Libertarian Democrat Point Of View: An Eccentricity

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Showing posts with label Narrow Banking. Show all posts

Thursday, June 18, 2009

It’s a blunt instrument, but it has the benefit of being simple and hard to game.

From Reuters:

"Felix Salmon

Macroprudential

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June 18th, 2009

Putting an end to too-big-to-fail: An IM exchange

How narrow should a narrow bank be?

TO BE NOTED: Against Narrow Banking: From Financial World:

"Past imperfect
We cannot, and should not, turn back the clock to the era of ‘narrow banking’, says Vince Heaney. Too much has changed

In turbulent times it is tempting to hark back to supposedly halcyon days. This tendency is currently manifested in calls for a return to an old-fashioned banking system; one in which commercial and investment activities are again separated, as in the US after the introduction of the Glass-Steagall Act in 1933.

Advocates of “narrow banking”, however, risk overlooking two points. First, you cannot turn the clock back. By the time the Glass-Steagall Act was repealed in 1999 regulation was merely catching up with the realities of banking. There had been huge growth in cross-border capital flows following the dismantling of capital controls and the demise of the Bretton Woods fixed exchange rate system.

In their strictest form, narrow banks would be even more proscribed in their activities than banks were during the era of bicycle-clipped bank managers such as Captain Mainwaring of Dad’s Army. Retail deposit-taking institutions, which benefited from deposit insurance guarantees, would not make loans. They would simply run the payments system and hold only safe and liquid assets, such as government bonds. In modern capital markets, such draconian restrictions would be very difficult to enforce.

Second, one would not necessarily want to turn back the clock even if one could do so. Deregulation has brought substantial benefits: it has promoted the efficient allocation of capital and supported growth by allowing companies and households easier access to credit.

Clearly, however, efficient capital allocation gave way to speculation as smart bankers, motivated by short-term gain, exploited the opportunities for circumventing a light-touch regulatory system. With taxpayers now footing the bill for the resulting crisis, it is both understandable and desirable that policy-makers want to address the shortcomings of existing regulation. Since banks cannot be relied upon to supervise themselves adequately and draconian measures are not feasible in globalised capital markets, the problem turns on where to draw the boundary between the regulated and unregulated sectors. How narrow should a narrow bank be? Because regulation lowers profitability in the regulated sector, there is an incentive for business to move into the unregulated sector once the boundary is drawn.

A sensible solution should recognise the inevitability of business moving towards the unregulated sector, but reduce the incentive for it to do so. It would clamp down only when an institution’s size and market share posed a threat to the system. At the same time, the framework should increase monitoring of the unregulated sector and impose restrictions by investment activity, rather than type of institution, to improve transparency. Finally, the regulatory grip should tighten during the upswing, not the downturn.

A consensus on the regulatory framework is emerging that incorporates these characteristics. In January, the Group of Thirty, an international body of financiers and academics, published a report entitled Financial Reform: A Framework for Financial Stability. Among the many recommendations, the high-risk proprietary activities of systemically important banks would be restricted by tougher capital requirements and the retention of a larger proportion of the risks on their own balance sheets. This represents a move towards separation of commercial and investment banking but stops short of prohibition. The G30 also addresses the pro-cyclical disadvantages of the current Basel 2 arrangements, proposing that not only are capital requirements raised but that institutions hold higher levels of capital when markets are “exuberant”.

Outside the regulated sector, the G30 proposes that larger “private pools of capital that employ substantial borrowed funds”, i.e. hedge funds, should register with a regulator and disclose more information. The report also advocates greater regulation by activity – proposing that over-the-counter securitised structured product and derivatives markets be subject to standards comparable with those for public securities markets.

The G30 is headed by Paul Volcker, former Federal Reserve chairman and adviser to President Barack Obama, and includes Tim Geithner, US Treasury secretary, Jean-Claude Trichet, president of the ECB, and Mervyn King, Bank of England governor. Although not all members were involved in writing the report, G30 insiders have told The Economist that everyone was behind the report in spirit.

This widespread agreement, and the report’s recognition that a global problem requires an international solution, raises the probability that proposals along these lines will form the basis for regulatory change in the G20 countries. No overhaul can hope to predict where the next crisis will arise, but reform will be imposed and, if intelligently designed, can at least avoid repeating the mistakes of the past."

Saturday, June 6, 2009

It’s tempting. With a narrow bank, we could separate the bank from the holding company, and send the subs to forage for themselves.

TO BE FILED:

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Martin Mayer was the featured luncheon speaker at the Grant's Spring Conference, which was held at the Plaza Hotel in New York on April 7. Following is the text of his remarks.
Tiers and Tears
There are many possible first cuts for the historian seeking the origin of our present trouble and for the observer seeking some hints about how to repair the damage. I am going to choose an obscure incident in 1979. The choice is personal, because quite by accident I was among the first to know something new and strange had happened, and to discuss ignorantly what it might mean.
The year is 1979. I’ve forgotten why I was in Washington, but among the items on my schedule was lunch with the Comptroller of the Currency. This was John Heimann, a friend of some years’ standing. He had re-staffed the agency and wanted me to meet his youngsters, and we lunched in his office, on the river side of L’Enfant Plaza, with a spectacular view of the planes taking off and landing at National Airport. Lunch was cold-cut sandwiches and sodas, and people came in and out bearing plastic plates. One of the last arrivals was a deputy who wanted to speak privately to the Comptroller. Johnny told him I could be trusted, and he blurted out his news.
This was the early days of interest-rate derivatives, and one of the most prominent instruments was a CD contract by which banks and investors could arrange to borrow or lend via certificate of deposit written on a date in the future. Like all defensible derivatives contracts, this one could be satisfied by the delivery of its content, in this case the CD. Ten banks were listed as suitable issuers of
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CDs that would be accepted in satisfaction of the futures contract. And on this day in 1979, word had come from Chicago that Continental-Illinois Bank was being dropped from that list. The long-feared “tiering” had come to commercial banking.
We are about to have an orgy of tiering, as the results of the stress tests arrive from the banks, and the Fed will move heaven and earth and supply endless oxygen and raise the dead to avoid admitting that some of these guys are much worse than others. From this commanding height, then, let us look both backwards and forwards.
John Heimann and I had been brought up in a world where someone who wanted a bank charter would have to demonstrate that the commerce of the place where he planned to put his bank needed a new bank. That world still remembered a time when shares in a bank were only half paid in, and the other half was subject to call whenever the bank needed capital. (Still true, by the way, for the district Federal Reserve Bank, which can call away three percent of the capital of its members if by any chance the Fed needs the money. Very few bank stocks were listed on an exchange.) Banks were not permitted to issue liabilities other than deposits. By law, checking accounts did not pay interest, and there were penalties for premature withdrawal of time deposits, which did pay interest, but could not legally be advertised as savings accounts. Arthur Roth, proprietor of a little bank in a little Long Island town that would grow to be the 18th largest in the United States en route to going bust, got sued by the Comptroller of the Currency in 1945 when he put the word “savings” above the teller’s window, fought it to the Supreme Court and won. But the Federal Reserve set the maximum interest rates
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a bank could pay on the time account, a little higher for longer terms, a little lower for shorter terms. With a handful of exceptions, that’s what every bank paid. S&Ls were permitted to pay a quarter of a point more than banks were permitted to pay, to encourage housing. But deposits at S&Ls were not accessible for payments purposes, and were not part of M—1, like bank deposits
Banks could and still can be chartered by either the federal government or a state authority. In all but a handful of states, banks were not permitted to have branches, whether they had state or federal charters. There was no thought that banks competed with each other for business. Banks grew with the success of the companies that borrowed from them, or the social connections of the young men who joined the cadre on the platform. A deposit in any bank was the equal to a deposit in any other bank; the government indeed insured deposits equally in all the banks. This had not been true for most of the 19th century; it was an accomplishment, and not a small one, accomplished to a significant degree by a stress test administered by a Resolution Trust Co. that permitted banks to reopen after the bank holiday.
We had a fractional reserve system: the bank loaned out most of its deposits but was expected to keep some portion “in reserve,” entirely liquid, to pay depositors who wanted their money back or wanted to use their checks to pay bills. Through the 19th century, the war was to keep money fungible, no matter what bank issued it, which meant that as much as possible the banks had to be fungible, too. Tiering in Chicago to the disadvantage of Continental-Illinois raised the specter of a throwback to wildcat banks risen zombie-like from the grave, to be exorcised by imposing a discount on their checks when accepting them for deposit.
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Collectively, the banks’ assets were the working capital of the nation--farmers buying seed and manufacturers paying wages and stores stocking their shelves. Because money could be called away from banks at sight, the preference quite apart from the reserves was for assets that rolled over on short maturity schedules. Until the 1920s, in most states, banks were not permitted to lend on the security of real property, and were not allowed to own real estate themselves, except for the bank’s own building. When the Federal Reserve was created in 1914, required reserves were set at 18% for the larger banks. Once the Fed was operating, member banks could add to their cash if needed by discounting commercial loan paper overnight at the Fed’s window. This represented an effective supervision of bank behavior, because through the 1920s most city banks borrowed most nights of the year from their district Fed, and the discount window had to approve the collateral offered. That information was secret. Indeed, banks were and are protected by secrecy laws and fenced off from criticism. It was and still is illegal, though we haven’t seen any prosecutions, to bad-mouth a bank’s capacity to pay its depositors.
I bore you with all this history because this is the soil on which the seeds of regulation and deregulation were scattered in the twentieth century. Coming into the new century, the device of the trust company, which a bank could own, allowed banks into various securities- and real estate-related activities (and also, lest one forget, opened a door for North Carolina National Bank to expand into Florida in the 1980s in the first small step toward converting NCNB to Bank of America and giving us this collection of gargantuan and still growing institutions that in the last
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five years have borrowed so far beyond their capacity to service). The Federal Reserve developed Fedwire very early in its existence to help the district banks manage their gold accounting, then made the system available to commercial banks, guaranteeing that eventually there would be one national interest rate, though for some years the district banks continued to set discount rates independently. In 1933, famously, Congress in the Glass-Steagall Act forbade commercial banks to engage in securities dealing and forbade investment banks to offer checking accounts. In 1951, the famous Accord between the Treasury and the Fed freed the Fed’s open market operations from the obligation to maintain high prices for government paper, and in 1956, a banking act allowed the ownership of banks by holding companies, beginning the great pumping operation that ultimately created the swamp we are now trying not very successfully to escape. Half a dozen years later, in what I called a revolution in my first book about banking, Walter Wriston of National City Bank and John Exter of the New York Fed developed the negotiable certificate of deposit, permitting banks to buy the liabilities they could use for expansion.
Incidentally, this was trickier than now understood–so astute an observer as John Plender got it wrong in a recent FT. The early CDs were still subject to Fed controls on interest rates. But while a six-month CD might be limited to one and one-half per cent, a three-year CD could yield three per cent. Thus an investor, purchasing in the market, could buy a three-year CD with only a year to run, effectively gaining a higher rate on his one-year loan. In 1970, as a reward for the big banks’ promise to buy the commercial paper of the near-bankrupt Chrysler (sound familiar?), the Fed lifted interest-rate controls on bank CDs larger than
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$100,000, and we were off to the races. It was these CDs that were the commodity behind the Chicago contract that was now forcing the Comptroller’s office to recognize that the market did not consider money from Continental’s balance sheet as good as money from the balance sheets of the other big banks.
This is the prism through which all banking regulation must be seen: because the banks supply the currency, which must be uniform, their obligations become obligations of the state if it turns out they can’t pay their bills. Andrew Sheng, later chairman of the Hong Kong Security and Futures Authority, provided the aphorism in his report to the world bank about the Asian crises of the 1990s: The losses of a decapitalized banking system, he wrote, are an implicit fiscal deficit. This recognition of the special status of the banks started as government guaranteed deposit insurance. There are other ways to try to assure that the banks’ assets cover their liabilities. One was the Glass-Steagall approach, forbidding the banks from securities activities. The new thing is explicit government backing for the face value of the asset portfolio. If your name happens to be Citibank.
Glass-Steagall was abandoned to the enthusiastic cheers of the finance economists, in 1999; I was among the few mourners. The argument in favor of resurrecting Glass-Steagall is simple and short: commercial banking and investment banking are very different activities requiring very different talents. The commercial banker wants to know how he is going to be repaid; the investment banker wants to know how he can sell the paper. Turns out you can sell a lot of paper expressing debts that will not be paid back. Because the losses of a decapitalized banking system are a fiscal deficit, because in the end tiering is
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impermissible when the currency has to be uniform, this failure to collect the debts ends as a burden on the taxpayer.
The insurance of financial instruments is often a questionable activity. The purpose of the insurance company is to make money on the policies, not to prevent the activities insured against. CDS is by no means the first insurance contract to be written with no expectation that it would ever pay off. Some homeowners whose houses burned down in the great Oakland firestorm of 1991 were kept waiting for their moneyfor more than half a dozen years while their insurance company hunted for loopholes. My own introduction to this problem was on Roosevelt Island, a nest of apartment houses built by New York’s Urban Development Corporation. I was working on a book about housing, and ran into a controversy about the use of aluminum wiring in some upstate apartment houses which suffered catastrophic fire. Looking deeper, I found that the New York City fire department was up in arms about UDC’s violations of the city’s fire code. Several of the buildings, for example, featured duplex apartments and skip-stop elevators, very fashionable in the 1970s. This design meant that if a fire broke out one one floor of the duplex the inhabitants’ only means of egress would be the terrace, perhaps twenty floors up. Not much point keeping a rope beside the window to help you get out when it’s twenty stories to the ground. I visited with the c.e.o. of the insurance company that had the policy on these apartment houses, and he was well and truly shocked. He called his c.o.o. to come by, and as the fellow came through his door he said, “Jim–how soon can we get out of those Roosevelt Island policies?”
Normally the insurance of a financial instrument has a political purpose
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more than an economic purpose. George Moore, later chairman of Citicorp, who tried to derail deposit insurance in 1933 as a National City Bank lobbyist for James Perkins, liked to say that the competence of bankers is not an insurable risk. Hy Minsky and Jan Kregel point out that the banker’s added value is not the money he supplies but his acceptance function. We pay bankers for the information they gather and the judgment they apply to that information. Casual insurance of financial instruments corrupts the lending process, as the real estate market so vividly demonstrates. I call your attention also to Mayer’s Third Law of Financial Engineering, first published in Institutional Investor in fall 1996, excerpted from my book The Bankers: The Next Generation in 1997. The Third Law holds that risk shifting instruments will tend over time to shift risk onto those less able to bear it, because them as got want to keep and hedge, while them as aint got want to get, and speculate. My wife was then working for Larry Summers, as the U.S. executive director at the IMF, and Larry came to the house on a social evening. I showed him the Third Law, not yet published, and he thought it was funny. But of course it was true. I’m afraid Larry might still think it’s funny.
CDS adds no information, especially in the situation where the process is cash settlement of a contract that depends from a reference instrument. If you want to know what the market thinks of the riskiness of a bond , you can find out easily enough in most cases by looking up the market price for the bond itself, though efficient pricing in the loans market has been impeded by the banks because they make money on the inefficiencies. In most situations you can short the stock or buy a put if you want to bet against the issuer. The riskiness of a basket of bonds--a CD-squared–will be an ignorant evaluation, not worth your
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having, useful to people who are manipulating the markets, but not to investors or honest traders. What has happened here is that some smart fellows went to Las Vegas and looked at how well the house did at the dice table, where bystanders can bet on whether the shooter makes his point or craps out. Recently, when a Congressman suggested that nobody should be allowed to buy a CDS unless he had an insurable interest in the paper to be protected, ISDA gave us a new definition of chutzpah by objecting that such a rule would reduce liquidity in the market.
Meanwhile, the existence of this multi-trillion-dollar stupidity probably makes the Geithner plan an essay in futility: there is no way to price insured instruments when nobody knows whether the insurance will pay off. One does wonder what value was asserted for the paper the Federal Reserve acquired from AIG in the great orgy of fall 2008. I fear we will never find out.
There has been an air of fiddling in this market from the start. The first textbook about credit derivatives, by Israel Nelken a dozen years ago, offers a paragraph of guidance for the dishonest trader: “Theoretically, employees could buy a default swap on their employer. Consider a trader who takes a very risky bet with the bank’s money. If the bet is successful, the trader earns a big bonus. If the bet is miscalculated ahd the bank defaults, the trader collects on the default swap. . . There is a moral hazard.”
It may be much worse than we know. Chris Whalen in his newsletter charges that in many transactions the CDS is supplemented by a secret “side letter” establishing a “finite risk.” By the terms of the side letter, the seller of protection would not be obliged to pay more than 6% of the face value of the bond or loan
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being insured. The regulators, accepting the lender’s assertion that the instrument was now insured, would not be informed of this side letter, and would lower the capital requirement that would otherwise be imposed on the buyer of the protection. This would be fraud, of course, but it may have happened; Whalen says there was a lot of it at AIG. If full value was paid out in situations where such side letters existed and were kept secret, the Fed and the Treasury have been swindled. Certainly, all documents relating to these transactions, which were accomplished with public funds, should now be placed on the record.
We note in passing that there is a case to be made that procedures for selling short should be improved in both the stock market and the bond market. The up-tick rule is a red herring, and the continually repeated statement that it was abolished two years ago shamefully neglects my reporting of 1988, in my book Markets, that the SEC on December 16th, 1987, had given Merrill Lynch a no-action letter exempting traders from the uptick rule because it “interfered with their index arbitrage.”
The astonishing thing about the continuing hoo-hah on “naked shorts” is that the remedy for this misuse of the short-selling mechanism is so obvious and simple: heavy penalties for failure to deliver. When we studied stock exchange history years ago we heard much about Dan’l Drew, Jay Gould’s partner in 19th century price manipulation, and his contribution to American poetry:”He who sells what isn’t his’n/Must buy it in or go to prison.” People who sell securities they don’t own and haven’t arranged to borrow are engaged in high-risk activities and should be told so. Particularly now that all the risks are increased –perhaps desperately so--by abuse involving the cash received by the seller who has
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borrowed the stock. The lender of the stock is assured that he is one hundred per cent safe because the cash from the short sale is segregated to his account, but the truth is that his broker often “invests” that money in CDOs for a better yield for himself. This abuse was first exposed by Hurd Baruch almost forty years ago, in the book Wall Street: Security Risk. Not much has been done to control it.
One of the reasons it keeps getting more difficult for margined players to change brokers is the new broker’s problem in repossessing the customer’s stock loaned out to short sellers. My understanding is that the standard prime-broker contract with hedge fund customers leaves wiggle-room for the broker and makes this danger exponentially worse. To the best of our knowledge today, the Federal Reserve system had to enter into a legally very dubious fiddle that made $80 billion available overnight to the already-bankrupt Lehman to facilitate the movement of its prime brokerage business to Barclay’s. When the panjandrums of the finance ministries and the central banks get over their G-20 high, perhaps they can set the gnomes to work rewriting the law of agency in the financial markets that now permits quasi-dishonest practice by the broker/dealers.
My colleague Barry Bosworth points out that diversification devalues knowledge. To which I add the observation that the combination of diversification and probability analysis invites overleveraging. Now Alan Greenspan in The Financial Times blames Harry Markowitz for the model that failed. While we are revising the Pantheon of the first decade of the 21st century, I offer another sacrificial lamb from the list of Nobel winners in economics who set us off in the wrong direction: Modigliani-Miller, with their mathematical proof that it doesn’t matter whether enterprises are financed by debt or equity. Among the
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ways we got so overleveraged was the continuing repurchase of their own equity by nearly all the great corporations.
Meanwhile, something has to be done about the banks, which are still the source of the nation’s currency. Intellectually, there is a strong case for returning to the “narrow bank” idea that Henry Simons put at the center of his conservative manifesto–which Hyman Minsky in 1986 wrote was still worthy of serious consideration after fifty years. Simons would restrict the asset side of the banks to Treasury bills. It’s tempting. With a narrow bank, we could separate the bank from the holding company, and send the subs to forage for themselves. When quantitative easing has run its course, there is going to be much too much money sloshing around, and no immediately plausible way to sop it up. The multiplier, the foundation of thinking about money and banking in this country, will be gone. I do like the idea of giving the Fed the authority to borrow. This would give us a new view of tiering: whose paper would sell for more, the Fed’s or the Treasury’s? And it would greatly diminish the role of the Fed, which seems to me quite necessary.
Since the days of Paul Volcker, who didn’t think much of bankers, the Fed has been hunting for ways to make a declining banking system seem profitable. And that’s one of the bigger reasons why we are where we are today. The Fed’s game is monetary policy, and the banks are the transmission belt of monetary policy. So the Fed wants to believe that the country really needs giant banks and that new business models for them will pay off without increasing risk. Straight alpha. As so often happens, the wish is father to the thought and the Fed’s economists have bought all sorts of nostrums of finance economics peddled by the
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banks. There is good reasoning behind the European system of separating monetary policy from banking regulation and policy. Congress is always receptive to giving the Fed the lead role, because in our system the Fed is part of the legislative, not the executive branch. (The Constitution gives Congress, not the President, the power to coin money and regulate the value thereof.) But it should study the European systems before proceeding. Alan Greenspan demanded that the Congress make the Fed the “umbrella regulator” of the financial services sector, and look where that got us.
In any event, there is no political force behind the narrow bank, and it’s probably just as well. Our economy needs the sort of information-rich lending that small banks do and could not continue to do if we went to a narrow bank. The best bet for improved regulation, I suspect, is a shift in focus from institution to instrument. More than twenty years ago, Scott Pardee, then chairman of Yamaichi in America, previously head of currency trading at the New York Fed, made the recommendation recently echoed by Elizabeth Warren, that there be a kind of FDA and approve or disapprove the contracts banks wished to trade. Many of the activities that have become commonplace on Wall Street–especially over-the-counter derivatives trading–should be prohibited to insured institutions. The 2005 amendments to the bankruptcy code that gave the settlement of derivatives priority should be repealed, just in case. The insurance of financial instruments, I suspect, should be permitted only to government agencies and to insurance companies regulated by insurance commissioners, with national standards for reserves and total transparency of asset portfolios. One cannot and should not to impede the syndication of loans, but given our experience
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with SIVs, banks should probably be required to keep ten to twenty per cent in their own portfolios. A minor item but important would be a requirement that every large bank keep its books in such a way that its risk management people–and its regulators–can at any moment pull up on a screen the holding company’s total exposure to each of its significant counterparties."

Thursday, May 14, 2009

Laurence Kotlikoff and John Goodman argue that banks need to return to being disinterested intermediaries.

From Free Exchange:

"Link exchange

Posted by:: Economist.com l WASHINGTON

Categories:: The econoblogosphere

TODAY'S recommended economics reading:

• Megan McArdle's post should strike fear into the heart of all District residents.

• Brad DeLong discusses misreadings of Adam Smith.

• Stephen Dubner has a novel plan for easing air-traffic congestion in New York.

• Laurence Kotlikoff and John Goodman argue that banks need to return to being disinterested intermediaries.

• Tyler Cowen poses a question at the intersection of economic theory and the decaying husk of an industry that is book publishing.

Comments

SIR –

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Don the libertarian Democrat wrote:

May 14, 2009 22:06

I am an advocate of Narrow/Limited Banking. Besides the post mentioned, I would recommend the following:

http://www.bcb.gov.br/Pec/seminarios/SemMetInf2007/Port/KevinJames.pdf

http://shop.ceps.eu/BookDetail.php?item_id=1757

http://www.voxeu.org/index.php?q=node/3232

http://www.economist.com/blogs/freeexchange/2009/04/rajan_roundtable_bre...

http://www.businessweek.com/magazine/content/09_06/b4118030606341.htm

Tuesday, May 5, 2009

we anticipate that policymakers would face tremendous pressure to allow firms to grow large again after their initial breakup

From The Economics Of Contempt:

"Too Big to Fail" Experts on "Make Them Smaller" Idea

Gary Stern and Ron Feldman, Minneapolis Fed President and Senior Vice President, respectively, are without question the leading experts on the "too big to fail" (TBTF) issue. In 2004, they published an excellent book called, Too Big to Fail: The Hazards of Bank Bailouts. TBTF is an issue they've been thinking and writing about for many, many years.

I've argued that the "too big to fail, too big to exist" idea is ridiculous, and is "the kind of thing people say at cocktail parties to make themselves sound smart without having to do any serious work." People who think the solution to the TBTF problem is to cap bank size fundamentally misunderstand the nature of TBTF.

Stern and Feldman recently addressed this proposed solution, which they call the "make them smaller" movement. And they agree that it's only satisfying on a very superficial level:

These dynamics of firm risk-taking mean that the make-them-smaller reform offers protection with a Maginot line flavor. That is, it appears sensible and effective—even impregnable—but in fact it provides only a false sense of security that may lull policymakers into inaction on other fronts.

They make many of the same points I made, such as the disconnect between bank size and systematic importance, and the limiting effect such a hard cap would have on FDIC resolution policy. Here's Stern and Feldman on bank size as an inappropriate metric:

[S]uch a metric [asset size] will not likely capture some or perhaps many firms that pose systemic risk. Some firms that pose systemic risk are very large as measured by asset size, but others—Northern Rock and Bear Stearns, for example—are not. Other small firms that perform critical payment processing pose significant systemic risk, but would not be identified with a simple size metric. We believe that a government or public agent with substantial private information could identify firms likely to impose systemic risk, but only by looking across many metrics and making judgment calls. Policymakers cannot easily capture such underlying analytics in a simple metric used to break up the firms.

On the difficulty of maintaining a hard cap on bank size:

The dynamic challenge concerns both the ability of government to keep firms below the size threshold over time and the future decisions of firms that could increase the systemic risk they pose.

On the first point, we anticipate that policymakers would face tremendous pressure to allow firms to grow large again after their initial breakup. The pressure might come because of the limited ability to resolve relatively large financial institution failures without selling their assets to other relatively large financial firms and thereby enlarging the latter. We would also anticipate firms’ stakeholders, who could gain from bailouts due to TBTF status, putting substantial pressure on government toward reconstitution. These stakeholders will likely point to the economic benefits of larger size, and those arguments have some heft. Current academic research finds potential scale benefits in all bank size groups, including the very largest.³ (Indeed, policymakers will have to consider the loss of scale benefits when they determine the net benefits of breaking up firms in the first place.)
...
Even if policymakers could get the initial list of firms right and were able to keep the post-breakup firms small, this reform does nothing to prevent firms from engaging in behavior in the future that increases potential for spillovers and systemic risk. Newly shrunken firms could, for example, shift their portfolios to assets that suffer catastrophic losses when economic conditions fall off dramatically. As a result, creditors (including other financial firms) of the "small" firms could suffer significant enough losses to raise questions about their own solvency precisely when policymakers are worried about the state of the economy. Moreover, funding markets might question the solvency of other financial firms as a result of such an implosion.

Such spillovers prompted after-the-fact protection of financial institution creditors in the current crisis, and we believe they would do so again, all else equal. One might call on supervision and regulation to address such high-risk bets. But the rationale for the make-them-smaller reform seems dubious in the first place if such oversight were thought to work.

Stern and Feldman's longtime proposal for solving the TBTF problem is to set up a credible insolvency regime for systematically significant banks and nonbank financial institutions, funded by insurance premiums that account for firms' spillover costs.

Posted by Economics of Contempt "

Me:

Don said...: Real Time Economics also posted this:

http://blogs.wsj.com/economics/2009/03/31/another-look-at-the-too-big-to-fail-problem/

"Stern offers a three-point approach for reducing the size and scope of spillovers from a firm’s failure to prevent the need for intervention:

1) Early identification: Central banks and other bank-supervision agencies can conduct failure simulation exercises to identify problems around derivatives contracts, resolution regimes and overseas operations. One option would be to require too-big-to-fail firms to prepare documentation of their ability to enter the functional equivalent of a prepackaged bankruptcy.

2) Prompt corrective action: Bank supervisors would take actions against a bank as its capital falls below certain triggers. “Closing banks while they still have positive capital, or at most a small loss, can reduce spillovers in a fairly direct way,” he says.

3) Communication: Policymakers must communicate that creditors may be put at risk of loss."

I used to agree with this, and called my view Bagehot's Principles. But it won't work, precisely because of the very problem that they state makes limiting bank size unworkable: namely, politics:

"On the first point, we anticipate that policymakers would face tremendous pressure to allow firms to grow large again after their initial breakup."

"this reform does nothing to prevent firms from engaging in behavior in the future that increases potential for spillovers and systemic risk"

Because they understand this, they present their plan as the following:

"In that vein, we recommend three interim steps that address concerns that might lead to support for the make-them-smaller option"

I'm fine with this, being a pragmatist, and because I follow Bagehot:

"We have confidence in our preferred approach of tackling spillovers directly by putting TBTF creditors at credible risk of loss."

That's Bagehot. Onerous conditions.

"Conclusion
There is no easy solution to TBTF. Our longstanding proposal to put creditors at risk of loss by managing spillovers will prove challenging to implement effectively. Cutting firms down to size may seem easy by comparison. It is not. The high stakes of making firms smaller will make it difficult to determine which to shrink, and even then, the government will not have an easy time managing risk-taking by newly shrunken firms.We do take the aims of the make-them-smaller reform seriously and in that vein suggest options in this regard that we think would be more effective, including a spillover-related tax built on the FDIC’s current deposit insurance premiums."

I agree, that limiting size is tough, and, even if you do, risk is still in the system. That's why I now favor Narrow/Limited Banking.

I support their proposals, but we've been trying them since Bagehot. Bagehot wasn't really for his own principles, in the sense that he was not a fan of the B of E, and saw these principles as being necessary because of having a Lender of Last Resort, like the B of E.

Since we have a LOLR, which will be taken as offering an implicit guarantee to intervene in a financial crisis, it is not enough to simply try and penalize banks. We must limit their function.

Don the libertarian Democrat

Tuesday, April 28, 2009

Liberal Democrats, are in favour of the forced break-up of the likes of Barclays and Royal Bank of Scotland into so-called narrow banks

TO BE NOTED: From the BBC:

"Making banks safe

Robert Peston | 12:05 UK time, Tuesday, 28 April 2009

Let's talk about banks' capital ratios, or the amount of capital banks are forced to hold as a proportion of their assets (or their loans and investments).

Stay awake. This stuff matters to you.

For those who don't know, banks' capital is a buffer against the losses they always face on lending and investing.

It's supposed to be the guarantee to depositors like you and me that we wouldn't be damaged when banks' loans go bad or when banks lose money on trading in securities: the hurt would instead be felt by shareholders and other providers of assorted forms of risk capital.

Now one of the main reasons the global economy is in such a mess is that big banks systematically lent far too much relative to their capital resources - which is mainly their fault but also that of numpty regulators, who allowed banks to drive a coach, horses and an entire wagon train through international rules that were supposed to ensure they kept adequate amounts of capital.

A few banks - such as Royal Bank of Scotland, Switzerland's UBS, Merrill Lynch and Citigroup of the US - took leave of their senses with their manic lending (by the way, the FT's Gillian Tett gives a particularly hair-raising account of their descent into madness in Fools' Gold, her new book).

The way most banks stretched their capital resources in their lending sprees both pumped up a dangerous bubble in asset prices and meant that when the bubble burst they didn't have enough capital to cover the losses.

So taxpayers, all over the world, had to step into the breach.

We taxpayers have pumped hundreds of billions of dollars of new capital into banks - we've nationalised or semi-nationalised loads of them - because the alternative of allowing the banks to fail was too scary for governments to contemplate (there was no desire to see the mobs of anxious depositors which formed outside Northern Rock's branches in September 2007 turn into a rampage outside most other banks).

But to state the bloomin' obvious, this global banking rescue is not something we'd want to repeat in a hurry.

It's quite important therefore that measures are taken to minimise the likelihood that banks will again systematically extend far too much credit relative to their capital resources.

However, closing this particular stable door is by no means simple, for two main reasons:

1) banks are global businesses, so new rules will have to be agreed by governments and regulators all over the world (never easy);
2) if we clumsily implement hastily and crudely devised requirements that all banks have to hold vast amounts of additional capital relative to their assets, there could be a permanent and significant reduction in the availability of credit - which could significantly reduce the potential for future global economic growth (we could all end up poorer from our natural desire to have a safer banking system).

For me, one of the big questions (about which there has been almost no public debate) is whether we should endeavour to make safe the global financial system that developed over the past few years - characterised by massive flows of capital across borders and the packaging of debt into securities for sale to investors - or whether we should give that up as a bad lot and regulate ourselves into a simpler but possibly poorer world, in which credit extended in any particular country is more closely matched by savings in that country.( NB DON )

The efforts of most governments, including our own, appear to be to sanitize the globalised status quo. It's obvious in our case why that's happening: as a nation, we don't save enough to meet households' or businesses' demands for credit (so we have to import credit from abroad).

But our government is doing its best to preserve the structures of financial globalisation, without explicitly making the case for doing so.

By contrast, it's possible to see in the words and deeds of the governor of the Bank of England that he believes some important elements of financial globalisation need to be rolled back (the Bank of England has, for example, been much more cautious about helping to rekindle securitisation - the conversion of debt into tradable securities - than Downing Street would like).

Here's the danger: we'll muddle through and devise yet another sub-optimal regulatory system.

Some of the second order issues were aired yesterday by Adair Turner, chairman of the Financial Services Authority (although he raised one very important question, which is whether financial innovation will always engender instability, and whether it's now clear that the costs of that instability outweigh the benefits of innovation).

Strikingly Turner said he was "open-minded to a [proposal]...that large systemically important 'too-big-to-fail' banks should have to maintain higher capital ratios than applied on average".

This is a nod to an idea that the chancellor is planning to float in a couple of weeks in a white paper on reforming regulation of the banking system (and the US authorities are moving in the same direction).

For what it's worth, there are two reasons why it might make sense to force our biggest and most complex banks to hold more capital than their smaller, simpler peers: if big super-banks have the privilege of knowing that we as taxpayers would always bail them out in a crisis, surely they've got to put in place treble protection against the risk that they'd call on us for such help; also the costs of holding the extra capital might encourage them to slim down and simplify their operations.

That said, such a regime could achieve the precise opposite of what would be intended.

The public imposition of a higher capital requirement on, for example, Barclays than on smaller, simpler banks would be a public declaration that Barclays would never in any circumstances be allowed to collapse.

And, paradoxically, that could give an unfair competitive advantage to Barclays - because safety-conscious depositors might well choose to give Barclays a disproportionate amount of wonga in the belief that there are no circumstances in which that wonga could be lost.

Which is partly why some, like the Liberal Democrats, are in favour of the forced break-up of the likes of Barclays and Royal Bank of Scotland into so-called narrow banks, so that these sorts of competitive distortions are minimised and so that banks don't abuse ordinary depositors' cash by gambling it in the supposed casinos of wholesale markets.

As I've recently noted, the Tories have also come out in favour of dismantling the big banking conglomerates - and Mervyn King, the governor, has said it's an idea he would like explored properly.

Even so, Lord Turner isn't in favour of the prohibition of Barclays-style universal banks, and nor are the chancellor and prime minister. They believe that delineating wholesale banking and retail banking in a clean way is easier said than done.

Certainly what's been striking over the past 20 months is that disaster has not been confined to one kind of bank: there have been egregious losses and humiliation for universal banks, such as Citi, UBS and RBS, as well as for narrower, more specialised banks, including Lehman, Bear Stearns, Washington Mutual and Northern Rock.

Oh, and lest we forget, the single biggest stimulator of the excesses of the banking system wasn't a bank at all: it was AIG, whose crazy insurance of financial products gave banks the lethal confidence to lend to those who could never repay."

Friday, April 24, 2009

Under LPB, people, not companies, bear risk as their mutual funds do well or poorly

TO BE NOTED: From Big Greg Mankiw:

"The Ideal Financial System

As seen by economists Larry Kotlikoff and Ed Leamer. Their suggestions remind me of narrow banking proposals."

And Forbes:

"A Banking System We Can Trust
Laurence J. Kotlikoff and Edward Leamer 04.23.09, 12:00 AM ET

Before throwing more money at Wall Street, let's understand what our financial system was supposed to deliver, what it did deliver and what price it charged.

The system was supposed to channel our hard-earned savings into the best real investments: new homes, offices, factories, equipment and research. And it was supposed to correctly price our assets.

It did neither. Instead, Wall Street morphed into a vast gambling enterprise, generating massive trades of existing securities without, in fact, raising the investment rate or growing the economy.

During the dot-com bubble, Wall Street funded all manner of silly businesses, and during the housing bubble, it put millions of people in homes they couldn't afford. This "expertise," which cost one-tenth of our output, was delivered by the best and brightest, with half of Harvard's graduating classes becoming high-class croupiers.

As for pricing assets, the stock market's been on a five-decade roller coaster, notwithstanding a relatively stable real economy. The market rose dramatically from 1950 through the mid-1960s. It then spent the next decade and a half falling through the floor. Then it rose like crazy in the late '90s, crashed, soared and crashed again.

We need a financial sector but not one like this. Nor do we need Wall Street hitting us up for its gambling debts. What we need is Limited Purpose Banking (LPB), which would transform all financial corporations, including insurance companies and hedge funds, into mutual funds. They would, henceforth, be called banks.

Under this system, banks would never fail for a simple reason. They'd never hold any financial assets and they'd never borrow except to finance their mutual fund operations. Instead, they'd be limited to their legitimate purpose--financial intermediation. Under LPB, people, not companies, bear risk as their mutual funds do well or poorly.

A new Federal Financial Authority (FFA)--would rate, verify, supervise custody, disclose and clear all securities purchased, held and sold by LPB mutual funds. Private rating companies could stay in business, but no one would need to trust them ever again.

Banks would initiate personal and business loans (including mortgages), send them to the FFA for processing and then sell them to mutual funds, including their own. Loans would activate when sold, so no bank would ever have an open position.

All mutual funds would break the buck with one exception: cash mutual funds. These funds would strictly hold cash and be valued at $1 per share. Owners of these funds would write checks against their balances and never have to worry about a bank run. Fractional reserve banking and the FDIC would be history.

LPB would include insurance mutual funds. These funds would pay off based on the losses experienced by contributors. If losses are larger than expected, less is paid out per loss. Hence, LPB prevents insurance companies from insuring the uninsurable, e.g., claiming they'll pay the same life insurance claims even if there's a plague.

All risk allocation arrangements can be run through mutual funds, including credit default swaps. Take a bank that markets the GE-Defaults-On-Its-Bonds-In-2010 fund. Under this closed-end fund, shareholders specify in advance if they want to get paid off if GE does default on its bonds in 2010 or paid off if GE doesn't default. All money put into the fund, less the mutual fund's fee, would be held in one-year Treasuries and paid out at the end of the year to the winning shareholders in proportion to their holdings.

Hence, Limited Purpose Banking can accommodate credit default swaps (CDS) as well as any other risk product. But what Limited Purpose Banking won't do is leave any bank exposed to CDS risk since people, not banks, would own the CDS mutual funds.

If such mutual funds sound revolutionary, they're not. Funds of this kind have been around for centuries. They go by the name "tontines," or systems of "pari-mutuel betting."

Limited Purpose Banking would enhance liquidity, since all funds would trade in the market even if their underlying assets are illiquid. It would permit the extension of as much credit as the public--which is the ultimate source of credit--wishes to provide by buying mutual funds that purchase household and business loans. And it would force banks to charge fees and pay their employees based on their mutual fund performances as determined by the market.

What LPB will eliminate is insider rating, freeriding on FDIC insurance, self-custody arrangements, no-doc loans, institutionalized gambling, me-now compensation plans, financial malfeasance and the possibility of future financial collapse. In other words, it would be a system we can trust.

Laurence J. Kotlikoff and Edward Leamer are professors of economics at Boston University and UCLA."

Wednesday, April 15, 2009

virtues of a “limited purpose banking” system, one that would greatly reduce banks’ abilities to take on risk

TO BE NOTED: From the NY Times:

April 15, 2009, 2:28 pm

The Post-Recession Appetite for Risk and Regulation

By Catherine Rampell

Wednesday, in his speech at Georgetown, President Obama proclaimed that “It is time to lay down tough new rules of the road for Wall Street to ensure that we never find ourselves here again.”

But just how restrictive will, and should, those rules be? Will there indeed be a permanently lower tolerance for financial risk-taking, when risk-taking and financial innovation have been a prized part of economic growth over the last few decades?

The lead-up for such “tough new rules” so far has been somewhat equivocal. America — unlike its European counterparts — has generally prioritized temporary stimulus over “permanent” regulation in the face of an economic contraction. We like to address a particular market failing in the short-term, rather than reassigning the way markets work for the long haul. In fact, America’s long-term trend over the last few decades has been toward less, rather than more, regulation. That political habit may be hard to break, no matter the volume of populist calls for straight-jacketing the private sector.

Still, a few prominent economists — whose discipline is usually seen as the bastion of laissez-faire — are fighting to sharply reverse this decades-long, freer-financial-market trend.

For example, Paul Krugman, the Nobel laureate and Times Op-Ed columnist, last week wrote about the need for new regulations to make banking “boring again” — in other words, by legally limiting bankers’ abilities to get too creative with the ways they slice, dice and assemble their financial toys.

Amar Bhidé, a business professor at Columbia University, has similarly argued for a return to “primitive finance,” which would mean greatly limiting what commercial banks are allowed to do, and reviving a more stringent version of Glass-Steagall.

And Laurence Kotlikoff, an economics professor at Boston University, has vocally proselytized the virtues of a “limited purpose banking” system, one that would greatly reduce banks’ abilities to take on risk. In this system, commercial banks would initiate only AAA-rated mortgages and business loans (approved and rated by the government, rather than by private ratings agencies), and then bundle and sell those loans within mutual funds. And that’s all these banks could do.

These aren’t the only economists arguing for what may sound like extreme curbing of the financial system. Other critics have more or less called securitization a dirty word, and suggested that the process of bundling loans and other financial products may be inherently toxic (no matter how much we upgrade the ratings agencies). They also fear that morally hazardous bailouts may yet increase banks’ appetites for reckless risks.

Others say, though, that we may emerge from the current crisis with financial institutions that are much more risk-averse than they were before the recession. In this situation, perhaps tighter regulations would not be necessary; perhaps they might even be detrimental. An economy needs some desire to assume risks in order to function and to grow, and perhaps, then, the government should be encouraging more financial innovation when the private sector’s instinct is to pull back. Besides, some say, maybe having a major financial meltdown only every 80 years or so isn’t such a bad track record, given the economic growth the existent system has produced (or at least enabled).

It will be interesting to see which, if any, of these views wins out in the coming months.

Readers, I put the question to you: What kind of financial system will emerge — either due to market forces or regulatory forces — once the dust of this crisis settles? And what kind of financial structure should we want to emerge?"

Tuesday, April 14, 2009

That wouldn’t prevent future financial crises outright. But it would probably stop them from causing a major global recession

From Reuters:

"Can you stop banks acting like lemmings?

Thursday, April 9, 2009

A case in point is the narrow banking debate

From Free Exchange:

"Rajan roundtable: Break up the banks

Posted by:: Philip Augar

Categories:: Rajan roundtable

Philip Augar is a former group Managing Director at Schroders who turned to writing about finance in 2000. His latest book is "Chasing Alpha: How reckless growth and unchecked ambition ruined the City’s golden decade".

RAGHURAN RAJAN'S reminder about the dangers of regulating in the midst of a bust is timely but goes only part of the way. Not only can enthusiasm for fighting the last war lead to inappropriate responses in a dynamic industry, it can also miss the opportunity to address more fundamental problems with the banking industry's structure.

A case in point is the narrow banking debate, often crudely summed up as "reviving Glass Steagall" and brusquely dismissed in Britain's Turner review as being "not feasible". Integrated financial institutions that combine retail, commercial and investment banking not only create institutions that are too big to fail (notwithstanding Mr Rajan's shelf bankruptcy plan) but they also perpetuate the conflict of interest that underlies many financial crises including the present one.

Disaggregating such institutions would be complex and would require global commitment. Recent consolidation, with big banks such as Bank of America and JPMorgan buying troubled broker-dealers, suggests regulators have prioritised avoiding failures over resolving the fundamental structure of the industry. But it is this integrated structure which largely got us here, with losses in exotic credit instruments infecting entire banks and, rapidly, the entire banking system. Mr Rajan wants to make these institutions better capitalised and "easier to close". I believe we must ask why they should continue to exist at all. Unless break-ups occur, I fear we will in due course face another crisis.

What might such a brave new world look like? Financial institutions would have to choose whether to be investment banks that underwrite and trade securities or whether to be banks that take deposits from savers and lend to borrowers. Banks making loans would keep the risk on their balance sheets and would need to deal with investment banks on an arm's length basis if they wished to hedge risk or offer clients other services. Investment banks would become providers of liquidity. They would be able to trade for themselves as well as clients but would not be able to advise clients.

Such a system would be transparent and free of conflict of interest. The risk of one part contaminating another would be minimal. Financial markets would be less liquid, the cost of capital might rise and financial institutions would be smaller. All of these are considered to be advantageous in the light of recent events. "

Me:
Don the libertarian Democrat wrote:

April 9, 2009 20:46

I'm an advocate of Narrow/Limited Banking, complemented by an Investment Sector which is supervised, non-government guaranteed, and self-insured. The government supervision should focus on the goal and use of the investments, not a particular group of investments.Rick Bookstaber has some good ideas about risk management in this sector. We should also place a monetary disincentive on size.

In all honesty, since we have a Lender Of Last Resort, there will always be a presumption that it will intervene if things get bad enough, even with an enhanced FDIC. As well, trying to outwit specialists in investment innovation is going to be a endless headache. However, we can more effectively investigate fraud, negligence, collusion, and fiduciary mismanagement, both criminally and civilly. A good start would be to stop crediting stupidity as an adequate explanation for reckless behavior.

The idea that we monitor financial concerns as if we are value investors, by being the most alert and focused when times are good, is an admirable idea, but is another proposal based on wishful thinking. Just think how hard value investing is in this environment, and how hard it is to tell people to slow down when they're making money.

Finally, asking the Fed to slow down the entire economy because you're concerned about a bubble in one sector seems like a poor choice. It's not just taking away the punch bowl, but a good part of the main meal as well. We've got to be more focused and preemtive than that.

It was proposed by Irving Fisher, Frank Knight, and other leading economists during the 1930s. It was also advocated by Nobel Laureate Milton Friedman

TO BE NOTED: From ESPlanner:

"Limited Purpose Banking

Sunday, March 15, 2009

By Scott Burns and Laurence J. Kotlikoff

In case you hadn’t noticed, the foxes are still guarding the banking henhouse. The only change: President Obama is reducing how many hens the foxes can kill while on guard duty.

The foxes, of course, are the financial wizards whose leadership almost entirely wiped out the capital of the banking system.
The old system relied on trusting people who lied and cheated. They are still running the show. They will lie and cheat again. We will be called upon to pay the bill, again.

We need a new financial system. We need limited purpose banking. It should be transparent, trustworthy and unsinkable. The key is to limit banks to their legitimate purpose. Not gambling, but financial intermediation, connecting savers to investors and lenders to borrowers.
Is this possible? Yes, it already exists in the only part of old system still above water – the mutual fund industry. Mutual fund companies like Fidelity, Vanguard, and TIAA-CREF stuck to their knitting. They didn’t leverage themselves 30 to 1 and promise things they could never deliver. These companies didn’t gamble with their own fortunes or the nation’s future. Instead, they bought mortgages, stock, real estate, and other securities. They packaged these assets in mutual funds. And they sold the mutual funds to the public.

The public, not the mutual fund companies, held the securities and took the risk. In so doing, the fund companies ensured their solvency and prevented runs on their funds. They avoided the double jeopardy of conventional banking--- financial shipwrecks that drown both the ships and the public. The one revealing exception was money market funds. There the mutual fund companies promised something they couldn’t deliver – that their money market funds would never lose money.

Mutual fund companies also have other safeguards. They use third-party custodians to hold the securities purchased by their mutual funds. This precludes a Bernie Madoff or an Allen Stanford from selling claims to securities they neither owned nor purchased. Mutual fund companies divulge their investments. Whether the assets in their mutual funds are toxic or nutritional, the mutual fund companies say what they hold.

The two things mutual funds can’t guarantee are the prices of the securities they purchase or the quality of the securities themselves. This can be improved (but not guaranteed) by compelling disclosure.

The compulsion must come from Uncle Sam. Sam needs to do what we proposed a year ago--- set up a Federal Financial Authority (FFA) to verify, fully disclose, and rate securities, as well as audit the Fortune 500 companies. As we’ve seen, our private, insider-rating agencies are not to be trusted. Neither is insider-accounting.

The FFA should also appoint and pay independent directors to the Fortune 500 companies to determine compensation for top management. This is the only way to stop top management from bribing their directors to let them steal from shareholders. The FFA would also supervise all custodial arrangements.

With an FFA in place, here’s how the new mutual fund-based banking system would work. Banks (our shorthand for all financial companies) would initiate mortgage, commercial, auto, credit card, and other loans. They would send them to the FFA for rating, package them in mutual funds, and sell them to the public.

Banks would not hold their loans. They would never be exposed to default risk. They’d provide no guarantee on their money market funds. Banks would also sell equity and real estate mutual funds. There would still be risk, but it wouldn’t be in the financial institutions that put our money to work.

Finally, banks would accept checking account deposits. To ensure they have zero exposure to a bank run, the banks would be required to hold 100 percent reserves (in cash and short-term Treasuries) against these deposits. Incidentally, this aspect of the plan – moving from the current 10 percent to 100 percent reserve requirements – is called Narrow Banking. It was proposed by Irving Fisher, Frank Knight, and other leading economists during the 1930s. It was also advocated by Nobel Laureate Milton Friedman.

By requiring banks to stick to their fundamental purpose – financial intermediation – and to proscribe their taking risk of any kind, we will never again have either bank runs or the specter of major financial companies going under.

Scott Burns is a principal of the Plano, Texas-based investment firm AssetBuilder Inc. a registered investment advisor. Laurence Kotlikoff is a professor of economics at Boston University"

Tuesday, March 31, 2009

This leaves only one workable approach: a return to narrow banking in which the activities banks can engage in are narrowly circumscribed.

TO BE NOTED: From CEPS:

"Paul De Grauwe is Professor of Economics at the University of Leuven and Associate Senior
Fellow at CEPS. This Commentary was previously published in What the G20 should do on
November 15th to fix the financial system, Barry Eichengreen and Richard Baldwin (eds), a
VoxEU.org Publication, November 2008.
CEPS Commentaries offer concise, policy-oriented insights into topical issues in European
affairs. The views expressed are attributable only to the authors in a personal capacity and
not to any institution with which they are associated.
Available for free downloading from the CEPS website (http://www.ceps.eu) 􀁹 © CEPS 2008

Returning to Narrow Banking
CEPS Commentary/14 November 2008
Paul De Grauwe
Bubbles and crashes have been part of financial markets for centuries. Allowing
banks – which inevitably borrow short and lend long – to get deeply involved into
financial markets is a recipe for disaster. The solution is to restrict banks to
traditional, narrow banking with traditional oversight and guarantees while requiring
financial firms involved in financial markets to more closely match the average
maturities of their assets and liabilities.
here can be no doubt that a reform of the international financial system is
necessary to avoid future crises. However, the G20 meeting in Washington on
15 November 2008, should also avoid an agenda that attempts to take on too
many problems. The leaders need to focus on the essential problem – the international
banking crisis and the factors that led to this crisis.
Banks’ inherent instability
It is useful to start from the basics. Banks are in the business of borrowing short and
lending long. In doing so, they provide an essential service to the rest of us, i.e. they
create credit that allows the real economy to grow and expand. This credit-creation
service, however, is based on an inherently fragile system. If the banks’ depositors or
lenders are gripped by collective distrust and everyone decides they want their money
back, bank will go broke; the money is not there since the deposits were invested in
illiquid assets. This is how a liquidity crisis erupts, setting in motion a devilish cycle
of insolvency and new liquidity crises.
Repeal of stability regulation
We learned from the Great Depression that in order to avoid such crises we have to
limit the risk-taking by bankers.
We unlearned this lesson during the 1980s and 1990s when the banking sector was
progressively deregulated giving banks opportunities to seek high-risk investments.
The culmination of this deregulatory movement was the repeal of the Glass-Steagall
Act in 1999 under the Clinton administration. This ended the separation of the
commercial and investment banking activities in the US – a separation that had been
in place since the banking collapse in the 1930s. Repeal of the Glass-Steagall Act
opened the gates for US banks to take on the full panoply of risky assets (securities,
T
derivatives and structured products) either directly on their balance sheets or
indirectly through off-balance sheet conduits.
Similar processes of deregulation occurred elsewhere, in particular in Europe, blurring
the distinction between investment and commercial banks, and in the process creating
‘universal banks’. It now appears that this deregulatory process has sown the seeds of
instability into the banking system.
The critical lack of a firebreak
Financial markets have, for centuries, been gripped by speculative fevers that have led
to bubbles and crashes; bubbles and crashes are an endemic feature of financial
markets. But financial market problems do not automatically affect banks. In the most
recent crisis, bubbles and crashes would not have been a major problem had banks not
been involved so deeply in financial markets. Banking sector deregulation, which
started in the 1980s, is what exposed the banks so catastrophically to the speculative
dynamics inherent in financial markets. Banks’ balance sheets became the mirror
images of bubbles and crashes occurring in the financial markets. An explosive
cocktail of credit and liquidity risks was created that was waiting to explode.
The failed Basel approach
The Basel approach to stabilise the banking system is based on an attempt to model
the risks that universal banks take and to compute the required capital ratios that will
minimise this risk. This approach is unworkable because the risks that matter for
universal banks are ‘tail risks’, i.e. events that are extremely rare but extremely large,
such as the nationalization of AIG or Lehman being allowed to go broke. The cost of
such events cannot be exactly quantified because they are so rare.
The only workable approach to ensuring bank stability
This leaves only one workable approach: a return to narrow banking in which the
activities banks can engage in are narrowly circumscribed. In this approach banks are
excluded from investing in equities, derivatives and complex structured products.
Investment in such products can only be performed by financial institutions,
investment banks, which are forbidden from funding these investments by deposits
(either obtained from the public or from other commercial banks).
In a nutshell, a return to narrow banking could be implemented as follows:
Financial institutions would be forced to choose between the status of a commercial
bank and that of investment bank. Only the former would be allowed to attract
deposits from the public and from other commercial banks and to transform these into
a loan portfolio with a longer maturity (duration). Commercial banks would benefit
from the lender-of-last-resort facility and deposit insurance, and would be subject to
normal bank supervision and regulation.
The financial institutions that do not opt for commercial bank status would have to
ensure that the duration of their liabilities is on average at least as long as the duration
of their assets. This would imply, for example, that they would not be allowed to
finance their illiquid assets by short-term credit lines from commercial banks.
International coordination to avoid a classic, regulatory race-to-the-bottom
A return to narrow banking can only occur if it is embedded in an international
agreement. This is where the G20 comes into the picture.
When only one or a few countries return to narrow banking, the banks of these
countries will face a competitive disadvantage. They will lose market shares to banks
that are less tightly regulated – a result that would provoke forceful lobbying against
the restrictions. In the end, the governments of these countries will yield and the
whole process of deregulation will start again.
A comprehensive international agreement will be necessary to remodel the banking
systems and to separate commercial banks from investment banking activities. This is
what a Bretton Woods II conference should focus on.
Clearly there are other desirable reforms, such as providing better incentive structures
for bank managers and rating agencies, or a better representation of emerging
countries in the IMF. The focus of Bretton Woods II, however, should be to reform
the banking system so that it does not get involved in bubbles and crashes that are
endemic to financial markets.
Additional comment & analysis from CEPS on the financial crisis
CEPS has been at the forefront of conducting policy research and analysis on the global
financial turmoil since it first emerged over a year ago. In addition to the present
commentary, you may visit our website to download all of our recent Commentaries on the
crisis:
“Europe’s Two Priorities for the G20”, Daniel Gros, 14 November 2008
“A call for a European Financial Stability Fund”, Daniel Gros and Stefano Micossi, 28
October 2008
“Restoring Confidence”, Karel Lannoo, 21 October 2008
“A Concerted Approach to Re-start the Interbank Market”, Daniel Gros, 10 October 2008
“Nationalizing banks to jumpstart the banking system”, Paul De Grauwe, 10 October 2008
“Credit Rating Agencies: Scapegoat or free-riders?”, Karel Lannoo, 10 October 2008
“The cost of ‘non-Europe'?”, Daniel Gros and Stefano Micossi, 7 October 2008
“Europe’s banking crisis: A call to action”, Open Letter by ten leading economists, 3 October
2008
“Crisis Management Tools for the Euro Area”, Daniel Gros and Stefano Micossi, 30
September 2008
“‘No recourse’ and ‘put options’: Estimating the ‘fair value’ of US mortgage assets”, Daniel
Gros, 23 September 2008
“The beginning of the endgame…”, Daniel Gros and Stefano Micossi, 18 September 2008
“The twin shocks hitting the eurozone”, Paul De Grauwe, 16 September 2008
“The crisis, one year on”, Karel Lannoo, 8 August 2008
“Cherished myths have fallen victim to economic reality”, Paul De Grauwe; 24 July 2008
“It's high time to create a truly European System of Financial Supervisors”, Karel Lannoo, 27
June 2008
“The US Housing Bust and Soaring Oil Prices: What next for the world economy?”, Daniel
Gros and Cecilia Frale, 5 June 2008
As early as April 2006, with the publication of A world out of balance?, CEPS provided an
analysis of the forthcoming problems by diagnosing a bubble in real estate markets. See A
world out of balance?, Special Report of the CEPS Macroeconomic Policy Group, Daniel
Gros, Thomas Mayer and Angel Ubide, April 2006."

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Don's Hermeneutics: Like Rabbi Yishmael's Rules, Only Not

"Searle's Sagacity":

"If a person can't explain something simply, then they don't know what they're talking about. The only exception being Kant."

"Corollary to Searle's Sagacity":

"questions should be simple and comprehensible, and meant to elicit a simple explanation."

"Samuel Johnson's Dictum":

One thing about passing fifty years of age is that I now feel old enough to invoke what I call Samuel Johnson's Dictum. It is thus: If I invoke a view based on an author that I read in the past, and that view is not actually held by that author, I'm more than willing to claim the view as originating with me. The beauty of this Dictum is that it is self-referential. It is based upon my reading of Johnson and on Boswell, but I can't remember the actual references that led me to believe that Johnson believed something like this. In any case, I do.

"Burke's Principle":

Another of my motley list of nostrums is what I call Burke's Principle. Burke's Principle holds that there is a distinction between:
1) Political Theory: A theory of the perfect society, the good life, etc. Your general political philosophy.
2) Politics: The rather messy art of governing which involves dealing with what is possible on earth and compromising as the need arises.

"Burke's Rule":

"All government, indeed every human benefit and enjoyment, every virtue, and every prudent act, is founded on compromise and barter. "

"Burke's Paradox":

"Mere parsimony is not economy. Expense, and great expense, may be an essential part in true economy."

"Burke's Prescience":

"You can never plan the future by the past.

Letter to a Member of the National Assembly (1791)"

"Burke's Wisdom":

"A very great part of the mischiefs that vex the world arises from words.

Letter to Richard Burke"

"Bagehot's Principles":

1) If the Fed exists, it will be the Lender Of Last resort, and that has to be taken in to account in real world Political Economy. It should lend freely in a crisis to solvent banks.

2) The rules for LOLR( from here on down this includes any government guarantee ) intervention should be clear, public, and followed, otherwise Moral Hazard is ineffective. All guarantees must be explicit.

3) The terms must be onerous.

4) The LOLR should get something valuable in return.

Here are a few others:

5) The taxpayer's interests should come first.

6) Moral Hazard needs to be constantly applied by quickly liquidating problem banks in normal times.

7) Any entity receiving a guarantee will have to be supervised or regulated effectively, and violations should be quickly and severely punished.

8) There is no doubt that any entity receiving a LOLR guarantee will need to be more conservative in its practices in order to limit the liability of the taxpayer.

9) There should be a class of financial concerns that can act more freely, but they should not receive LOLR guarantees. They will be strictly supervised or regulated though, and are subject to laws against fraud, etc."

Sources which back up my view of Bagehot:

http://www.pittsburghlive.com/x/pittsburghtrib/opinion/columnists/guests/s_593875.html

"Who can forget the end of "Planet of the Apes" when Charlton Heston, kneeling before the half-buried remains of the Statue of Liberty, slams his fists into the sand and cries, "You maniacs! You blew it up! Ah, damn you ... damn you all to hell!"

Now imagine the same scene, but with a half-buried Morgan Stanley building standing in for Miss Liberty and a time-traveling Walter Bagehot playing the lead and you've got the perfect Hollywood dramatization of the real-life tragedy that, with luck, is having its denouement on Wall Street.

Bagehot? The great Victorian man of letters, best remembered today as the second and most celebrated editor of the British magazine The Economist, wasn't exactly a hunk. But he certainly could have delivered those futile last lines with real conviction, for he was among the first to recognize the vast destructive potential of that newfangled weapon of Victorian finance: the modern central bank.

Bagehot first alerted readers to this potential and offered his suggestions for containing it in an article that appeared in The Economist after the great panic and credit crisis of 1866. That panic witnessed the spectacular collapse of Overend, Gurney & Co., which had long been Great Britain's premier investment house.

Bagehot understood that, during such panics, the Bank of England alone commanded the confidence needed to serve other financial firms as a "lender of last resort." But as Bagehot put it later in his book "Lombard Street: A Description of the Money Market" (1873), the bank's "faltering way" -- its arbitrary and inconsistent use of its unique lending powers -- tended only to make things worse.

"The public," Bagehot wrote, "is never sure what policy will be adopted at the most important moment: it is not sure what amount of advance will be made. ... And until we have on this point a clear understanding with the Bank of England, both our ability to avoid crises and our terror at crises will always be greater than they would otherwise be."

The ultimate source of trouble, Bagehot believed, was the very existence of the Bank of England and the special privileges it enjoyed. But because nothing save a revolution seemed likely to do away with the "Old Lady of Threadneedle Street," as it was called, Bagehot's preferred, practical solution was for the bank expressly to commit itself to lending freely during crises, though on good collateral only, and at "penalty" rates.

The restrictive provisions were supposed to limit aid to otherwise solvent firms panic had rendered illiquid.

Bagehot's recommendation has since become a sort of master precept of central banking -- albeit one that's mainly honored in the breach by central bankers.

To be fair to today's central bankers, there's never been much agreement on how to apply Bagehot's rule in practice. Just what do "good collateral" and "penalty rates" mean in times like these?

While no one might precisely be able to define good collateral -- and one can debate whether the rate at which banks offer to lend unsecured funds to other banks, known as the London Interbank Offered Rate, or LIBOR rate, plus 8 percent constitutes a "penalty" rate -- who even pretends that recent central bank lending has been based on good collateral?

But rescuing insolvent firms is the least of it. The real damage comes from the Treasury's utter lack of any consistent last-resort lending rule. The recently enacted financial institutions bailout bill does little to clarify this.

That's just the sort of thing that troubled Bagehot almost a century and a half ago, when central banks were still in their swaddling clothes. Yet central bankers and governments still don't get it, despite the lip service they pay to this great thinker from our past."

http://www.theweeklystandard.com/Content/Public/Articles/000/000/015/921taekw.asp?pg=1

"The Unwisdom of Crowds
Financial panics still require what Walter Bagehot prescribed--that practical men violate their own principles.
by Christopher Caldwell
12/22/2008, Volume 014, Issue 14

Neither Barack Obama nor John McCain had much of value to say about the financial crisis as it raged through the headlines this fall. Rather than shred their campaign strategies, they played it safe, as most politicians would have. But in the name of justice we ought to recall that there was one candidate who did foresee our predicament with considerable accuracy when it still lay far in the future. Ron Paul, in almost every speech he made during the Republican primaries, spoke of bubbles, reckless credit growth, and the "unsustainability" of present policy. So why isn't there more demand for the common-sense solutions he put forward? Because common sense is not much use in a financial panic.

This was the great discovery of Walter Bagehot, the prolific 19th-century essayist and journalist, who was editor of the Economist from 1860 to 1877. (His name rhymes with gadget.) Ninety-nine percent of the time, common sense is a synonym for practicality. But in a serious banking crisis, doing the commonsensical thing--hunkering down and counting your pennies--has proved to be not practical at all. Bagehot's Lombard Street is an insider's look at the Bank of England, and at the principles on which political and financial leaders act when advanced economies come under pressure. Those principles are depressing in the extreme for anyone with an uncomplicated idea of how a democracy works. But they are effective. That is why, in the so-called Anglo-Saxon world, Bagehot's book still provides the bedrock of policy thinking during financial emergencies, including our present one.

Lombard Street was published in 1873, seven years after the sudden collapse of Overend, Gurney & Co., a bank that lost £11 million, spread panic among investors, sparked a run, and became "the model instance of all evil in business." The crisis made such a deep impression on British finance and government that the country did not have another bank run for 141 years--not until Northern Rock collapsed in the summer of 2007. (English investors must have longer memories than American ones. Most of our own noxious subprime mortgages were contracted, and the securities built on them concocted, after Enron became our own model instance of evil in 2001.) It was the Bank of England that took charge of averting panic, during the Overend, Gurney crisis and thereafter. It did so by injecting credit into the economy, by bailing people out. Bagehot approved of this. Many ordinary retailers could not pay their suppliers until they got the money for the things they sold. Without credit, they would be ruined, and the ruin would spread to those to whom they owed money. This was not a question of moral failing, it was just the way a modern economy worked.

But the modern economic system interacts with the modern political system--democracy--in a rather uncomfortable way. Indeed, at more than one juncture in Lombard Street, Bagehot framed the problem of booms and busts as part of the "increasingly democratic structure of English commerce." People in a democracy are most comfortable when their institutions do the same things that they would do as individuals. In a crisis, banks--like everyone else--reflexively hoard their money. But a central bank must do the opposite. It must lend freely.

This was the most basic affront to common sense that the Bank of England presented, but it was not the worst. The worst was that the bank could carry out its necessary duties as a lender of last resort only by breaking the law. The basis of the bank's operating procedure--and of its soundness--was the Bank Act of 1844. We would call it a regime of sound money. It included stringent caps on the ratio of notes issued to reserves held. These caps were hewed to when the economy was running smoothly. Yet at the time Bagehot was writing, a quarter century later, the law had already been suspended three times. Not just that. "No similar occasion has ever yet occurred," Bagehot wrote, "in which it has not been suspended." So the law on which the solvency of the British nation rested was ironclad, except when someone felt a need to break it.

Stranger still, never did the Bank of England acknowledge its duty as the lender of last resort. Some of its governors even denied that any such duty existed. Bagehot thought the bank should come clean about what it really was:

There should be a clear understanding between the Bank and the public that, since the Bank hold our ultimate banking reserve, they will recognise and act on the obligations which this implies--that they will replenish [the reserve] in time of foreign demand as fully, and lend it in times of internal panic as freely and readily, as plain principles of banking require.

But there was a reason for the central bankers' dissembling. If the bank ever acknowledged a duty to rescue banks by generous extensions of credit, it would create a form of moral hazard. Thomson Hankey, a Bank of England director whom Bagehot much admired (and to whom the financial writer James Grant devotes an admiring essay in his new book Mr. Market Miscalculates), called Bagehot's lender-of-last-resort views "the most mischievous doctrine ever broached in the monetary or banking world in this country."

In practice, Bagehot was right and Hankey was wrong. The bank was beyond question the lender of last resort. In principle, Hankey was right and Bagehot was wrong. Unless there was a real, credible threat that a bank would be allowed to fail, the guarantee of rescue would simply get priced into any financial bubble that developed, making things worse when the bubble popped. The situation required what we would now call "strategic ambiguity"--both Hankey's doctrine and Bagehot's practice, which contradicts it.

The situation today requires the same mix. Central banking is thus often a high-stakes game of chicken. And sometimes, when banks enter the game insufficiently scared, it will be played out to the end. It certainly was in September when the U.S. Treasury terrified the financial world by not coming to the rescue of Lehman Brothers. This was a catastrophe in terms of Bagehot's practice, but it will produce benefits in terms of Hankey's principle. It will discourage people from paying more than is reasonable for assets on the belief that they come equipped with an insurance policy (the promise of a central bank rescue) that has been underwritten by taxpayers. The Republicans who nearly derailed the Treasury's Troubled Assets Relief Program in September played a similar role.

A final problem is that there are limits to how accountable a central bank can be. Everyone is always hollering for clear rules and transparency. But a dirty secret of regulation is that it frequently influences conduct most effectively when it is capricious and opaque. Any regulatory system will reveal its vulnerabilities over long use. If it addresses economic problems in a predictable way, savvy investors will find a way to "game" that predictability. You can draw an analogy with antidepressant drugs. There is no permanent right match of medication for a depressive. Antidepressants work only until the mind (or is it the brain?) finds a way around them, at which point a new, unfamiliar drug must be substituted. In the same way, no matter how good the content of a regulatory regime, it must change periodically if big market players are to be kept from profiting off it.

As Bagehot outlined his system, he was conscious that the practical realities of banking required him to heap paradox upon paradox. There is a hint of both Andrew Jackson and Thomas Aquinas in the way he referred to central banking as an "unnatural" thing in its very conception. "The business of banking ought to be simple," he wrote. "If it is hard it is wrong." If it is hard, the banker is either delegating poorly or has entangled his institution in complex transactions where it has no business. According to Bagehot, "Adventure is the life of commerce, but caution, I had almost said timidity, is the life of banking."

Centralizing a society's cash reserves is complicated, reckless, and artificial:

A republic with many competitors of a size or sizes suitable to the business, is the constitution of every trade if left to itself, and of banking as much as any other. A monarchy in any trade is a sign of some anomalous advantage, and of some intervention from without. . . . The natural system of banking is that of many banks keeping their own cash reserve, with the penalty of failure before them if they neglect it.

In his ideas of company size, Bagehot harkened back to the 18th century rather than ahead to our own. To modern eyes, Bagehot is, as a factual matter, simply wrong. The natural tendency under free-market conditions is towards consolidation, and even monopoly. If you want small firms, you must protect them through government--whether this means Teddy Roosevelt-ian trust-busting, French-style subsidies to tobacconists, the EU's hounding of Microsoft, or the NIMBY anti-Wal-Mart campaigns aimed at preserving Mom-and-Pop stores. Bagehot sometimes contradicted himself on this point, noting also that "a large bank always tends to become larger, and a small one tends to become smaller," but his application of the word unnatural to a large central bank was frequent and must be taken as his settled view. It is curious that Bagehot, a contemporary of Marx, came to the opposite (and false) conclusion about how firms evolve.

Where Bagehot would agree with Marx is in his belief that there is something predictably destabilizing about modern economies. You don't need banks to have a precarious economy, or one liable to speculation--Bagehot noted that there were no banks, as we would understand them, in 1720, at the time of the South Sea Bubble and the Mississippi Scheme. But modern banking is precarious by design. "In exact proportion to the power of this system is its delicacy," he wrote. "I should hardly say too much if I said its danger." The power, delicacy, and danger all have the same source. In fact they are just different names for the same thing: leverage.

At the very opening of the book, Bagehot illustrates with exquisite simplicity how, at least in a boom economy, traders on margin can "harass and press upon, if they do not eradicate, the old capitalist." The old capitalist in question is the poor sap who believes all this stuff about neither-a-borrower-nor-a-lender-be and is foolish enough to be using his own cash:

If a merchant have £50,000 all his own, to gain 10 per cent on it he must make £5,000 a year, and must charge for his goods accordingly; but if another has only £10,000, and borrows £40,000 by discounts (no extreme instance in our modern trade), he has the same capital of £50,000 to use, and can sell much cheaper. If the rate at which he borrows be 5 per cent, he will have to pay £2,000 a year; and if, like the old trader, he make £5,000 a year, he will still, after paying his interest, obtain £3,000 a year, or 30 per cent, on his own £10,000. As most merchants are content with much less than 30 per cent, he will be able, if he wishes, to forego some of that profit, lower the price of the commodity, and drive the old-fashioned trader--the man who trades on his own capital--out of the market.

Later, Bagehot showed that this need for leverage is no different for those selling money than it is for those selling dry goods. The banker can no more choose not to lend than the merchant can choose not to borrow:

The bill-broker has, in one shape or other, to pay interest on every sixpence left with him, and that constant habit of giving interest has this grave consequence: the bill-broker cannot afford to keep much money unemployed. He has become a banker owing large sums which he may be called on to repay, but he cannot hold as much as an ordinary banker, or nearly as much, of such sums in cash, because the loss of interest would ruin him.

In finance, once you can have leverage, you must have leverage. Once you have some leverage, getting more of it than your competitors is a matter of survival. And when governments and central banks debate whether to loosen or tighten up money, they face a constant clamor from the financial world to permit more leverage still. That is why, even in democracies, the instruments of monetary policy tend to be kept far from the influence of voters, and even hidden from view. Otherwise, credit tends to spiral. Bubbles result.

Nothing could be more foolish than to assume that this process of spiraling speculation is unleashed by "greed," unless by greed you mean human nature. Credit spirals are a darker aspect of the world Adam Smith described in The Wealth of Nations and Bernard de Mandeville did in the Fable of the Bees. Just as society can be improved by the uncoordinated action of the selfishly motivated, an economy can collapse for reasons having nothing to do with anybody's cupidity.

We should be moral in the way we think about money, but a credit system tends to make a mess of moral accounting. Bagehot described London's financial district as "a sort of standing broker between quiet saving districts of the country and the active employing districts." Decent, puritanical Suffolk farmers want to put their money in a safe place; Lancashire entrepreneurs want money to put to work. Thanks to London bankers, both can follow their wishes and make a profit in the process. We have an idea that the Suffolk dairyman is the "moral" party here (he's saving) and the Lancashire speculator the "immoral" one (he's gambling). But, once a banking system intervenes, they are both gambling and they are both saving. In good times you are welcome to mouth the folkloric cliché that holds farmers to be better people than financiers. When depression looms, you had better realize that the rain falls on the just and the unjust.

Many Americans who have wound up underwater on their houses and maxed out on their credit cards are greedy, climbing, brand-intoxicated, materialistic shopaholics who thought the world owed them a living. But just as many of them are not. They are trapped, as surely as financial institutions are, in a system based on wild borrowing. Participation in this system is not exactly required, but it is not exactly optional, either. One's quality of life is determined not just by one's purchasing power but also by one's relative economic standing. Chagrin at seeing one's neighbors get richer faster may be a sign of bad character, but do not for a minute assume there is nothing to feel chagrin about! When it comes to the very goods people deem most essential--the proper mate; the schooling of one's children; the size, location, elegance, and comfort of one's house--relative standing is more important than absolute wealth.

Those who kept their money in savings banks in the 1990s lost out to those who did things we are supposed to disapprove of, like "spending money they didn't have," borrowing profligately to invest in stocks and even bonds, which appreciated at an average of 15 percent a year over the decade. Among rich people, how one entered the present decade had more to do with how one had done in the stock market than with how one had done in the labor market. Is that just? Of course it's not! It's easy to see now. But while the boom was going on there was all sorts of rationalizing about why it was okay that the social hierarchy should be reordered through stock and housing speculation. One line of argument was that people who did not have a ton of money in stocks, as well as those who rented rather than bought the houses they lived in, were foolish. This line of argument peaked at the turn of the decade, when Americans elected a president who had argued that the public was foolish for not launching its retirement savings onto the open seas of the stock market.

Bagehot saw that a speculative mania eventually sweeps up everyone in its path. "Every great crisis reveals the excessive speculations of many houses which no one before suspected," he wrote, "and which commonly indeed had not begun or had not carried very far those speculations, till they were tempted by the daily rise of price and the surrounding fever." Avaricious people get hurt, but it is in the nature of crashes that they are not the ones who get hurt most. A tragic figure present in almost every historic account of speculation and collapse in history is the person who believed, year after year, that the boom was an illusion, and held himself aloof until, at the very last minute, whether out of self-doubt or deference to the opinions of his fellow man, he entered the fray and was (having bought at the top, rather than the bottom, of the market) wiped out. What a wicked irony! His punishment is as much for his long and wise forbearance as for his momentary weakness.

So the "cultural contradictions of capitalism" run deeper than we thought. The classic idea, as laid out in their different ways by the economist Joseph Schumpeter and the sociologist Daniel Bell, is that capitalism rewards diligence; diligence produces wealth; wealth begets idleness; and idleness undermines capitalism. But when, as now, push comes to shove, we can ask whether there is really anything particularly capitalist about the virtues of diligence and self-restraint. The real capitalist virtues appear to be optimism and luck. From a central-banking perspective, the cultural contradictions are not results of capitalism but elements of it.

The problem with central banking is that it reacts to a system that has been mismanaged by rewarding the managers. That is why objections to central banking, although they can come from the right (Ron Paul, Jim Bunning) or the left (Barney Frank, William Greider), tend to be populist. Bagehot was no populist. He was comfortable with the idea that what some people think should be more important than what other people think:

Almost all directors who bring special information labor under a suspicion of interest; they can only have acquired that information in present business, and such business may very possibly be affected for good or evil by the policy of the Bank. But you must not on this account seal up the Bank hermetically against living information.

Although he would surely fault Treasury Secretary Hank Paulson for many things, the criticism most often heard at present--that Paulson is too close to former colleagues on Wall Street, where he worked for years as CEO of Goldman Sachs--would strike Bagehot as misplaced.

Because it is on Wall Street, alas, that "the state of credit" is to be determined:

The state of credit at any particular time is a matter of fact only to be ascertained like other matters of fact; it can only be known by trial and inquiry. And in the same way, nothing but experience can tell us what amount of "reserve" will create a diffused confidence.

To be blunt, credit is successfully reestablished when financial elites say, "When." Credit is close to a synonym for the mood of the ruling class. To say an economy is based on credit is to say it is based on animal mysteries. Glamour, prestige, élan, sprezzatura, cutting a figure . . . that is what the economy is made of. It is a rather terrifying thought. Viewed as Bagehot viewed it, from the perspective of a central bank in a crisis, an advanced economy looks an awful lot like a primitive economy."

http://blogs.iht.com/tribtalk/business/globalization/?p=680

"Loyal readers, please take a moment to check out Gretchen Morgenson’s column this week. She’s taken a close look at the buyout of Bear Stearns organized by the Federal Reserve, and she has come to an intriguing conclusion: that the Fed not only wanted to prevent financial havoc - it also wanted to deter speculators who were betting on big banks to fail.

Adherents of the Walter Bagehot school of central banking - and I have been among them at times - have cried foul at the sight of big bailouts and the granting of emergency credit at low interest rates. The Bagehot argument is that emergencies that arise from the risks that banks have chosen to take should not be treated with overwhelming sympathy. Emergency credit should be offered, yes, but at rates that will make banks think twice about using the safety net again. That’s not the case this time around (neither in the United States nor in Britain, and probably not in Europe either by the time the folks in Brussels are finished), so the central banks may be telling financial institutions that they can take silly risks without fear of disaster.

But if Morgenson is right, there is a long-term purpose here, too: to reduce the winnings of those who bet on failure, and thus to reduce the incentives to bring that failure to pass. And let’s face it, the speculators aren’t operating in a vacuum; their bets can start to snowball with market sentiment, as they did against Lehman Brothers last week. Still, the Bagehot argument (often called moral hazard) is also a powerful one - which one do you agree with?"

http://blogs.wsj.com/economics/2007/08/20/from-bagehot-to-bernanke/

"In his 1873 book “Lombard Street,” the closest thing to a user’s guide to central banking, Walter Bagehot criticized the Bank of England’s handling of earlier panics by responding “hesitatingly, reluctantly, and with misgiving.”

Federal Reserve Chairman Ben Bernanke, who has read his Bagehot and kept a copy in his Princeton office when he was a professor, responded to recent developments first by pumping money into the markets through the New York Fed’s open-market operations and then last week by easing the terms on loans to banks from the Fed’s discount window.

Bagehot (pictured at right) still makes for good reading at times like this.

“What is wanted and what is necessary to stop a panic is to diffuse the impression, that though money may be dear, still money is to be had. If people could be really convinced that they could have money if they wait a day or two, and that utter ruin is not coming, most likely they would cease to run in such a mad way for money. Either shut the Bank at once, and say it will not lend more than it commonly lends, or lend freely, boldly, and so that the public may feel you mean to go on lending. To lend a great deal, and yet not give the public confidence that you will lend sufficiently and effectually, is the worst of all policies; but it is the policy now pursued.”

Robert Feldman, Morgan Stanley’s chief economist for Japan, writes in a note today that it’s key to distinguish between internal discredit — private domestic lenders retreating — and external discredit, which Bagehot defined as a foreign drain on a bank’s money. (Bagehot’s solution to the problem of external discredit is to still lend freely but “at very high rates.”) That doesn’t apply in today’s floating rate system, Feldman says, and exchange rates don’t provide a good substitute, with the dollar’s drop against the yen suggesting we have external discredit while the strengthening against the euro saying we don’t.

Feldman writes: “My view is that the modern counterpart of ‘external discredit’ is moral hazard. The credit of the U.S. IS a problem, since no one knows how big the subprime and related housing market problems really are. Given how poorly banks know their clients, the ‘high rates’ part should come into play. There is no way to re-establish confidence unless those who have made loans to questionable borrowers pay a price for rash lending. Only then will markets regain confidence that risk is under control.

“The next stage of the credit problem — and whether it affects the real economy seriously — depend on eliminating the moral hazard,” Feldman says. “The faster the moral hazard in eliminated, the less impact on the real economy.”

Fed officials are acutely aware of the moral hazard, having resisted action for weeks to not be seen as bailing out risky investments. But they also don’t want a crisis to feed on itself. The Fed stressed its statement, in lowering the discount rate for banks, that it would accept “a broad range of collateral…including home mortgages and related assets.” The central bank sought to reassure a market that had been roiled by risky investments in subprime mortgages.

That’s how the Bank of England halted a panic in 1825, as Bagehot recounts: “A panic, in a word, is a species of neuralgia, and according to the rules of science you must not starve it. The holders of the cash reserve must be ready not only to keep it for their own liabilities, but to advance it most freely for the liabilities of others. They must lend to merchants, to minor bankers, to ‘this man and that man,’ whenever the security is good. In wild periods of alarm, one failure makes many, and the best way to prevent the derivative failures is to arrest the primary failure which causes them. The way in which the panic of 1825 was stopped by advancing money has been described in so broad and graphic a way that the passage has become classical. ‘We lent it,’ said Mr. Harman, on behalf of the Bank of England, ‘by every possible means and in modes we had never adopted before; we took in stock on security, we purchased Exchequer bills, we made advances on Exchequer bills, we not only discounted outright, but we made advances on the deposit of bills of exchange to an immense amount, in short, by every possible means consistent with the safety of the Bank, and we were not on some occasions over-nice. Seeing the dreadful state in which the public were, we rendered every assistance in our power.’ After a day or two of this treatment, the entire panic subsided, and the ‘City’ was quite calm.”

http://www.realclearmarkets.com/articles/2008/03/bagehot_central_banking_and_th.html

"Bagehot advocated in 1873 that a Lender of Last Resort in a crisis should lend at a penalty rate to solvent but illiquid banks that have adequate collateral. The doctrine has been criticised as having no place in our modern interbank market, but this is wrong. Bagehot’s prescription aims to eliminate the coordination problem of investors at the base of the crisis. It is still a useful guide for action when the interbank market stalls.1 It makes clear that discount-window lending to entities in need may be necessary in a crisis.

Bagehot's doctrine, however, is easy to state and hard to apply. It requires the central bank to distinguish between institutions that are insolvent and those that are merely illiquid. It also requires them to assess the collateral offered. Central banks, because of information limitations, are bound to make mistakes, losing face and money in the process. This doesn’t mean they should not try.
Poor collateral versus massive liquidity

The collateral should be valued under “normal circumstances”, that is, in a situation where the coordination failure of investors does not occur. This involves a judgment call in which the central bank values the illiquid assets. A central bank that only takes high quality collateral will be safe, but will have to inject much more liquidity and/or set lower interest rates to stabilise the market. This may fuel future speculative behavior. Some of this may have happened in the Greenspan era, in the aftermath of the crisis in Russia and LTCM, and after the crash of the technological bubble. The ECB and the Federal Reserve have accepted now partially illiquid collateral that the market would not. This seems appropriate and releases pressure to lower interest rates to solve the problem, something that should be done only if there are signs of deterioration in the real economy. The problem is that central banks are extending the lender of last resort facility outside the realm of traditional banks to entities, like Bear Stearns, that they do not supervise and, therefore, over which they do not have first hand information. How does the Fed know whether Bear Stearns or other similar institutions are solvent? It seems that the Fed is not following Bagehot’s doctrine here.

Finally, if banks and investors are bailed out now, why should they be careful next time? This is the moral hazard problem: help to the market that is optimal once the crisis starts has perverse effects in the incentives of market players at the investment stage. The issue is that only when the moral hazard problem is moderate does it pay to eliminate completely the coordination failure of investors with central bank help. When the moral hazard problem is severe, a certain degree of coordination failure of investors - that is, allowing some crises - is optimal to maintain discipline when investing and, amending Bagehot, some barely solvent institutions should not be helped."

http://www.house.gov/jec/imf/blueprnt.htm

"This goal is not new. In fact, it underlay Walter Bagehot's (1873) classic policy prescriptions for domestic central banking: to lend freely at a penalty rate on good collateral. Bagehot argued an elastic and immediate supply of liquidity was essential to an effectively structured lender of last resort, and that appropriate loss sharing rules in the form of collateral requirements and penalty interest rates would discourage abuse of the safety net."

http://online.wsj.com/public/article_print/SB120908336730343529.html

"By slashing interest rates too much in 2007-2008, the Fed has accentuated the foreign drain and thus made the alleviation of the domestic drain more difficult. Yet, despite this mistake, Bagehot would approve of other actions the Fed has taken to deal with the domestic drain by unblocking specific impacted domestic markets. These include (1) swapping Treasury bonds for less safe private bonds, (2) opening its discount window to shaky borrowers, and (3) maybe even rescuing Bear Sterns. He would also approve of the relaxation of capital constraints on Fannie Mae, Freddy Mac and so on, for mortgage lending. Yet these measures will be insufficient if the foreign drain continues.

To repeat Bagehot's Rule: "very large (domestic) loans at very high rates are the best remedy for the worst malady of the money market when a foreign drain is added to a domestic drain." The Fed, and the U.S. government more generally, have so far got it only half right."

http://findarticles.com/p/articles/mi_m2751/is_56/ai_55015114/pg_6

"More than a century ago, a British economic journalist, Walter Bagehot, set out the classical principles for a central bank acting as lender of last resort: lend freely in a crisis at a penalty rate against collateral. Adapted to international lending, Bagehot's rule is the proper rule for a restructured, more effective IMF."

http://maverecon.blogspot.com/2007/08/central-banks-in-time-of-crisis.html

"In a number of recent blog contributions, we have sketched the role of a modern central bank as ‘market maker of last resort’ (MMLR). This MMLR is the analogue, in a world where intermediation is increasingly through financial markets, to Bagehot’s lender of last resort (LOLR) in a world where most intermediation took place through banks (see e.g. Willem H. Buiter and Anne C. Sibert “The Central Bank as the Market Maker of last Resort: From lender of last resort to market maker of last resort"; Willem H. Buiter “Central banks as market makers of last resort, again”; Willem H. Buiter and Anne C. Sibert “A missed opportunity for the Fed”).

The market maker of last resort function can be fulfilled in two ways. First, the central bank can make outright purchases and sales of a wider range of securities than they currently do. Second, central banks can accept a wider range of securities as collateral in repos, and in collateralised loans and advances at the discount window than they currently do. Following Bagehot’s rule, the MMLR should buy these securities outright or accept them as collateral only on terms that would imply a stiff financial penalty to the owner. The central bank of course already applies a liquidity ‘haircut’ even to liquid instruments offered as collateral in repos or at the discount window. Because the MMLR would have to establish a buying price ‘in the dark’, that is, unaided by recent relevant market prices, and would inevitably take on much more credit risk than central banks have become accustomed to, the ‘haircuts’ should be severe – a financial version of ‘short back and sides’.

http://www.independent.org/pdf/tir/tir_07_3_wood.pdf

"Further crises in 1857 and 1866 prompted the debate between Bagehot and
Thomson Hankey, a director and former governor of the Bank of England. Notwithstanding
the Bank’s undoubted responsibility, as trustee of the nation’s reserve, to
support the financial markets, Bagehot wrote:
If we ask how the Bank of England has discharged this great responsibility,
we shall be struck by three things: first, . . . the Bank has never by any
corporate act or authorised utterance acknowledged the duty, and some of
its directors deny it; second, (what is even more remarkable), no resolution
of Parliament, no report of any Committee of Parliament (as far as I know),
no remembered speech of a responsible statesman, has assigned or enforced
that duty on the Bank; third (what is more remarkable still), the distinct
teaching of our highest authorities has often been that no public duty of
any kind is imposed on the Banking Department of the Bank; that, for
banking purposes, it is only a joint stock bank like any other bank; that its
managers should look only to the interest of the proprietors and their
dividend; that they are to manage as the London and Westminster Bank or
the Union Bank manages. (1873, 153–54)
Although the Bank usually in the end supplied the market, its “faltering way”
caused needless uncertainty and more severe panics than if it communicated clearly
that it could be counted on (Bagehot 1873, 64). According to Bagehot, the rules—
to lend freely at penalty rates on sound collateral—under which assistance would be
provided should be stated also.
The public is never sure what policy will be adopted at the most important
moment: it is not sure what amount of advance will be made. The best
palliative to a panic is a confidence in the adequate amount of the Bank
reserve, and in the efficient use of that reserve. And until we have on this
point a clear understanding with the Bank of England, both our liability to
crises and our terror at crises will always be greater than they would
otherwise be. (1873, 196–97)"

One which doesn't quite:

http://www.portfolio.com/views/blogs/market-movers/2008/05/13/bernanke-on-bagehot?rss=true

"Bernanke on Bagehot

I doubt a week has gone by since last summer during which I haven't seen some pundit or other trot out Walter Bagehot's dictum that in the event of a credit crunch, the central bank should lend freely at a penalty rate. More often than not, this is contrasted with the actions of the Federal Reserve, which seems to be lending freely at very low interest rates.

Ben Bernanke, in a speech today, addressed this criticism directly:

What are the terms at which the central bank should lend freely? Bagehot argues that "these loans should only be made at a very high rate of interest". Some modern commentators have rationalized Bagehot's dictum to lend at a high or "penalty" rate as a way to mitigate moral hazard--that is, to help maintain incentives for private-sector banks to provide for adequate liquidity in advance of any crisis. I will return to the issue of moral hazard later. But it is worth pointing out briefly that, in fact, the risk of moral hazard did not appear to be Bagehot's principal motivation for recommending a high rate; rather, he saw it as a tool to dissuade unnecessary borrowing and thus to help protect the Bank of England's own finite store of liquid assets. Today, potential limitations on the central bank's lending capacity are not nearly so pressing an issue as in Bagehot's time, when the central bank's ability to provide liquidity was far more tenuous.

I'm no expert on Walter Bagehot, and in fact I admit I've never read Lombard Street. But I'll trust in Bernanke as an economic historian on this one, unless and until someone else makes a persuasive case that Bagehot's penalty rate really was designed to punish the feckless rather than just to preserve the Bank of England's limited liquidity."

"So, we have, what I will call "Grant's Graham For Investing":

1) Decent Size

2) Current Assets Exceed Liabilities By Two Times

3) 10 Continuous Years Of Profit

4) 20 Continuous Years Of Dividends

5) 10 Years Of Earnings Growth Exceeding 33%

6) Price To Earnings Ratio Less Than 15

7 ) Price To Book Ratio Less Than 1.5"

"Cake As Gift Theory":

Now, I feel similarly about government incentives. When Fannie and Freddie tempted investors, this led to the housing bubble. I think that I'm going to call this the Cake As Gift Theory. I hand you a cake assuming that you have the good sense to eat it over time, and you gorge yourself and eat it at one sitting and get sick. Clearly I'm responsible for this by handing you the cake. Give you a gift or incentive, clearly I must assume that it will cause you to be irrational.

"Spigot Theory":

One other pet theory I have about finance, besides Bagehot's Principle, is the Spigot Theory. I might rename it. It applies to the low rate of interest or the sloshing pool of money explanations for the current crisis. Turn the tap too far, then you can't stop the tub from overflowing, even if you're a human agent standing right next to the tub. I call this a mechanistic explanation as opposed to an explanation based on human agency.

"The Pragmatic Milton Friedman Principle":

The Pragmatic Milton Friedman Principle. Friedman introduced a concept called the Negative Income Tax. He proposed it saying that it was a pragmatic compromise between the Welfare State and a basic libertarian position.

"Hardy's Harangue": To Me:

"There is no scorn more profound, or on the whole more justifiable, than that of the men who make for the men who explain. Exposition, criticism, appreciation, is work for second-rate minds. "

"Titchmarsh's Two Truths":

1)"Perhaps we could regard numbers as a sort of medium of exchange, like money. Most people are really interested in the goods and services which the world offers, and to them money is only a symbol for these. But it is not a meaningless symbol. A system of barter, in which we do without money and merely exchange goods, would be very inconvenient, and practically impossible in a complicated society. So a system in which we reduce all mathematics to statements such as "I have more fingers than you have noses" would be too cumbrous to contemplate seriously. Numbers are symbols, and very useful and interesting ones. To mathematicians who work with them every day they acquire a reality at least equal to that of anything else. "

2) "The question what numbers are has been much debated by philosophers, and they do not seem to have reached any agreement about it. There is nothing particularly surprising or distressing about this. It has been said that mathematicians are happy only when they agree, and philosophers only when they disagree. Philosophic doubts about the nature of number have never prevented mathematicians from getting on with their calculations, or from agreeing when they have got the right answer. So perhaps the situation is satisfactory to all parties. "

"Thoreau's Truth":About Government:
"I heartily accept the motto, "That government is best which governs least"; and I should like to see it acted up to more rapidly and systematically. Carried out, it finally amounts to this, which also I believe--"That government is best which governs not at all"; and when men are prepared for it, that will be the kind of government which they will have. Government is at best but an expedient; but most governments are usually, and all governments are sometimes, inexpedient."

"Will's Warning": Concerning The Use Of "Socialism":
Hyperbole is not harmless; careless language bewitches the speaker's intelligence. And falsely shouting "socialism!" in a crowded theater such as Washington causes an epidemic of yawning.

"Kling's Principle":About Regulated Banks And Unregulated Financial Entities
"The banks seem to find a way to take risks, and the unregulated folks seem to find a way to get guarantees."

"Janeway's Dictum": On Political Economy
"Political economy is not a science, it's a clinical art, like medicine."

"Cowen's Creed": On Policies

"YOU CAN’T TURN BAD TO GOOD The good New Deal policies, like constructing a basic social safety net, made sense on their own terms and would have been desirable in the boom years of the 1920s as well. The bad policies made things worse. Today, that means we should restrict extraordinary measures to the financial sector as much as possible and resist the temptation to “do something” for its own sake."

"Hendry's Heartfelt":

"I antagonise people,' says Hugh Hendry. 'It's part of my skill set."

"Diebel's Dare:

"You can’t be forced out further on the yield curve than a perpetual.”

"Peston's Promise": Good Until ...

"And, as I've been pointing out for some time, we are being asked to provide life support to a swathe of the real economy, from steel makers to car manufacturers.

The Government will succumb and will lend taxpayers' money to non-financial companies.

In a way, there's no choice, because we'll be hobbled for years as an economy if our few remaining manufacturers and exporters are wiped out."

"Trader's Narrative's Due Diligence":

"The process of investigation undertaken by an party to gather material information on actual or potential risks involved in a financial transaction or relationship."

The Quotes Above

W. Bagehot, R.W. Emerson, M. Proust, W.H. Auden, W. Bagehot, P.Levine

Read J.L. Austin "A Plea For Excuses" here:

http://www.ditext.com/austin/plea.html

Read " Reflections on the Revolution in France by Edmund Burke 1790" here:

http://www.constitution.org/eb/rev_fran.htm

P. Levine reading "They Feed They Lion"

http://www.ibiblio.org/ipa/poems/levine/they_feed_they_lion.php

Read H.D. Thoreau " On Civil Disobedience " here:

http://sunsite.berkeley.edu/Literature/Thoreau/CivilDisobedience.html

Read W. Bagehot " Lombard Street" here:

http://bagehot.classicauthors.net/LOMBARDSTREET/LOMBARDSTREET9.html

Read Irving Fisher's "The Debt-Deflation Theory Of Great Depressions" here:

http://fraser.stlouisfed.org/docs/meltzer/fisdeb33.pdf

Read H.D. Thoreau "Walking" here:

http://www.ecotopia.org/ehof/thoreau/walking.html

About Rabbi Ishmael's Rules, see here:

http://en.wikipedia.org/wiki/Baraita_of_Rabbi_Ishmael

Read E.C. Titchmarsh on "Counting" here:

http://www-groups.dcs.st-and.ac.uk/~history/Extras/Titchmarsh_Counting.html

Read Granville Barker's "Voysey Ineritance" here:

http://books.google.com/books?hl=en&id=jFNFAAAAIAAJ&dq=the+voysey+inheritance&printsec=frontcover&source=web&ots=7TZP8W9Hlh&sig=yEoasq-eebAqE6H0iOnVaJhqFRs&sa=X&oi=book_result&resnum=4&ct=result#PPA6-IA3,M1

Read Henry James "The Sacred Fount" here:

http://www2.newpaltz.edu/~hathaway/sacredfount.html

Read "The Calculus Of Consent" here"

http://www.econlib.org/library/Buchanan/buchCv3Cover.html

Read "Did Reagan Rule In Vain? A Closer Look at True Expenditure Levels in the United States and Europe by Jacob Funk Kirkegaard " here:

http://petersoninstitute.org/publications/interstitial.cfm?ResearchID=1096

Read "The Postulates Of Political Economy" by Bagehot here:

http://books.google.com/books?id=ZrA-AAAAIAAJ&dq=bagehot+political+economy&printsec=frontcover&source=bl&ots=dN6OiMA8wi&sig=gV8nfKIxA1hYR9oAIxvQFdNZD0w&hl=en&ei=15uXSZf7CoKqsAPHz-mLAQ&sa=X&oi=book_result&resnum=2&ct=result#PPP1,M1

Read W.Buiter "Helicopter Money" here:

http://www.nber.org/~wbuiter/helijpe.pdf

Read Remarks by Governor Ben S. Bernanke
Before the National Economists Club, Washington, D.C.
November 21, 2002 Deflation: Making Sure "It" Doesn't Happen Here"

http://www.federalreserve.gov/boardDocs/speeches/2002/20021121/default.htm#f8

Shema by Primo Levi

You who live secure
In your warm houses
Who return at evening to find
Hot food and friendly faces:

Consider whether this is a man,
Who labours in the mud
Who knows no peace
Who fights for a crust of bread
Who dies at a yes or a no.
Consider whether this is a woman,
Without hair or name
With no more strength to remember
Eyes empty and womb cold
As a frog in winter.

Consider that this has been:
I commend these words to you.
Engrave them on your hearts
When you are in your house, when you walk on your way,
When you go to bed, when you rise.
Repeat them to your children.
Or may your house crumble,
Disease render you powerless,
Your offspring avert their faces from you.

Translated by Ruth Feldman And Brian Swann

For me, being a Jew means feeling the tragedy of yesterday as an inner oppression. On my left forearm I bear the Auschwitz number; it reads more briefly than the Pentateuch or the Talmud and yet provides more thorough information. It is also more binding than basic formulas of Jewish existence. If to myself and the world, including the religious and nationally minded Jews, who do not regard me as one of their own, I say: I am a Jew, then I mean by that those realities and possibilities that are summed up in the Auschwitz number.

– Jean Améry, At the Mind's Limits, p. 94

J.L. Austin

'there is no simple and handy appendage of a word called "the meaning of the word (x)"'

...our common stock of words embodies all the distinctions men have found worth drawing, and the connections they have found worth marking, in the lifetime of many generations: these surely are likely to be more numerous, more sound, since they have stood up to the long test of survival of the fittest, and more subtle, at least in all ordinary and reasonable practical matters, than any that you or I are likely to think up in our armchair of an afternoon – the most favorite alternative method

L. Wittgenstein

94. But I did not get my picture of the world by satisfying myself of its correctness; nor do I have it because I am satisfied of its correctness. No: it is the inherited background against which I distinguish between true and false.

95. The propositions describing this world-picture might be part of a kind of mythology. And their role is like that of rules of a game; and the game can be learned purely practically, without learning any explicit rules.

96. It might be imagined that some propositions, of the form of empirical propositions, were hardened and functioned as channels for such empirical propositions as were not hardened but fluid; and that this relation altered with time, in that fluid propositions hardened, and hard ones became fluid.

97. The mythology may change back into a state of flux, the river-bed of thoughts may shift. But I distinguish between the movement of the waters on the river-bed and the shift of the bed itself; though there is not a sharp division of the one from the other.

98. But if someone were to say "So logic too is an empirical science" he would be wrong. Yet this is right: the same proposition may get treated at one time as something to test by experience, at another as a rule of testing.

99. And the bank of that river consists partly of hard rock, subject to no alteration or only to an imperceptible one, partly of sand, which now in one place now in another gets washed away, or deposited.

100. The truths which Moore says he knows, are such as, roughly speaking, all of us know, if he knows them.

Jackson's Rules Of The Road

I'm going to be a happy idiot
And struggle for the legal tender
Where the ads take aim and lay their claim
To the heart and the soul of the spender
And believe in whatever may lie
In those things that money can buy
Thought true love could have been a contender
Are you there?
Say a prayer for the pretender
Who started out so young and strong
Only to surrender

Gotta do what you can just to keep your love alive
Trying not to confuse it with what you do to survive

And in the end they traded their tired wings
For the resignation that living brings
And exchanged loves bright and fragile glow
For the glitter and the rouge
And in the moment they were swept before the deluge

Don't confront me with my failures
I had not forgotten them

But its a long way that I have come
Across the sand to find you here among these people in the sun
Where your children will be born
You'll watch them as they run
Oh its so far the other way my life has gone

I caught a ride into the city every chance I got
I wasn't sure there was a name for the life I sought
Now I'm a long way gone down the life I got
I don't know how I believed some of the things I thought

Rock me on the water
Sister will you soothe my fevered brow
Rock me on the water, maybe Ill remember
Maybe Ill remember how
Rock me on the water
The wind is with me now
So rock me on the water
Ill get down to the sea somehow

But you said "morocco" and you made me smile
And it hasn't been that easy for a long, long while
And looking back into your eyes I saw them really shine
Giving me a taste of something fine
Something fine

V. Frankl

"In camp too, a man might draw the attention of a comrade working next to him to a nice view of the setting sun shining through the tall trees of the Bavarian woods (as in the famous water color by Dürer), the same woods in which we had built an enormous, hidden munitions plant. One evening, when we were already resting on the floor of our hut, dead tired, soup bowls in hand, a fellow prisoner rushed in and asked us to run out to the assembly grounds and see the wonderful sunset. Standing outside we saw sinister clouds glowing in the west and the whole sky alive with clouds of ever-changing shapes and colors, from steel blue to blood red. The desolate grey mud huts provided a sharp contrast, while the puddles on the muddy ground reflected the glowing sky. Then, after minutes of moving silence, one prisoner said to another, 'How beautiful the world could be!'

Libertarian Democrat Point Of View: An Eccentricity

Thursday, June 18, 2009

It’s a blunt instrument, but it has the benefit of being simple and hard to game.

Macroprudential

Putting an end to too-big-to-fail: An IM exchange

How narrow should a narrow bank be?

Saturday, June 6, 2009

It’s tempting. With a narrow bank, we could separate the bank from the holding company, and send the subs to forage for themselves.

Thursday, May 14, 2009

Laurence Kotlikoff and John Goodman argue that banks need to return to being disinterested intermediaries.

Comments

Tuesday, May 5, 2009

we anticipate that policymakers would face tremendous pressure to allow firms to grow large again after their initial breakup

Tuesday, April 28, 2009

Liberal Democrats, are in favour of the forced break-up of the likes of Barclays and Royal Bank of Scotland into so-called narrow banks

Friday, April 24, 2009

Under LPB, people, not companies, bear risk as their mutual funds do well or poorly

"The Ideal Financial System

Wednesday, April 15, 2009

virtues of a “limited purpose banking” system, one that would greatly reduce banks’ abilities to take on risk

The Post-Recession Appetite for Risk and Regulation

Tuesday, April 14, 2009

That wouldn’t prevent future financial crises outright. But it would probably stop them from causing a major global recession

Thursday, April 9, 2009

A case in point is the narrow banking debate

It was proposed by Irving Fisher, Frank Knight, and other leading economists during the 1930s. It was also advocated by Nobel Laureate Milton Friedman

Tuesday, March 31, 2009

This leaves only one workable approach: a return to narrow banking in which the activities banks can engage in are narrowly circumscribed.

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Thursday, June 18, 2009

Macroprudential

Saturday, June 6, 2009

Thursday, May 14, 2009

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Tuesday, May 5, 2009

Tuesday, April 28, 2009

Friday, April 24, 2009

"The Ideal Financial System

Wednesday, April 15, 2009

The Post-Recession Appetite for Risk and Regulation

Tuesday, April 14, 2009

Thursday, April 9, 2009

Tuesday, March 31, 2009

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From "The Snowfall" by D. Justice

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