It’s hard to discern what took place in a closed-door session at a remove, but some of the tidbits coming from last weekend’s Federal Reserve conference at Jackson Hole were worrisome. Note I didn’t have this sense about last year’s meetings, based on a reading of Jim Hamilton’s commentary (which may simply mean Hamilton was charitable, but I suspect not).
Nevertheless, even though I have only have some odd data points, they all seem to align. That could, of course, simply be due to too small a sample size.
Nevertheless, let’s go through the indicators.
First, before the conference, Bloomberg reported that:
The world’s top central bankers gather at their annual U.S. mountainside symposium today with a sense there’s not much more they can do to repair credit markets and rescue the global economy….“All the central banks can provide now is time for the banking system to heal,” Myron Scholes, chairman of Rye Brook, New York-based Platinum Grove Asset Management LP and a Nobel laureate in economics, said…
The article quoted former Fed governor Lyle Gramley and former Fed researcher Brian Sack also resorting to that unbankerly word “heal”.
That might seem to be a useful recognition of the limited authority central bankers have. However, the Fed is increasingly in the hands of economists, many of them academics. “Heal” suggests the markets will somehow find a better equilibrium on their own. I wonder what evidence there is to support that view.
Perhaps more important in the US, the Fed is not just the central bank but also an important financial regulator, and the proposals advanced by Hank Paulson would greatly increase the Fed’s regulatory role. Yet the Fed has been almost completely unwilling to consider regulatory measures, despite early identification of failures on that front.
The big dead body in the room is the near-total breakdown of the private sector securitization process. The litany of failings is well known: lack of transparency; bad incentives; the central, problematic role of conflict-ridden rating agencies; frequent reliance on insurance (monoline guarantees or credit default swaps) that are now to costly and/or viewed with some skepticism.
The expedient, which has been the default modes through the entire credit crisis, was to have the Federal government assume the risk, in this case by expanding the role of government-affiliated mortgage issuers and guarantors. And while Ginnie and the GSEs went from accounting for roughly 40% of new mortgage issuance pre-crisis to 90% post, the debt markets began rebelling in February, pushing up agency spreads, and today there is considerable uncertainty as to what lies ahead Freddie and Fannie.
Now admittedly, Jackson Hole might not be the best format for figuring out whether and how to address the securization model. But as a central element of the problem, it merits real study, with input from people with relevant technical expertise. Is any such effort underway? From what I can tell, no.
Second, central banks appear to have gone from being concerned about the possibility of a systemic crisis to being concerned about inflation. Yet both risks are still live.
1440 Wall Street quoted Pimco’s Paul McCulley:
This was my third year attending the Kansas City Fed’s annual Jackson Hole Symposium. As always, I was honored to be invited and found the event, both the formal meetings and the informal discussions, to be engaging. But, quite frankly, I found this year’s confab to be the least intellectually satisfying of the three I’ve attended. Why? Policy makers, and even more so academics, just don’t seem to collectively “get it” when it comes to understanding what is unfolding in the capital markets right now, and the implication for a whole array of policies, not just monetary policy.
Now I don’t have any concrete evidence that McCulley’s specific beef with the Fed included its interest rate stance, but given Pimco’s rate cut cheerleading, it’s a likely guess.
But the fact that Pimco may be partisan doesn’t make McCulley wrong. The current situation, with strong inflationary and deflationary pressures (remember, the stagflationary 1970s did not have a deflation component) is out of bounds of modern experience, and likely any widely-used economic models. And the Fed and EU really are not the source of the inflationary pressures. China, and to a lesser degree other developing economies, have been the impetus behind rising energy costs (food is more complicated and more contested). As we have pointed out, monetary policies have considerable lags. Money supply growth in the US, UK, and EU is low to stagnant. Are central bankers acting like drunks under the lamp, applying the only remedies they have even though they aren’t a fit for the problem? Again, quite a few people to be trying to find solutions within established paradigms when we are way outside them. I don’t pretend to have an answer here, but I worry that not enough people are asking the right questions.
Third was this item from the Economist by Greg Ip, on a paper by Anil Kashyap and Raghuram Rajan, of the University of Chicago, and Jeremy Stein of Harvard University, that got quite a lot of attention at the conference. Note it was also discussed in shorter form by Sudeep Reddy, Ip’s successor on the Fed beat at the Wall Street Journal, on its Economics Blog.
What is truly disconcerting and disheartening is the arguments made in the paper itself and its assumptions about regulations. From the Economist:
Reeling from billions of dollars of loan losses, banks have started to sell assets and rein in lending to keep their capital from eroding. This may be individually rational, but collectively it is imposing a vicious cycle of tightening credit, weakening growth, and further loan losses on the world economy. Small wonder that, once they get through this mess, many central bankers want to raise capital requirements—at least during good times. Had banks been forced to hold more capital, the boom might have been more constrained, and there would be less of a bust.
Yves here. With all due respect to Ip, this opener is more than a tad disingenuous. First, as reported in the Financial Times, banking regulators are being toughminded about having banks get their capital ratios up. Ip says that this move is self-directed when in fact it is externally imposed.
Since regulatory forbearance (letting banks have or use various equity fig leaves, and/or going easy on them with how their assets are valued) is the norm in past banking crises, I must imagine that regulators feel some external pressure, aka market demands, to be tougher on banks this time. John Dizard commented earlier that regulators had a plan that was a tad optimistic:
Think of the main US banks and dealers, along with their regulators, as the Iraqi government – though without the same unity, purpose or long-term planning…The US banks and dealers are through the first quarter, and are backstopped by a Federal Reserve that has gone from vestal virgin to camp follower….It is not fair to say the Fed does not have a plan. It does. The plan is for the banking system to recapitalise for a new on-balance sheet world by raising a minimum of $200bn in a short period of time, not longer than two quarters…
Let us put the Fed’s plan in the context of the world of the capital markets. Consider Washington Mutual’s $7bn recapitalisation of last week. We would have to have a Washington Mutual recap a week for the next six months to get the Fed’s plan done. All the uncommitted capital available to the private equity funds could be dedicated to this purpose.
So the Fed’s undue optimism about the ease of raising funds may be one reason financial institutions are looking to shrink their balance sheets. But another may be much more straightforward: in the cold light of day, there aren’t as many good credits as there seemed to be at the peak of the lending frenzy. This line of though is consistent with the idea, discussed here before, that the economy is over-leveraged and debt levels need to go down. Thus deleveraging is necessary and salutary.
But that is not the premise of the paper, which assumes that any reduction in leverage must be a Bad Thing:
This sounds sensible. It may also be deeply flawed, according to a provocative new paper….Compelling banks to hold more capital—typically, equity—goes against shareholders’ interests, because it results in a lower return on equity. This ultimately hurts economic growth because capital is diverted from projects that might have higher returns. In addition, worthy borrowers are denied loans. It may also be counterproductive, by encouraging banks to game the system.
This sort of thinking is what got us into this mess. We have demonstrated that the losses of banks are socialized. They are wards of the state. Therefore, they are not entitled to high returns. There are plenty of parties that are keen for high return ventures, such as private equity firms. There is no reason for those to be undertaken by the banking system.
Regulated parties ALWAYS try to game the system. If that were a legitimate argument, we’d have no rules of any sort.
Back to Ip:
So what is the solution? The novel proposal of the authors, Anil Kashyap and Raghuram Rajan, of the University of Chicago, and Jeremy Stein of Harvard University, is “capital insurance”: push banks to buy policies in normal times that deliver an infusion of fresh equity during crises. The proposal was the buzz among the assembled central bankers as they focused on how to deal with the next cycle.The authors conclude that it is difficult to wean banks from leverage. Indeed, they question whether regulators should even try. Limited capital leads to good governance, they say. Supply bankers with too much equity and they will waste it on inefficient projects. Force them to rely on short-term debt, they say (rather overlooking evidence from the current crisis), and they will lend carefully lest wary investors yank their funds.
I’m glad to see the skeptical interjection from Ip. How does limited capital lead to good governance? Limited capital means higher leverage. That is tantamount to arguing that one will drive a car more carefully at 90 miles an hour than 45. One might be more focused mentally at 90, but one has much less ability to change course or slow down, and any accident is sure to be fatal.
To Ip again:
Moreover, higher capital requirements may not prevent banks from tightening the screws on the economy during downturns. In America banks are rapidly tightening lending conditions even though their “tier-one” capital—mostly shareholders’ equity—stood at 10.1% of risk-weighted assets as of June 30th, well above the 6% that regulators consider “well capitalised” (see left-hand chart, below). Bankers are not hoarding capital because they have hit their minimums, says Mario Draghi, governor of the Bank of Italy. Rather, they are worried that markets will punish banks where the capital buffers slip.
The answer here is pretty simple. Banks are delaying foreclosures, playing accounting games (even the supposedly conservative Wells Fargo has gone this route, stretching out its foreclosure process to present a more flattering picture). Bridgewater Associates estimates banks have taken only 1/5 of the losses they estimate they have already suffered. Banks have tightened up because they know where they really stand, and it isn’t pretty.
To Ip again:
Mr Draghi, like many regulators, argues that capital ratios should be tightened—perhaps mimicking Spain’s well-regarded system, where capital requirements rise during lending booms and fall during busts. But Messrs Kashyap, Rajan and Stein argue that since crises are rare, that will saddle banks with lots of wasted capital most of the time.
Bank crises are rare? Let’s see, S&L crisis, late 1980s-early 1990s, Japan bubble era end 1990-?, Asian-Russia-LTCM crisis 1997-1998, dot-bomb era (Greenspan was worried enough about deflation to run negative real interest rates for some time) 2001, and our current mess, 2007-?. I don’t consider three to five crises, depending on how you count them, in a mere twenty year period to be rare.
And again, we have this fictive disease of “too much capital” Who created this concept? Oh, I forget, two of the authors hail from the University of Chicago. As the Financial Times’ Martin Wolf noted:
Equity capital is the most important cushion in the financial system. Also helpful is subordinated debt. If Bear Stearns had had larger equity capital, the authorities might not have needed to rescue it. Capital requirements must be the same across the entire financial system, against any given class of risks. But there must also be greater attention to the adequacy of that other cushion: liquidity.
This is a motherhood and apple pie statement, yet somehow that basic understanding has been turned on its head. You don’t run a system at the limits of its tolerance all of the time, or even most of the time. But the author deem that to be desirable behavior.
Now to the proposal:
…banks be made to choose between higher capital requirements and buying capital insurance. A pension or sovereign-wealth fund would earn a premium and in return deposit, say, $10 billion of treasuries in a lockbox. When a predefined point is met, the funds would be released to the bank….
This may be insurance in form, but not in substance. Insurance works for the provider either when he can write policies against well diversified pools (think auto or homeowners’ insurance) or customers value it enough that they are willing to pay for a pricey product (think travel insurance).
Here you have fairly undiversified risk. Advanced economies move together far more than they used to, thanks to globalization, and banks do to, thanks to international product syndications and wide-ranging operations among the top players. The FDIC had to be bailed out by Congress in the S&L crisis, and the signs are that it will need to be again (even though it is musing raising deposit premiums, it’s pretty clear than any increase sufficient to cover expected losses will be deemed to be kicking the banking system when it’s down).
That is a long-winded way of saying that realistically-priced insurance will be unattractive. So you either have a product that will be perceived to be too costly, or one that will be priced too cheaply, and will therefore fail in a crisis.
And there is another problem. We learned in the our current mess that all those fancy risk reduction techniques did not reduce systemic risk. Why? One reason (I think this was a musing by Timothy Geithner) is that per the driving metaphor, having better brakes meant everyone felt comfortable driving faster. There was no net improvement in safety from having (theoretically) better risk reduction tools.
Ip gives some caveats too:
Numerous questions dog the proposal, among them who would define the trigger point, where to set it, and what countries and types of firms (besides banks) should participate. Alan Blinder, of Princeton University, noted that crises hurt almost everyone. Unless an insurer can be found who benefits from a crisis, “the insurance premium is going to be extremely high, because you’re making people pay in times when they don’t want to pay.”
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Also, although the present system has hardly been perfect, it is not necessarily broken. True, it has encouraged risk-taking and short-term borrowing, and banks have allocated their resources neither efficiently nor wisely. Yet, for all the pain, no large bank has yet failed—thanks in large part to the capital they had been forced to hold. And banks have raised a remarkable amount of new capital, equivalent to almost two-thirds of cumulative write-offs so far, although this is getting harder.Of course, the crisis is far from over. The conference fretted that with the financial shock now a year old, the real economy may still have not felt its full effect. It may yet be too early to overhaul today’s capital arrangements. But change looks inevitable and even unconventional ideas are guaranteed a hearing.
We earlier called that sort of thing Extreme Measures.
What is scary is the subtext: this paper got a positive reception, and it appears to be due to a dearth of critical thinking and a deep-seated reluctance to regulate. This does not bode well for coming up with good long-term solutions to our financial plight.
Yves Smith 
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More Northern Rock style events for everyone then?
Refering to Draghi and Italy. Well, the Italian banks are sweeping the foreclosure mess under the carpet by simply not foreclosing on people from what I hear.
But I would definitely worry that the Bank of Italy has quite simply no idea what its country’s banks derivative books look like as the Italease case showed. The central bank inspectors were going through its books in the months before it blew up and there’s no evidence they detected the problems.