"An Even Worse Financial System Than the One With Which We Began"

Martin Wolf is pessimistic about the whether the financial system can be reformed, but nevertheless offers some toughminded suggestions.

Oddly, he seems to see the big obstacles not as political, but as practical, that markets are too big and interconnected, and sees that as an intractable problem. I agree that it will almost certainly not be solved, but I see the impediments as political. The error is in clamping down on clever intermediaries, Yes, you do try to do that, but what you’d need is international coordination to clamp down on fiduciaries of all sorts too. For instance, one of the big uses of derivatives is to allow insurance companies to evade regulatory restrictions and do stuff they are not supposed to do, like make currency bets. Now if wealthy individuals want to go to the casino, or the markets, fine, but parties in the Other People’s Money business need to be held to a much higher standard.

And that means criminal liability. Right now, the SEC cannot bring a criminal case unless it has the cooperation of the Department of Justice. Not that the SEC has exhibited much will to do so in recent years, mind you, but tougher standards and more serious penalties are needed. The 1990s were rife with all sorts of chicanery that got at more some fines that, relative to the profits earned, were trivial. It’s no wonder that there was sol much pilferage packaged as innovation.

We even have a new term in the wings: bankslaughter, courtesy Paul Collier (hat tip Mark Thoma)

The authorities would also need to be willing to shut down or severely curtain products of limited to no value to the real economy that increase connectedness between markets. Credit default swaps top my list. They affirmatively destroy value. The idea that a market can do a better job than a lender of assessing credit is absurd. A lender is in direct contact with a borrower and can obtain non-public information. The CDS market is not a “market” in the efficient market sense, but is a handful of dealers. And the lack of a cash basis for CDS means the pricing will be inefficient.

Wolf also does not think “too big to fail” institutions can be broken up. Willem Buiter disagrees and provides a road map.

So I do not think the situation cannot be remedies. But it won’t be, at least not yet.

Wolf understands the problem, but only alludes to the implications, It is now abundantly clear, to use that Richard Nixon turn of phrase, that the big banks not only have a license to steal, but the goverment now undermines its risks. That plus the failure to try to engineer controlled deleverging (high leverage is systemically destablizing) guarantees that if we do not sink into Japan-style maliase, we will have an even bigger crisis in pretty short order, five year at the very outside. The failure to implement real reforms will cost us dearly, and sooner than anyone wants to believe.

From the Financial Times:

With one bound the banks are free, or so it seems. Already, the panic of the autumn of 2008 is fading. The period within which lessons can be learnt and changes made is closing. Yet without radical changes, another crisis is certain. It may not even be that long delayed….

Yet what has emerged after the crisis is, as I argued last week , an even worse financial system than the one with which we began. The survivors are an oligopoly of “too-big-and-interconnected-to-fail” financial behemoths. They are the winners not because they are necessarily the best businesses, but because they are the best supported. It takes no imagination to realise what these institutions might now do, given the incentives for risk-taking.

So what is to be done? The characteristic, but futile, response is to move the regulatory deckchairs on the deck of the Titanic…

The starting point has to be with “too big to fail”. We need a credible system for winding up even huge financial institutions. The most attractive proposals are for “good banks”, in which unsecured creditors become shareholders. That would be easier if, as President Barack Obama has proposed, and Mervyn King, governor of the Bank of England, has argued, a regulated institution has to produce a plan for an orderly wind-down of its activities.

Yet bank failures are like buses: you do not see one for hours and then a fleet arrives together. The authorities cannot make a credible promise that they would be prepared to put all affected institutions through bankruptcy in a systemic crisis. This would be a recipe for still-greater panics. “Too big and interconnected to fail” is a reality. It is so, because, as Andrew Haldane of the Bank of England pointed out in a recent speech, the financial system is an increasingly tight network.*

My colleague John Kay has argued that the right response is to create “narrow banks”, which are perfectly safe, leaving the rest of the financial system to go on its merry way, subject to a then-plausible threat of bankruptcy. I find this idea both attractive and unpersuasive. The attraction seems evident. It is unpersuasive in part because it is so hard to agree on what narrow banks should do. It is also unpersuasive because the narrower the banks are made to be, the more vital is the role of the rest of the financial system and so the less plausible it is that governments would let it collapse.

If institutions are too big and interconnected to fail, and no neat structural solution can be identified, alternatives must be found: much higher capital requirements and greater attention to liquidity are the obvious ones. At present, big financial institutions operate with next to no capital: in the US, the median leverage ratio of commercial banks was 35 to 1 in 2007; in Europe, it was 45 to 1 (see chart). As I noted last week, this makes it rational for shareholders to “go for broke”, with the results we have seen. Allowing institutions to be operated in the interests of shareholders, who supply just 3 per cent of their loanable funds, is insane. Trying to align the interests of management with those of shareholders is then even crazier. With their current capital structure, big financial institutions are a licence to gamble taxpayers’ money.

So how much capital makes sense for systemically significant institutions? “Much more than today” is the answer. Moreover, the required capital must also not be risk-weighted on the basis of banks’ models, which are not to be trusted. Shareholders’ funds should make up a minimum of 10 per cent of capital. In the US, it used to be far higher.

Higher capital is, in addition, a good way to internalise the negative “externalities” – more precisely, risks – created by one institution for the entire system. Ideally, therefore, the required capital should be correlated with the systemic significance of institutions, as the excellent new annual report from the Bank for International Settlements argues. Moreover, the requirement should be set against all activities, on the basis of fully consolidated accounts.

Within a far better capitalised financial system, it would also be relatively easy to operate a “macroprudential” regime, with the required capital rising during booms and falling during busts. Again, the bigger the stake of shareholders, the less one would worry if the rewards of managers were aligned with them. Even so, regulators have to have some sort of control on the incentives of management, as long as taxpayers bear residual risk.

Two difficulties remain: the transition; and regulatory arbitrage.

On the former, a demand for much higher capital ratios today would imperil the recovery. The answer is a lengthy transition, perhaps of as much as a decade. On the latter, it is evident that the so-called “shadow banking” system cannot be allowed to operate outside capital constraints if entities within it are likely to be systemically significant, as proved to be the case for money market funds. Moreover, capital ratios would have to be imposed by all significant countries. But the US is powerful enough to force movement in that direction by insisting that any foreign bank operating within it must be appropriately capitalised.

In sum, deleveraging is the right starting point for a healthier financial system. This would work best if we also eliminated today’s huge fiscal incentives for borrowing.

It is cautious incrementalism, not radicalism, that is now the risky option. Where should such radicalism start? The answer is clear: it is the incentives, stupid.

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  1. "DoctoRx"

    Nassim Taleb has been proposing since at least last year what Yves seems to be saying. He recommends banning ALL derivatives except plain vanilla options, especially CDS-type stuff; and having a basic, regulated/nationalized depository banking system to process checks and do utility-like stuff.

    Let the gamblers do whatever they want with enough regulation to be sure that no matter how large they are, they cannot bring down "the system" (whatever that actually is).

  2. attempter

    Martin Wolf says:
    “Too big and interconnected to fail” is a reality. It is so, because, as Andrew Haldane of the Bank of England pointed out in a recent speech, the financial system is an increasingly tight network.*.

    IOW, it is so because it is so.

    While a piece like this gives the simulation of wanting some kind of reform, it's really a version of supporting the status quo.

    Obviously if you assume, a priori, as corporatist dogma, that we must have a financialized globalist system, where casino gambling with entire economies is considered legitimate activity rather than capital crime, then you are going to claim to be stuck with Too Big To Fail casino banks, and an obvious reform like what Buiter called "Glass-Steagal on steroids", to which there is indeed nothing but a political obstacle, is going to seem unacceptable.

    As for a more reality-based system, to answer Wolf's question as to what "narrow" banks would do, how about this radical idea: take deposits and make loans.

  3. Bruce Krasting

    Say you ran a pension fund. You have lots of diversified assets in your portfolio. These assets have to pay your future obligations. In that mix you own $50mm of Ford bonds.

    Smart guy comes and says,"You are earning 200 over treasuries on the F paper, and it is illiquid. Sell the F bonds for cash and buy something else. Then write me a cds on $50mm Fords and I will pay you 205 over the curve.

    So the pension person has the same risk as before, gets a net better return for the same risk and has achieved liquidity in the portfolio that can be used for better purposes.

    So what is wrong with that? In this case CDS improves liquidity and diversifies risk. It is a 'good' thing.

    Which is more correct? 1) the blowup of 08 caused the collapse of the cds market or 2) the collapse of the CDS market caused the blowup of 08?

    I think 1.

  4. david4skeptic

    From FT:

    "Allowing institutions to be operated in the interests of shareholders, who supply just 3 per cent of their loanable funds, is insane."

    I agree with that, and more.
    But, at least in the US,
    the electorate seems too
    apathetic (no lobbyists)
    for real change to happen
    very soon. The financial
    problems aren't serious
    enough yet to rival
    Michael Jackson in
    public interest.

    David B.

  5. RTD

    It's absurd that money market funds, which essentially operate as banks, are not regulated as such. Now that the gov't is insuring their deposits, it's criminal to not regulate them as banks. Of course, the moment we start regulating them as such, they will no longer be able to offer higher returns than banks, and their reason for existence disappears. To that I say – good.

  6. Anonymous Jones

    Bruce —

    With all due respect, your statement, "net better return for the same risk" is false on its face. You have added another party to the deal, and counterparty risk has obviously risen. This is the main problem of interconnectedness and the supposed diversification of "risk." These products made everyone think they had eliminated risk. They hadn't. The risk was just hidden behind a complex network of derivatives too thick to see through. There is risk in life. Someone is going to be left holding the bag when certain bets don't turn out right. To not accept that there is risk and that all this financial machinery is just hiding it not eliminating it is to live in peril of a major collapse at any moment.

  7. Hugh

    Too big and interconnected is too big and interconnected to exist. Financial institutions are across the board insolvent if real evaluation of their assets and debts were done. This brings us back to nationalization and Glass-Steagall so that we could take them apart recreate the vanilla lending and deposit functions, segregate the good assets from the bad, nullify the truly stupid CDS and SIV stuff, and at the end of the day have some realistic idea of what the recapitalization costs of a reformed banking system would be.

    As an aside, CDSs serve no useful function in the real world. They are used to justify deals that on their own terms can't be justified. So it is with Bruce's example. I doubt that Bruce's credit rating is as solid as that of treasuries. In a general downturn like the meltdown, he can go broke whereas the treasury notes will still be there. So there is more risk from dealing with him than the US government. This is obvious I know but it is usually forgotten by those who seek to justify CDSs as a legitimate investment vehicle. CDSs are only less risky if the risk of a general downturn is ignored.

  8. dd

    Smart guy isn't so smart unless he has an executed credit support annex detailing the credit event triggers and required collateral. The pension fund has traded its legal position as creditor of Ford to that of contingent debtor of smart guy subject to collateral calls. So unless the pension plan is as smart as "smart guy" and has negotiated terms that replicate the default terms under the Ford bond, it ought pass as it could well take on far more risk (credit event triggers) than owning the bonds outright.

  9. dd

    Yes, there is the issue of the offset on "the buy something else" but that too has the same risk issues embedded in the Ford bond offering unless it's Treasuries and even then the curve must be considered (short or long end?)
    So Bruce, we need you to do the math and explain exactly how the pension plan comes out ahead other than it has more liquidity in the short term; something it does not lack at the moment and exactly how that liquidity is put to a "better use" in the current environment.

  10. Sai Duthaluru

    I have a comment on this statement : "Now if wealthy individuals want to go to the casino, or the markets, fine, but parties in the Other People's Money business need to be held to a much higher standard".

    It is not wealthy individuals but institutions, MFs, pension funds, 401Ks that invested for alpha and lost other peoples money.

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