well done.

"To be fair, shareholders sometimes tried to exercise their own duty of control, if ineffectually. For years, they resisted the acquisitive ambitions of Royal Bank of Scotland, only to lose their resolve at the top of the cycle. RBS’s resulting ABN Amro purchase is one main reason for its subsequent collapse into state ownership."

Job well done.

"The same recklessness characterised many borrowers. A depressing number of now-bankrupt companies made big debt-financed acquisitions at the peak of the boom. Others, such as Chrysler and EMI, are in crisis because the banks lent vast sums at the last minute to an equally reckless private equity industry."

Job well done.

"So, in general, you might think, let the borrower beware. The snag is, of course, that too much lending leads inevitably to too little, thus posing systemic threats to the economy – a problem now being urgently addressed by various governments."

If it's inevitable, how come people seemed unprepared? Of course, I don't believe that many were that surprised.

"Nor are all borrowers in the same category. I recently found myself perusing the personal ads on a supermarket notice board in the English Midlands. A striking number were for “house sharing” – seeking other families to move in and share the financial burden.

There is the plain sense here of a duty foregone. Most people know little or nothing of finance. But banks are accredited experts. If a bank says you are good for a loan, it is putting that expertise into practice.

To borrow Sir Ronald’s phrase, you are entitled to take that for granted. And, if the result is a choice between sharing your home with strangers or losing it, you are entitled to feel aggrieved."

You cannot take anything for granted. You should assess the competence of the bank that you put money in, or borrow money from. You are legally and morally entitled to your business with the bank being on the up and up.

"Let us now revert to the depositors. It might seem extraordinary that the UK has no special provisions to protect them from collapse, as opposed to insuring them after it. Most other countries, from the US and Japan to Mexico and South Korea, have had such provisions for many years."

I'm assuming he means the FDIC. Can we imagine how much worse this crisis would be without it? I assume that many free market followers would end it, although I don't hear many calling for it in this crisis.

"The usual method is a so-called “resolution regime”, whereby, if a bank seems in danger, the state intervenes and takes it into protection. It is then sold on, usually to a healthier bank. The implicit assumption is that the interests of depositors trump those of shareholders or creditors."

I believe that this is true.

"In the UK, as Sir Ronald also observed, that task was performed by the Bank of England until its independence in 1997. In the ensuing reshuffle of responsibilities, that part got left out. It is now being reinstated under legislation due for completion in February. But it took the collapse of Northern Rock to bring it about."

I believe that we have that here.

"This is the more extraordinary because, as Professor Julian Franks of the London Business School observes, the UK has had just such a regime for its utilities ever since they were privatised in the 1980s. And a bank is nothing if it is not a utility.

Both the electricity and water regulators, for instance, have powers of last resort to protect customers. If an electricity supplier goes bust, the regulator takes it over and sells it on. This happened in October to a small supplier with some 40,000 customers, Energy4Business. There was no fuss, no publicity. It was routine."

Are Banks like a Utility?

"This all leaves a worrying sense of muddle. In both the UK and US, the response of the authorities to the banking crisis has been piecemeal and uncertain, at least partly because there is no clear sense of priorities. It all badly needs sorting out."

This is true. There is a difference between Pragmatism and Trial and Error, and lurching backwards and forwards in a manner that signals unpreparedness and incompetence.

"Let the last word on this go to the Victorian banker and commentator Walter Bagehot. “The business of banking,” he wrote, “ought to be simple: if is hard, it is wrong”.

Ditto for the legal framework. Lawmakers take note."

As per usual, Bagehot is correct, and his statement is simply a version of Searle's Sagacity.

"demand for people who can actually judge credits on their own, rather than relying on ratings agencies and buy-side quants to do it for them. "

Felix Salmon on the Justin Fox post on low-information assets and high-information assets:

"Justin Fox has a great post on Bengt Holmström's distinction between low-information and high-information assets:

There are low-information assets--cash, bank deposits, money-market securities--where, most of the time, nobody really needs to know anything about their underlying value. Then there are high-information assets--stocks are the best example--where the value is highly uncertain, and every investor assesses it differently.

Securitization is the process of transforming low-information assets, like corporate debt, into high-information assets, like opaque CDO-squareds. And I think this insight is the best way of answering Richard Wagner's exam question about securitization:

The burden of non-performing loans is thus dispersed throughout the economy rather than residing with the original lender. Does this development weaken the incentive offenders of lenders to monitor borrowers and thereby weaken overall economic performance?

Classically, the answer to this question -- the one which all of Wagner's students gave -- was no. Investors in CDO-squareds, under the kind of assumptions commonly made by economists, have perfect information about all the underlying loans."

There comes a point when these assumptions become depressing rather than comical.

"In reality, of course, they don't. But more to the point, it's orders of magnitude harder to understand a CDO-squared than it is to understand a single loan -- and single loans are hard enough to understand themselves. You can start making correlation assumptions and the like in an attempt to simply matters, but that only pushes off the moment of reckoning: you still need to crunch a lot of data to come up with empirically-based correlation assumptions, and no one ever had either the ability or the inclination to do that."

They had a theory and a model, but not the data. Instead, apparently, they inserted data from other investments into their models.

"Financial innovation nearly always involves a move towards higher-information assets from lower-information assets. This is not a good thing. It's easy to say things like "don't invest in something you don't understand", but how on earth is anybody meant to understand something as high-information as the stock market, let alone things like CPDOs?"

I'm not sure of the point. Also, I'm beginning to lose the thread about High-Information. I'd need to know more about what else this phrase applies to. I'm also a bit confused about "understand".

"A lot of the boom in debt markets during the Great Moderation, I think, was a result of buy-siders being seduced by instruments which they believed required little if any sleeves-rolled-up credit analysis. Maybe one surprising consequence of the credit crunch will be an increase in demand for people who can actually judge credits on their own, rather than relying on ratings agencies and buy-side quants to do it for them."

I still believe that it was Wishful Thinking. However, I completely accept his conclusion.

"I think we're in a bad state of the world when we rely on theorists."

Justin Fox has an interesting post:

"I've done a lot of bashing here of those who think the 1999 repeal of the Glass-Steagall Act separating banking from the investment business is to blame for all our troubles. I've also argued that securitization—at least fancy-pants securitization—has been partly at fault. So it was interesting to hear an economist I admire make the opposite arguments Thursday. The occasion was a Columbia Business School symposium on on Preventing the Next Financial Crisis, and the economist was MIT's Bengt Holmström.

Holmström is a theorist, and he has charming habit of reminding people that his theories are just, you know, theories. But at the same time he has ample experience with real-world economic phenomena. He's been on Nokia's board of directors for a decade, and he once briefly served on the board of a Finnish investment bank. ("Never go on the board of a bank, because you will never know what goes on there.") Most important, he was back home in Finland (at the Helsinki School of Economics) during the Scandinavian financial crisis of the early 1990s."

It's a good sign when a theorist knows what a theory is in relation to the world.

"That Scandinavian financial crisis--a favorite topic of this blog--was similar in so many ways to today's crisis: There were lots of real estate loans gone bad, sharp drops in house prices, bankrupt banks, and government takeovers of the various national financial systems. "But there was zero securitization," Holmström said."

That's a very important point.

"Holmström's theoretical contributions mainly have to do with the economics of information, and that's where he located the problem in both Scandinavia in the early 1990s and the U.S. now. There are low-information assets--cash, bank deposits, money-market securities--where, most of the time, nobody really needs to know anything about their underlying value. Then there are high-information assets--stocks are the best example--where the value is highly uncertain, and every investor assesses it differently.

"The key is who should hold what," Holmström said. Complex, high-information assets don't pose big financial-system risks in and of themselves. Earlier this decade, "the Nasdaq fell 90% and nothing happened." The problem is when leveraged liquidity providers (a.k.a. banks) end up with lots of high-information assets on their books. "When you're in the liquidity providing market and rolling over 25% every night, you don't have the luxury of wondering whether you can trust somebody."

I disagree with this. I agree with the Steve Hsu post that Banks do deal in and need to engender trust. This should not and cannot be overlooked. Trust and Negligence don't necessarily go together.

"A financial crisis happens when market participants suddenly realize that what they thought were reliable low-information assets are really risky high-information assets. And that usually happens after an extended period during which market participants become willing to accept almost anything as a low-information, liquid asset. Holmström: "If you come to the phase of the cycle where everybody thinks everything's liquid, you're going to have a problem."

You do if it's false.

"Holmström said he doubted government could ever regulate away that occasional tendency. "How do you prevent people from considering equity to be the same as Treasuries? You can't legislate that." But he did think was something to the idea of treating liquidity providers differently from other financial players."

Besides regulations, there are legal and ethical standards of business that should necessitate giving people a clear picture of what they're buying. Obviously, since there's crime, you can't just legislate against that either if you mean by regulate or legislate totally prevent.

"During the Q&A, an audience member who said he was at Salomon Brothers when Citicorp and Salomon's parent Travelers merged in 1998 ("I watched those nice stodgy Citi bankers try to boogie like the Salomon Brothers investment bankers") wondered if Glass-Steagall repeal wasn't part of the problem.

Replied Holmström: "I'm for going back to some separation between liquidity providers and the rest of the market. I don't think it's coincidental that this happened after Glass-Steagall repeal."

A couple of other people on Holmström's panel then chimed in with the argument I've made--that the issue was letting investment banks and other market players (it all began with money market mutual funds) grow into a liquidity-providing shadow banking system, an evolution that began long before Glass-Steagall repeal.

"Investment banks led the way, but commercial banks decided they liked it too," retorted the ex-Salomon guy in the audience. "The abolition of Glass-Steagall put this kind of behavior in the hands of people with much bigger balance sheets."

See, this isn't yet a very well thought out theory. A followed B in time.

"Holmström's summation: "I'm a theorist. I'm allowed to speculate. I think we're in a bad state of the world when we rely on theorists."

He is absolutely correct. Below, he also is, sadly, correct:

Update One more nice Holmström quote from my notes, on nationalizing banks:

One of the things governments can do very easily is take over banks, because they're very bureaucratic. It's much harder to take over institutions where imagination is required."