I think you have to be a little careful. Every time you stop something, it’ll show up somewhere else if there’s a need for it. And is it better that it be in an entity that you regulate and you monitor reasonably closely? Or in an entity that you don’t regulate?
To the extent the entity you don’t regulate can absorb those losses, that’s not a bad thing. But to the extent that it cannot, and it all comes back into the system via these interconnected markets, you’re no better off. In fact, you’re worse off because you’re blindsided by the risks migrating to places you don’t look at.
That is from a conversation with Tyler Cowen.
In what I call the chess game of financial regulation, every regulatory move leads to a counter-move by the financial sector. Many regulatory ideas, including the idea that Rajan wisely scorns of not allowing banks to hold risky assets (requiring (narrow banking), are unwise if you look ahead one move.
I think that one way that you can tell you have made a bad move in the regulatory chess game is when you observe extensive financial innovation. It seems to me that a lot of innovation reflects attempts to take advantage of opportunities created by regulatory mistakes. Risks that you thought you were controlling are in fact changing shape or migrating.
The correct response is not to outlaw innovation. That just leads to another counter-move. The correct response when you see extensive financial innovation is to go back and understand how your regulations encourage that innovation and come up with ways to attenuate those incentives.
I do wonder whether all the regulations introduced ostensibly to reduce money laundering really have helped with the problem, or do people up to no good just find ways around them.
Has anyone on this list got any figures or web links?
Can you elaborate on why financial innovation should not be outlawed? Is there any social benefit to financial innovation? I would argue that these innovations have only a negative social value.
It really gives me intellectual whiplash when I see this sort of language. In any other sector the presumption of control and regulation as a good thing and innovation as a bad thing would signal a very different political affiliation.
@Kevin Erdmann – Can’t we agree that the financial sector is different?
If we only focus here on the innovation to be found in the structure of the financial instruments themselves, isn’t there an intrinsic need for straightforward, transparent, well understood value propositions? For clear assignment of risk? This seems to be different from other types of innovation, where utility delivered via black-box solutions isn’t necessarily bad.
What does any of this innovation do except distort the value propositions, encouraging a greater risk tolerance without really reducing any systemic risk?
I think that “Is there any social benefit to financial innovation? I would argue that these innovations have only a negative social value.” is an extreme statement that could only be made by starting from a very biased set of priors. Certainly, though, some innovations are better than others, and some are created as regulatory arbitrage.
Banks and other major financial actors are backstopped if they get in trouble.
This creates an incentive to profit while increasing risk of getting in trouble.
Hence regulation to prevent this dynamic.
If financial innovation is mostly “innovating ways around regulators so we can better dump risks and losses onto the government” then its not good.
You can argue that the backstop shouldn’t exist…but majority politicians from both parties always vote to backstop when it counts and everyone knows it.
I’m sure that shareholders of Fannie Mae, Freddie Mac, Bear Stearns, Lehman Brothers, AIG, Countrywide Financial, and for that matter, Citigroup and Bank of America, and Investors in private MBSs, would be fascinated to hear about how financial losses are backstopped.
Maybe the fact that the “bailout” complaints somehow manage to encompass several of these organizations, whose shareholders were wiped out, might suggest that there is some observational bias at work here.
I will admit to not being as much of an expert on this as you. As a laymen I only have the time to pull from public sources and use some basic common sense.
https://projects.propublica.org/bailout/main/summary
It lists inflows of $740B and outflows of $632B. Obviously, the inflows came later than the outflows and they don’t provide a detailed timeline of the inflows. I’m going to place ten years of discounting (2008 to 2018). If you think that is to harsh then use one of the lower discount rates I’m about to throw out.
If we use a 3% style CPI it is $550B return versus $632B outlay.
If we use a 8% style “long term investment returns” that I was taught growing up then it is $332B return versus $632B outlay.
If we use stock market 2008 to 2018 returns of 12.5% it is $227B return versus $632B outlay.
And of course given the risk involved in the assets purchased you could easily argue for a way larger discount rate.
There were also lots of other stimulus that helped to re-inflate asset prices (where the inflow number basically comes from) that the government had to issue debt for.
I ask a basic question. The condo I’m about to sell went for $370k in 2008. I bought it for under half that a few years later. Who ate that loss (or more accurately, who ate a portion of the collective losses on a ton of instances of that)?
I get that its value has reinflated over the last ten years (though not close to $370k again) and that would make the loss seem a bit less if you held it over that whole time, but there is a time value of money issue too.
I get the impression that some of that loss got eaten by the government on an NPV basis.
I get that shareholders in many of these companies were wiped out. Though debt holders don’t appear to have taken a haircut.
https://seekingalpha.com/article/70098-bear-stearns-bondholders-win-big
Management of many of these firms (the people really making the decisions to “innovate” and take on this risk) in many cases got on in life just fine.
I understand that the topic is getting into some uncomfortable areas, but financial institutions are given special privileges by the public to do some uncomfortable things.
You listed a set of investors (Fannie Mae, Freddie Mac, Bear Stearns, Lehman Brothers, AIG, Countrywide Financial etc…) and described their financial losses as backstopped because their shareholders lost their investment.
Well, if their investors money was all that was at stake that would be fine, but these institutions are allowed some rather special rules to risk quite a bit more than just their investors money.
And it was a set of innovations surrounding mortgage securitization that made investments look much safer than they really were.
This is a pattern I see in economic retrospectives in general.
In housing, the aggregate story that gets repeated is that we have had a manufacturing employment crisis that was temporarily masked by an unsustainable housing boom. Yet, there is no place where this actually happened. There are cities with declining employment that didn’t have housing booms. There are economically strong cities that should have had housing booms but didn’t. And, there are some cities that had housing booms because they were economically strong. And, in most places, home prices and construction rates can be explained by fundamentals.
Similarly, here, the repeated claim is that we are under the thumb of a financial sector that privatizes gains and socializes losses. Except that there isn’t a single significant set of investors who actually did that. And we didn’t even actually socialize any losses.
The response I see to that is usually some sort of claim about how you can’t measure the costs in dollars and cents because the government was exposed to risks that might have had large costs if outcomes had been different. This is some mighty motte and bailey action.
I think we’re talking apples and oranges here.
You are pushing back on a fairly specific narrative about the housing crisis that you see as inaccurate. Fair enough.
I’m arguing that financial innovation directly related to the making ever more complex securities contracts isn’t in the public interest, and we have a really obvious example of how that can cause a great deal of harm. It may not have ultimately meant a huge net public bailout last time for the firms involved, but it did cause a great deal of economic damage.
I understand your reticence in blocking “innovation”, but contracts have an intrinsic responsibility to be understandable, and financial institutions are given a specific set of privileges which come along with a set of responsibilities to the public to help maintain system stability.
There are plenty of ways for financial institutions to innovate. Just don’t do it by obfuscating risk through complexity. Spreading and chopping up risk out doesn’t make it go away. It just makes it hard to see.
Well, some of my comments were in reaction to asdf. I would have some quibbles with your last reply, but your last paragraph here appears to be a reasonable response to your initial comment, so I’ll leave it at that.
Investments are risky. Banks and all orgs want to have the freedom to choose their investments, and get the private benefit of successful investment (good). Yet minimize the private cost of the bad investments – get somebody else to pay.
I see most “financial regulation” as ineffective yet still costly compliance activity with the idea of reducing risk, yet actually keeping gov’t as being ready to bailout those Big Banks that are Too Big To Fail.
The US actually has, most years, too few bank failures, a sub-optimal number. But in very bad years, it has too many, or so many at risk that the gov’t does a bailout.
Far fewer, but more clear regulations would be better, including a higher required equity capital ratio.
A big social problem with the inequality issue is how too much of the world’s profit is going to the financial sectors — protected by the captured regulators.
Does current banking regulation allow someone to open a narrow bank? Let’s say in the extreme case you were simply going to hold all deposits as cash, in the bank’s federal reserve account. Why would a bank like that need FDIC insurance?
Regulation is the minor player in finance.
That industry has been hit by continuous waves of technology advance in communications since 1820. Technology dwarfs any regulation in finance and many other sectors, but especially finance.
Back when I was a portfolio manager, I used quite a few derivatives, mostly interest rate swaps and credit default swaps. I got a chuckle when our general counsel described a swap contract as “something that takes an illegal transaction, and transforms it into a legal transaction”.
He’s now an attorney for the SEC.
Financial markets are characterized by information asymmetries and multilevel principal-agent problems. Because of that, recent experience has been that usually “financial innovation” means “this instrument can be marketed as if it were a safe investment, but it’s actually very unsafe if not outright worthless”, e.g. multilevel CDOs full of no-doc mortgages.
Personally, I don’t see the big worry about financial innovations like discount brokerages or online/telephone banking. But I suppose what is meant by financial innovatin here has to do with mortgage securitization. If it is true, as Paul Krugman states,”the rapid growth in finance since 1980 has largely been a matter of rent-seeking, rather than true productivity,” going back to the regulators is not going to help anything. Successful rent-seeking implies misplaced faith in regulation. In the US, the tax system seems to be an important driver of financial innovation. A good place to start any reform would be to go back and finish the job of corporate tax reform. Replacing in corporate income tax with a VAT would no doubt reduce simplify the job of financial regulation.
Finance is an arbitrary distinction.
https://www.idiosyncraticwhisk.com/2019/01/housing-part-341-arbitrary-categories.html