naked capitalism

Mervyn King, the governor of the Bank of England, gets it. Why does he have so little company on this side of the pond?

King discussed what it would take to fix the financial services industry, and it’s more ambitious than anything you see under consideration in the US. Per the Independent:

The Governor said he advocated a “three-legged stool” approach to shake up the industry. This would consist of raising capital requirements, the creation of living wills for winding up banks if they fail, and an overhaul of the industry’s structure…

Changes would not occur overnight, he warned. “Whatever the pros and cons of various alternatives, the system that has the least going for it is the present system. That’s the one that has brought us financial crisis of ever-growing severity. That’s why asking radical questions about the structure is the right way to conduct the debate.”

The structure was crucial because “from time to time things will happen that we can’t prevent or imagine or calibrate the risk of in advance”, Mr King said. “When it happens, the right thing is not to pretend in advance you can stop it from happening but to design a system that is resilient enough, so that when it still happens one part of the sector doesn’t bring down the other.”

Those who have read Richard Bookstaber’s Demon of Our Own Design will recognize that King is in effect calling for the system to be less tightly coupled. In system dynamics terms, the financial system now is tightly coupled, meaning when a process is initiated, it moves in a sequence that cannot readily be interrupted. Risk mitigation efforts in tightly coupled systems often backfire, since the overly tight integration means any itervention is likely to produce unexpected, typically unwelcome, outcomes.

What frustrates me is that so many who speak of reforming banking in the US keep thinking in terms of traditional banks which take deposits and make loans. Traditional banks were not the epicenter of the crisis, and focusing on them, as opposed to capital market, will lead to incomplete and inadequate remedies.

The big trend in banking over the last 30 years is the way in which traditional banks have been disintermediated. Banks’ share of total lending has fallen continuously during this period. Credit is now what Timothy Geithner has called “market based credit” in which loans are typically packaged up and sold to investors, rather than held by banks. For a whole host of reasons, a comparatively small number of firms dominate this activity globally. Just as the rise of personal computers took us from mainframes to distributed computing, so did the rise of securitization take us from a world of stand-alone banks to one of intermediated credit. And as “the network is the computer,” so to are “the debt markets are the banking system.” And those debt markets are in the hands of very few people who understand full well that they own infrastructure that is vital to modern commerce.

The object lesson du jour is a comment in the Financial Times by Raghuram Rajan, which sets up a lot of straw men (is being too big really the problem? Big can be good. Oh, and activity limits will be really hard! Yes, Virginia, regulating is real work. It has been so long since anyone in the US has done it well that we have forgotten what it takes). His last paragraph is particularly barmy:

In reality, proposing limits on size and activity is just an attempt to diminish the deleterious effects of another previous and now anachronistic intervention — deposit insurance. When households did not have access to safe deposits, deposit insurance made sense. With the advent of money-market funds, households gained access to near riskless deposits. Money-market runs can be eliminated by marking them to market daily; they do not need deposit insurance. To encourage community-based banks, deposit insurance may still make sense because small banks are poorly diversified and subject to bank runs. But for large, well-diversified banks, deposit insurance merely contributes to excess. We will bail out these banks anyway in a time of general panic. Why encourage the poorly managed ones to grow without market scrutiny by giving them deposit insurance along the way? Why not phase out deposit insurance as domestic deposits grow beyond a certain size? That would be far more effective in reducing risk than size or activity limits, and far easier to implement.

Yves here. Where was Rajan during the crisis? Did he miss the run on Revere Fund as a result of the Lehman bankruptcy, a run that was on its way to morphing into a full blown run on ALL money market funds? The government had to step in and guarantee money market funds, remember?

And had AIG been allowed to fail, $20 billion in commercial paper would have been downgraded. The blowback to money market funds would have made the Lehman fallout look like a stroll in the park. Money market funds are also meaningful repo “lenders,” and prices on some types of paper that was widely accepted for repos also fell in the crisis.

The idea that there is any perfectly safe short term investment vehicle absent a state guarantee is ludicrous. The role of banks (and later, other vehicles have stepped into this function) is maturity transformation, aka borrowing short and lending long. If you have maturity transformation, you have the risk of bank runs, If you forbid maturity transformation, you will see very little in the way of credit (the world is uncertain, and most people like and need the flexibility of deposit-type arrangements.

Steve Waldman isn’t too happy with that paragraph either (”No system that expects sales clerks and schoolteachers to monitor financial firms is reasonable or politically sustainable,” for instance). Waldman instead proposes to insure depositors rather than bank, which is an interesting but as he points out, modest, idea.

But the bigger point here is that I see perilous little grappling with the problem that King flagged, that of industry structure. The idea that we can’t get from A to B is absurd; the 1933 and 1934 securities regulations represented enormous change and proved effective and durable. Do we need yet another financial system near death experience to mobilize the needed thinking and action?