I’m surprised the little conundrum has not dawned on the officialdom sooner.
Any return to safer practices means less leverage and less freely available credit. Less freely available credit, short term and maybe even intermediate term, means less rapid growth (with a binge as big as we had, the drying-out will take time), although it will presumably mean a more sustainable rate of growth. But policy makers think the economy has a God-given right to growth, and more is better.
Now I actually think that intellectually, a lot of people do recognize the first set of conflicts intellectually, but emotionally, they do not want to make the choice. It’s the modern version of St. Augustine’s plea, “Lord, give me chastity, but not just yet.” And as a piece by Gillian Tett in the Financial Times illustrates, some of the interconnections may not be obvious to those trying to rewrite the rules:
But as the political jostling – and lobbying gathers place – the more important sector to watch might yet be the securitisation world. To most non-bankers, the word “proprietary trading” conjures up images of sharp-fanged bankers or hedge funds darting between assets, eager to make a quick buck.
However, in practice the big concerns of global regulators may lie elsewhere. After all, what blew the really big holes in the balance sheet of banks such as Citi, Merrill Lynch and UBS back in 2007 and 2008 was the fact that these banks had all taken huge quantities of so-called “super senior collateralised debt obligations” (or supposedly safe mortgage assets) onto their trading books.
While those trading books were supposed to be used for short-term deals (including “proprietary activity”), in practice those CDO assets were held for a long time, using the bank’s own capital.
This move was driven partly by necessity (the banks could not flog the super-senior assets anywhere else). However, another crucial issue was that Basel capital rules allowed banks to hold these items in their “trading book” with virtually no reserves, whereas provisions would have been demanded had these instruments been placed in the normal banking book.
So, in light of that, international regulators linked to the Basel committees are eager to dramatically tighten trading book rules, to force banks to hold more capital. And this might yet give a new twist to Volcker’s plans. Most notably, if the Obama threat to clamp-down on “proprietary trading” can be redefined as an attack on the abuse of the “trading book”, then groups such as the Basel committee will almost certainly lend their support. And if the debate does then move into that redefinition of “proprietary trading” then the banks will find it hard to fight back.
That will undoubtedly please some US politicians. However, there is one catch. One key reason why credit was so cheap in the early years of this decade was that banks were pumping out CDOs. And a central factor behind that was that it was cheap – and easy – to produce CDOs when banks kept burying the super-senior debt on their own books, or with entities such as AIG.
Yves here. The short form of what Tett said is CDOs are bad news (that may seem like an overly broad conclusion, but my book takes you through their destructive uses). The FDIC’s proposed rules on securitization would ban “resecuritizations” which would include CDOs whose elements were tranches from other bonds. But that was one of the major raisons d’etre of CDOs was to bundle up the bits of securitizations that investors did not want, structure the cash flows again, and sell the various pieces. So not having an outlet for the unwanted tranches would constrain the securitization process and make less credit available
A second set of conundrums may be operative as well. Our economic and financial model of the last 30 years, that of a high degree of international trade and robust cross border capital flows, may be inherently unstable. There are three factors that suggest why.
The first is empirical: large cross border capital flows are associated with bigger and more frequent financial crises. Correlation is admittedly not causation, but that conclusion emerges resoundingly from Carmen Reinhart and Kenneth Rogoff’s work on financial crises. Similarly, the post war period through the mid-1970s, which was notably free of major incidents, was one of capital controls and less trade than now.
The second is that we have a defect in our current currency arrangements, similar to one that plagued the gold standard. Countries that run sustained trade deficits are punished via deflationary adjustments. But there are no mechanisms from discouraging countries from running sustained surpluses, particularly by pegging their currencies too cheaply. France accumulated large gold reserves in the runup to the Great Depression in just this fashion, as China and the Asian tigers have accumulated large foreign exchange reserves in our day. While it is easy to blame the profligate borrower, it takes two to tango.
The third is that it may prove impossible to have an effective international regulation for capital markets firms. As a second Financial Times piece, on Obama’s plans to increase capital ratios, indicates, some of the measures the US would like to implement do not sit well with European banks:
If the much-debated “Volcker rule” that would ban deposit-taking banks from proprietary trading is not approved, the Federal Reserve and other bank regulators could be asked to fine-tune capital requirements to make risky activity more expensive.
However, at the Group of Seven meeting in Canada earlier this month finance ministers complained to Tim Geithner, the US Treasury secretary, about the rule, unveiled a month ago by Paul Volcker, the veteran former Fed chairman.
“We can’t just transpose or copy ideas proposed by Obama to the European continent,” Michel Barnier, the European commissioner, told a press conference this week.
Dominique Strauss-Kahn, writing in the Financial Times yesterday, complained of “locally reasonable but globally myopic initiatives” and argued that global regulators needed to work more closely to form a co-ordinated approach.
Another impediment to effective international regulation is Dani Rodrik’s policy trilemma: that nation-states would have to cede too much authority to an international regulator. Now there could be some half-way houses on some issues, although it isn’t at all clear how to make transitions even on narrow issues.
So that means if the authorities do not find a way to reduce the high degree of interconnectedness in our financial system, another big blowup in the not-too-distant future is likely. And as the Depression did, that may force a reversion to institutions that are national in scope. Again from the FT, quoting Dominique Strauss-Kahn:
“If banks have to lock up pools of liquidity in every national jurisdiction, their capacity for intermediating capital across borders could fall, and their charges for doing so rise, to the detriment of the world economy,” he said.
Yves here. It would be better if I were wrong, but it may be that intermediating capital across borders with insufficient checks is indeed part of the problem. If so, then policy makers are faced with the sort of choice they hate, namely, among unattractive options, where the best is the least bad. There may be no way to have large, fairly unfettered cross border capital flows and financial stability. While greater growth looks enticing in the short term, the political and social costs of the periodic blow-ups now look too high relative to the apparent gains.