Buiter on the Failure of Financial Capitalism

We have the rare spectacle of Willem Buiter admitting he doesn’t have an answer, but in fairness, he is looking at a throny problem.

Buiter considers the question of what to do about the financial sector once the crisis has passed. He provides a scathing assessment of the workings of financial capitalism, but is pessimistic that regulation can be effective. Highly paid traders will outsmart supervisors; regulators, out of prolonged contact with their charges, will be corrupted intellectually, identifying overmuch with the industy’s world view; the minders will be inclined to one of two extremes, either to restrict bank activity unduly, or to go too far overboard in their salvage operations should anything bad happen.

There is a flaw in Buiter’s reasoning, however: he assumes the status quo ante will return in the absence of government intervention. Enough pieces of critical infrastructure are hopelessly impaired that I doubt that will happen.

The biggest, and one that poses a major conundrum, is that private securitization has ground to a halt. It depended on credit enhancement, which is now suspect, and has also become scarce and costly. The monolines are no longer in that business; with bank balance sheets impaired, there are far fewer credit default swaps protection writers. Plus, given concerns about counterparty problems leading to more generalized failures in the CDS market, it’s not clear how receptive investors would be to CDS as the means for providing credit enhancement.

Plus with so many investors burned directly or indirectly by supposed AAA paper that fell rapidly from grace, it may take a generation before memories fade and willingness to buy the product returns.

So in the US, we see Fannie and Freddie stepping into the credit enhancement breach, even though that will soon create problems of its own.

That is a long-winded way of saying that the industry is already losing important businesses that led to high profits, swagger, and outsized pay. Give it two more bonus cycles, with the attendant job cuts, and you’ll see a humbler, easier to contain players.

The critical step seems to be to recognize that banks (both the investment bank type as well as traditional commercial banks) are wards of the state and to treat them accordingly. That in turn means not being hesitant to restrict the scope of their business. If you want to take risks, fine, go be a private partnership and don’t expect any help if you screw up.

My short list (some of them cribbed or adapted from a proposal by Amar Bhide) of what to do would be:

1. Force as much OTC activity as has reasonable trading volume onto exchanges. That means at a minimum interest rate swaps, currency swaps, and credit default swaps. Yes, this will require standardization and some buyers will lose access to variants they might have liked. Too bad. Protecting the economy and the taxpayer is more important than indulging every investor’s pet need.

This of course will also considerably lower the profitabilty of the industry. Again, too bad. They screwed up and cost the populace a ton of dough. There are consequences for mistakes of that magnitude. They should consider themselves lucky not to have been subject to public beheadings.

Lower profits for banks has positive consequences. It means less talent and other resources are sucked into the FIRE economy (and remember, the FI in that equation are at best service providers to the real economy, and worse, when they become too large, parasites).

2. Prohibit off balance sheet vehicles.

3. Prohibit Level 3 assets; allow only Level 1 and strictly defined and audited Level 2 assets. This means regulators will not have anything overly arcane to assess; they ought to be able to get a clear picture of risks, processes, and exposures if they are dogged.

4. Prohibit these regulated institutions from lending, providing other funding, or investing in concerns that have Level 3 assets.

Hedge funds would continue to be unregulated. I might also prohibit any unregulated entity from going public. Speculators playing with investors’ money is tempting enough; having them have even less skin in the game via a public floatation makes it easier for them to get so large as to pose a danger. Yes, this can create problems of succession, but Wall Street dealt with it for a hundred years or so. These guys ought to be smart enough to figure it out.

I’d also have pretty draconian penalties for breaking the rules, the sort that can have individuals involved and their supervisors forfeit a lot of dough and go to jail.

Thus I’m not as pessimistic about the ability to leash and collar the industry, perhaps because I lived in it briefly when it was more heavily regulated and it functioned much better for society as a whole than it does now. And the bankers still made a very nice living, although nowhere near as egregious as the pay scales of late. The real constraint is political will, and I don’t think things have gotten bad enough yet for the public to demand an end to rule by finance. But that attitude will change if real estate prices fall another 10%.

From Buiter:

The worst outcome of the current financial crisis would be a return to the status quo ante that produced the pathologies, anomalies and contradictions that are its root causes.

I believe that the Western model of financial capitalism – a convex combination of relationships-based financial capitalism and transactions-based financial capitalism – has, in its most recent manifestations (those developed since the great liberalisations of the 1980s), managed to enhance the worst features of these two ideal-types and to suppress the best. This period has been characterised by a steady increase in the relative dominance of the transactions-based financial capitalism model in the overall financial arrangements of the world, most spectacularly in the US, the UK, and such smaller countries like New Zealand and Iceland, somewhat less in most of continental Europe and elsewhere.

The key policy issues created by the recent excesses of the financial sector, once the immediate financial crisis has been euthanised, are those of governance and regulation. Governance issues include prominently the question of remuneration for top managers and superstars. I will not address this issue here. Regulation (and public ownership) inevitably become issues in all industries where widespread, systemically significant externalities, free rider problems and public goods features ensure that decentralised, competitive outcomes are inefficient. They are especially acute in the area of financial intermediation, because leverage permits the scaling up of financial activity to astronomical levels in no time at all. The damage that can be done by a rogue individual, a rogue firm or a rogue instrument is unparalleled among legal business activities.

Financial intermediation is playing with fire; there is no escape from this. Any economic activity undertaken for profit or power which has trust and information as its two key inputs is bound to be vulnerable to abuses, distortions, excesses and deception.

Effective financial intermediation is also a key and necessary feature of any economic system capable of delivering sustained increases in material well-being. If every economic agent were required to be financially self-sufficient, we’d all still be living in trees.

Getting ex-ante financial surpluses from economic agents whose planned saving exceeds their planned capital formation matched efficiently with the ex-ante financial deficits of economic agents whose planned capital formation exceeds their planned saving can, given time, increase the productive efficiency of an economy by orders of magnitude.

Transactions-based financial capitalism emphasizes arms-length relationships mediated through markets (preferably competitive ones), is strong on flexibility, encourages risk-trading, entry, exit and innovation. It is lousy at endogenous commitment: reputation and trust are not a natural by-product of arms-length relationships. Commitment requires external, third-party enforcement.

Relationships-based financial capitalism emphasizes long-term relationships and commitment. It has, however, compensating weaknesses. Investing time and other resources in building up relationships with customers creates an insider-outsider divide that is very difficult to overcome for new entrants. It also encourages, through the interlocking directorates of the CEOs and Chairmen (seldom women) of financial and non-financial corporations, a cosy coterie of old boys for whom competitive behaviour soon no longer comes naturally. At its worst, it becomes cronyism of the kind that was one of the key ingredients in the Asian crisis of 1997.

The financial system that during the first decade of this century ruled the roost in the US, the UK, increasingly in continental Europe and in its outposts in Australia, New Zealand, Iceland etc., combined many of the weaknesses of the transactions-based system (opportunism, myopia, lack of commitment), with the worst features of the transactions-based system – a dreadful clubbiness and homogeneity of outlook and perspective, and a ruthless closing of ranks when the sector as a whole was threatened with legislation or regulation. Let me just remind you of some of of the issues that prompted vigorous lobbying: the taxation of non-doms; taper relief under the UK capital gains tax for private equity magnates; tax havens; proposals for reporting obligations, transparency and audited accounts for highly leveraged financial entities above a certain size, regardless of their legal nature and regardless of what they call them selves; anti-cyclical capital adequacy requirements and liquidity requirements for highly leveraged entities.

It’s time to learn from these lessons and to act on what has been learnt. Acting now would not mean rushing into hasty if-it-moves-stop-it forms of regulation. We have had 20 years to think about this. It is clear where the problems are. In the past 20 yearns, the financial sector has, starting as a useful provider of intermediation services, grown like topsy to become an uncontrolled, and at times out-of-control, effectively unregulated, hydra-headed owner of licenses to print money for a small number of beneficiaries. The sources of much of these profits turned out to be either a succession of bubbles or Ponzi schemes, or the pricing of assets based on the belief that risk disappeared by trading it. This belief that there is a black hole in the middle of the financial universe that will attract, absorb and annihilate risk if the risk it packaged sufficiently attractive and sold a sufficient number of times is closely related to the firm conviction of every trader I have ever met, that he or she can systematically beat the market. The fact that all traders together are the market did not constrain these beliefs. General equilibrium and adding-up constraints are not the markets’ forte.

So is tighter regulation of the financial sector, and especially of highly leveraged entities above a certain size the answer? It would be part of the solution if we could find and keep the right regulators and design and implement the right regulations. Here, however, I hit a blind wall.

Quis custodiet ipsos custodienses?
Who polices the police or, more to the point, who regulates the regulators? No doubt they are formally accountable to some departmental minister or even to Parliament/Congress. But does that fill me with confidence their their actions will promote efficiency and fairness? No, it does not. If regulation is to be effective, it may have to be hands-on and quite intrusive, if only for the regulator to acquire the information (s)he requires to make an informed judgement.

Effective supervision runs into some rather impenetrable obstacles.
First, a $5 million dollar a year trader will run rings around a $150,000 a year regulator.

Second, regulators involved in intrusive and hands-on regulation are virtually guaranteed to be captured by the industry they are meant to be regulating and supervising. This regulatory capture need not take the form of unethical, corrupt or venal behaviour by the regulators or members of the private financial sector. It could instead be an example of what I have called cognitive regulatory capture, where the regulator absorbs the culture, norms, hopes, fears and world-view of those whom he regulates. We cannot just appoint ethical Vestal Virgins to be regulators, regulators who start out pure and stay pure despite their daily associations with people who don’t instinctively play by the rules of the House of the Vestals

Third, even if (1) and (2) don’t apply, regulators will serve their own parochial, personal and sectional interests as much as or even instead of the public good they are meant to serve. No bank regulator wants a bank to fail on his or her watch. As a result, either excessively conservative behaviour will be imposed by the regulator on the regulated bank or other financial intermediary (ofi), that is, we will have if-it-moves-stop-it-regulation, or the regulator will mount an unjustified bail out when, despite the regulator’s best efforts at preventing any kind of risk from being taken on by the regulated entity, insolvency threatens.

I don’t know the solution to this conundrum. To minimise the risk of the first two problems emasculating regulation, any regulation will have to be as much arms-length and impersonal as possible, rather than invasive, intrusive and hands-on. A further key requirement is that institutions that are deemed too big and too systemically important to fail should be de-coupled from their owners and their top management if a publicly organised and/or funded rescue effort is mounted.

So any institution-specific support operation should require that the entire board and top management resign and leave without even a bronze handshake, the minute an agreement is reached. A special resolution regime (along the lines the FDIC runs for insured deposit-taking banks) with Prompt Corrective Action and a special form of regulatory insolvency that can be invoked by the regulator before the financial entity at risk is balance sheet insolvent or cash-flow insolvent. The shareholders should get nothing up front, but would have to take their place at the end of the line of claimants to whatever value can be realised under the special resolution regime.

The regulator as deus ex machina, doing his philosopher king bit in the disinterested pursuit of the public good is a dangerous fiction. Attributing competence and disinterested benevolence to regulators is as sensible as relying on self-regulation by the financial sector. So there will have to be a messy compromise. Clearly, things got badly out of hand in the private financial sector this past couple of decades, and the sector’s capacity to take on excessive risk will have to be restricted severely if we are to avoid another credit orgy of the kind we saw during the years 2003-2006. But am I confident that regulators will do more that bolt the door after the horse has bolted – never to return? I am not. But I am ready to be pleasantly surprised.

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  1. vlade

    Again, forcing CDSes in the current form on exchanges is not possible. The jump-to-default risk means your margin has to be equivalet to the 1-recovery rate (which cannot be determined). This makes CDSes very capital intensive. Overall, it might not be a bad thing, but their “good” impact will shring rapidly. We might as well kill them straight away (which would not necessarily be a bad thing).
    A similar thing goes for IR swaps, although with different reasons. To margin those, you’d need in effect to start trading strips of futures not just quarterly, but daily, and far, far in future – 50 years at least. Again, futures with their margining will have different capital requirements, and you might find that people will switch to swaptions, caps/floors etc.. (which would then have to move to the exchange as well).
    Also, what will you do about parties in Bahamas and Caymans trading OTC derivatives? W/o international support, you will always have some bolt holes where people who want to trade OTC will be able to. It might mean that companies in US/UK will have to pay much more for hedging costs, and that the banks would move away from London/US in the same way as the bond business moved from NY. Moreover, I don’t believe that the political situation in the UK would let this happen unless there was nowhere to move for London banks – the UK economy is right now too dependant on them, and the rebuilding of manufacturing/export services will take years and weak pound (if it ever happens).

    I have an easier solution. Break them up. Make them small, and mandate that they have to be small (or medium size)! If there was 100 investment banks of the same importance, one dead bear would cause a wince, but not a panic. Moreover, people would have to start competing on price/product rather than “we’re big, so it’s prestigious to get screwed by us”.

  2. Yves Smith


    Isn’t the jump to default in most distressed cases really an issue? Unless you have the discovery of a massive fraud, most companies are visibly distressed before they default. How often have bonds gone from near par to 30 with no stops in between? For instance, MBIA’s and Ambac’s CDS went to up-front payment based on the expectation of default.

    As for moving offshore, yes, you’d need coordinated action on this front from the big central banks. But if you do that, is anyone in the Caymans etc going to have a big enough balance sheet to be a credible player?

    I worked with O’Connor & Associates (major equity and FX derivatives firm in the early days of the business). For quite a few years, it made a handsome living on the exchanges, Then the markets became too efficient and it needed to do more OTC trades. It didn’t have the balance sheet to do that and entered into a JV that was an interim stage to an acquisition by Swiss Bank.

    Anyone with any brains should know not to buy OTC derivatives provided by an inadequately capitalized player. But with CDS, people have apparently become desensitized to that risk. If that market gets into trouble, which I think is likely, the lesson learned will be sufficiently traumatic to curtail that sort of behavior for at least a decade.

  3. vlade

    there’s a capital and there’s a capital :).
    Margins require real money, tier1 will be happy with “retained earnings” (which might be MTM less provisions gain from the last year, as opposed to a real hard cash) IIRC.

    The jump to default problem is more of a two-defaults at-once-problem. Say Y wrote your swap on X, and margined it so far successfully. Now, something bad happens to X, which casues not only X to experience sharp spread increase, but at the same time sinks Y (for example, becasue unbeknowst to you, Y has some other exposure to Z which is not a public company but goes bust if X is bust – say it’s a parts manufacturer that X uses extensively). The drop in the spread is so rapid that your margin won’t save you. Yesterday they were 90, today they are 30, and Y can’t find the money quickly enough for a massive margin call.

    Moreover, it could well be in Y’s interest to write the swap even in the worst situation, as for them it’s a win-don’t loose situation. That is, if the X doesn’t default (and there are not large margin calls), Y pockets the premium. If X does default, well, Y goes belly up so who cares whether it slightly dead or really dead? (and yes, there’s stuff about trading insolvent, but if you don’t get caught who cares, and if you’re insolvent, well, that’s just one more problem. I don’t really believe that even catching Enron red-handed made that much difference on this).

    I still think that splitting them up would be the cleanest solution, with the fewest unexpected consequences (after all, when US had a huge number of small regional banks, the banking system as a whole was relatively stable and robust. it’s only now that we have a few failure points where the whole net can unravell on killing one node)

  4. vlade

    just to make clear – I’m not arguing it shouldn’t go to an exchange (in some form), but that when it will, it will be a very different product which will loose a number of attractions that it has now (small capital cost, no need to shell out any money etc..)

    And I don’t even say it’s necessarily a bad thing, either. Mostly because once you have a derivative more liquid than the underlying, the price drivers change – so I think it would be wise to explicitly tie the derivatives to the real world.
    Off topic (slightly:)
    I’d really like to know how many synthetic MBS based CDOs were sold… I.e. how many times the US market was sold :)

  5. Yves Smith


    I wish smaller could work with IBs the way it does with commercial banks. The problem is that trading operations have considerable economies of scale. Profits are highly correlated with the scope of your investor coverage. It enables you to lay off positions faster and gives you considerable information advantages.

    Moreover, there are pretty high barriers to entry and high minimum scale requirements. You need a certain minimum trading and IT infrastructure and product range (oh, and ability to trade in all major time zones). So if everyone has more or less the same nut to cover, the guy who has X trading volume (all other things being equal) is vastly more profitable than the guy with 0.6X.

  6. vlade

    Yes, but the profit comes at the expense of a considerably larger risk (as we just see). I’m not saying that the profits wouldn’t be lower and the banks wouldn’t scream – but I think we (as society) would be much better off.

    That’s why I’ve also mentioned that there would be more of a real financial innovation going on, and even possibly more of a price compentition (unless people would decided that running a bank is no proposition and we would end up with 10 small banks instead of 10 big banks – which is the major risk) -> the customer(s) being better off.

  7. Yves Smith


    I’d rather have smaller players too, that’s why I think they should all be private. That also impedes them getting too big, plus people are much more cautious with their own dough than with OPM>

    However, I also recall the heyday of the bond business in the 1980s. Salomon and First Boston were the dominant players. Even though all the big firms were in the business, they were also rans. Customers strongly preferred to deal with the big trading firms. They could deal in bigger sizes and had better knowledge of who owned what.

  8. TallIndian

    CDS have another problem (besides ‘jump to default’ risk) — there is no way to delta hedge them.

    O’Connor, CRT, Susquehana et al made money trading on exchanges because they could delta hedge options positions very easily and then worry later about vega, gamma etc.

    Even interest rate swaps/options can be delta hedged.

    Alas, no such hedge exists for CDS.

  9. vlade

    yep, nothing that is discontinuous can be delta hedged (you can fudge ala CPPI, but it’s just that – a fudge). Even swaps (or any instrument) in illiquid/non-continuously (in limit) trading market cannot be delta hedged.

    That said, it can be still statically replicated (which is I think where we missed each other’s argument about hedging last time – you taking the hedge as a delta hedge and me as a static replication). For margining, you could thus use static replication.

    The static replication is very costly though, and more so in the world of MTM accounting.

  10. a

    “nothing that is discontinuous can be delta hedged”

    Either you don’t mean this to be taken literally, or you are asking that it be taken too literally. All markets are discontinuous (they are closed for a part of the day). Yet we manage to delta hedge.

  11. vlade

    Unfortunately, my institutional knowledge doesn’t go that far :), but this seems a valid point. My problem is that if you let something to be OTC, the people will find a way how to do OTC (as you’re undoubtedly aware, you can trade almost everything that is on exchange also OTC – including equities). If you move everything onto exchanges, it will be more expensive (including for customers), and kill some legitimate business. Peope are just too bloody inventive :).

    I’d fully second the private vs. public though – the more I think about public companies (or rather, I’d say with dispersed ownership – you can have strong single shareholder even in a public company, but it’s rare), the more I think that it’s a vehicle for moving money from owners to the management.

    Incidentally, the bonds are something that would be a prime target for moving to exchanges (indeed, if we had bonds on exchanges, people today would have much clearer, if sadder, view of how much their stuff is worth), but we (well, regulators, really) have failed to enforce even that. I’d much much rather see bonds on exchanges, as it would help a lot and is easy than derivatives where the effort/risk/payout ratio is much lower (I believe).

  12. vlade

    Even with literally I’m still right – you “almost” delta hedge. If you’d be really delta hedging you’d have to be hedging every nth of a second. Fortunately, with the market being fairly liquid there are (most of the time) no large “gaps” in the market, so you can afford to delta hedge only now and then (but it’s still not a perfect hedge, you just can work to reduce the residual risk to acceptable levels)

    If you look at non-liquid assets, where you might be able to trade say only twice a month, the gapping in the prices is much more likely – and you cannot hedge the gap, as there’s nothing to hedge it with, you just have to bear the cost (either directly, or by overhedging).

  13. Richard Kline

    Yves: I’m in favor of the basics of your proposal as the backbone of a Re-regulation Memorandum. The Powers that Be are not yet acting as if they are the conservators of the financial industry, but after commercial re and equities go south this will be much more obvious. Won’t happen until after the elections in the US, but still.

    I would add that hedge funds cannot remain completely unregulated: their size and the size of their individual positions have to be inhibited to the point where they cannot, of themselves, pose a systemic risk. Let them do what they want more or less and fall where they may, but they have to wear a cormorant collar so that they don’t grow too big. That is something that will take international coordination, yes; your proposal that regulated financial concerns cannot deal with hedgies or others who, among other things, threaten to grow to big would limit capital flows to noncompliant concerns over and beyond the limitation of a ban on public offering.

    Yves and vlade: I’d take your two ideas on scale and players, but swap the basics. Regulate the ibanks, letting them grow bigger (if not into behemoths), but act to keep hedgies and unregulated ones small if numerous. Systems tend to optimize around nodes, so even if we split up ibanks we will end up with sustained pressure for concentration around some of them. If we ban overt growth we’ll likely just end with collusion by well-positioned players. Better to have known nodes we can watch than crypto- or erratic nodes we can’t. Yes, ibank leverage over regulators increases, but if we give regulators real power those who like to have real power can be attracted to the roles. A 150k regulator can indeed control a 5000k trader if the regulator can freeze up and shut-down the the traders position with a phone call.

    I realize from what you say that CDSs lose much of their utility if traded—but they shed most all of their dis-utility if so converted, which is considerable. Because they are cheap up front, they are too easily positioned even while remaining fragile and potentially subject to spontaneous combustion; not a very good insurance policy, and one without dedicated reserves. Insofar as I can tell—you tell me, it’ls your deal—the _real_ function of the CDS doesn’t seem to be to actually provide ‘insurance’ at all, the function is to get a fee at one end and create ‘an aura of confidence’ at the other. I’d be reasonably in favor of actual insurance-like, exchange traded products, but as you suggest these would be so expensive that few would care to purchase and fewer offer them. Let’s get rid of ‘an aura of insurance’ for instruments which have real value _added_, or price the actual positions to their real levels of risk, even better.

    Re: securitization, the idea in principle has some merit, but not as it came to be executed. (I speak in the past tense purposefully.) The concept of selling income-stream tranches from ABSs is so ripe for abuse, misconception, and risk we would be better off without it. These securities, if and as they come back, should be outright holdings of the underlying bundled obligations, and moreover should be much smaller, pool-size rather than sea-size in the case of mortgages. The idea of size was to spread out risk, but as we see that ‘reasoning’ has proved to be fallacious. Make these smaller with real risks, so that if one goes bad it’s a loss but not a major loss; then price them at a discount for solid estimates for losses with clear protocals for renegotiation or foreclosure for individual obligations. We can make securitized debt work if we make these into securities rather than fee-opportunities for multiple financial intermediaries. That’s one idea anyway.

  14. Richard Kline

    To vlades: Yes, bonds on exchanges would be a great idea. You get to see what the value in in real time, so the priced-in risk comes back much closer to reality.

  15. a

    “If you’d be really delta hedging you’d have to be hedging every nth of a second.”

    Damn it, and all this time I thought what I was doing was delta hedging.

  16. a

    “I would add that hedge funds cannot remain completely unregulated: their size and the size of their individual positions have to be inhibited to the point where they cannot, of themselves, pose a systemic risk.”

    You don’t need to regulate hedge funds. It suffices to regulate prime brokers, by saying how much capital they must hold vs collateral that hedge funds have deposited.

  17. Anonymous

    Incentivize the regulator with a payday just the same as the trader.

    Give the 150K regulator a bonus based on assets seized from court cases against traders he catches breaking the rules.

  18. vlade

    you were delta hedging, as that is the industry accepted shortcut for “imprecise, but good enough” hedging in fairly liquid markets.

    If you were really (in the, say, Black-Scholes classical way – if you remember, BS use continuous process, hence a need for a continuous delta hedge) delta hedging your risk, you would have 0 risk all the time.

    I’d call your attention to some of the papers on CPPI, which tend to deal with problems of (really) discontinuous trading, such as trying to hedge a portfolio for a fund of funds (where the funds can transact say only once a month).

    Alternatively, and somewhat more readably, I’d suggest chapter 47 of Wilmott’s “On Quantitative Finance”, second edition (it’s the volume 3). I will quote from the introduction to the chapter: “The Black-Scholes analysis requires the continuous rebalancing of a hedged portfolio according to the delta-neutral strategy. This strategy is, in practice, impossible.”

  19. Anonymous


    What do you mean by “Prohibit Level 3 assets”?

    As you known, level 3 simply refers to the way assets should be valued in certain circumstances (no observable market prices, etc.).

    What’s the alternative? Historical cost with an impairment test?

  20. Tom

    What a disappointing post. I honestly hope you were just trying to be controversial.

    1. Force as much OTC activity as has reasonable trading volume onto exchanges. Won’t happen, no way. At most we get some standardisation and creation of exchange tradable assets.

    2. Prohibit off balance sheet vehicles. Won’t happen. Tighter rules perhaps, but no way will all off balance sheet be consolidated – and why should it? If you truly don’t own the risk, why should you have to consolidate it and set aside capital? Ivory tower idea at best.

    3. Prohibit Level 3 assets; allow only Level 1 and strictly defined and audited Level 2 assets. Won’t happen. At best you’ll have an increase in capital requirement.

    4. Prohibit these regulated institutions from lending, providing other funding, or investing in concerns that have Level 3 assets. See 3.

    As for regulating hedge funds – yeah, ok, like that will happen. 2 men and a bloomberg have to create some huge compliance/reporting operation? They’ll ust move to the caymans and still trade your market. As “a” said, Prime broker regulation is the only realistic solution.

  21. Anonymous

    OLd news, but:

    The market stability regulator would have various authorities over all three types of federally chartered institutions. A new prudential regulator, the Prudential Financial Regulatory Agency (“PFRA”), would be responsible for the financial regulation of FIDIs and FIIs. A new business conduct regulator, the Conduct of Business Regulatory Agency (“CBRA”), would be responsible for business conduct regulation, including consumer protection issues, across all types of firms, including the three types of federally chartered institutions. More detail regarding the responsibilities of these regulators follows.

    Market Stability Regulator – The Federal Reserve

    The market stability regulator should be responsible for overall issues of financial market stability. The Federal Reserve should assume this role in the optimal framework given its traditional central bank role of promoting overall macroeconomic stability. As is the case today, important elements of the Federal Reserve’s market stability role would be conducted through the implementation of monetary policy and the provision of liquidity to the financial system. In addition, the Federal Reserve should be provided with a different, yet critically important regulatory role and broad powers focusing on the overall financial system and the three types of federally chartered institutions (i.e., FIIs, FIDIs, or FFSPs). Finally, the Federal Reserve should oversee the payment and settlement system.


  22. Anonymous

    The sub-thread about delta hedging is comical. One of the main lessons of this crackup should be that models supporting a shared delusion are worthless.

  23. Anonymous

    Yves, I was intrigued by your comment over at the FT that staffing the regulator with more women would reduce the problem of regulatory culture capture. (Think of the FSA being run by a British equivalent of Tanta :) )
    Could you expand on it in a post over here?

  24. Yves Smith

    Anon of 12:01 PM,

    Sorry for the imprecision. Regulated entities will be prohibited from holding or lending against assets that cannot be valued on a Level 1 or Level 2 basis.

  25. Yves Smith


    Point 3 effectively regulates PB lending. You could formulate it more narrowly, to prohibit lending against Level 3 assets, but we’ve had assets be reclassified by IBs from Level 2 to Level 3, so I’d prefer a broader prohibition.

  26. Anonymous


    Why did you not allow my comments to post? (The practical issue of Wall Street payola to Congress, etc….)

    Are you only interested in arguing how many angels can be put on a pin?

  27. Anonymous

    As to “fixing” the financial system to prevent human greed such that we do not experience another fatal blow to the financial system and again foist the cost on the lowly taxpayer, the solution is straight forward and very implementable, however, it is not so welcome by the very conspirators and their cohorts that literally caused it to fail in the first place.

    This catastrophe was the direct result of a fine-tuned plan to transfer wealth from the unsuspecting to the creators of this heinous and nefarious manipulation of the public trust by removing and/or blocking the necessary laws and regulations to protect our financial system, so that they could selfishly benefit through fees, bonuses, and ill-earned profits. The idea that “they” had no way of knowing the outcome or had a final end game strategy wherein they become even more empowered and wealthy is just laughable.

    The very notion that these persons and entities should be allowed to keep these gains and to lay claim to ever deserve to oversee the financial system, that they will likley recreate with yet new but eviserated rules, is tanamount to legally consentual treason and borders on a financial terrorist plot against all Americans as the future result will surely be the complete and utter financial collapse of America. We need not discuss how to fix it, rather we must demand that these purpetrators be dethroned and held accountable for their actions. The FED is a failed experiment and a fiat currency is only as good as the governance that controls it’s value or it surely will become what it really is…worthless colored paper.

    Substantive recrafting of the existing system is now mandatory or there will be worldwide flight from the dollar like never seen before and there is already evidence of a flight to other assets and currencies. It can be done with little cost to the taxpayer, no dumping enormous liabilities on future generations, and will deter further attempts to pervert the monetary system and reign in the “irrational greed” that has raked so much havoc since the beginning of our nation. But alas, no one really desires to fix any of this, just make it look like “they” took some corrective actions without fixing the “root cause” of this ever recurring symptom of a failed monetary system and governance let alone holding the perpetrators accountable for their actions.

    So, why do you bother spewing forth all these ideas to correct this mess when the criminals, and yes they are just as much a criminal if not worse than any murderer because they destroy peoples lives and have no remorse at all. Truly, there needs to be an independent investigation and ALL persons found culpable in the creation, propagation, and planned collapse of this “scheme for profit” should be tried and when found guilty, imprisoned for life with out parole and completely stripped of every last single shekel they have as well as every monetary asset in their control no matter where on Earth it is hidden, unless they are Muslim, then of course the normal standard beheading is equally sufficient and less of a cost burden on the taxpayers.

    Lastly, you get the government you deserve, and it seems you get the financial system they shove down our throats unless we rise up and demand a change, a real change that completely revamps this cretinous system of mental financial chicanery devised to benefit the few at the expense of the many. It is just so wrong, one day it will explode into an uprising like never before in history unless the politicians realize that enough is enough, no more legal robbing of the middle and lower classes or systematic destruction of the middle class to benefit the wealthy.

    This great nation should in fact be the envy of all the world and be a highly respected leader in how to use wealth creation for the benefit of all mankind not just for the few mentally jaded individuals who can not see past their delusion of self-oriented wealth versus the true wealth of helping others. It really doesn’t matter because as history shows, the many will always seek out and destroy the few unless the few (even if only out of self-preservation) are morally and ethically compelled to do good not evil with “their” money. You see money amassed through deceit and trickery is not really “theirs” at all, and must be redistributed to it’s true owners.

    No I love the US, am not a communist or socialist, can but do not own a Ferrari, can but do not even own my own home, and no don’t wish to be President since most people don’t really look critically at a candidate past their pretty facade and warm and fuzzy spoken platitudes and empty promises, though if no one else is willing to take this country back to a leadership position in the world with a regard for all countries and peoples of the humane race, but then Americans are not very smart when it comes to having their “choice” of candidates spoon fed to them by the very institutions that also caused this mess, so I expect to be relegated to the mung heap as the likes of Ron Paul and Ross Perot, (heck he even showed you a chart of all this), but you never know in life, maybe a devastating run on the dollar, followed by a massive collapse of banks and a stock market crash, food shortages and disruptions in services, then maybe people may wake up and cry out for new leadership and a better way…but likely not, as they say in Haiti, “let them eat dirt.” Oh how we have evolved!

  28. Yves Smith

    Anon of 5:06 PM,

    I did not “not allow” you to post; in fact, my tech guy says that Blogger, unlike other blog hosts, does not permit blocking individual IP addresses (since I’ve has some spam, and a particularly vituperative troll, this has come to be of interest).

    Two regulars have been having intermittent (some have lasted a couple of days) trouble with commenting. I asked my tech guy to investigate, but since you can’t get live people, it’s not clear even how to go about resolving this.

    I suggest a) rebooting and b) trying another browser.

    Sorry about the inconvenience.

  29. Carlomagno

    Anon of 12:01 PM,

    Sorry for the imprecision. Regulated entities will be prohibited from holding or lending against assets that cannot be valued on a Level 1 or Level 2 basis.

    Anon of 12:01 PM was me (sorry, was in a hurry and didn’t provide a handle).

    What would be the implication of this? As soon as an asset on your balance sheet goes “illiquid”, you have to dump it? Mandatory fire sales?

  30. Yves Smith


    This Level 2-Level 3 distinction isn’t about liquidity, but about price determination. You can have a very illiquid asset be Level 2, as long as it can be priced using inputs from a market that has “observable prices.”

    A classic example (at least until credit default swaps started messing up the pricing mechanism) was corporate bonds. Plenty of corporate bond issues just don’t trade. Institutional investors lock them up.

    But you can easily price a A+, seven years remaining to maturity, __ % coupon, no sinking fund bond. Corporate bonds are fungible, and buyers purchase them based on their attributes (ie, a Dow Chemical bond might be a close substitute for a Verizon bond, but no one would regard Dow Chemical stock as a substitute for Verizon shares).

    Thus, lending to private equity deals (too idiosnycratic) wouldn’t qualify. PE firms would have to raise funds in the public or private placement markers, or you might see new bond funds dedicated to this sort of lending sold to institutional investors. Old-style commercial lenders might fund smaller deals.

    The objective is to keep regulated players out of hard to value assets where they have demonstrated a propensity to get themselves in a heap of trouble.

    Banks will no doubt still devise new creative ways to blow themselves up. The goal isn’t to keep banks from going under, that’s simply impossible, but to greatly lower the odds of systemic events.

  31. Carlomagno


    Thanks for your reply. I understand the level 2-3 distinction (that’s why I put “illiquid” in quotation marks). Still, I think my point stands.

    If I understand correctly, your proposal is to prevent regulated entities from holding assets whose “natural state” is level 3. My point is that assets sometimes migrate from one level to another. In case an asset moves from level 2 to level 3 (because observable inputs become unavailable), doesn’t your proposal result in a forced sale?

    (NB that I’m not entering into a debate about the legitimacy of current practices of reclassifying assets from level 2 to level 3. No doubt some financial institutions have abused this possibility for reasons that we are all aware of.)

  32. Mencius Moldbug

    You have not solved the problem until you’ve eliminated maturity transformation. Any reconstruction of the financial system which depends on a central liquidity insurer will ensure a recurrence of the crisis.

    All financial crises in history are associated with term transformation. There’s a more debatable connection between smallpox and the smallpox virus.

    Liquidity insurance always fails, because it is intrinsically dependent on some authority which decides which loans are good loans and which loans are bad loans. Today this function is performed, obviously quite badly, by the NRSROs.

    Assessing loans is a task in the same category as running a restaurant, coaching a basketball team, or making a movie. It is not a natural function of government. The State can do it, but it cannot do it well.

    But liquidity insurance cannot be provided by the private sector. It is not 100% secure unless the liquidity provider has the power of fiat, an attribute of sovereignty.

    If the liquidity insurer trusts some rating agency, it is thus delegating the power of fiat to them, and thus making them a de facto part of the State – as Yves so astutely points out. Ergo, the two need to be separated but are also indivisible. The resulting system is born to suck.

    (The worst course of action for the State in a liquidity crisis is to stand around for years, publicly musing about whether or not it wants to buy the bad assets which it lent its credibility to. Naturally, this is exactly what the present authorities are doing. Either liquidate or bail out. Hope is not a third option.)

    A world without term transformation and liquidity insurance is not a world without lending or banking. It is a world in which, if you want to borrow money for 30 years, you need to find someone who is willing to lend money for 30 years. Rocket science this is not.

  33. linear algebra

    finally, a credible projection for the duration of the current unpleasantness–two more bonus cycles and completion of the headcount reductions reflecting permanently changed business conditions. This recent unpleasantness really isn’t grounded in markets, models and regulation. It’s about culture, institutions and people. All of whom are going to turn out to be a great deal less permanent than they anticipated.

  34. Anonymous

    I think it would be interesting if one were able to construct a list of all asset categories that would now be considered as “Level 3 assets”. Does anyone have good knowledge about this?

    That way we could introduce more specificity into the discussion when we talk about “Level 3 assets”. At this point, it is a very nebulous concept for many people.

    If we’re going to eliminate Level 3 assets from the balance sheet of the investment banks, then it would help to know exactly what kind of assets we are talking about.

  35. Anonymous

    In truth, ALL “derivatives” are level 3 assets, though only a sub-group are officially labeled as such.

  36. a

    “If you were really (in the, say, Black-Scholes classical way – if you remember, BS use continuous process, hence a need for a continuous delta hedge) delta hedging your risk.”

    Gosh, talk about a little knowledge is a dangerous thing. You claimed at the beginning “nothing that is discontinuous can be delta hedged”. I chided that this could only be true if you meant this too literally. Indeed you did. You get out a textbook and you pontificate that there is something called “real” delta hedging and – surprise – according to this definition, nothing actually is delta hedged. Fine. You’re abusing language, in order to prove you have read Wilmott. I’m *so* impressed.

  37. TallIndian

    Not sure of the semantics behind the ‘delta hedging’ debate.

    Sure, markets are closed half the time.

    The point is that even when markets are open, there is no way to delta hedge a CDS position (let alone the gamma, vega, theta, etc.)

  38. Independent Accountant

    Moldbug has hit on a critical problem, i.e., the issue of what I term “unmatched maturities”. The Savings and loan crisis of the early 1980s was largely due to S&Ls having deposits which could be immedicately withdrawn as liabilities and 30-year fixed rate mortgages as assets. The public was fooled into thinking a few S&L crooks caused the crisis. No. As interest rates went up, the market value of the mortgages the S&Ls held fell. That the S&Ls were doomed was obvious by 1973. Deposit taking financial institutions should be prohibited from “riding the yield curve”, to make money. This would not eliminate the problem of credit risk, only that of interest rate risk.

  39. Juan

    Would it not, perhaps, be worthwhile to consider more than the strictly financial but that sphere’s longer run, and contradictory, relations with the real value creating economy, i.e. the transition from one form of capitalism to another, what drove this and why rentier capitalism can only but become what we see today.

    Limits are not soley within the financial.

  40. a

    “The point is that even when markets are open, there is no way to delta hedge a CDS position (let alone the gamma, vega, theta, etc.).”

    Yes, agreed.

  41. joe

    I’m with anonymous.
    The FED is no more than a failed experiment.
    Where do I sign up?
    But I will demand an answer to the question: If not the FED, then what?
    If a. is a Ronpaulista who wants to restore the gold standard, I will keep my campaign contribution.
    Ever upward.

  42. Anonymous

    If not the FED, then what? Well, being that the FED isn’t anything but part of the “private” banking system these days, I would suggest the FED be killed and regulation be carried out by the Federal Government. Actually, don’t you know, the FED deserved to die by the end of the ’20’s? jdboise

  43. Anonymous

    Surely the basic problem is that hedge funds using leverage pretended to achieve superior returns whicb were really the conseuqnce of that leverage. This meant that they could atract the best by paying the best, due to their enormous charge driven earnings (2 + 20). Banks had to compete and the rest, in ssalary terms, is history.

    Simple solution – ban leverage for non supervised firms and supervise the hell out of the rest. Seems to me this would kill the illusory profit lines and the ned to pay stupid salaries at the same time.

    No problem with paying for good supervision then I suspect.

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