Category Archives: financial markets

Timothy Taylor on Shadow Banking

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He writes,

if you still think banks are the core representative institutions in the financial system of high-income economies, you are a few decades out of date. If you are concerned about the dangers of financial sector risks cartwheeling into the real economy, you need to think about the shadow banking sector. Muscatov and Perez point out that while banking regulators do try to think about risks from the shadow banking sector, “Still, many areas of NBI remain obscured from regulators’ view, and not all NBI is subject to supervision.”

NBI is “non-bank intermediation.” Read the whole post.

Freddie and Fannie are non=bank intermediaries. Back in the late 1980s and the 1990s, they drove traditional lending institutions out of a large segment of the mortgage market. They did not do this through inherent advantages of scale or business model. They did it because they enjoyed small advantages from a regulatory standpoint, including lower capital requirements.

The moral of the story is that the “better” job you do of regulating banks, the more room you leave for other financial intermediaries to take over niches. I do not think that you can get financial regulation to achieve the goal of stabilizing the financial system. I think that it just winds up being a tool for allocating credit to politically preferred uses.

The Trust Variable

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Noah Smith worries about the way economists invoke trust.

So although trust, in some form, is probably important in our economic lives, we don’t yet have the tools to measure it, we don’t know exactly how it’s important, and we definitely don’t know how to control or alter a society’s level of trust. Until we understand trust a lot better, it would be a mistake to rely on it too much when trying to explain the world around us.

Read the entire essay. I agree with his qualifications, but I would rephrase his conclusion. It sounds like he could be saying that if something is hard to measure and control, then look for other variables to explain and control the world. Instead, I would say that one should be humble about one’s ability to explain and control the world.

The first step in getting a better handle on trust is to define it well. As Smith indicates, the standard practice is to measure people’s answers to very broad survey questions (“How strongly do you agree with the statement that most people can be trusted?”) That is very unsatisfying.

When I worked at Freddie Mac, we were subjected to given some management training of the “teambuilding” sort, one of the goals of which was to improve trust within the organization. This lead us to think about trust, and one insight that some of us arrived at was that trust involves more than just a belief that someone else is well motivated. Often, trust breaks down because we lose confidence in other people’s competence. Even if you have very general views about other people’s motives, you are likely to assess other people’s competence relative to their specific occupations.

This factor of competence assessment is embedded in my views of the role of finance in economic fluctuations. In Specialization and Trade, I argue that financial intermediation can expand when people trust financial intermediaries. In particular, as we experience financial intermediaries meeting their obligations, we gain confidence in their competence (as well as in their motivation). This leads to more trust, more expansion of financial intermediation, and so on, until, in Minsky fashion, the intermediaries are engaged in dangerous activities, and we get a collapse, including a collapse of trust.

So trust is not “social capital” that you want to see increased indefinitely. At least in the case of financial intermediation, it is best for trust to be at some intermediate level. Not so low that relatively low-risk, high-return investment opportunities are missed. But not so high that you get an excess of relatively high-risk, low-return projects (e.g., sub-prime mortgage loans) that are funded.

Who Needs Liquidity?

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Lynn Stout writes,

Wall Street is providing far more liquidity (at a hefty price—remember that half-trillion-dollar payroll) than investors really need. Most of the money invested in stocks, bonds, and other securities comes from individuals who are saving for retirement, either by investing directly or through pension and mutual funds. These long-term investors don’t really need much liquidity, and they certainly don’t need a market where 165 percent of shares are bought and sold every year. They could get by with much less trading—and in fact, they did get by, quite happily. In 1976, when the transactions costs associated with buying and selling securities were much higher, fewer than 20 percent of equity shares changed hands every year. Yet no one was complaining in 1976 about any supposed lack of liquidity. Today we have nearly 10 times more trading, without any apparent benefit for anyone (other than Wall Street bankers and traders) from all that “liquidity.”

Pointer from Mark Thoma.

I was appalled by this paragraph (and by others in her essay), for a number of reasons.

1. It appears on a site calling itself “pro-market.” The conceit is that they are battling crony capitalism. However, the essay does not assert, much less establish, any connection between cronyism and trading volume.

2. Note that since 1976, some activities have been affected by the advent of a device known as the computer chip. The fact that we have nearly 10 times as much trading as then should be no shock. The cost of trading has likely fallen by way more than 10 times (feel free to compare brokerage charges adjusted for inflation). Who is Lynn Stout to suggest that the price elasticity of trading ought to be zero?

3. I would appreciate it if Lynn Stout could tell us how she thinks we should measure the benefit of liquidity. I believe that any thoughtful economist would say that this is a difficult issue. I have said that as individuals and nonfinancial firms we wish to hold liquid, riskless assets and issue risky, illiquid liabilities. Financial firms do the opposite. I am quite sure that this produces real benefits. But I would be hard pressed to arrive at even a conceptual approach to quantifying those benefits.

I believe that there is cronyism embedded in the relationship between Wall Street and Washington. But that does not justify pure demagogic bashing of investment bankers.

Finance, Fragile, and Anti-Fragile

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Tyler Cowen writes,

The first factor driving high returns is sometimes called by practitioners “going short on volatility.” Sometimes it is called “negative skewness.” In plain English, this means that some investors opt for a strategy of betting against big, unexpected moves in market prices. Most of the time investors will do well by this strategy, since big, unexpected moves are outliers by definition. Traders will earn above-average returns in good times. In bad times they won’t suffer fully when catastrophic returns come in, as sooner or later is bound to happen, because the downside of these bets is partly socialized onto the Treasury, the Federal Reserve and, of course, the taxpayers and the unemployed.

America’s mortgages are structured so that the lender-investor is going short on volatility. If interest rates do not move much, the lender does well. If home prices do not move much, the lender does well. But if interest rates rise, the lender is stuck with a below-market asset. And if home prices fall, the lender gets stuck with a house with a value below the amount of the loan.

Tyler is saying that for the typical financial market player, going short on volatility is a great personal strategy. When it works, you get a nice salary and bonus. When it fails, someone else–a shareholder, a taxpayer–bears much of the cost.

If you know your Nassim Taleb, you will recognize going short volatility as “fragile,” with the opposite strategy as “anti-fragile.”

I wonder if stock market investment is one of those fragile strategies nowadays. You can make money year after year going long the market–until it stops.

Anyway, Tyler argues that the changes in the income distribution of recent decades

a) have been focused at the top 1 percent, not between the 99th percentile and the lowest percentile

b) been driven by finance

c) and within finance have been driven by these short-volatility, fragile strategies.

He is pessimistic about regulators’ ability to stop the short-volatility strategies. I think he is wise in that regard.

Was the Fed necessary?

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George Selgin writes,

Nationwide branch banking, by permitting one and the same bank to operate both in the countryside and in New York, would have avoided this dependence of the entire system on a handful of New York banks, as well as the periodic scramble for legal tender and ensuing market turmoil.

Selgin’s thesis is that the banking laws as of 1900 gave privileges to New York banks and that part of the impetus for the creation of the Fed was the preservation of those privileges.

Rep. Hensarling on Risk-Based Capital

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He said,

Risk-weighting is simply not as effective. First, it is far too complex, requiring millions of calculations to measure capital adequacy. Second, it confers a competitive advantage on those large financial institutions that have the resources to navigate its mind-numbing complexity. Third, regulators have managed to get the risk weights tragically wrong, for example, treating toxic mortgage-backed securities and Greek sovereign debt as essentially risk-free. One myopic globally imposed view of risk is itself risky. Finally, risk-weighting places regulators in the position of micro-managing financial institutions, which politicizes credit allocation. Witness the World Bank recently advertising its zero risk rating under the Basel Accords for their “green bonds.”

Clearly, he understands what I call The Regulator’s Calculation Problem. Pointer from John Cochrane.

Read the rest of John’s post and weep. Weep because this could have been a year when a strong center-right Republican Presidential candidate, running on an agenda that includes these sorts of proposals, could have been so easy to support.

The Fed is not about Monetary Policy

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Lawrence H. White writes,

The fact that M2 has hardly budged from its established long-term path indicates that quantitative easing was not a change in monetary policy, in the sense that it was not used to alter the path of the standard broad monetary aggregate in a sustained way.

I think that the best way to think of all forms of government intervention in financial markets, including regulation and so-called monetary policy, is to remember that the goal is to allocate credit. Talk about financial stability or economic management is just smoke and mirrors.

White’s paper is on the problem of “exit” for the Fed, meaning reducing its balance sheet. But “exit” is not desired if my hypothesis, that the goal of government is credit allocation, is correct. Already, the balance sheet has remained large for far longer than was expected by anyone who thought of the Fed as conducting monetary policy. My hypothesis predicts that five years from now the Fed will have a balance sheet of approximately the same size, or larger. If the Fed were about monetary policy, such a prediction would seem ludicrous.

Another Minsky Moment?

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That was my reaction to reading this.

Brian Lockhart says, “The payout ratio for S&P companies was $200 billion more than GAAP earnings. Companies are borrowing money to buy back stock to drive up earnings-per-share. How do they pay that back? They have to take future earnings in order to pay back the debt they’re using.”

In my talk in Oslo on bubbles, I said that whenever asset prices are high relative to some historical pattern, there are always two narratives available. One narrative says “Bubble.” The other narrative says that historical norms have been superceded by new patterns. In other words, “This time is different.”

I do not have a strong view about which narrative best fits the current stock market.* I do take it as given that the ratio of share prices to earnings is on the high side relative to historical norms.

*My portfolio has for quite some time been relatively light on stocks, but I have not bailed completely and not gone short.

Un-taxed Owners of Corporate Shares

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Steven M. Rosenthal writes,

In a report published today in the journal Tax Notes, my Tax Policy Center colleague Lydia Austin and I found the other three-quarters of shares now are held in tax-exempt accounts such as IRAs or defined benefit/contribution plans, or by foreigners, nonprofits or others.

Pointer from Tyler Cowen. Other things equal, this should lead corporations to pay higher dividends. What other implications are there?

Timothy Taylor has thoughts.

My Thoughts on Too Big to Fail

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Nobody asked me. Instead, they asked Ben Bernanke and other usual suspects.

Bernanke criticized the notion that a breakup of large financial firms will promote financial stability, or mitigate excessive risk taking. In his remarks, Bernanke argued that in addition to the social costs, size also has benefits when it comes to banking. “In the long run, a US financial industry without large firms will likely be less efficient,” he said.

Pointer from James Pethokoukis. I like the way I expressed it in this post.

From 1980 to the present, our largest banks went from teeny-tiny banks to super-sized banks. I would like to dial them back to what I might call Goldilocks banks. I have three tests for that.

1. The Great Day test. Imagine that an official in Washington gets a call from the CEO from the nation’s largest bank requesting to meet right away, and the official says, “Take a number like everyone else.” It will be a great day when that happens.

2. The “Take my lumps” test. Suppose that you buy shares of stock or bonds issued by the nation’s largest banks. I want you to say, “If that banks gets into trouble, I’ll just have to take my lumps.”

3. The Dry Underpants test. If the Treasury Secretary and the Fed Chair learn that the largest bank in the country is toppling, they should be able to keep from wetting their pants.

I don’t have a precise number in mind, but if today’s largest banks have $2 trillion in assets, then I think that something like $200 billion might work.

During the crisis of 2008, the banks were big enough that Bernanke and Hank Paulsen failed all three tests.

Note that I do not claim that breaking up big banks would do anything for financial stability. What I see it doing is giving big banks a bit less leverage with policy makers and giving taxpayers a bit more leverage with them. To me, that is enough of a win.