if banks are doing their job, the banking system is illiquid, and the rest of the economy —us— have lots of cash. In Econ 101 this is known as “maturity transformation.” Liquidity-wise, the banking system is simply the mirror image of the economy. Thus, compelling banks to become more liquid inevitably drains cash from all of us who are not banks.
This is another way of saying what I like to say, which is that the public wants to issue risky, long-term liabilities and to hold riskless, short-term assets, and financial intermediaries accommodate this by doing the opposite. This implies that for financial firms, a liquidity crisis blends into a solvency crisis. Banks must shrink their activity if there is sudden pressure on them to make their balance sheets more liquid.
In a more recent post, he writes,
what did cause the crisis? The causes were complex, but one force overwhelmed all others: regulation. Bad regulation. Mainly, the Basel I and Basel II Capital Standards.
He is referring to the Financial Crisis of 2008. Actually, I don’t believe that Basel II was all that important, because it still was mostly unimplemented by the time of the crisis. I would focus on Basel I and also on the Recourse Rule of 2001, which we might think of as Basel I(a).
More interestingly, he goes on to say,
the great untold secret of the crisis was the strength of the US commercial banking industry.
As crazy as this sounds, it may be spot on. Yes, Citigroup was in trouble, as he acknowledges. But most other commercial banks were not in bad shape. Some U.S. investment banks (aka “shadow banks”) were shakier, but the real problems were in Europe. He writes,
European banks in 2007 had aggregate tangible equity of roughly 1 trillion euros (at the time, about $1.1 trillion.) With a sensible leverage ratio of 5.0%, this equity would have supported E20 trillion in assets. But by 2000, the average European bank leverage ratio already had dwindled to 3.8% (insufficient), and then fell further — to 3.0% (wow) in 2007.* That may not sound like a big deal, but it’s more than a 20% systemic increase in leverage in just 7 years. This meant that for European banks alone, the Basel Regs goosed asset demand by at least E7 trillion ($8 trillion).** To think of it another way, European bank assets in 2007 exceeded what would have been prudent leverage (i.e. 5%) by E13 trillion ($15 trillion) — a third of European banking system assets.
I would add that many of the beneficiaries of the “AIG bailout” were European banks.
There is a lot of potential for revisionist history here.
Thanks for giving this airtime. I would say that if a banking system nearly collapses during a 5% housing contraction, you have a banking problem. If a banking system nearly collapses during a 25% housing contraction, you have a housing contraction problem. But, the “banking problem” story had already basically been written and accepted before home prices began to decline, so the story didn’t change when it took a 25% contraction to maim the financial system.
I would say that if home prices simply go up, then down, and are flat over a 5 year period, then you have a banking problem. No prudent business would assume multiple-standard-deviation moves to the upside in an asset class are something that can be relied upon (with leverage nonetheless). Assets go up and down, sometimes by quite a lot…if you don’t understand that you should be running any business.
The biggest difference of the 1929 crash and 2008 crash is the length to hit bottom. In 2008 we had a 6 – 8 month bottom. (Spring – Summer 2009) We have to remember 1929 – 1932 how many times there were headlines that the economy was turning. They always assumed that they hit bottom but frankly the bottom was hit on Banking Holiday 1933. And only with the Banking Holiday 1933 did investors and average citizens know who will survive and won’t. (Remember lifetime savings were lost overnight.)
In 2008/2009, we did not know the dominio effect of failing financial institutions and there was concerns beyond Citibank. Without the AIG bailout, do General Electric or Goldman Sachs survive the writedowns? Given GE Capital was mostly liquidated in 2015 that would make sense. Does Bank Of America survive with the Countrywide loss mounting against them as investors start fleeing?
I guess the big question I have is by summer 2009, consumers and investors knew who was surviving in general and it avoided another round of financial failures.
The European high-leverage fad worked out fine in the end, though, because they mostly loaded up on very safe assets like Greek government debt.
LMAO
Long term assets are fewer, larger and less liquid than short term assets. The matching error carried in balancing the one against the other is then bank risk. But the securitization process skipped the market balancing act between the two, instead the bundling was done without being observed by market participant. Matching risk became obscured,pricing was blind.
I’m pretty sure the reason Basel I regs were so terrible is that the Basel regulators were captured by the Euro Banks, and agreed to reduce capital requirements from 5% down to 3.8%, then further down to 3.0%. Their logic was, essentially, the rocket scientist spreadsheet wizards know how to get more leverage for the same risk. Wrong.
What is needed is higher capital requirements, and fewer other regulations. What made Basel so terrible was that banks accepted lots of other regulation & accounting & reporting requirements, in order to get a green light for more leverage, more risk.
Banksters are quite willing to accept regulations, and possible bailouts, based implicitly on ‘we followed YOUR gov’t regulations, so it’s the gov’t fault’. In the meantime making high ROI profit based on risky investments until the crash.
LTCM should have been allowed to go bankrupt, and all other big banks / investment groups since then when their risky bets fail — with the gov’t ready to help main street more directly (like loans to small, local banks) if needed.
A charming nugget in those Cantercap pieces:
“If it smelled a little too much, no problem. A small fee to AIG got you a credit default swap. Hey presto, AAA.”
And here we have the great lesson from reinsurance: in addition to the risk assumed and transferred to the reinsurer, there is the “financial” risk of insufficiency of assets or income of the reinsurer; in this case AIG, which brought the then French Finance Minister (now at IMF) tp plead for U S Treasury “reinsurance” of AIG to maintain the AA and aaA tier assets of critical French banks. She was NOT alone in her prayers.