John Bougearel of Structural Logic

TO BE NOTED: From Zero Hedge:

Guest Post: The Proposed Grayson-Glass-Steagall Act Of 2009

Posted by Tyler Durden at 9:25 AM

Submitted by John Bougearel of Structural Logic

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This is a debate which needs to be aired in the widest possible way.

TO BE NOTED: From the FT:

"Insight: When it comes to global banks, size matters

By Gillian Tett

Published: June 18 2009 19:37 | Last updated: June 18 2009 19:37

Do the big global banks need to be cut down to size? That question has been hovering, half-stated, over the financial system ever since Bear Stearns blew up.

But until this week, most policymakers were reluctant to attack the big banks too publicly, in terms of size. After all, this has been the decade when global leaders – or the infamous “Davos man” – worshipped at the altar of free-market capitalism, globalisation and innovation.

Inside the Davos creed it was long assumed that private sector banks had the right to be as big as the market would bear, since scale was supposed to make finance efficient, and thus better able to promote innovation.

Now that creed has crumbled. The collapse of Lehman Brothers has shown the havoc that can ensue when large, interconnected banks implode.

Worse, in the aftermath of Lehmans, as governments have rushed to rescue the banks, the potential fiscal costs – and risks – have become clear. In the UK, for example, the balance sheet of the Royal Bank of Scotland at its peak was not far from the size of the British economy.

Thus, a new debate about “size” is finally starting. On Wednesday Mervyn King, Bank of England governor, warned that regulators might need to rethink the wisdom of letting some banks become “too big to fail”. In Washington, the Obama administration has voiced similar thoughts, albeit more diplomatically and obliquely.

On Thursday, though, an even more interesting and outspoken intervention emerged. Philipp Hildebrand, the next head of the Swiss National Bank, revealed that the central bank was considering introducing “direct and indirect measures to limit the size” of large international banks (which in the case of Switzerland means Credit Suisse and UBS).

“A size restriction would of course be a major intervention in an institution’s corporate strategy,” Hildebrand, the central bank’s current vice-chairman, observed with masterful understatement. “Naturally the SNB is aware that there are advantages to size. [But] in the case of the large international banks, the empirical evidence would seem to suggest that these institutions have long exceeded the size needed to make full use of these advantages.”

Now, to be fair to Hildebrand, I should stress that he only presented size controls as a policy of last resort. He is not, in other words, demanding the immediate break-up of UBS or Credit Suisse.

For what really worries the SNB is not any abstract issue about size, but the very practical problems that emerge when big banks collapse due to the absence of any international regime to wind down a large, cross-border bank smoothly – or restructure its operations.

What Hildebrand really wants to see is a credible international framework to handle big bank failures in a way that does not blow up the financial system. Call it, if you like, a call for a global Chapter 11 regime for banks.

Hildebrand is also a realist who spent the early years of his career working for a US hedge fund. He does not consider it a good trading bet to sit around waiting for global bureaucrats to actually produce a global insolvency regime any time soon. Hence his determination to start talking about plan B – and to stop banks from becoming too big if there is no global framework in place to deal with a collapse.

Whether Hildebrand’s idea will actually fly is unclear. Some Swiss politicians hate the idea of introducing measures that might leave their banks at a disadvantage relative to others. And Credit Suisse and UBS have powerful lobbying muscle, precisely because they are so ... er ... big.

Hildebrand is not the only western policy maker mulling these concepts. And he has successfully stuck his neck out before. Last year he was the first western central banker to call for the use of a leverage ratio to help monitor bank capital levels. The concept was loathed by Swiss banks, but is now being introduced into Switzerland and may yet be incorporated into a revamped Basle code.

So it will be worth watching closely to see how the SNB’s debate about size curbs develops. And I, for one, think the proposals deserve to be taken seriously. Quite apart from the fact that the world is littered with banks which are too big to fail (but too costly to keep saving), the world also has banks that are too big to manage. The sorry tale of UBS’s disastrous dealing with subprime securities is a case in point. So are the sagas of Citigroup and Merrill Lynch. Thus making banks smaller may not only be good for non-banking taxpayers, but it might yet bring some real benefits for bankers too – not just in small countries (such as Switzerland) but places which tend to worship size too (such as the US). This is a debate which needs to be aired in the widest possible way.

gillian.tett@ft.com"

government needed to show clearly how public borrowing will come down in future

TO BE NOTED: From the BBC:

"A grown-up debate

Post categories: Bank of England, Budget, UK economy

Stephanie Flanders | 23:13 PM, Wednesday, 17 June 2009

Whisper it softly, but there was the beginning of a grown-up debate about financial sector reform and public spending in Wednesday's two big speeches at the Mansion House.

When it comes to better regulating the banks, Robert Peston has flagged up the key points of difference between the chancellor's speech and governor of the Bank of England's, including the governor's pointed call for the Bank to have more powers to match its new responsibilities.

Mervyn King quoted an American economist saying: "[i]f some banks are thought to be too big to fail... then they are too big." Whereas the chancellor said in his speech that "the solution is not as simple, as some have suggested, as restricting the size of the banks."

It sounds like a pretty straightforward disagreement. And these two sophisticated men will not be surprised to see it written up that way. But as Robert notes, on this point the difference is one of tone more than of content.

The truth is that both are right. That is what makes this stuff so hard.

In effect, Mervyn King said in his speech that it was not sustainable to allow banks to grow big doing reckless things, all in the knowledge that if things get too tough, the government will bail them out. "Something must give."

He's right. But the chancellor is also right that there aren't any easy solutions.

If banks stay small, you might avoid the too-big-to-fail problem - most of the time. But you might also raise the chance of individual bank failures, by making each bank less capable of absorbing shocks for themselves. And if the past few years teaches anything, it is that if every bank has made the same mistake, they are all going to get bailed out by the government, regardless of how big they are, and regardless of the stern warnings politicians might have given out in the past. Governments don't let entire banking systems go to the wall.

Both the chancellor and the governor know this. They also know that how well different countries' banking systems have fared during this crisis seems to have had very little to do with the structure of banking regulation in place before the crunch.

Australia, Canada and Singapore have all come out of this rather well. Each came into it with entirely different regulatory set-ups, with the central bank playing a greater or lesser role than here in the UK.

There is much more to be said on this topic. Suffice to say here that this is a difficult and profoundly important debate which isn't going to be over any time soon. Given the recent history, I'd say it's no bad thing that it's being held in the open.

It's probably too much to hope for a grown-up exchange of views on public spending as well. Certainly we didn't get it in Prime Minister's Questions on Wednesday, as the prime minister once again banged the drum on Tory cuts - even at the cost of mis-describing the government's own plans for public investment in the years ahead.

He suggested that such investment would continue to rise until the London Olympics in 2012. Yet the Budget Red Book clearly shows capital spending starting to fall from next year. Downing Street later "clarified" the prime minister's remarks, suggesting that he was also including expenditure on the Olympics itself, and the proceeds of future asset sales, which have yet to be specified. Hmmm.

Darling had a pro forma attack on the opposition in his speech. He said that "to attempt to balance the books now, simply by cutting public spending across the board... would be sheer madness". To my knowledge, that's not exactly what her Majesty's Opposition has proposed, but you get the idea.

The most striking thing about the chancellor's speech was his refusal to enter into a debate - with his own party or with the Conservatives - over what would be cut or what would be saved.

"Given the uncertainties ahead," Darling said, "it would be a mistake to try now to set in stone detailed spending plans for individual departments five years ahead." As Nick Robinson was quick to point out, that's a message for Ed Balls as much as for George Osborne. For now, at least, the chancellor does not appear to want to enter the fray.

Mervyn King had his own comment on the budget in his speech, to the effect that the government needed to show clearly how public borrowing will come down in future. Famously, he has said that before, in his testimony to the Treasury Select Committee. But since then, we have had a Budget in which Alistair Darling probably thinks he provided just such a plan. Apparently the governor disagrees. But who knows, maybe one of these days they can have a grown-up debate about that as well."

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

Post a comment (1)

Posted by: Felix Salmon

Tags: banking, regulation

The central banks in both the UK and Switzerland seem to be utterly fed up with the fact that their banking systems are full of too-big-to-fail banks. What can they do about it? I asked Peter Thal Larsen, in London:

Felix Salmon: Peter, it’s looking as though regulators in both the UK and Switzerland have reached the point at which they don’t want to have any too-big-to-fail banks at all. Is there a serious possibility that the likes of UBS, Credit Suisse, Barclays, RBS, HSBC etc will be split up into small-enough-to-fail chunks?

Peter Thal Larsen: It’s definitely the hot regulatory topic of the moment. I’m not sure we’re yet at the point where big banks are going to be broken up. But central bankers are clearly drawing a line in a sand: if banks are going to become large, they cannot do so on the taxpayers’ ticket.

FS: Yet it’s impossible for a bank with a trillion-dollar balance sheet not to be TBTF, right? And TBTF just means that ultimately taxpayers will pick up the bill if the bank runs into problems. So short of breaking up TBTF banks, what other options are there for taxpayers to lose that contingent liability?

PTL: Well, there’s a couple of options, neatly summarised by Mervyn King last night. You can force TBTF banks to hold much higher levels of capital as a form of insurance. Or you develop a bankruptcy process that allows you to wind down even large, complex banks in an orderly way. Though I’m still not clear how this would work in practice.

FS: King also suggested that separating retail banking from investment banking might be a good idea. Do you think that might help? My view is that given what happened to eg Northern Rock and Lehman Brothers, it’s far from clear that doing one thing badly is better than doing both things.

PTL: I don’t think a new Glass-Steagall is the answer. It’s too difficult to draw a line between the two activities, and if you do so without international agreement you just create an arbitrage opportunity. As you say, even narrow banks can fail. But my sense is that this is a stick that King is wielding in order to force banks to think seriously about the alternatives.

FS: So let’s say I’m a TBTF bank, and I’m feeling chastened by King’s speech. What can/should I do? Unilaterally break myself up for the Greater Good?

PTL: I doubt it will get to come that. But the TBTF banks do need to come up with a way of persuading the authorities that they can fail without costing the taxpayer a fortune. King described this as banks making a will. It may be complex, but it’s the least bad option. The alternative is that regulators will come up with more draconian solutions, as the Swiss did today.

FS: What’s the probability that the Swiss draconian solution is going to make its way into reality? And is it basically a combination of higher capital adequacy standards with a promise that if a bank gets into trouble, its retail-facing components would be saved while the rest of the bank would be allowed to fail?

FS: And isn’t there a basic credibility problem with all such promises? Aren’t they a bit like the US government saying that Fannie Mae and Freddie Mac debt didn’t have a US government guarantee?

PTL: Credibility is certainly a big issue. Though the Swiss seem to have made more progress on this than the rest of us. They’ve already pushed through higher capital requirements for UBS and Credit Suisse, and are now talking about having the power to rescue only the utility-like parts of those banks if there is a future problem. But the really explosive stuff is what they’re threatening to do if they can’t get agreement on new rules. They are talking about capping balance sheet size or asset-to-GDP ratios. So UBS and CS have a big incentive to co-operate.

FS: I’ve been throwing around a number of $300 billion as a sensible cap on balance sheet size. What do you think of balance-sheet caps?

PTL: It’s a blunt instrument, but it has the benefit of being simple and hard to game. As with all these rules, though, it needs some kind of international agreement to be workable. And it’s not enough in itself. Northern Rock’s balance sheet was $200bn, but it still had to be rescued because Britain didn’t have a proper deposit insurance scheme.

PTL: The other question, to which I don’t know the answer, is whether we need big banks to serve multinational companies. Or are we saying that only the US and China can have big banks, because they’re the only countries that can afford to rescue them?

FS: A cap makes sense as a step in the right direction, no? Big US banks aren’t going to be able to suddenly redomicile themselves if the US enacts a cap, and neither are the big Swiss banks. It might not be sufficient, but I don’t see the harm. As for servicing multinationals, you need international reach, for sure, but you don’t need a trillion-dollar balance sheet. Advice requires no balance sheet, and if you want to extend a loan, you can just syndicate it.

PTL: On size, I suspect you’re right. Ideally, you would put in place some kind of automatic factors that acted as a brake on banks getting bigger. In the past, banks had an incentive to become TBTF because they got cheaper funding if counterparties believed they would be bailed out. If you have a credible bankruptcy process, or make them hold more capital the bigger they get, banks will have to prove that there is a commercial logic to being big. Best to use the threat of a cap as a way of forcing banks to come up with a better solution.

FS: I like that, phone up the IIF and say “come up, by year-end, with a better way of counteracting incentives to grow too big, or else we’ll implement a hard cap”. When a banker knows he is to be hanged in a fortnight, it concentrates his mind wonderfully.

PTL: That’s it. Use bankers’ naked self-interest to the public advantage. Which is why I think bankers have a real incentive to come up with a workable bankruptcy process. It’s their best hope for getting the government to leave them alone in future."

Me:

I still think that this is the best proposal so far:

http://blogs.ft.com/maverecon/2009/02/re gulating-the-new-financial-sector/

“17. The distinction between public utility banking/narrow banking vs. investment banking: (the rest) has to be re-introduced. I advocate a form of Glass-Steagall on steroids, with a heavily regulated and closely supervised narrow banking sector, engaged in commercial banking (taking deposits and making loans) and benefiting from LLR and MMLR support. The investment bank sector will also be regulated and supervised, but more lightly, and according to the same principles as other systemically important highly leveraged non-narrow bank institutions.

Universal banking has few if any efficiency advantages and many disadvantages. Economies of scale and scope and banking are soon exhausted. They tend to be fat to fail, have a lack of focus, and suffer from span-of-control negative synergies etc. Universal banks or financial supermarkets use their size to exploit market power and try to shelter their risky, non-narrow banking activities under the LLR and MMLR umbrella of the narrow bank that’s hiding somewhere inside the universal bank.

18. Splitting banks into public utility or narrow banks does not solve the problems of banks (narrow or investment) becoming too big or too interconnected to fail. It is therefore necessary to penalise bank size per se, to stop banks from becoming too large to fail (if they are interconnected but small, they are still not systemically important). I would penalise size through capital requirements that are progressive in size (as well as leverage).”

- Posted by Don the libertarian Democrat

Obama plan is little more than an attempt to stick some new regulatory fingers into a very leaky financial dam rather than rebuild the dam itself

TO BE NOTED: From the NY Times:

"Only a Hint of Roosevelt in Financial Overhaul

By JOE NOCERA

Three quarters of a century ago, President Franklin Roosevelt earned the undying enmity of Wall Street when he used his enormous popularity to push through a series of radical regulatory reforms that completely changed the norms of the financial industry.

Wall Street hated the reforms, of course, but Roosevelt didn’t care. Wall Street and the financial industry had engaged in practices they shouldn’t have, and had helped lead the country into the Great Depression. Those practices had to be stopped. To the president, that’s all that mattered.

On Wednesday, President Obama unveiled what he described as “a sweeping overhaul of the financial regulatory system, a transformation on a scale not seen since the reforms that followed the Great Depression.”

In terms of the sheer number of proposals, outlined in an 88-page document the administration released on Tuesday, that is undoubtedly true. But in terms of the scope and breadth of the Obama plan — and more important, in terms of its overall effect on Wall Street’s modus operandi — it’s not even close to what Roosevelt accomplished during the Great Depression.

Rather, the Obama plan is little more than an attempt to stick some new regulatory fingers into a very leaky financial dam rather than rebuild the dam itself. Without question, the latter would be more difficult, more contentious and probably more expensive. But it would also have more lasting value.

On the surface, there was no area of the financial industry the plan didn’t touch. “I was impressed by the real estate it covered,” said Daniel Alpert, the managing partner of Westwood Capital. The president’s proposal addresses derivatives, mortgages, capital, and even, in the wake of the American International Group fiasco, insurance companies. Among other things, it would give new regulatory powers to the Federal Reserve, create a new agency to help protect consumers of financial products, and make derivative-trading more transparent. It would give the government the power to take over large bank holding companies or troubled investment banks — powers it doesn’t have now — and would force banks to hold onto some of the mortgage-backed securities they create and sell to investors.

But it’s what the plan doesn’t do that is most notable.

Take, for instance, the handful of banks that are “too big to fail”— and which, in some cases, the government has had to spend tens of billions of dollars propping up. In a recent speech in China, the former Federal Reserve chairman — and current Obama adviser — Paul Volcker called on the government to limit the functions of any financial institution, like the big banks, that will always be reliant on the taxpayer should they get into trouble. Why, for instance, should they be allowed to trade for their own account — reaping huge profits and bonuses if they succeed — if the government has to bail them out if they make big mistakes, Mr. Volcker asked.

Many experts, even at the Federal Reserve, think that the country should not allow banks to become too big to fail. Some of them suggest specific economic disincentives to prevent growing too big and requirements that would break them up before reaching that point.

Yet the Obama plan accepts the notion of “too big to fail” — in the plan those institutions are labeled “Tier 1 Financial Holding Companies” — and proposes to regulate them more “robustly.” The idea of creating either market incentives or regulation that would effectively make banking safe and boring — and push risk-taking to institutions that are not too big to fail — isn’t even broached.

Or take derivatives. The Obama plan calls for plain vanilla derivatives to be traded on an exchange. But standard, plain vanilla derivatives are not what caused so much trouble for the world’s financial system. Rather it was the so-called bespoke derivatives — customized, one-of-a-kind products that generated enormous profits for institutions like A.I.G. that created them, and, in the end, generated enormous damage to the financial system. For these derivatives, the Treasury Department merely wants to set up a clearinghouse so that their price and trading activity can be more readily seen. But it doesn’t attempt to diminish the use of these bespoke derivatives.

“Derivatives should have to trade on an exchange in order to have lower capital requirements,” said Ari Bergmann, a managing principal with Penso Capital Markets. Mr. Bergmann also thought that another way to restrict the bespoke derivatives would be to strip them of their exemption from the antigambling statutes. In a recent article in The Financial Times, George Soros, the financier, wrote that “regulators ought to insist that derivatives be homogeneous, standardized and transparent.” Under the Obama plan, however, customized derivatives will remain an important part of the financial system.

Everywhere you look in the plan, you see the same thing: additional regulation on the margin, but nothing that amounts to a true overhaul. The new bank supervisor, for instance, is really nothing more than two smaller agencies combined into one. The plans calls for new regulations aimed at the ratings agencies, but offers nothing that would suggest radical revamping.

The plan places enormous trust in the judgment of the Federal Reserve — trust that critics say has not really been borne out by its actions during the Internet and housing bubbles. Firms will have to put up a little more capital, and deal with a little more oversight, but once the financial crisis is over, it will, in all likelihood, be back to business as usual.

The regulatory structure erected by Roosevelt during the Great Depression — including the creation of the Securities and Exchange Commission, the establishment of serious banking oversight, the guaranteeing of bank deposits and the passage of the Glass-Steagall Act, which separated banking from investment banking — lasted six decades before they started to crumble in the 1990s. In retrospect, it would be hard to envision even the best-constructed regulation lasting more than that. If Mr. Obama hopes to create a regulatory environment that stands for another six decades, he is going to have to do what Roosevelt did once upon a time. He is going to have make some bankers mad."

idea that fraud and reckless lending flourished because US financial markets were unable to honestly and efficiently intermediate

TO BE FILED: From Vox:

"Global imbalances and the crisis: A solution in search of a problem

Michael Dooley Peter Garber 21 March 2009

Print Email Comment Republish

This column argues that current account imbalances, easy US monetary policy, and financial innovation are not the causes to blame for the global crisis. It says that attacking Bretton Woods II as a major cause of the crisis is an attack on the world trading system and a sure way to metastasise the crisis in the global financial system into a crisis of the global economic system.

The current crisis is likely to be one of the most costly in our history, and the desire to reform the system so that it will not happen again is overwhelming. Our fear is that almost all this effort will be misdirected and unnecessarily costly. Three important misconceptions could lead to a disastrous reform agenda:

1. That the crisis was caused by current account imbalances, particularly by net flows of savings from emerging markets to the US.
2. That the crisis was caused by easy monetary policy in the US.
3. That the crisis was caused by financial innovation.

In our view, a far more plausible argument is that the crisis was caused by ineffective supervision and regulation of financial markets in the US and other industrial countries driven by ill-conceived policy choices. The important implication of the crisis itself is that for the next few years, at least, the misbehaviour that flourished in this environment will not be a problem, unless replicated under government pressure to restore the flow of credit to the uncreditworthy. If anything, excessive risk aversion and deleveraging will limit effective private financial intermediation. So the first precept for reform is that there is no hurry.

When markets recover, the key lesson is that the industrial countries need to focus on moral hazard, public and private, as the source of the problem and apply the prudential regulations they already have to financial entities that are too large to fail. It is not sensible to try to limit international trade and capital flows, to ask central banks to abandon inflation targeting, to stifle financial innovation, or to regulate entities such as hedge funds¹ that do not generate systemic risks.

International capital flows

One “lesson” that seems to be emerging is that international capital flows associated with current account imbalances were a cause of the crisis and therefore must be eliminated or at least greatly reduced.² The idea that fraud and reckless lending flourished because US financial markets were unable to honestly and efficiently intermediate a net flow of foreign savings equal to about 5% of GDP, while having no problem with intermediating much larger flows of domestic savings, is astonishing to us. If so, would not the much larger gross capital flows into and out of the US also cause an outbreak of bad behaviour even without a net imbalance? If this were true, we would have to stop all capital flows, not just net imbalances. In the US context, we are unable to think of any plausible model for such behaviour.

If capital inflows did not directly cause the crisis perhaps they did so indirectly by depressing real interest rates in the US and other industrial countries. We have emphasised that capital inflows to the US from emerging markets associated with managed exchange rates caused persistently low long-term real interest rates in both the US and generally throughout the industrial world (Dooley, Folkerts-Landau and Garber 2004, 2009). Low real interest rates in turn drove asset prices up, particularly for long-duration assets such as equity and real estate.³ At the same time, low real interest rates temporarily reduced credit risks and a stable economic environment generated a marked decline in volatility of asset prices.

We have not argued that a “savings glut” in emerging markets is the fundamental driving force behind these capital flows. We have argued that the decisions of governments of emerging markets to place an unusually large share of domestic savings in US assets depressed real interest rates in the US and elsewhere in financial markets closely integrated with the US. These official capital flows are not offset, but reinforced, by private capital flows because managed exchange rate pegs are credible for China and other Asian emerging markets.

Low risk-free real interest rates that were expected to persist for a long time, in the absence of a downturn, generated equilibrium asset prices that appeared high by historical standards. These equilibrium prices looked like bubbles to those who expected real interest rates and asset prices to return to historical norms in the near future.

Along with our critics, we recognised that if we were wrong about the durability of the Bretton Woods II system and the associated durability of low real interest rates, the decline in asset prices would be spectacular and very negative for financial stability and economic activity. The hard landing predicted for Bretton Woods II was not to be caused by low real interest rates per se but by the sudden end to low interest rates as unsustainable capital inflows to the US were reversed. This is not the crisis that actually hit the global system.

But the idea that an excessive compression of spreads and increased leverage were directly caused by low real interest rates seems to us entirely without foundation.⁴ The alternative hypothesis is that an effective deregulation of US markets driven by government-dictated social policy, especially in mortgage origination and packaging, allowed the ever-present incentive to exploit moral hazard to flourish.⁵ This could just as well have happened with stable or rising real interest rates, as it did, for example, during the lead up to the US S&L crisis in the 1980s, another government manufactured disaster. Falling real interest rates in themselves should make a financial system more stable and an economy more productive.

Imagine a global system with permanent 4% equilibrium real interest rates. Now imagine a system with permanent 2% real interest rates. Why is one obviously more prone to fraud and speculation than the other? The vague assumption seems to be that capital inflows were large and interest rates were low, and this encouraged “bad” behaviour.

The current conventional interpretation is that low interest rates and rising asset prices generated an environment in which reckless and even dishonest financial transactions flourished. One version of this story is that rising real estate prices led naïve investors to believe that prices would always rise so that households with little income or assets could always pay for a house with capital gains on that house. Moreover, households could borrow against these expected capital gains to maintain current consumption at artificially high levels. This pure bubble idea does not provide much guidance for reforming the international monetary system. Clearly we should enforce prudential regulations that discourage people from acting on such expectations. But do we really want to reform away anything that causes real interest rates to fall and asset prices to rise?

Easy money and financial innovation

There is no sensible economic model that suggests that monetary policy can depress or elevate real long-term interest rates. The Fed could in theory target nominal asset prices (for example equity prices), but it would then lose control over the CPI. Would Alan Greenspan’s critics have preferred a monetary contraction necessary to depress the CPI enough to allow the real value of equities to rise? The Fed could, and may still, inflate away the real value of financial assets but this requires inflation as conventionally measured. This may yet come, but it was not a part of the story in recent years, and it is still not expected by market participants.

Third in the roundup of usual suspects in the blame game is financial innovation. There is no doubt that innovation has dramatically altered the incentives of financial institutions and other market participants in recent years. Securitisation of mortgages, for example, clearly reduces the incentives for those that originate credits to carefully screen applications. But securitisation also reduced the cost of mortgage credit and increased the value of housing as collateral. Private equity facilitated the dismantling of inefficient corporate structures. Venture capital has directed capital to high-risk but high-reward activities. Before we give up these benefits we need to ask if it is possible to retain the advantages of these innovations without the costs associated with the current crisis.

The problem was not financial innovation but the failure of regulators to recognise that innovation generated new ways to exploit moral hazard. Even more, it was the wilful ignorance of policymakers in often overriding the instincts of regulators and financial institutions in order to implement a desired flow of funds to uncreditworthy borrowers.

Fraud is not a financial innovation. The unhappy fact is that any change in the financial environment can generate new ways to undertake dishonest and imprudent positions. The regulators in turn have to adapt their procedures for monitoring and discouraging such activities. If it is really the case that regulators cannot understand the risks associated with modern financial markets and instruments, then there is a strong case for trying to return to a simple and relatively inefficient system. But we do not believe the story that no one can understand these innovations. To the contrary, it seems clear to us that the bankers that used these innovations to exploit moral hazard knew very well what they were doing and why. The first-best response to this is to attract a few of the many quants who are now unemployed to help enforce the prudential regulations already on the books.

Conclusions

In this crisis, three macro-financial institutional arrangements remain to hold the financial system together. These are the dollar as the key reserve currency with US Treasury securities as the ultimate safe haven, the integrity of the euro, and the global monetary system as defined by the Bretton Woods II view. Attacking the latter as a major cause of the crisis and seeking its end is, at the end of the day, an attack on the basis of the international trading system. It is a sure way to metastasise the crisis in the global financial system further into a crisis of the global economic system.

References

Bernanke, Ben (2007) “Global Imbalances: Recent Developments and Prospects" speech delivered at Bundesbank Berlin September 11.
BIS 78^th Annual Report (2008).
Dooley, Michael P., David Folkerts-Landau and Peter M. Garber (2004) “The Revived Bretton Woods System,” International Journal of Finance and Economics, 9:307-313.
Dooley, Michael P., David Folkerts-Landau and Peter M. Garber (2009) “Bretton Woods II Still Defines the International Monetary System,” NBER Working Paper 14731 (February).
Dunaway, Steven, Global Imbalances and Financial Crisis, Council for Foreign Relations Press, March, 2009.
Economic Report of the President (2008)
Economist (2009) When a Flow Becomes a Flood,” January 22.
Paulson, Henry (2008) “Remarks by Secretary Henry M. Paulson, Jr., on the Financial Rescue Package and Economic Update,” U.S. Treasury press release, November 12.
Sester, Brad (2008) “Bretton Woods 2 and the Current Crisis: Any Link?", Council on Foreign Relations

Notes

1. Of course, a bank thinly disguised as a hedge fund should be regulated as a bank just as a hedge fund thinly disguised as a bank should be.
2. See Paulson (2008), Dunaway (2009).
3. This is arithmetic, not economics. A permanent fifty percent decline in the level of real interest rates, for example from 4% to 2%, is the same thing as a doubling of an infinite maturity financial asset’s price, provided that the payout from that asset is unchanged. For practical purposes, thirty years is good enough to about double prices.
4. This view has taken hold in central banks see Bernanke (2007), Hunt (2008), BIS (2008). In the financial press, see Sester (2008) and Economist (2009). It should be noted for the record that these claims are always raw assertions, without theoretical, empirical, or even logical basis.
5. The financial system problems in many other countries are independent of regulatory problems in the US. The banking collapses in Iceland, the UK, and Ireland were home grown. The loans of the European banking system to Eastern Europe and to emerging markets in general were independent of US financial system behavior.

Don't agree; there was real panic after Lehman was allowed to fail. Noise prompting depositors to take their money out

TO BE NOTED: From:

"Information Processing

Steve Hsu

Professor of physics at the University of Oregon. Homepage. Archive (list of posts, by date and category).

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Tuesday, June 09, 2009

Plight of the risk managers

I'd like to recommend this podcast interview with Riccardo Rebonato. Rebonato, the author of the prescient book Plight of the Fortune Tellers, written before the financial crisis, is a former physicist turned quant.

Rebonato does not mince words, pointing out the weaknesses of mathematical models, and noting that most quants, although mathematically sophisticated, often lacked deep knowledge about markets and banking (I assume he does not include himself in this group). In my experience many quants never questioned the basic efficient market assumptions underlying their models, although some certainly did -- in particular, those with trading experience.

Rebonato is polite, even urbane, but disagrees with Econtalk interviewer Russ Roberts on many important issues. The most important question, which Rebonato addresses immediately, is whether enlightened, self-interested managers of financial institutions can be relied on to properly manage risk. Regulators accepted, on faith, the self-regulating abilities and properties of a system managed by such people. Thus, one of the main ingredients in the crisis was the ideological (as opposed to political or financial) capture of regulators by efficient market proponents.

Other interesting topics covered are the divergent risk tolerances and interests of bond holders vs equity holders vs regulators of banks [1], and whether moral hazard (anticipation of a bailout) played a role in the crisis -- Russ, the anti-government libertarian, says yes. Rebonato says no, the story only makes sense if told at the institutional level, whereas individual incentives were different. I think Rebonato's logic is impeccable. It's more persuasive to me that incentive schemes which allowed huge compensation based on short term (ultimately illusory) gains were much more of a factor. (See Clawbacks, fake alpha and tail risk.)

Dr. Riccardo Rebonato

Riccardo is Global Head of Market Risk and Global Head of Quantitative Research and Quantitative Analysis for Royal Bank of Scotland based in London. Prior to joining the Royal Bank of Scotland, he was Head of Complex Derivatives Trading Europe desk and Head of Derivatives Research at Barclays Capital, where he worked for nine years.

Riccardo is a Visiting Lecturer at Oxford University in Mathematical Finance and Adjunct Professor at the Tanaka Business School, Imperial College, London.

Before joining the financial world, Riccardo was a Research Fellow in Physics at Oxford University (Corpus Christi College) and, before that, Visiting Scientist at Brookhaven National Laboratory.

Riccardo is the author of the books Plight of the Fortune Tellers ('07), The Perfect Hedger and the Fox (Wiley ’04), Modern Pricing of Interest-Rate Derivatives (Princeton University Press ’02), Interest-Rate Option Models (Wiley ’96,’98), Volatility and Correlation in Option Pricing (Wiley ’99). He has published several papers on finance (option modelling, computational techniques, risk management) in academic journals. He is a regular speaker at conferences worldwide.

[1] Footnote: see my earlier post on the vacuous Modigliani-Miller theorem. I recently learned from Vernon Smith's memoir (see pages 230-231 and 276) that he has similar opinions. Google books link; also search under "MM".

Posted by Steve Hsu "





And from EconLog:
Riccardo Rebonato of the Royal Bank of Scotland and author of Plight of the Fortune Tellers talks with EconTalk host Russ Roberts about the challenges of measuring risk and making decisions and creating regulation in the face of risk and uncertainty. Rebonato's book, written before the crisis, argues that risk managers often overestimate the reliability of the measures they use to assess risk. In this conversation, Rebonato applies these ideas to the crisis and to the challenges of designing effective regulation.

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Readings and Links related to this podcast

Podcast Readings HIDE READINGS

About this week's guest: Riccardo Rebonato's Home page About ideas and people mentioned in this podcast: Books: Plight of the Fortune Tellers--Why We Need to Manage Financial Risk Differently, by Riccardo Rebonato at Amazon.com. Risk, Uncertainty, and Profit, by Frank Knight. "Enterprise and Profit: The Salaried Manager" (Pt. III, Chapter X), discusses the role of individual decision-makers within firms. On Econlib. Articles: "Risk versus Uncertainty, or Mr. Slate versus Great-Aunt Matilda," by Morgan Rose on Econlib. "Efficient Capital Markets", by Steven L. Jones and Jeffry M. Netter. Concise Encyclopedia of Economics. "Financial Regulation", by Bert Ely. Concise Encyclopedia of Economics. "Deposit Insurance", by George G. Kaufman. Concise Encyclopedia of Economics. "Externalities", by Bryan Caplan. Concise Encyclopedia of Economics. Podcasts and Blogs: Taleb on the Financial Crisis. EconTalk podcast. Acemoglu on the Financial Crisis. EconTalk podcast. Cochrane on the Financial Crisis. EconTalk podcast. Kling on Fannie and Freddie and the Recent History of the US Housing Market. EconTalk podcast. Meltzer on Inflation. EconTalk podcast.

Highlights

Time	Podcast Highlights HIDE HIGHLIGHTS
0:36	Intro. [Recording date: May 22, 2009.] Book, risk and uncertain, decisions in an uncertain world; written beforehand but prescient about the economic crisis. History of finance and housing in the United States, how banking changed. In 1990s, up to end of 2006; hiccup of 1998, after the fact purely contained to financial sector; within 6-9 months a blip. Regulators who look after soundness of banking system came to rely on quantitative models and the banking system being the forefront by making use of these quantitative models. Two steps back from technicalities, philosophy of faith in self-regulating properties of the system, managed by enlightened self-interested mangers and CEOs; skilled. Quants came from background in mathematical finance, not deep thinkers, not deep knowledge of the banking system. Supposed to guarantee that sufficient capital would be set aside to act as safeguard against unlikely events. We know now that that didn't happen. Book: we are not in a position of saying anything about extremely rare events. Might collect daily, monthly, quarterly data, spanning a few years--information about the last few years. Even with data going back to the 1950s or 1940s, leap of faith to say they are relevant to present market conditions. What about events every 100, 1000, or 4000 years? A 99.975 percentile one year horizon corresponds to one event that should not happen more frequently than once every 4000 years. Quants might have sophisticated theory, but how do we know the data are sufficiently homogeneous--belong to the same patch of history--to be giving information relevant today as opposed to 3 years ago. Similar point made on EconTalk, talking about the Great Depression: no consensus about how we got into it or how we got out of it because it's a one-time event. Easy to have a theory, hard to be confident that it applies today. Humility rather than hubris.
7:59	Little more technical: one technique that came to be popular in the banking is Value at Risk. What is idea behind it and why did it become popular? Measure of risk with some nice features: expressed in units of money. If your value at risk one day, 95th percentile, is $20 million, it means you should exceed a loss of $20 million only 5 days out of 100, so basically one day in 20. Won't be a perfect measure, but gives idea of day-to-day volatility when nothing extraordinary happens. For a trader or for a bank as a whole. Look carefully at the time-frames we are talking about. Can I infer the type of losses I might typically incur over that period, one month or a few months? Yes. Supposed to be used to determine capital; but capital should be there to absorb losses that occur not just once every 20 days, but once every hundreds of years; any time to protect the solvency of the institution. Before the regulators slapped on a multiplier; didn't ask for more remote percentiles; just take a safety factor. Safety factors have illustrious pedigree. Physics, engineering: use same formula calculate the thickness of steel ropes (cables) in elevators; but at the end of the day, they multiply by 10. Calculations for landing gear of aircraft multiply by 1.1; always a safety factor. Sensible because it allowed the bank to calculate a statistical number that was meaningful; but then a multiplier. Goal of regulator: to prevent insolvency or disaster because if it spreads the entire financial system could be at risk, systemic problems, runs on the bank, recent problems. What nest egg, what buffer do you have to keep so that in the worst case scenario, your firm still survives?
13:40	Complicated question: inherent tension between bondholders and stockholders in a bank, and between regulators and owners. How big would the buffer be without regulation? How much economic capital--the buffer--should a bank keep to entice its investors, both equity and bond, to be comfortable? Not precise; what are some of the conflicts? Lot of thinking after the crisis about the alignment of interests even of any enlightened owner and the interests of society. Economic capital: the nest egg, but how severe an event? Folklore came up with a number: the 99.975 percentile--events that should happen not more frequently than once every 4000 years. Really bad luck, recent crisis! How did that number come up? Example: I am a bank with a certain rating. How many AA-rated institutions went from double-A to default in one year? Probably a handful. Divide that over total number of companies, get approximately one in 4000. So to convince bondholder that I am a AA company I should set aside enough capital in order to convince them I will only go bust once every 4000 years. Align capital I am holding with observed frequency of default of a AA company within one year. Signaling device to tell regulators: I am double-A. Regulators shouldn't be asking for a great spread, because I am AA. In case of a bondholder, the only thing of interest is solvency--just want their money back. Why not go for triple-A? Because the shareholders care about the return on capital? So to convince bondholder that I am AAA, I'd have to hold so much capital that the shareholder would not get a great return for each dollar of that capital. Compromise. For most banks, the equilibrium is around AA level. Bondholder, short a put, only loses money if the bank defaults; but if things go extremely well, he doesn't share in the upside. Shareholder likes volatility, long a call. Recent crisis has made very clear that a shareholder can be perfectly rational but willing to accept a level of risk that a regulator may not like. June or July 2007, shareholder of one of the banks that eventually got in trouble looks at his portfolio: would have to need a repeat of the 1930s to take a big loss; to insure himself against that possibility he'd have to lock in losses that most likely he won't have to bear. Perfectly acceptable to take that risk. Regulators' view: in that calculus you haven't taken into account the systemic risk. Regulators' view is to step in to not allow taking on that level of risk. Those investors had extremely high rates of return during 2003-2006. If someone had said this is getting a bit out of hand, your competitors wouldn't have been doing the same. In 2006, plenty of signs, liquidity was too abundant, risk premia compressed too much, asset prices too high. Fracture line of an earthquake; people knew it had to give, not sustainable for a long period of time; but where and when the crack would occur. Stepping out too early is disastrous. Greenspan, irrational exuberance, uttered around 1994, 1996. Pulling out would mean having to explain to the shareholders what you are doing when everybody else is becoming rich.
23:35	Competitive market issue, also a social issue. Small world, investment banks; events and parties where your colleague is doing very well, you look the fool in the short run if you pull out. Central question, heard that story before: that's the music that's playing, so if you are there to dance, you have to dance to the music. Everyone's investing in these mortgage-backed securities, etc., but it's the only game in town. Yet, there were people who did not play along. Range across institutions of how much exposure. Any speculative thoughts on why institutions differed? Bear Sterns vs. J.P. Morgan. Some institutions big in this area for a long period of time. Late-comers fared less well. Goldman Sachs, JP Morgan. Different levels of inventory reflected different stages of getting into this business. Could have been emerging markets, which were extremely resilient. Summer 2007, wobble in emerging markets; head trader described it as a week of panic buying of emerging market paper! For same amount of risk, less and less compensation being paid. Some have said this wouldn't have happened had the investment houses never gone public. Asymmetry of incentives facing traders, executives on one hand and investors on the other; not playing with their own money. From point of view of a private firm, it would have been a reasonable risk to take. Regulators different, system; level playing field. If I step off the bandwagon, disadvantage to a more reckless person or institution who remains on; people will have withdrawn their funds from me. Asset fund manager in the United Kingdom stepped out of the dot-com bubble a bit too early and got fired three weeks before the bubble burst. Difficult to swim against the tide; regulator should intervene to level the playing field, you will all be inhibited from taking this kind of risk.
30:15	Two questions. One: amount of leverage in play here is one reason these gambles were so large. One thing to say you had a bad quarter or bad year; but why did you take such a roll of the dice that these losses in the U.S. housing market destroyed your legendary company? Simple answer: they were so leveraged--they had borrowed so much to finance that gamble that losing the gamble didn't just mean a bad quarter, but death. Point number two: People who swim against the tide, standard argument is investor psychology is such that no one really cares about risk. But in current environment, psychology might thus go the other way. Akerlof and Shiller book, Animal Spirits, talks about the importance of sentiment; reversals of sentiment affect markets and real economy. How do we get out of the current environment--v or double-v as shape of the downturn? Very uncertain, unstable state. A week ago, stock prices were going up, people saying we'd get out very quickly; a week later, a bit of negative information. Might become more cautious if protracted period of decline. If plan A works and we get out with a v-shaped recovery, expect risk aversion will disappear much more quickly than we think possible today. Good that we get out quickly, but same behavior will result again in the same risks and problems. Where will that liquidity come from?
34:51	Basel II, regulatory arbitrage. Basel II was trying to make the capital a bank has to set aside more in line with the risk. Basel I, formulaic, simple rules for capital that did not reflect the risk taken by banks. Credit-worthiness of the bonds you hold--government of OECD countries considered very, very safe; banks of those countries considered very safe; little differentiation between lending to a double-A company and lending to a corner shop. Set aside $1000 to either the latter has higher return for apparently same risk. Basel II was attempt to remedy that. Overconfidence in statistical techniques' abilities to quantify risk. How did the ratings agencies come into this regulatory arbitrage issue? Set-up was role of the ratings agencies with securitization--process whereby banks accumulate assets, e.g., mortgages, package them, and by virtue of the diversification create a portfolio less risky than any of the individual items. Tranche the portfolio in different sections: first section bears risk of first losses, so gets more return if things go well; all the way up AAA. Ratings agencies were to check amount of diversification to be sure it was up to the right level. Human nature, and conflict of interest--rating agencies only got paid if the securitization went through. Agencies worked with the investment houses to meet the criteria for AA, AAA, and A ratings. Teacher sets test but goes over questions with the students the day before. Portfolios met the specific requirements, but not the best way to set up system. But someone who goes to hire a student from that kind of school knows to be skeptical. Everyone knew this about the ratings agencies. Value of franchise: only 18-24 months ago, enlightened self-interest of market players was viewed as best safeguard for financial system. If the ratings agency debase the currency of their name, they will lose credibility by giving away AAA for nothing. Self-regulating efficient market.
41:10	Mark to market: what role did it play in the crisis? Whole problem or irrelevant? Controversial topic. Not fair to point to that. Like saying if I didn't have a thermometer this patient wouldn't have a fever. Dynamics of mark-to-market forcing certain actions. Nexus where it got things into trouble was that when securities got downgraded, certain institutions had to sell them. This caused forced unwinding, Special Interest Vehicles (SIVs), nobody talks about it today. Mark-to-market is good where there is a willing buyer and a willing seller. Equilibrium is good information about the fundamental value of what is bought and sold. If unbalanced selling or buying, mark to market ceases to have the same information content. Why are buyers no longer there? Could be that liquidity disappears. Pseudo-arbitrageurs, agents who bring things back to fundamentals don't have the firing power to deploy their money. Two sides, some information still there. Loss of trust may simply reflect vagaries of today's supply and demand. Mark-to-market requirement and regulatory capital buffer: If I'm holding an asset, will hold for 5 years. Mortgages will be paying out over time. Some will go into default, some will be prepaid, etc. I'm not going to resell. Meanwhile, if there is an increase in the default rate, the market value of this goes down. I may not be in compliance with my capital requirements today but over time I may be fine on a cash-flow basis. Somewhat compelling argument--forced to sell it because of the capital requirement, though I wouldn't ordinarily sell it. When creating a security, you have a choice to place it on the banking book or the trading book. Trading book attracts less capital but forces you to mark to market on a daily basis. Perhaps people have been placing into the trading book when the sky was blue, price high, prices almost for everything, a lot of things whose prices disappeared when liquidity was withdrawn. Traded loan on trading book; but if you plan to hold it to maturity, place it on your banking book, in which case you get a different capital and a different recognition of a value. Unless impairment, value of 100. Choices that were made through 2006-2007 was to place in trading book--less capital, abundant liquidity, blue sky days.
47:53	Too big to fail. Enlightened self-interest, or maybe just self-interest. Some have argued that too much risk was taken because at the end of the day, "too big to fail" or U.S. Central Bank behavior would bail out these bad decisions. In the United States we have banks that are regulated by the Federal Deposit Insurance Corporation (FDIC). Also shadow banking system, investment banks not guaranteed, but it turned out that they kind of were--erratic decision: Lehman Brothers died, Bear Sterns sold at discount, Merrill Lynch sold to Bank of America, AIG made whole all the way through. How much was there a socialization of losses and a private set of gains? Fannie Mae and Freddie Mac turned out to be a catastrophic institutional structure that turned out to be implicitly guaranteed; many investment banks were not guaranteed at all. Was that rational? Instead of thinking of an institution in the abstract, think of the decision-makers. Perhaps institution might survive, but the individuals who made those bad choices don't. Deterrence from rolling the dice. Could argue it goes the other way: a lot of traders made a great deal of money along the way, and though some CEOs were both humiliated or financially destroyed, others turned out fine. CEO of AIG announced his resignation today, saying he was leaving the most horrible job in the world. Before the event, cannot know if you are going to be one of the survivors or not. If you are rescued by the government you have lost control.
51:58	Systemic risk. There is a negative externality, so when you take a risk you are careful, but you are not as careful as you would be if you had to bear the other social costs of the other firms that will be called into question. Back to March of 2008, turning point when U.S. Federal Reserve became active in the financial system to a degree that had been unimaginable previously. Weekend in March, Bear Sterns informed Fed and Treasury that it was not going to be able to meet its obligations. Failure of democracy that Fed and Treasury never explained the urgency other than saying it was urgent and that it had to be done. Meltzer podcast, few cases where firms were allowed to fail, failure of incentives. Claim was that if they had failed so much would have cascaded down. A few months later they let Lehman Brothers fail, which people have debated. We now have information about their assets--they've gone through bankruptcy. Claim was that if Bear Sterns had been allowed to go through that, whole system would have frozen up. But whole system froze up anyway. Was that Bear Sterns an unsustainable event? What if it had been allowed to go through bankruptcy? Intense debates. Should we let the market work out its own problems or should we intervene? Records of different central bankers, they were more averse to interventions. Some central banks said rescue of Bear Sterns was a mistake. When Lehman came around, people who favored the open market had the upper hand. When they saw what happened, the central banks said that's it, no more. We would have had a preview of Lehman in March. John Taylor has a claim that the spike in the spreads occurred after the Lehman failure, not concurrent; and it was really the TARP bailout that spiked interest rates. Don't agree; there was real panic after Lehman was allowed to fail. Noise prompting depositors to take their money out. Pure speculation, counterfactual. Regulators in the dark--face their own set of incentives. In the United States, Ben Bernanke, an expert on the Great Depression was eager to not have another one under his watch.
57:09	European perspective: tendency to blame much of the crisis on various U.S. policy decisions behind the housing crisis. In 1990s, and can even trace it back to the 1930s under Roosevelt, United States eagerly subsidized price of housing, inflating housing prices. Blames tax policy, Fannie and Freddie, but was it large enough? Those sympathetic to that argument often ignore similar housing price appreciations in Europe: Spain, Ireland, South Africa, Australia around the world. John Taylor argument: excess of liquidity searching for yield as central banks pushed out money. When something of the recent magnitude occurs, there is no single cause. Perfect storm, confluence. China prompts them to invest in Treasuries, depressing the yields and Fannie and Freddie, pumping them into housing in particular. Why housing? Environment with pretty low return on lots of assets in 2006, for many investors the most solid thing to invest in was houses. Home refinancing in the United States; houses looked at not as place to live but a place to invest. Magnitude and complexity and leverage of the instruments attached to mortgage securities. Government aiding and abetting increase in housing, but not the only cause. Money chasing places to go. But why Ireland and Spain and not England and France? Have to look at data; suggest looking at availability of mortgages.

destabilised financial system to a more solid system with more modest systemic guarantees where even “too big to fail” firms are allowed to fail

From the FT:

"US crisis: the role of systemic risk guarantees

June 2, 2009 11:46am

by FT

By Carolyn Sissoko

US Federal Reserve

In recent years many large financial institutions have become used to the idea that governments stand ready to rescue the financial system when it gets into trouble. Swift regulatory intervention in the US whenever there was a systemic event encouraged this view. Over time, confidence in the government’s ability to act as the financial system’s executive manager resulted in a transfer of the responsibility for controlling systemic risk from the banks to the government.

In the early years of the 20th century, there was no central bank; systemic risk was resolved by the coordinated action of the banks through clearinghouses. While the founding of the Federal Reserve in 1913 might have transferred the responsibility for systemic risk away from the banks themselves, the Fed’s behaviour during the 1930s did not lend credence to this view. The systemic risks of the Great Depression were addressed by policymakers in Washington after Franklin D. Roosevelt became president, not by the central bank.

Experiences such as the Great Depression leave scars. For decades after, banks were managed with the understanding that, while the Federal Deposit Insurance Corporation would save their depositors, the banks themselves would in all likelihood be allowed to fail in the event of a systemic crisis.

In 1984, the implicit expansion of the federal safety net to include the creditors of “too big to fail” banks took place when the FDIC’s resolution of Continental Illinois protected the bondholders of the holding company. Continental Illinois was seized in 1984 in a move that was, at the time, the largest bank restructuring undertaken by the US.

Then in 1987 when the stock market crash left some of the investment banks with too little collateral to back their financing needs, the New York Federal Reserve Bank president intervened to protect them. In 1991 Congress condoned this expansion of the federal safety net by revising the Federal Reserve Act to enable the Fed to lend in an emergency against the collateral held by investment banks - or even hedge funds.

In a speech in February 1998, Alan Greenspan, then Fed chairman, made the new role of the central bank explicit by stating: “The management of systemic risk is properly the job of the central banks. Individual banks should not be required to hold capital against the possibility of overall financial breakdown. Indeed, central banks, by their existence, appropriately offer a form of catastrophe insurance to banks against such events.”

In short, over the past 25 years the US government has engaged in a large expansion of the protection offered to the financial system: the counterparties of a “too big to fail” bank could expect to be repaid even if the bank failed and the Fed chairman himself had taken responsibility for handling systemic risks. Every bank was encouraged to focus only on its own profits. Monitoring counterparties’ balance sheets was unnecessary, as long as they were large, and, as for the financial system as a whole, that was the regulators’ problem.

Unfortunately in a free market economy, the strongest bulwark against systemic risk is the fact that firms want to protect themselves from bankruptcy. So, the losses from trading with counterparties that go bankrupt are minimised by shunning counterparties that have weak balance sheets. Similarly, if the firm sees systemic instabilities building up, it has an interest in bolstering its own capital position to weather the coming storm. By encouraging financial firms to ignore these risks, the government stripped the financial system of its most stabilising forces.

Therefore, the first question we should ask when reviewing the consequences of the crisis is: how has the US government performed in its new role as guarantor of the financial system?

Under the circumstances, it would be hard to give the regulators a passing grade. While some officials at the Fed and the Commodity Futures Trading Commission recognised the dangers of “too big to fail” banks, of the outsized risks taken on by Fannie Mae and Freddie Mac, of over-the-counter derivative markets, and of predatory subprime loans, these individuals were unable to generate a sense of urgency commensurate with the seriousness of the problems. The regulatory agencies had, in almost every case, been forewarned of disaster looming somewhere on the horizon; in every case they chose not to act.

This abject failure on the part regulators is a red flag; the recent transfer of responsibility for financial stability from the private sector to the central bank was a bad idea. The free market principles that held sway through the 19th and much of 20th century left individual financial firms with most of the responsibility for protecting themselves in a systemic crisis and encouraged them either to be well-capitalised or to risk failure.

The evidence indicates that the wholesale transfer of responsibility for systemic risk to the central bank has resulted in a financial system that is seriously undercapitalised. In a genuine free market system risk does not naturally flow to where it is least monitored and where capital requirements are lowest, because each firm protects its own balance sheet by trading only with counterparties that are well capitalised and competent risk managers.

How do we address the crisis, then? First, avoid being misled by Orwellian claims that turn the concept of a free market on its head and portray the banks’ mismanagement of risk as natural economic behaviour. It is government intervention in the form an excessively broad safety net for financial institutions that creates this behaviour. Second, recognise that the stability of the financial system requires a lender of last resort with very narrow responsibilities: it lends only to banks that play a role in the money supply and that have recently been approved by examiners as sound. The reason a central bank lends generously to banks in a crisis is not to protect the banks from failure, but to minimize the likelihood of a sudden decline the money supply. Third, recognise that the only way to shrink the mandate of the Fed is to make it possible for all firms to fail.

Congress needs to enact a resolution authority so that bankrupt financial institutions can fail without causing an implosion in derivative markets. The Fed was forced to take extraordinary action in 2008 to protect the stability of the money supply. This move was the unfortunate consequence of mistakes made in the 1980s and 1990s that allowed bad decisions to snowball by 2006 into a situation where credit default swaps and subprime mortgages began to serve, in part, as the collateral backing our money
supply. The challenge is to lay out a path from our profoundly destabilised financial system to a more solid system with more modest systemic guarantees where even “too big to fail” firms are allowed to fail.

Carolyn Sissoko was an adjunct professor of economics at Occidental College in Los Angeles and is currently writing a book on the financial crisis"

Me:

In my mind, the system of Implicit Government Guarantees to intervene in a Financial Crisis is the main cause of this crisis. However, it formed the basis of banking and investment for the last 25 years. It has produced major financial crises by wedding deregulation and guarantees, an unholy union. But everyone knows that the government will intervene to stop a panic or debt-deflation, or other large financial crises. Hence, there's no point in pretending that the opposite would be the case. Given that, we are left with guaranteeing and regulating.

Now, we can either guarantee banking and investment, as Gorton is advising, or split the two up.

Firstly:

"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, which is preferable, or regulated though, and are subject to laws against fraud, etc. They should be self-insured.

Or:

Narrow/Limited Banking on the one hand, and a version of 9 above on the other hand.

I would like a system that has a firm and sound base, and, having that, allows another part of the financial universe to experiment and innovate, which will happen in any case. But not acknowledging the reality of the guarantees is what we previously had, and what we cannot allow to continue. We are learning the price of fooling ourselves with overblown views of our ability to stand firm on principle or ideology. When that does happen, it's more than likely to be in defense of a lost cause.

Posted by: Don the libertarian Democrat

authority “should be totally funded by those institutions that are regarded as systemically important or too big to fail”

TO BE NOTED: From the FT:

"US poised for finance regulation shake-up

By Tom Braithwaite, Sarah O’Connor and Krishna Guha in Washington

Published: May 17 2009 23:30 | Last updated: May 17 2009 23:30

Congress will next month start the biggest regulatory overhaul of the US financial system in decades, bringing into the open a frantic lobbying effort between banks, regulators and policymakers on what it contains and who pays for it.

The House financial services committee, chaired by Democrat Barney Frank, will hold hearings early in June into reforms outlined by Timothy Geithner, Treasury secretary, say people familiar with the timetable.

But the complexity, coupled with a crowded legislative agenda, means one key pillar – a resolution authority allowing a regulator to seize a failing bank holding company – is not likely to be put in place until year-end.

The cost of the resolution authority and a proposed systemic risk regulator could be borne by both large banks and small, according to people involved, in spite of the entreaties from the hundreds of small US institutions that they should not pay a levy.

Cam Fine, chief executive of the Independent Community Bankers of America, said the authority “should be totally funded by those institutions that are regarded as systemically important or too big to fail”. He said he “felt pretty good about where we stand” and was confident of Mr Geithner’s support.

Other smaller institutions such as hedge funds are also expressing concern that they will suffer from severe “haircuts on contracts” entered into as counterparties with the seized institution, according to one lobbyist.

Sheila Bair, the chairman of the Federal Deposit Insurance Corporation, has been lobbying for early introduction of seizure powers that could be used to take over a large systemically important bank if it was severely weakened by another sudden downturn in the economy.

The FDIC has a long-established system of seizing deposit-taking institutions, running them for a short time before winding them down or selling them, all with the aim of protecting depositors. But the largest banks are organised into bank holding companies, which stand outside current powers.

Mr Geithner has said new powers would allow for an orderly winding up of a systemically important institution, avoiding a repeat of the messy fall-out from Lehman Brothers’ collapse last year or the expensive bail-out of AIG, the insurer.

But several people involved say the way the regulation is interlinked means it would be difficult to fast-track a resolution authority specific to bank holding companies. The current timetable envisages the legislation being voted in the House in the summer and in the Senate late this year.

The eventual legislation is likely to leave open the question of which institutions count as “systemically important” and fall under the new authority’s power. People familiar with the plans say there is reluctance to draw up any fixed list or set of criteria; it would be better, they say, to maintain a certain ambiguity in order to maximise flexibility and induce a sense of caution.

Details of the regulatory overhaul – which also includes increased supervision of the retail market for financial products, standardising rules governing deposit taking institutions and increasing oversight of over-the-counter derivatives – are still being debated."

To us, that week, it looked very much like a run on the entire financial system

TO BE NOTED:

Sunday, May 17, 2009

How TARP Began: An Exclusive Inside View

May 14, 2009 04:01 PM ET | Rick Newman | Permanent Link | Print

When it first came into existence last September, TARP—the troubled assets relief program—sounded like just another ungainly government acronym. But since then, it has become an integral—and controversial—part of America's recession economy.

TARP's chief architect was Henry "Hank" Paulson, President Bush's treasury secretary, who led the financial rescue along with Federal Reserve Chairman Ben Bernanke and New York Fed Chairman Tim Geithner, who's now Paulson's replacement at treasury. Their initial plan was to use the $700 billion in TARP funding approved by Congress last October to purge financial firms of their so-called toxic assets.

[See why the banks still aren't fixed.]

But TARP morphed into an über-bailout that included direct cash injections into banks, the auto rescue, the AIG intervention, and other government efforts to revive the economy. If it sounds like a trial-and-error experiment, well, that's how it felt to the policymakers who designed it, too. "When we looked for easy solutions, we kept coming up empty," says David Nason, who was a senior Treasury Department official during the Bush administration. "Hank used to say all the time, 'We're going to have to do this with duct tape and fishing wire.' "

Nason and some of his Treasury colleagues did much of the jury-rigging, running doomsday scenarios, negotiating emergency deals with banks, wooing incredulous members of Congress, and devising ways to deal with problems once considered unthinkable. Frustrated Treasury Department officials, for instance, foresaw much of the carnage but found themselves poorly equipped to stop it. Anxious finance ministers from around the world began calling Treasury last summer to find out what the government planned to do about the developing crisis. The most tense moment may have been the September failure of Lehman Brothers, which occurred with alarming speed after British financial regulators scotched a takeover bid by the British bank Barclays.

[See 6 surprises from the recent bank stress tests.]

Nason and two other former Treasury officials, Philip Swagel and Kevin Fromer, spoke recently at a panel discussion sponsored by the Milken Institute. Their remarks form one of the most thorough accounts to date of how the government struggled to contain the worst financial crisis since the Great Depression. (See a video of the full discussion, which I moderated.) Here's a condensed version of their remarks:

David Nason, former assistant treasury secretary for financial institutions: The first inflection point was March 16, 2008, which was the acquisition date by JPMorgan Chase of Bear Stearns. The sheer time it took for this institution to go from viable to nonviable was breathtaking. Just two days before, the regulator [the Securities and Exchange Commission] had said Bear had adequate liquidity of $8 billion. This is an important inflection point because it was the first time the government had stood up and said we are going to support nonbanking institutions. We knew at that point the times had changed. We knew the policy ramifications were going to be very difficult and far reaching.

[See 5 signs the bailouts are getting better.]

We worried most significantly about the consequences of other similarly situated firms. It was a very trying and stressful time because when we looked for easy solutions, we kept coming up empty. The government did not have a ready-access pool of money to support or manage the resolution of financial institutions. The political climate was very challenging—at the time, people saw this as a bailout for fat cats on Wall Street. And there was some jurisdictional squabbling in Washington.

Philip Swagel, former assistant treasury secretary for economic policy: Right after Bear failed, the economy looked like it was actually in pretty good shape considering the problems in housing and the financial sector. Overall growth was positive, driven especially by exports. In the wake of Bear's failure, we looked at options, including many things that are now familiar: buying assets, insuring assets, buying pieces of pieces of institutions, in other words injecting capital, and a massive bailout from the bottom from refinancing every troubled homeowner. And we said those are all things you could write down, but back then, you had rebate checks that had been enacted but weren't yet going out, and we had positive growth. It would have been hard to imagine getting the authority to do those things or the approval from Congress for a contingency fund in case things got worse.

Nason: The next inflection point was July 2008. The government was worried about the big investment banks, CDS [credit-default-swap] spreads were blowing out, we were also worried about Fannie Mae and Freddie Mac. These were some of the most leveraged institutions on Earth. Together, they had over $5 trillion in exposure if you consider the guarantee obligations that they had. Match that against about $60 billion in capital. We were also concerned that the housing correction was turning out to be significantly worse than the GSEs [government-sponsored enterprises, such as Fannie and Freddie] expected. We were very concerned that the GSEs were being overly optimistic about their ability to manage risk and withstand future losses.

[See the best and worst bailed-out banks.]

The GSE equity prices were getting punished during this time. More important to us, however, was the debt market. It was very clear to us there's no way the U.S. financial system is going to allow a firm the size of Fannie Mae to collapse( NB DON ). We were very worried about the trillions in debt they had outstanding, and what it would do to confidence if we let that debt go.

At this time, the Treasury was getting calls from finance ministers' offices from different parts of the world inquiring, "What is the government's relationship with Fannie Mae and Freddie Mac?" It's odd, but this appeared to be the first time that people were focusing on the fact that these are quasi-governmental institutions.

During this time period, the home loan banks, another GSE with similar exposure to the housing market, decided to postpone an auction. Every auction was something that we focused on and were worried about.

[See the banks most likely to pay back their bailout funds.]

We made the decision based on this set of circumstances that we had to support the GSEs. How were we going to do that? What did we have in our toolbox? Essentially nothing. We had about $2 billion of backup credit support for the GSEs. For $1.4 trillion organizations. This was clearly not enough to support these institutions in any real way. And we had no ability to provide any kind of equity support at all. So we decided we had to go up to Congress, bite the bullet, and ask for authority to backstop these institutions.

On July 30, 2008, the president signed a bill into law to provide equity support to these institutions. And we had the ability to support their debt up to the federal debt limit.

We made the judgment not to request the authority to nationalize the GSEs. It would have muddied the political discussion. I'm not sure we would have gotten the authority, and at this time, there wasn't a pressing need to do so. There's a long, tortured story about how the GSEs and Washington interface. But we wanted to have broad authority to support the GSEs and prevent their collapse.

[See why the auto bailout is a good model for other struggling firms.]

The entire month of September was an inflection point under my definition. But the first inflection point associated with September is Sept. 7, 2008, when the GSEs were forced into conservatorship. That came after regulators determined that they were drastically undercapitalized.

Two days later, AIG's stock fell 19 percent. Lehman's discussions to sell itself to the Korean Development Bank failed. The next day, Lehman put itself on the market for sale, with no clear takers. After some very tense discussions about whether there would be a purchaser, like JPMorgan was for Bear Stearns, we were very distressed to know that there were no takers.

So from the 10th to the 14th, the Federal Reserve, with the Treasury's support, decided to flush the system with liquidity. The Federal Reserve expanded the level of collateral the primary dealer credit facility would take, they increased the collateral that the term securities lending facility could take, and they increased the ability of banks to support nonbanking institutions. The government was putting "foam on the runway" to try to deal with what we were afraid of, which was how the market would react to a Lehman Brothers bankruptcy.

The next day, Lehman Brothers filed for bankruptcy.

The question is: Did we let Lehman Brothers fail? That assumes it was a choice that we made. The simple truth is that the government was presented with an institution with a $600 billion balance sheet, with enormous leverage. Confidence in the institution was virtually nonexistent. The only way to stabilize a firm under these circumstances is to stop a run on the institution, stop counterparties from claiming their debts should immediately come due. That was manageable in the Bear Stearns situation because someone was willing to guarantee all or most of those liabilities.

[See how bailouts can butcher capitalism.]

The public posture was that government support would not be available. But there wasn't a single credible buyer at the table who was turned away by us.

So when people ask, "Why did you let Lehman Brothers fail?" I ask, "What is the deal that the government turned down that would have prevented Lehman's failure?" If there's not someone willing to take on a balance sheet as large as that of Lehman Brothers, what is the government to do? The government has a few options: We have a lending facility at the Fed, you could provide a loan to them secured against collateral, or you could guarantee all their liabilities. That might have been the right decision, but we had no authority to do that before TARP.( NB DON )

Looking back, if we could have plugged some of the holes in our authorities, maybe this could have been done differently. I don't think we would have gotten those authorities if we had asked for them before September.

[See why the feds rescue banks, not homeowners.]

Of course, things continued to be unpredictable. We didn't predict that the U.K. bankruptcy process would essentially destroy all confidence in that funding model and that business model. And we didn't expect that the commercial paper market would essentially shut down because Lehman Brothers' commercial paper was impaired. Those two markets were the transmission vehicles that killed confidence, which we didn't expect.

That same day as Lehman, Bank of America acquired Merrill Lynch. We didn't have a second to catch our breath. The day after the Lehman bankruptcy, AIG got a $50 billion loan from the Federal Reserve. There was no significant discussion over whether the Federal Reserve was going to provide backup facilities to AIG because of two distinguishing characteristics: One, they were huge. They were global. They were bigger than Lehman Brothers. But the more important distinction is that the Fed is in the business of providing loans when it is "secured to its satisfaction." And AIG had the benefit of having solvent, highly regulated, very valuable insurance subsidiaries to which the Federal Reserve felt comfortable extending its loan facilities.

[See more companies likely to fail this year.]

After that we get to Sept. 17 2008, which was essentially the creation of the TARP concept. It was at that point that there was a meeting of the minds between Paulson, Bernanke, and Geithner that enough is enough, we're going to break the back of this crisis, and we're tired of not having the tools to deal with this crisis. And the judgment was made that we were going to ask for broad authority from Congress.

At that point, it was essentially 24-hour duty at the Treasury Department. Some people slept there.

Kevin Fromer, former assistant treasury secretary for legislative a ffairs: For context, this was a program about the size of the entire federal operating budget on an annual basis. Congress usually works through that process for 10 or 15 months, just to keep the lights on. We were asking Congress for $700 billion in basically a week or two. In the context of a national election. An election year is typically not the year to do big things.

We had one week left in the legislative calendar. It was not possible to do it in a week. I wasn't sure it was possible to do it at all. We needed to get somewhere fast, so we sent up the infamous three-page bill, which was draft legislative text the committees needed to start the discussions.

[See why the markets hate the idea of bank nationalization.]

Swagel: It was very difficult to say, if this shock happens, you will get this economic effect. In September, the nation as a whole didn't understand that what was happening in the credit markets would matter to them. There was this sort of Wall Street-Main Street divide. It was hard to explain to people why this mattered.

The week of Lehman and AIG, there was a panicked flight from mutual funds, and that led to a lockup in commercial paper. In our view, that was really the key, the CP market breaking down. That had a direct link to investment. Businesses use that to fund their daily operations. That would lead to a direct plunge in business spending, and that's exactly what we've seen over the last two quarters. A very sharp decline in business investment.

The one-month Libor [London interbank offered rate] spread is a measure of stress in bank lending. It's really, do you trust a bank to hold your money for a month. After that week, the stresses in the bank funding markets were huge. To us, that week, it looked very much like a run on the entire financial system. ( NB DON )

Nason: We were afraid of a complete and utter collapse of the global financial system.( NB DON )

Swagel: Imagine if the Fortune 500, blue-chip companies, can't buy paper clips or meet their payroll. All the things these firms rely on money-market funds and commercial paper for. And it goes downhill from there. It starts with the big firms and then every firm in the nation.

Fromer: This was an extremely difficult communications challenge. It made it enormously difficult to sell the package to Congress and for them to sell it back home. They were angry when they came back from home after the election. They had seen the amount of money they were being asked to put into institutions, getting anecdotal information from small businesses and lending institutions, and the picture was, we've invested significantly in these institutions, and we're not seeing credit flow to consumers and small businesses.

The markets were volatile for quite some time, and people became desensitized to volatility in the markets. What people didn't understand, which was quite reasonable, was the credit markets, how credit is provided in this country. That's not a criticism; it's arcane to anybody without a certain educational background. It's an almost-impossible-to-explain set of circumstances.

Nason: People were getting used to seeing the stock market go up and down. We were trying to explain, "What's happening in the equity market is not really what we're worried about. We're worried about some other market that you've never seen and aren't familiar with," and people look at you like you're insane because you're asking for $700 billion and you can't provide anything besides a chart to show why it's important.

[Here's the chart, which shows how rapidly widening credit spreads reflect a seizure in the credit markets.]

People could appreciate the money-market mutual funds situation. There is $3.3 trillion of money invested in money-market mutual funds. A panic in these funds helped in terms of selling the importance of our message. And the commercial-paper market stress was important in communicating this as well. If that market collapses, you could have huge employers saying, I'm going to start laying people off. I'm going to start shutting plants down, I'm going to start defaulting on my bonds, and that's going to trigger bankruptcy( NB DON ). Those are the kinds of things you had to say, in the doomsday scenario, to convince people that this was critical to the system.

After [the first TARP vote] failed in the House [on September 29], then the equity markets finally responded. [The Dow Jones industrial average plunged 778 points.]

Fromer: It was clearly a response that forced a number of people to say, "OK, we get it now."

Swagel: Even after the legislation passed, stresses in bank funding still got worse. So we got what we needed; we were thinking about buying assets, but we needed to think more broadly.

Nason: There were two purposes at the time. This is a critically important point and something the current administration is suffering under. The dual purposes were financial system stability and provision of credit to the economy. People are not focused at all on the fact that the former is the primary reason we went up and asked for emergency authority. To derail a total breakdown of the financial markets and the global financial system. And we believe and hope that the confluence of programs put into place in a very short period of time actually did that.

The second part of it is, getting credit flowing into the economy. People seem to only focus on, "Why isn't this money being put into the economy?" That's important, of course, but you have to remember a significant portion of this money was there to be a buffer against future losses.

Swagel: To me, the stabilization of the financial markets is the salient accomplishment of the TARP and the actions of the Treasury in the fall. The normal playbook for dealing with a bank crisis is first, winnow out the banking sector so the zombie institutions don't clog up the credit channels and divert resources. As a society, I'm not sure we're going to do that. Next is stabilize, inject capital into the firms that are left so they're still viable. And No. 3 is do something about the balance sheets. Give certainty about the performance of the assets and the viability of the firms. I think we did No. 2, we stabilized the system. No. 3 is still the ongoing challenge.

Nason: The reason the TARP morphed from asset purchases to injecting capital is really quite practical. Asset purchases were taking longer than we had hoped, and it was more complicated with the vendors. Also, we needed to be in lockstep with our brethren around the world. The U.K., France, and Germany were prepared to guarantee the liabilities of the banking sector and were going to deploy capital into their banks.

Fromer: The folks in place right now clearly have the advantage of looking back at what we did and the conditions that existed when we did it. They're benefiting from experience. A number of them were part of the process going back to last summer.

Swagel: The job of the TARP has not been done, but the first step is done. In terms of the larger picture of what matters to families, we're still pretty far away from getting back to normal.

Nason: There are still valuation problems with a lot of the assets on bank balance sheets. Then we still have to deal with inevitable credit contraction.

Fromer: It's not conceivable to me that there's a TARP II. It's going to take time for these programs to stand up and operate and invoke full participation from all quarters. Given dynamics right now, I think it's unlikely there will be another TARP."