Of Marx and Smith and Mice and Maddoffs

If we lived in a perfect world of either perfect market capitalism or perfect government planning, there’s a lot of things that wouldn’t exist. There would be no corruption, no hidden information, no excesses or shortages, and absolutely no need for banks, insurance companies, and stock, real estate, or insurance brokers. That’s right. The entire FIRE lobby wouldn’t exist. Not only would we not need lobbyists, but we wouldn’t need the industries they represent. The Financial Markets exist because we don’t have any perfectly beneficent centrally planned governments or any form of real capitalism with perfect markets. They can’t exist. They are theoretical models period.

We have blended economies. They’re mishmashes of government intervention and mess-ups and failing markets and limping-along-as-best-they-can-markets. Nearly every economic transaction in the real world is fraught with some kind of chance for a misfire. You hire a real estate broker who you hope you can trust to guide you through the treacherous process of buying and selling the biggest asset most folks will ever have. You don’t know what’s a fair price, you don’t know where the buyers or sellers are and if either are honest or hiding The Money Pit from you, and you certainly don’t know who is a good or bad mortgage loan lender and lawyer to help ensure that you get a loan and a title free of bad encumbrances. That process is the same when you have a baby and you need a doctor and a hospital and you trust your insurance company to get a good deal for you. It’s the same when you look to save up for your pension or your kid’s college. The entire FIRE industry is there to help you navigate a bunch of imperfect markets with a lot of imperfect information. They’re supposed to be the experts who will help you navigate moral hazard and hidden information for you.

Except when they don’t.

Then, their government regulators are there to protect you and them from the bad eggs in the business. No one should be protected from their own stupidity, but these markets are so fraught with hazards and problems, that anything can happen. Bernie Maddoffs happen despite everything. So, do Goldman Sachs’ untoward influence in the NY Fed and the Treasury and financial panics. The key to these markets is middle-path economics. Yes, I’m a Buddhist and a Financial economist so I have to use the don’t tune the string too tight or it breaks, or tune the string to loose or it won’t play metaphor. It’s a balancing act. The financial markets play a unique role in a mixed market economy. The way we treat them must be unique also.

I got drug back from the bliss of the first few days of spring break where the last thing I should be thinking about is the financial markets (not teaching) but the only thing I should be thinking about is the financial markets (researching) by an email by the petulant clown. Did I want to handle or look at the discussion here? It’s a thread at FDL started out with a nod to the WAPO editorial here by Simon Johnson and James Kwak then a retort at the NYT by Paul Krugman here. The central question is financial reform. The specific question is should we break up big banks? Johnson and Kwak join ex-Fed Chair Volcker and say yes. Krugman says no, just toughen their regulation. My bottom line is all of the above. Break them up AND toughen the regulation.

I got into banking the year the MCA was passed which was the first stab at the heart of the old new deal banking laws and Volcker was Fed Chair. I worked for a commercial bank and for a huge savings and loan. I later worked for the FED. You know I teach this stuff now and, of course, research it. There were several reasons for breaking down the old laws set up directly as a result of the bank failures of the 1930s. The first was that the U.S. banks were losing competitive ground around the world to huge Japanese banks. So, just as back then we were worried about losing the car industry and other industries to Japan, we were looking for ways to compete with big Japanese Banks. The answer was to let our big banks get bigger. You had to be bigger to compete globally or so they thought.

There was a second reason for messing around with the banking laws other than it was the start of the Reagan/Greenspan/Gramm years where they mistakenly thought we’d have anything remotely resembling real market capitalism with the same ideological fury that Trotsky/Che/Castro thought we’d actually see a real communist state. It was the invention of the money market fund. Money Market Accounts were draining savings deposits out of traditional banks and savings and loans. Depository institutes were hemorrhaging deposits.

Under the depression laws, banking was simple. You had balance sheet and income statement formulas, essentially. You were allowed to take in certain kinds of deposits upon which you held insurance and paid stated rates of interest set up for you. Then you were allowed to invest in certain kinds of securities and make certain kinds of loans. The prudence of your underwriting standards were judged by auditors at the state and federal level quarterly. You estimated what you thought your loan losses would be (based mostly on looking back at past data) and held some of that in a loan loss reserve. You put some of your cash in the vault and some at the FED or a big bank depending on who chartered you (the feds or your state). I lived in Nebraska where banks were also limited to one main bank and one branch. They eventually invented ATMS to get around that. Thrifts could branch. (Oh, I forgot to add that you played Golf in the ABA league with FED Folks and other Bankers on Wednesday afternoons.) Every day at a certain time, you balanced your balance sheet, sent it to the Fed and they checked the formulas. (I’ve been on both sides of that dance, I know it well.)

All that worked really nifty until we got tremendous inflation and interest rates needed to go up to cover the costs of that and they couldn’t by law. When brokerage firms introduced high paying Money Market Mutual funds (MMAs) which didn’t have to follow the same formulas as the banks (and didn’t have the same guarantees of insurance), the formulas quit working. Every one still wanted to borrow for their homes and cars at low rates of interest and every one wanted high rates of return from the funds. Depositors were told the MMAs were mostly safe but not insured and many depositors switched to being ‘investors’.

The biggest difference between the ‘shadow banking’ system and the banking system that most folks deal with is the fiduciary responsibility. Banks take deposits and in a fractional banking system, they create more money with those deposits. They now have the FDIC or another guarantor that will insure a good deal of their depositors. In return, they must be prudent with their lending and are restricted on where they place their investments. They also hold their required reserves and must keep a reasonable reserve for loan losses. The Shadow banking industry takes in investments with no guarantee that they will return a dime to their customers. They can invest in some wildly risky assets. They just have to be upfront and tell their customers what they’re getting into via a prospectus of some kind. They are somewhat ‘insured’ through side bets and hedging activities. These are counter investment strategies meant to manage the risk. Some of these markets are not regulated and are very thin. The SEC makes sure they’re not lying on the prospectus and that they don’t trade on inside information.

Owners of bank capital and owners of shadow bank capital still have residual rights to assets upon any liquidation of the institutions. The only real difference here is that a huge portion of the liabilities for banks are completely guaranteed by depositor insurance so bank owners have a better chance of seeing a portion of their equity back upon a bank failure. Also, most banks don’t really fail. They are married off to bigger banks. Owners of financial institutions that don’t rely on deposits don’t have that safety net. All of their investment depends on the payoffs of the assets in liquidation in bankruptcy court. They are, of course, secondary or tertiary to the interests of the holders of bonds and hybrid capital like preferred stock, etc. It’s not the same game at all.

This is the way that the old post Depression banking laws were supposed to protect the banking system and the banks. The banking system was supposed to not collapse because a huge portion of deposit institutions’ liabilities were guaranteed by folks like the FSLIC or FDIC. Savers were protected. Speculators were on their own. That was until the recent bailouts. You can see the differences in the shut down of LTCM in 2000 and the Lehman Brothers shut down in 2008 and everything post-Lehman. Many of the shadow financial institutions have been brought into the banking system regulated the FED. They now have to answer to the FED, the SEC, and whatever state regulator they usually deal with. Should they take in deposits, they go under the banking laws and the purview of the FDIC. The best deal they got is they now get to borrow at the discount window and they can pledge and sell the FED their crappy assets.

When banks go under or look shaky, the FDIC and the FED arrange for them to merge into other banks. One of the reasons that we have seen increased concentration since the 1980s is that many failed thrifts were either reborn as banks or they were merged into banks throughout the 1980s. This strategy is still used. J.P. Morgan was forced into several shotgun marriages. Wells Fargo had some arranged marriages too. The problem with these things is that it dilutes the capital position of the bank, so the Fed usually has to provide a pretty big dowry or allow the bank to live with a poor capital position until the stronger bank can fully absorb the bad loans and investments of the insolvent bank. They’ve basically done this to the point where they’ve weakened a lot of big banks.

But remember, since banks take on deposits and deposits are mostly insured, the dilution of capital isn’t as bad as when you marry a defunct brokerage firm with an investment bank. Again, the sources of the liabilities and the placement of assets is strategic with financial institutions because they make money on spreads or arbitrage. The savings and loans had problems because their assets were mismatched. They had thirty year mortgage loans as assets that repriced maybe every 5 years in the early 1980s. They usually brought in about 5 – 6 %. Prior the the 1980s, they were matched against savings accounts which paid less. After they were allowed to do certificates of deposits based on money markets, the liabilities were paying market rates of interest of maybe 11 – 12 % and these things were repricing upwards every six months. The losses became astronomical. Believe me, I was trying to stop the hemorrhage of the biggest one in the center of the country around 1982. It wasn’t possible and I had the unpleasant duty of telling every one that bankruptcy and liquidation was inevitable. It wasn’t fun at all.

Okay, hopefully, that’s some “bankground”. Here’s Krugman’s argument.

Breaking up big banks wouldn’t really solve our problems, because it’s perfectly possible to have a financial crisis that mainly takes the form of a run on smaller institutions. In fact, that’s precisely what happened in the 1930s, when most of the banks that collapsed were relatively small — small enough that the Federal Reserve believed that it was O.K. to let them fail. As it turned out, the Fed was dead wrong: the wave of small-bank failures was a catastrophe for the wider economy.

The same would be true today. Breaking up big financial institutions wouldn’t prevent future crises, nor would it eliminate the need for bailouts when those crises happen. The next bailout wouldn’t be concentrated on a few big companies — but it would be a bailout all the same. I don’t have any love for financial giants, but I just don’t believe that breaking them up solves the key problem.

So what’s the alternative to breaking up big financial institutions? The answer, I’d argue, is to update and extend old-fashioned bank regulation.

Here’s the support by Simon and Kwak of ‘rightsizing’ banks.

In the moment of most intense crisis, Goldman became a bank holding company, subject to the supervision of the Federal Reserve and able to borrow from the Fed’s official “discount window” — effectively gaining government support. Yet today the firm is also allowed to carry out essentially the same activities (including securities and foreign-exchange trading, as well as real-estate-related transactions) as it did prior to the meltdown of 2008, when there was supposedly no government backing.

If you were exempt from paying speeding tickets, no matter how fast you drove, what would you do? Perhaps, immediately after observing a horrific crash or having a near-death experience, you would be more careful. But soon you would feel the need to get somewhere quickly. And you might even think that your special legal status merely reflected your advanced skills. How long until the next big accident?

Since Democrats lost the special Senate election in Massachusetts in January, the president has shown some new fire. In a major potential course correction, he proposed the “Volcker Rule,” named after former Fed chairman and current Obama adviser Paul Volcker, which would constrain the risk-taking and the size of the largest U.S. banks.

So, here’s my argument against Krugman and for the Simon and Kwak support of the Volker law. There are several arguments that support allowing a market to become concentrated and then strongly regulating it. These things are generally due to either ‘economies of scale’ (you have to be big to minimize costs), some kind of natural monopoly (like deBeers with the Diamond mines), or you have to argue that banking is some kind of ‘public good‘. I’m thinking Krugman might be thinking that banking is some form of public good and that just regulating it effectively will eliminate these problems. As I’ve said before, banking is a unique industry and it does have the feel of a public good. It provides necessary funds for businesses to expand and it pools funds from small savers. There’s a public interest in protecting that line of business. I’m not certain you could argue that it meets all the criteria for a public good however.

My first question concerns the effectiveness of that regulation to date. It’s been arguably ineffective since the Reagan years. One big problem is that we have the captured regulator syndrome. Congress appears to operate on the whims of the FIRE lobby. Fannie and Freddie were railroaded by political appointees and ineffective congressional oversight. The SEC is so ineffective and understaffed as to be laughable. The Fed is not that innovative and sticks within what it perceives are its narrow charter items. The FDIC is interested in solvency period. The banks are bigger and have more muscle than their regulators right now. I think we’ve gone passed the point of relying on regulation alone.

Second, The literature shows mixed results on economies of scale in the financial industry. I don’t think they need to be big to be competitive globally or to achieve any level of effectiveness so do we get anything from them being big? Frankly, I think it’s just the opposite. I think I’d be easily able to prove the following hypotheses. As banks get bigger they become less customer service-oriented and less able to underwrite efficiently and prudently. They become more concerned with lobbying for less oversight. Lack of competition in the financial industry narrows the product offerings and the pricing becomes less based on ATC (minimum Average Total Cost) and resembles monopoly pricing put into place by restricting quantities of products sold. In short, they become a type of cartel.

I also believe that recently the cheap cost of money from the Fed has allowed them to chase more assets that provide paper profits rather than actually provide loans where the profits come from rates of returns on actual business projects. (i.e. No one is forcing these guys to lend so they’re just running up profits by switching their customers’ portfolios and their own in and out of stocks, bonds, and derivatives. They are momentum trading and creating the momentum simultaneously. Also, the FED and the Treasury appear to be enabling this.) Their ‘bigness’ is granting them special favors that isn’t removing moral hazard, information asymmetry, or improving the state purpose of the market.

Michael Konczal at WAPO argues that Congress should be looking at doing both big bank bust-ups and regulating the shadow banking industry heavily. In the past, I’ve argued for both also.

For me, it’s not an either/or but a both/and question. I think we should do both (a) and (b), impose a hard size cap of $400 billion to $500 billion and then expand regulation over all the broken-up shadow banks. If you look at the conclusion of 13 Bankers, I think Simon Johnson and James Kwak are in a similar boat. And from the point of what to do with the Dodd bill in place, the question for progressive reformers is whether to push for something like Sen. Sherrod Brown’s amendment on limiting bank size in addition to the resolution authority powers in Dodd’s bill (Title II), not instead of those powers.

Why do I think this is important? A variety of reasons, but one is that we haven’t dealt specifically with the issue of a scope of guarantees post-2008 crisis. I really think of this financial reform bill as something that should have been attached to TARP. “If you want a $800 billion loan, we are going to undo the ’90s derivatives deregulation, make you follow consumer protection laws as if you were regular banks instead of shadow banks, and give ourselves the right to do FDIC-like resolution on you.” Then we could begin to have a discussion on how to deal with the shadow banking sector as a Step 2. Instead, it is all being forced into Step 1.

Mark Thoma at Economist’s View has entered the fray with this opinion.

There are at least three goals for financial reform. The first is to prevent bubbles from happening, or at least reduce their frequency. The second is to reduce the consequences should a bubble occur, and then pop, and the third is to reduce the political power and influence of the financial industry, and to take other measures that reduce the chance of regulatory capture. Regulations won’t help if they can’t be sustained, or if they are used to cement existing market and political power rather than reduce it.

Breaking up banks certainly helps with the third goal, but I don’t think breaking banks into smaller entities is enough by itself to reach the first two goals. It may help to prevent bubbles, but long ago when banks were smaller we still had these problems so reducing size alone does not prevent bubbles from inflating. As for the second goal, reducing the fallout when problems do occur, it’s not at all clear to me that one thousand highly interconnected small banks failing is easier to deal with (from the perspective of saving the economy) than one large bank.

There are parameters other than size that are important. One of these parameters — a key one in my view — is interconnectedness. If banks are highly interconnected, then they are likely to fail en masse and create problems. Another is the distribution of risks across banks. If there are 1,000 small banks, but 500 of them all have just one type of asset in their portfolios (or have very similar assets in what is supposed to be a diversified portfolio), they will all be subject to the same risks and they are likely to fail together. And if they are connected to the other 500 banks in the industry — e.g. they have borrowed a lot from these banks — then the failure of one half of the market would threaten the other half.

Thus, while reducing the size of banks is important from a political economy perspective, and also from a market power perspective, it is not enough. We need leverage limits, limits on connectedness, limits on the concentration of risks, etc.

To a certain extent this is what I’ve argued before when I’ve shown you concentration ratios in the banking industry. Try to find an ATM that is run by your bank these days outside of their decreasing number of branches. You can find tons of those ATMS where some private company and your bank will fee you, but no bank ATMs. Banks see ATMS as teller substitutes now. They no longer see them as mini-branches. They’ve got monopoly concentration in the credit card offerings and deposits, hence you deal with them or try to find some place else to go. If you’re lucky, you can join a credit union. If you’re a lot of poor folks, you join the ranks of the unbanked where every one fees you further into poverty. (You know it’s profitable because Walmart has gotten into the act.)

Just a reminder:

J.P. Morgan Chase, an amalgam of some of Wall Street’s most storied institutions, now holds more than $1 of every $10 on deposit in this country. So does Bank of America, scarred by its acquisition of Merrill Lynch and partly government-owned as a result of the crisis, as does Wells Fargo, the biggest West Coast bank. Those three banks, plus government-rescued and -owned Citigroup, now issue one of every two mortgages and about two of every three credit cards, federal data show.

This alone is a good reason to break up big banks. Also, it’s easier to deal with a dead small bank that a dead big one. I’d hope Dr. Krugman addresses this in his next installment.

Okay, I’ve bored you with banking long enough! Have a great weekend and blame myiq2xu for this! He asked for it.