Category Archives: financial markets

Bank Regulation, Left and Right

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One possibility I am considering for this panel discussion is to give a spiel on how free-market economists have been more hawkish than mainstream economists when it comes to bank regulation. I was inspired by listening to Robert Litan recount some of the history at a talk last night on Trillion Dollar Economists. You may recall that may take on that book is that it has great material, but I would have liked to see different organization and emphasis. I was reading it with my high school economics students in mind.

Anyway, here is the spiel.

Long ago, two groups of free-market economists decided to “shadow” the Fed. The Shadow Open Market Committee, which I believe started in the 1970s, issued pronouncements critical of monetary policy. The Shadow Financial Regulatory Committee (SFRC) , issued pronouncements critical of regulatory policy starting in 1986.

The SFRC had both a deregulation agenda and a regulation agenda. Their deregulation agenda was mainstream. Observers of banking regulation across the political spectrum recognized that deposit interest ceilings were no longer workable, that the Glass-Steagall separation of banking and securities was no longer workable, and that prohibitions against interstate banking and branch banking were no longer workable. People had known since the late 1960s that those regulatory boats were sinking, and the laws that Congress passed in the 1980s were just the long-awaited permission to abandon ship.

Take Glass-Steagall, for example. In 1968, the distinction between a loan and a security was obliterated by GNMA. A few years later, the distinction between a deposit and a security was obliterated by money market funds. Even though some people try to blame the financial crisis on the repeal of Glass-Steagall, the fact is that it collapsed 20 years before it was repealed and nobody has said that you could bring it back.

It was the SFRC’s hawkish regulatory agenda that was out of the mainstream. In particular, if you read through its old statements, you will see that the SFRC issued many warnings that bank capital regulations were inadequate. They pleaded for tighter regulation of Freddie Mac and Fannnie Mae, for higher capital requirements for banks, and for regulators to require banks to have a thick layer of subordinated debt which would put the onus for failure on the private sector rather than the taxpayers. These calls went unheeded. The SFRC economists were viewed as cranks, whose judgment on these matters was impaired by an irrational distrust of government agencies.

The Financial Supermarket Bubble and Banking History

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Here is a chart, using the Google ngram tool, showing the frequency of the appearance of the term “financial supermarket” over time.

Note the spike in the mid-1980s. Given that these are books, which appear with a slight lag, I would say that the spike in the media was in the early 1980s.

At this panel, I don’t know whether I will have time to get into the history of bank concentration in the U.S., but here it is.

1. The market share of the largest banks follows a hockey stick pattern since 1950. It stayed very low until the late 1970s, and then around 1980 it started to grow exponentially. Growth of banks had been retarded by ceilings on deposit interest rates, branching restrictions, and Glass-Steagall restrictions. Banks had been trying to find loopholes and ways around these restrictions, and regulators had been trying to close the loopholes. Then, during the period 1979-1994, the regulators stopped trying to maintain the restrictions, and instead cooperated in ending them. That was when the hockey stick took off.

2. The regulators thought that this would bring more competition and consumer benefits. What the banks had in mind was something else. That is where the chart comes in. The bankers all thought that “cross-selling” and “one-stop shopping” would be killer strategies in consumer banking. In 1981, when Sears bought Dean Witter, many pundits thought that putting a brokerage firm inside a department store was going to be a total game-changer.

3. It turned out, though, that consumers did not flock to brokerage firms in department stores, or to any of the other one-stop-shopping experiments in financial services. The economies of scope just weren’t there.

4. Meanwhile, concentration in banking soared thanks to mergers and acquisitions. I’ve read that JP Morgan Chase is the product of 37 mergers and Bank of America is the product of 50. All of these took place within the past 35 years.

5. Just five years into this exponential growth process, Continental Illinois became insolvent, and that was when “too big to fail” began. So out of the 35 years where we were on the exponential part of the hockey stick, 30 of them have taken place under a “too big to fail” regime. In short, the concentration in banking got started during the “financial supermarket” bubble, and from then on was supported, if not propelled, by “too big to fail.” But the market share of the biggest banks is not something that grew naturally and organically out of superior business processes.

6. As another historical point, when the S&L crisis hit, the government set up the Resolution Trust Corporation. Each failing institution was divided into a “good bank” and a “bad bank,” with the good bank merged into another bank and the assets of the bad bank bought by the RTC. While this was a somewhat distasteful bailout, it was conducted under the rule of law. When TARP was enacted in 2008, Congress and the public were led to expect something similar to the RTC, with TARP used to buy “toxic assets” in a blind, neutral way. Instead they ended up calling the biggest banks into a room and “injecting” TARP funds into them. They also spent TARP funds on restructuring General Motors. It was the opposite of government acting in a predicable, law-governed way. It was Henry Paulson and Timothy Geithner making ad hoc, personal decisions. I think that in the U.S., that is what bank concentration leads to–arbitrary use of power. That is why as a libertarian I do not think that allowing banks to become too big to fail is desirable.

The Problem of Big Banks

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Stephen G. Cecchetti and Kermit L. Schoenholtz write,

Imagine the following simple approach (like that of Acharya et al). Let the capital structure of a bank’s long-term liabilities be clearly stated and then honored if and when necessary. That is, think of the bank as having a hierarchy of long-term debt ranging from the most senior (call it tranche A) to the most subordinated (tranche Z for zombie!). Whenever a bank’s capital position is deficient – say, because the market value of its equity sinks below a threshold ratio to its book assets – the resolution authority automatically makes some of the debt into new equity, starting with the Z tranche and then climbing up the alphabet until there is sufficient capital to return the bank above the regulatory minimum. Provided that there is sufficient long-term debt to absorb the losses, the concern remains a going one. (The resolution authority could still replace management and shut down risky activities in an effort to prevent a serial failure.)

Pointer from Mark Thoma. This is an alternative to the idea of divesting the firm’s assets according to a “living will.” The authors write,

But let’s not overstate the attractiveness or simplicity of the phoenix plan. No scheme can eliminate policy discretion, as crises often lead governments to change the rules on the fly (think of the 2008 TARP legislation that followed the failure of Lehman).

The way I read this, we really cannot get back to the rule of law if we have too-big-to-fail banks. That is what I will be arguing in two weeks. These institutions will be given special treatment, particularly in a crisis. In 2008, AIG was eviscerated in order to provide a liquidity injection to Goldman Sachs, Deutsche Bank, and others. Does anyone think that the decisions would have come out the same if the Treasury Secretary had been a proud alumnus of AIG rather than of Goldman Sachs?

Some of my other thoughts for the panel.

1. Suppose that we were to limit any financial institution to $250 billion in liabilities that are not backed by capital. Currently, the largest banks in this country seem to have over $1 trillion in liabilities.

2. What can you not do with a $250 billion portfolio? What would such a bank be precluded from doing, other than buying another huge bank?

3. I think it is pretty hard to know for certain the extent of economies of scale and scope in banking. However, my intuition is that the big banks did not get where they are today through natural market competition. In other industries, dominant firms are characterized by focused excellence. Intel is very good at designing and manufacturing chips. Walmart is very good at logistics. What is JP Morgan Chase very good at? Citigroup?

Another characteristic of dominant firms in competitive markets is that they grow by doing more of what they are good at. In contrast, banks grow primarily through mergers and acquisitions.

4. How much does too-big-to-fail matter? Well, try to imagine what the computer industry would look like if the government had designated the dominant firms as of 1970 as too big to fail. We would still have Wang and DEC, but I doubt that we would have Apple or Microsoft.

5. If we imagine banks without TBTF, then it is likely that at times in the past the stock prices of some of the large banks would have been very low, which would have halted their growth through acquisitions and perhaps forced management to divest poorly-managed business lines in order to appease shareholders.

We cannot have large banks without TBTF. We cannot have TBTF without an unfair playing field and mockery of the rule of law. So we should break up large banks.

The State of the Economy

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1. There have been several posts pointing out that wage growth has been slow, even though the unemployment rate has fallen.

2. There have been several posts, including some of mine, on low long-term interest rates. More recently, the WSJ talked with James Bullard.

Right now, “the markets are making a mistake” and expect the Fed to maintain its ultra-easy policy stance longer than Fed officials themselves currently expect, Mr. Bullard said. When it comes to these expectations, “I would prefer that those be better aligned than they are.”

3. Scott Sumner writes,

The 4-week moving average of layoffs came out today at 287,750. Total civilian employment in September was 146,600,000. The ratio of the two, i.e. the chance of being laid during a given week if you had a job, was below 2 in 1000. That’s only happened once before in all of American history–April 2000.

However,

We are even seeing a lower employment/population ratio in the key 25-54 demographic, compared to seven years ago.

Read his whole post.

On (1), I would note that a few years ago wage growth was violating the Phillips Curve on the high side, and now it is violating the Phillips Curve on the low side. And yet mainstream macroeconomists stick to the Phillips Curve like white on rice. I would emphasize that the very concept of “the” wage rate is a snare and a delusion. Yes, the Bureau of Labor Statistics measures such a thing.

Instead, think of our economy as consisting of multiple labor market segments, not tightly connected to one another. There are many different types of workers and many different types of jobs, and the mix keeps shifting. I would bet that in recent years the official statistics on “the” wage rate have been affected more by mix shifts than by a systematic relationship between “the” wage rate and “the” unemployment rate.

On (2), I view this as evidence for my minority view that the Fed is not a big factor in the bond market. Instead, the Fed is mostly just following the bond markets. When it actually tries to affect the bond market, what you get are “anomalies,” i.e., the failure of the bond market to do as expected by the Fed.

On (3), I think that we are seeing a Charles Murray economy. In Murray’s Belmont, where the affluent, high-skilled workers live, I am hearing stories of young people quitting jobs for better jobs. On the basis of anecdotes, I would say that for young graduates of top-200 colleges, the recession is finally over. The machinery of finding sustainable patterns of specialization and trade is finally cranking again.

In Murray’s Fishtown, on the other hand, the recession is not over. I would suggest that we are seeing the cumulative effects of regulations, taxes, and means-tested benefits that reduce the incentive for firms to hire low-skilled workers as well as the incentive for those workers to take jobs. As Sumner points out, President Obama’s policies have moved in the direction of making these incentives worse.

Housing Re-Bubble?

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Nick Timiraos reports,

the [Federal Housing Agency home price] index shows U.S. prices now standing just 6.4% below their previous peak in April 2007.

…The Case-Shiller national index, which is set to report its own measure of July home prices next Tuesday, showed that home prices in June were 9.9% below their 2006 peak.

Some comments:

1. Overall, consumer prices have risen about 15 percent since 2007, so you might say that on an inflation-adjusted basis home prices are more like 20 or 25 percent below their 2007 peak.

2. However, even on an inflation-adjusted basis, house prices are higher than they were in late 2003, by whichi point cries of “bubble” already were being heard.

3. If I were Scott Sumner, perhaps I would say that this suggests that the 2007 prices were not really a bubble. Indeed, the real anomaly was the crash in house prices in 2008-2009, due to tight money. But I am not Scott Sumner.

4. The case that we are in another bubble strikes me as weak. It is certainly is not a sub-prime lending phenomenon. Two phrases that I hear a lot in casual conversation with real estate folks are “all-cash deal” and “foreign buyer.”

5. Even if house prices were to fall sharply again, my guess is that there would be many fewer loan foreclosures. Lenders are taking on much less risk, and instead home buyers are taking on more of it.

6. It seems to me that we are much closer to full recovery in the housing market than we are to full recovery in the labor market. Does that not pose a problem for the theory that the recession was mostly an aggregate-demand phenomenon caused by the loss of housing wealth?

7. Again, today’s economy feels so much like 2003 and 2004. Very low r, seemingly below g. Last decade, Bernanke labeled this a “global savings glut.” This decade, Larry Summers calls it “secular stagnation.”

8. In June of 2004, I wrote Bubble, Bubble, is there Trouble? arguing that low r was the central economic puzzle, and that given low r, housing prices were not out of line. I have been excoriated since then for failing to call the housing bubble. In 2009, that excoriation seemed warranted. Today, it seems like you could change the date to June of 2014 and re-print it.

More on DeLong-term Interest Rates

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Brad DeLong writes,

the most likely–possibility is that the fact that r < g for the government is a byproduct of an extremely large outsized risk premium because of private financial markets’ failure to mobilize the risk-bearing capacity of the public and failure to establish trust and overcome moral hazard in the credit channel. Thus more government debt provides the private sector with something that it is willing to pay through the nose for: a low-risk way to transfer purchasing power into the future.

Pointer from Mark Thoma.

Imagine you had a bank that, whenever it got into trouble through bad investments, could pay off its creditors by taking wealth from people at gunpoint. Such a bank could issue debt with a low risk premium. It is not as clear to me as it is to Brad that the social optimum is for this bank to be very large. Particularly when its “investments” may earn so little in return that at some point even taking wealth at gunpoint may not be enough to enable the bank to meets its obligations.

Gender and Risk-Taking

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Jason Collins favorably reviews The Hour Between Dog and Wolf, a book by John Coates, who says that hormonal responses to success and failure serve to reinforce risk-taking and risk aversion. I note from the book description on Amazon:

Dr. John Coates identified a feedback loop between testosterone and success that dramatically lowers the fear of risk in men, especially younger men—significantly, the fear of risk is not reduced in women.

I count this as additional support for what I have said I would do if I were financial regulatory czar: change the gender of the CEO’s of the largest banks.

DeLong-Term Interest Rates

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Brad DeLong writes,

when I look at the sub-zero 5-Year TIP and at the 0.6%/year 6-10 Year TIP I read that as Ms Market decoupling its inflation expectations from its real growth and real interest rate expectations, and not in a good way.

Read the whole thing. Pointer from Mark Thoma. My thoughts:

1. To me, the biggest macroeconomic/financial mystery today is the low ten-year real interest rate.

2. Ten years ago, the biggest macroeconomic/financial mystery to me was the low ten-year real interest rate. That, combined with loose mortgage credit standards, fed a housing bubble.

3, Why aren’t corporations borrowing like crazy? Issuing long-term bonds to buy back stock would seem akin to owning a money-printing press. (And yes, this is an argument that stocks are not overvalued.)

4. One possible story is that savers in China and Russia do not trust their domestic financial markets, so that their savings are pouring into the U.S., and from here spilling over to western Europe. But that would presumably make it expensive for Chinese and Russian borrowers. Is that the case?

Ralph Musgrave on 100 percent reserve banking

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He writes,

if it is thought that a 25% or so capital ratio really DOES MAKE banks entirely safe, then there is no difference between the risk run by bank shareholders and depositors. That is, shareholders and depositors essentially become the same thing. And that is what full reserve consists of: it is a system where only shareholders fund lending entities / banks

Pointer from John Cochrane.

The way I think of this is that there are several ways that people take positions in bank assets. You can be an insured depositor. You can be an uninsured creditor. You can be a shareholder. And you can be a taxpayer who sometimes takes part in bailouts.

As the bank’s capital requirements go up, some of the uninsured creditors and insured depositors have to be induced to become shareholders and/or the bank has to hold fewer assets. Unless the bank is able to offset these effects by taking on higher risk, this will reduce the value of the subsidy provided by taxpayers.

It is my view that relatively few people want to hold mutual funds that invest in risky projects. They would prefer instead to be insured depositors. They probably are willing to collectively provide insurance. However, in practice, the government ends up eager to bail out not only insured depositors but uninsured creditors and often shareholders as well.

The Fed and Money Markets

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Jon Hilsenrath writes,

Because banks have so much cash, the fed-funds market where they tap reserves experiences very little day-to-day trading. One New York Fed study shows daily trading volume in the market has contracted from an already-thin $200 billion before the financial crisis to nearly $50 billion. Moreover, traditional U.S. commercial banks are especially inactive. The most active players are government sponsored Federal Home Loan Banks and foreign banks.

“The fed funds market is but a shadow of what it was prior to the crisis,” Raymond Stone, an analyst at Stone McCarthy Research, said in a note to clients Wednesday. “It is no longer clear that the funds rate is the key determining factor of the behavior of short-term interest rates.”

Read the whole thing.