Yves here. Steve Waldman wrote a definitive post in 2009, Capital can’t be measured, on a core issue that Black discusses here. A key section:
So, for large complex financials, capital cannot be measured precisely enough to distinguish conservatively solvent from insolvent banks, and capital positions are always optimistically padded. Given these facts, and I think they are facts, even “hard” capital and leverage restraints are unlikely to prevent misbehavior. Can anything be done about this? Are we doomed to some post-modern quantum mechanical nightmare wherein “Schrödinger’s Banks” are simultaneously alive and dead until some politically-shaped measurement by a regulator forces a collapse of the superposition of states into hunky-doriness?
Yes, we are doomed, unless and until we simplify the structure of the banks. When I say stuff like “confidence intervals surrounding measures of bank capital are greater than 100%”, what does that even mean? Capital does not exist in the world. It is not accessible to the senses. When we claim a bank or any other firm has so much “capital” we are modeling its assets and liabilities and contingent positions and coming up with a number. Unfortunately, there is not one uniquely “true” model of bank capital. Even hewing to GAAP and all regulatory requirements, thousands of estimates and arbitrary choices must be made to compute the capital position of a modern bank. There is a broad, multidimensional “space” of defensible models by which capital might be computed. When we “measure” capital, we select a model and then compute. If we were to randomly select among potential models (even weighted by regulatory acceptability, so that a compliant model is much more likely than an iffy one), we would generate a probability distribution of capital values. That distribution would be very broad, so that for large, complex banks negative values would be moderately probable, as would the highly positive values that actually get reported. If we want to make capital measurable in any practical sense, we have to dramatically narrow the range of models, so that all compliant models produce values tightly clumped around the number we’ll call capital. But every customized derivative, nontraded asset, or unusual liability in a bank’s capital structure requires modeling. The interaction between a bank holding company and its subsidiaries requires multiple modeling choices, especially when those subsidiaries have crossholdings. A wide variety of contingent liabilities — of holding companies directly, of subsidiaries, of affiliated or spun-off entities like SIVs and securitizations — all require modeling choices. Given the heterogeneity of real-world arrangements, no “one-size-fits-all” model can be legislated or regulated to ensure a consistent capital measure. We cannot have both free-form, “innovative” banks and meaningful measures of regulatory capital. If we want to base a regulatory scheme on formal capital measures, we’ll need to circumscribe the structure and composition of banks so that they can only carry positions and relationships for which we have standard regulatory models. “Banks’ internal risk models” or “internal valuations of Level 3 assets” don’t cut it. They are gateways to regulatory postmodernism.
By Bill Black, the author of The Best Way to Rob a Bank is to Own One and an associate professor of economics and law at the University of Missouri-Kansas City. Jointly published with New Economic Perspectives
Representative Jeb Hensarling, Chair of the House Financial Services Committee has announced that he will introduce a Republican plan to repeal key provisions of the Dodd-Frank Act and replace them with “market-based” regulation. I have explained in a prior column how theoclassical economists, for over 40 years, have created repeated criminogenic environments in finance due to their unholy ideological war against effective financial regulation. The dominant policy view among economists and senior anti-regulatory policy advisers of every administration since President Carter embraced the myth that economists had invented means by which the “markets” will effectively “regulate” finance.
The reality is, first, that what they falsely call “market” “forces” are what creates the perverse incentives that cause our recurrent, intensifying crises. Second, their “market” regulation makes those incentives even more perverse. Third, the theoclassical myths and anti-regulatory policies generate regulatory complacency based on the myth that the problem of those perverse incentives has been vanquished by “incentive compatible” regulation.
It is ironic that economists’ proudest boast is that have unique insights and predictive abilities because of their understanding of the incentive of self-interest. They brag that they have been taught to “think like economists” and understand that self-interested behavior is ubiquitous. As we have all observed, they are actually so supremely bad at understanding how perverse the incentives they worship are in the real world that their predictive record is abysmal – and getting worse.
The most famous (to nerds) policies arising from this myth are requiring banks to issue subordinated debt – and allowing them to treat this debt as “equity.” Theoclassical theory predicted that the purchasers of bank subordinated debt were the ideal source of “market discipline.” The purchasers of bank sub debt are lenders to the banks who contractually agree (in return for a higher nominal interest rate) that if the bank is liquidated through bankruptcy or a receivership the lender will not be repaid until after all secured and general creditors are paid in full. As a practical matter, this means that sub debt holders are almost certain to be wiped out if the bank is liquidated. That fact is supposed to ensure that the sub debt holders will have the proper financial incentives to be zealous in preventing any actions by management that could endanger the bank’s health. Bank sub debt is also sold in minimum denominations of $10,000, is typically purchased by lenders in blocks of over $1 million (often tens of millions of dollars), and is typically purchased by lenders that would be considered highly financially sophisticated. Together, this means that theoclassical economists predicted that sub debt holders would combine the proper financial incentives to provide the ideal “private market discipline” because subordination of their loans to the banks meant that they were exposed to very large risk of loss and because they had enough money at risk (“skin in the game”) that it was worthwhile for them to spend the money necessary to conduct effective “due diligence” and determine the bank’s true financial condition. The sub debt holders’ characteristic high financial sophistication meant that high ability to conduct effective due diligence was married to the proper incentives.
But there is a more subtle advantage that is supposed to be unique to “private market discipline” – it is not subject to the due process and equal protection clauses of federal and state constitutions. Potential sub debt holders do not need to have any basis for refusing to buy a bank’s debt. Once they have bought the debt they do not need to have any basis for refusing to renew the sub debt. They can insist on any “debt covenants” they wish before purchasing or renewing their sub debt. They can exercise those debt covenants without any procedural requirements that slow down regulatory actions.
There was only one problem with sub debt – it never worked as predicted by the theoclassical economists. There was never, anywhere in the world, an effective case of private market discipline by bank sub debt holders. As George Akerlof and Paul Romer noted in their 1993 article “Looting: The Economic Underworld of Bankruptcy for Profit,” sub debt was typically “covenant lite” rather than stringent. The theoclassical theory predicted that sub debt should have particularly stringent covenants and that they would be enforced zealously.
The universal failure of their sub debt predictions, of course, did not cause theoclasscial economists to admit error. Instead, they developed “incentive compatible” “risk-based” Basel II capital standards. These standards were preposterous and failed even more spectacularly than sub debt.
The newest theoclassical variant on “market” regulation is Hensarling’s Republican plan. This variant relies on the myth that “capital” is a thing of great value sitting in a bank’s vaults that can easily be measured and that all we have to do is require higher capital requirements and banks will not fail or at least will fail at no or minimal cost to the public. To believe this myth one need only be ignorant of accounting, finance, and regulation.
First, capital is merely an accounting residual. Assets – Liabilities = Capital. This means that if assets are overstated or liabilities are understated (or both) capital will be overstated. Second, the way “accounting control fraud” works is to massively overstate asset values. As Akerlof and Romer explained:
We begin with a point about accounting rules that is so obvious that it would not be worth stating had it not been so widely neglected in discussions of the crisis in the savings and loan industry. If net worth is inflated … incentives for looting will be created.
Yes, the point was “obvious” 23 years ago before a Nobel Laureate in Economics (Akerlof) put it in print in a famous article. By the end of 1993, we, the S&L regulators, had been putting the point to practical use for a decade as the core of our crackdown on the fraudsters. Indeed, we prioritized the S&Ls reporting the highest profits for investigation and closure. Akerlof and Romer’s article is one of the first things any Representative should read upon being named to the House Financial Services Committee. The Chair should be among the last people in the world to propose relying on capital to create effective private market discipline. But my readers know that Hensarling has never and will never read the relevant economics and criminology literature.
Third, it is epidemics of accounting control fraud that have driven our three modern financial crises – the savings and loan debacle, the Enron-era frauds, and the most recent financial crisis. Hensarling’s plan assumes that the banks’ reported capital is real rather than the product of fraud.
Similarly, “income” is merely an accounting residual. If the bank overstates revenue or understates expenses and losses, its income can be massively inflated. Charles Keating’s Lincoln Savings, for example, reported that it was the most profitable S&L in America when it was actually the suffering the worst losses of any S&L. Jamie Diamond, JPMorgan’s CEO, made this point in his March 30, 2012 letter to shareholders.
Low-quality revenue is easy to produce, particularly in financial services. Poorly underwritten loans represent [fictional] income today and losses tomorrow.
Hensarling however, is peddling not only the myth of “market” regulation but also the myth that capital regulation and accounting can be made “simple.”
The Republicans’ better approach will relieve financial institutions from regulations that create more burden than benefit in exchange for meeting higher, yet simple, capital requirements.
If he believes his words quoted above, then Hensarling has demonstrated to the world that he does not understand even the most basic aspects of banking. Let me be clear. Higher capital requirements are a good idea. The claim that such capital levels would be “too expensive” is bad economics. The idea that there should be a strong minimum capital requirement as a percentage of total liabilities rather than a more complex risk-weighted standard is also a good idea. The idea that a high capital requirement creates effective “market” regulation and obviates the need for vigorous real examination and regulation is a dangerous myth that would create the future criminogenic environments that would ensure future massive crises.
Keep in mind that Trump is getting behind Hensarling 100%. You want Hensarling? Vote Trump.
Thanks for reminding us that we can vote for Evil behind door #1, or Evil behind door #2.
Very bad headline if you ask me.
It’s clear by looking at Hensarling’s Bio that he has the inteligence, education and experience to understand the issues at hand, if he wasn’t a committed minion of the neoliberal cult;
I think it’s clear that the problem with Hensarling is not that he doesn’t understand banking, the problem with Hensarling is that he doesn’t care a wit about the interests of little people, because they don’t contribute a lot of money towards his re-election.
The trouble with Hensarling is that he does exactly what he is told by the people who give him a lot of money.
The trouble with Hensarling is the trouble with most of our political class, they are bought and paid for by the .1%, and the rest of us just don’t count.
actually he seems to be acting exactly as Gramm would have. he had been the one to push to remove the separation of banks and wall street. that made the 2008 debacle so much. worse. so just like his mentor he wants to create a new debacle again. i remember when he first ran for office, all he did was say he was a conservative. wonder if he realizes how his efforts just might end capitalism in the US?
In a sense, it’s worse than that–Hensarling is basically running unopposed. The only other candidate running for the Texas 5th district is a one Ken Ashby of the Libertarian Party. I have been unable to find any contact info or website for Ashby, which tells me he’s not even interested in running a real campaign.
Hensarling doesn’t care about the little people not because they don’t donate to him, but because they don’t even have a choice.
Ah, Jeb Henarling. A man dear to my heart, for reasons I’ll explain, and which even touch on his understanding of markets.
It is September 2008, the week after Lehman’s bankruptcy, and the House is voting on the emergency Treasury bailout bill. I am watching on C-Span on my computer in a crappy little studio apartment in Mountain View, CA, where I had been for several months trying to raise VC for my latest startup. I’ve been getting margin calls for the past month on my holding of Cisco stock, against which I had borrowed for several years to fund my startup to that point. I know that if the market continues to collapse I’ll be wiped out in short order. In fact, I even had a chart, of how much the margin calls would be depending on how far Cisco fell, how many shares my broker would liquidate, the amount of income tax I’d owe that I couldn’t pay, etc.
But back to Jeb. About five minutes into the vote (IIRC) it’s obvious that something is going wrong. After an initial wave of Dems voting Yes and a mixed split of Repugs voting Yes and No, voting has taken a darker turn and the Repugs are voting en masse against their own leadership (Boehner) and President. Pelosi realizes that Boehner can’t deliver the fraction of his caucus that he’d promised and she signals to the Dems that she won’t ask them fall on their swords to save the financial system if the Republicans won’t provide enough votes to give her cover. Suddenly the No votes start to pile up, and quickly exceed the Yes votes. C-SPAN has set up a split screen here: on the left is a camera shot of the well of the House, with the running vote total underneath. On the right is the DJIA in real time. As the vote starts, the DJIA is showing signs of recovery, and is up several hundred. But as soon as Yes momentum starts to ebb the DJIA starts to go off a cliff. Vertiginous about sums it up.
Now it’s about two minutes to go on the vote but there’s no salvaging the bill. The No’s are over 218. The camera shot of the House floor show a few of the “No” floor leaders celebrating, among whom is Jeb Hensarling dancing a little Texas jig, complete with cowboy boots (black with red accents, IIRC). With 1 minute to go Steny Hoyer, the Democratic Majority Leader comes out of the Democratic cloakroom, where he’s been looking at the reaction of Wall Street to the imminent failure of the rescue bill. He walks to the podium, grasps the lecturn with both hands, and in an appeal for sanity and for colleagues to reverse their ill-considered No votes, warns that the Dow is down 500 at that point and falling fast. It’s a futile appeal. The bill is doomed, and Jeb Hensarling just continues to dance his little jig.
So I know Jeb Hensarling. As I sat there watching this unfold in real-time, running the numbers in my mind on my margin exposure, I swore that if anyone ever shot him, I’d contribute to their legal defense fund. The offer is still open, btw, for any comers. And the consequences for Jeb of all this? When the Repugs took over the House again in 2010, Boehner made him chairman of the House Financial Services Committee. And if anyone does shoot ol’ Jeb, I hope they bury him in the same pair of stupid fu&*ing black cowboy boots with red accents.
Just had to share that.
Sad part is, IIRC, about a day later they did pass that bill – after the Dow had swooned. I suspect you were not alone. BTW – I am no lawyer, but your offer to pay for a killer’s defense may be illegal. I get the sentiment, but consider your words riskier than borrowing against Cisco stock. Beware.
yes, you may be right. that’s why i didn’t offer to pay for the bullet ;-) but i appreciate the admonition – i’m too old to be saying incautious things, especially on the interwebs.
I wonder how many of them had shorted the market, then closed their positions and turned around and voted to pass the same bill a few days later.
Cantor at the front of the line.
The worst part of this suggestion is that since the House and Senate both have repeatedly refused to apply “insider trading” restrictions to themselves, under both Democrat and Repug regimes, it would have been completely legal for them to do so.
– regulatory postmodernism
Search came up with more positives than I would’ve thought.
But what if you take the proposal but say a 25% capital level i.e. 3 to 1 leverage as a max.
As a Texan who started out as a dyed in the wool Republican, I’ve come to realize that Texas is Wonderland. The S&L crisis hit us hard, but since that time, the economy of Texas has been better than most if not all of the rest of the U.S. When the rest of the U.S. was suffering the 2007-2008 financial crisis, things in Texas were only mildly depressed. Since then, we have been on an economic wave.
Texas is ‘bidness friendly’ and regulation light. I’m sure Hensarling sees Texas as a great model for the U.S., which explains why his bill looks like it was written by ignoramuses.
In practice, Texas is the poster child for corruption , fraud and market incentivized theft. We are business friendly by overlooking (applauding?) lawlessness. Of course businesses love to come here – they can conduct corrupt schemes without the slightest fear of a regulator trying to stop them.
Before too much longer, the jig is going to be up. I have no doubt that the next crash will hit us hard –
When the s hits the fan, I wonder if Hensarling will realize that Texas is only a good short term model, which extracts a steep price in the long term.
I believe David Stockman has it just about right.
Offering a link to Bloomberg’s interview of Hensarling pimping his bill.
So bizarre. Thankfully, McKee pushed back on Hensarling’s bizarre statement that “we were told that Dodd Frank would lift the economy. . .”
McKee: “That one’s new to me, I’d never heard it would lift the economy, I heard it would make us safer.” Hensarling held on like an 5 year old being told there’s no Santa Claus. The rest of his statements in the interview were equally bizarre.
It baffles me that partisan politics is so vital to him that he would welcome a repeat of the 2007 Financial Crisis just to score some shade against the Obama administration.
In a separate interview with a more sentient guest it was pointed out that the bill had no chance and would be vetoed on it’s own, but there’s a chance it could get attached to appropriation bills. God help us if it does.