If anyone had any doubts as to whether the Federal Reserve should assume the role of systemic risk regulator, a comment in the Financial Times by Board of Governors member Kevin Warsh, based on a speech he is to give later today, puts the matter firmly to rest. No matter how logically positioned a central bank may be to assume this job, Warsh’s remarks illustrate that the Fed has learned nothing from the crisis, and is still in the thrall of neoclassical economics ideology, which is blinding it to facts on the ground.
Warsh argues, incredibly, that industry structure is not a problem. Huh? We have an oligopoly of twenty firms or less that control the international debt markets that are critical to modern commerce. That is a major and thorny problem. Central bankers may not be prepared to admit that publicly, but I don’t think clever obfuscation is what what we are getting from Warsh.
This is the beginning of the critical part of his Financial Times comment:
We must resurrect market discipline as a complement to prudential supervision. Otherwise, the spectre of government support threatens to confuse price signals and create a class of institutions that operate under different rules of the game.
Yves here. This section alludes to the misguided faith in living wills as a solution. That “market discipline” can work ONLY IF the “connectedness” of firms is reduced. The repo market is nearly as large as the traditional banking system. Repos are a major way the major capital markets firms are enmeshed (repos typically provide around 50% of the financing of a broker-dealer). Credit default swaps are another mechanism that can produce cascading counterparty defaults. The derivatives “reform” bill will have only a small portion of credit default swaps clear centrally, only blunting rather than solving this problem.
And even that is less than ideal. Look at what happened at Lehman and Bear. Even though the net worths of the top echelon were diminished by their firms’ failures, they still made enormous amounts of money. Failure of their business does not leave key decision-makers impoverished. The old partnership model, where the owners were jointly and severally liable (meaning if the firm went broke, creditors could go after their personal assets) worked well. The industry’s love affair with risk dates from the mid-1980s, when all major investment banks save Goldman had become public companies (and Goldman’s business mix shifted radically towards trading after it went public in 1999). Back to Warsh:
First, stakeholders need better, more timely information about financial institutions.
Yves. Help me, this is Greenspan 2.0, the idea that market can remedy all ills (and he went on in this vein in the 1990s, that regulation should seek to produce the cost of capital that the markets would). How, pray tell, are “stakeholders” going to enforce “market discipline” on systemically important firms? They can’t even discipline the management of garden variety public companies, witness burgeoning CEO pay. We hae a massive governance problem with public companies: liquid, anonymous markets for shares create two very bad side effects. First, it is extremely costly and difficult to pressure management (and worse, they get to spend the company’s money fighting you). It’s much easier simply to sell your shares, which is what most unhappy investors do. And mere share sales rarely exert much pressure. And with average holding periods for stocks well under a year, can most shareholders rightly be considered investors?
SecondMoreover, even if shareholders did want to act like investors, public disclosure is inherently deficient, and more so in financial services than in most fields of enterprise. A company simply cannot disclose competitively sensitive information, like the success of its R&D initiatives, planned acquisitions or product development.
And what would “stakeholders” need to make intelligent decisions about a financial firm, so as to impose “market discipline”? They’d need to know how risky it was. To determine that, they’d need to have access to its trading positions on a pretty real time basis. That also just happens to be the very most competitively sensitive information a leveraged, active trading operation possesses. So Warsh’s “market discipline by stakeholders” construct is unadulterated garbage.
But it gets worse:
Second, reforms must encourage robust competition. Smaller, dynamic companies, properly supervised, should be able to take market share. This is the way to level the playing field, far better than bullying or co-opting the largest, most interconnected institutions. But this won’t happen if policy divides those that are too big to fail from those that are not. It won’t happen if select incumbents have permanent funding advantages. And it won’t happen if policy preferences deter would-be competitors from taking on the big guys.
Yves here. Does Warsh know absolutely nothing about this industry? Look at the history over the last 25 years. Smaller, dynamic companies have NOT taken market share. The only ones that have gained ground on traditional investment banks were behemoth commercial banks who used their balance sheets and the fact that they had some experience in trading (admittedly plain vanilla product like foreign exchange, but at least it was a place to start). It took JP Morgan and Citbank more than a decade to make meaningful headway (and if you went from when they started those initiatives, in the early 1990s, and did an NPV from then to now, I bet it’s still not very pretty. Five or ten years of investment with no meaningful payoff is not an attractive proposition). Some banks made faster progress in the 1990s by getting in at close to the ground floor in the derivatives business, which favored players with large balance sheets.
Even as of 1985, the story of capital markets businesses was simple: huge barrier to entry. You need to be able to trade positions in the Pacific, European, and US time zones. You need a high minimum level of infrastructure, which includes solid risk management tools (well as solid as they get…..). You need a lot of capital. You need to be an attractive enough platform to attract and retain “talent” (I hate that word, it is not “talent” per se, but staff with very narrow skills that are well nigh impossible for outsiders to acquire).
And scale and integration is an issue in these businesses. Look at the fate of Lehman. It fit the profile of a smaller, dynamic player. Its dynamism led it to focus narrowly on an area where it thought it could be competitive, real estate, in the hope it could have higher returns and grow its way into being better able to compete with the industry leaders. We know how that movie ended.
You need 100% of the minimum infrastructure to be competitive in these businesses. That infrastructure has high fixed costs. It is pretty hard to be half pregnant. If you only have 50% or 60% of the transaction volume of the leading firms, you have inferior economics. You have to be satisfied with earning a lot less than the big dogs, or push into riskier businesses to try to improve returns. Or maybe you get lucky and get in on the ground floor of a new business area, but “innovations” are so transparent in this industry, it isn’t realistic to think you can preserve a first or early mover advantage (indeed, Goldman historically did well by being a fast copier rather than an innovator).
And consider further: these businesses are so large that all the incumbents are public. In the old days, when commercial banks fought their way up the industry food chain, investors would tolerate the long and seemingly futile investments. No one has those time horizons any more.
Back to Warsh:
Third, it is up to financial institutions to demonstrate that they can fail without a need for extraordinary government support. Simplifying corporate forms and structures so companies can quickly be unwound, particularly across borders, would be a welcome development. In a global economy, big is not bad. But greater dispersion of assets and liabilities demands unprecedented international co-operation. Policy co-ordination with other major countries is needed.
Yves here. Huh? Yes, Lehman’s 100+ legal entities were a bit de trop, but any bank or securities firm is going to need local licenses and local corporate entities, at a minimum, one would assume one per country in which it has a securities or banking license. And there may be valid reasons (aside from tax optimization) to have more than one per county.
Bankruptcy is a profoundly local affair. Warsh’s turn of phrase, ” up to financial institutions to demonstrate that they can fail without a need for extraordinary government support” is very peculiar. How does someone “prove” that? Harvey Miller, the most highly respected bankruptcy lawyer in the US, per Andrew Ross Sorkin’s account, said it would take two weeks to prepare a (proper) US bankruptcy filing for Lehman. Bear went down in a mere ten days. How much of a BK filing is generic versus needs to be updated is beyond me, but the need for two weeks suggests you need a fair bit of reasonably current information. And Miller specifically stated:
I’ve been a trustee of broker-dealers, little cases, and the effect of their bankruptcies on the market was significant. Here you want to take one of the largest financial companies, one of the biggest issuers of commercial paper, and put it in bankruptcy in a situation where this has never happened before. What you are going to do now is take liquidity from the markets. The markets will collapse. This will be Armageddon.
Yves here. Miller had the clearest view of what would happen. He was not even consulted before the Lehman BK. There is not much evidence from Warsh’s remarks that he or anyone at the Fed has talked to lawyers in the US or other jurisdictions to see if its streamlining idea buys as much benefit as the Fed believes it will.
Warsh’s remarks seem to be politically driven. Bear was bailed out, and there was a huge hue and cry afterwards. Freddie and Fannie were put into conservatorship, which led to more complaints about rescues. So the Bush administration needed to prove its cojones, that it was willing to let someone go bust, and Lehman, which was not as big a credit default swaps market participant as Bear, was deemed dispensable. That proved to be a mistake, at a minimum in the way it was executed. So then we’ve had a reaction against that, a “No More Lehmans” policy.
But the public is still very unhappy about bailouts. So since rescues are now looking unacceptable, the powers that be now want to be able to allow big firms to fail. But this seems implausible without the very structural reform that Warsh dismisses. For one, Citi, with its massive foreign deposits, will not be allowed to go bust, so unless that wee problem is addressed, we already have a rather large exception to this living wills policy (even if Citi is made to go through the motions like everyone else).
The real question is, the next time a big US firm goes asunder (which it will, the cheap liquidity the Fed is providing in combination with a lack of meaningful checks on risk-taking guarantees it at some point) will the Fed and Treasury feel compelled to test these living wills in a crisis or will they cobble together a rescue? Warsh’s remarks leave me convinced that the odds are high that whatever the decision is, it will be made to prove the wisdom of past Fed conduct, and will therefore be the wrong one.