Category Archives: markets

Remarks on the Canadian banking system

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A commenter writes,

Before the depression, the US heavily regulated banks and restricted the founding of branches; there lots of small banks tethered to local markets. In contrast, Canadian banks didn’t face such stringent regulations and were larger and more diversified. For this reason, in the US we had an epidemic of bank failures, and Canada did not.

My thoughts:

1. The best part of Canadian banking is their mortgage design: a five-year rollover, with recourse. Recourse means that if your house goes down in value, you cannot just turn the keys in to the lender and walk away. They can come back to you to make up their loss. Our 30-year, fixed-rate, no-recourse mortgage has lots of credit risk and interest-rate risk that sits with the lender, until stuff happens, and then it goes to the taxpayer. We got stuck with losses from interest-rate risk during the S&L crisis, and we got stuck with losses from credit risk during the 2008 crisis.

2. The worst part of Canadian banking is the high concentration in large banks. As in Europe, this goes along with a very stunted equity market. Firms raise capital using debt, and they owe that debt to big banks. The U.S. system, with its much more prominent stock markets, is better.

3. The worst part of the U.S. financial system is the political power of trade associations and large banks. The trade associations have leverage over Congress, and the large banks have leverage over everybody in Washington. In Canada, the big banks have to respect the regulators. Here, the bank executives can go over the heads of the regulators any time they need to.

4. Over the last thirty years, we have seen a decline in the relative importance of the stock market in the U.S.:fewer public firms, many fewer IPOs, and firms raising less of their capital in the stock market. At the same time, we have gone from a fragmented banking system to one that is very highly concentrated. Household wealth also has become more highly concentrated.

I think that if you don’t do something to limit the growth of big banks, you end up with big-bank-dominated corporate finance, meaning less active equity markets and a less democratized financial system. Also, given our political culture, you end up with the political system subservient to the CEOs of the biggest banks. In short, you combine the worst of Canada and the worst of the U.S.

Financial Policy if I were in charge

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This afternoon, I am supposed to participate in a discussion of financial regulatory policy. There are so many participants, including big shots like John Taylor and John Cochrane, that I may end up not saying anything. I probably will just hand out the post that I put up in 2010, which I still like very much. Here it is:

1. Extricate the government from the mortgage market as soon as is practical. I foresee reducing the maximum mortgage amounts that of Freddie and Fannie to zero in stages over a period of three years, then selling off their portfolios two years after that. I would even get rid of FHA. I would also get rid of the mortgage interest deduction. My guess is that the market would evolve toward higher down payments, and probably toward mortgages like the Canadian five-year rollover.

2. Housing aid to poor people would take the form of vouchers. No other Federal involvement in housing.

3. I would support a law that says that lenders must not make loans with the intent of exploiting borrower ignorance. Allow case law to develop to define rules and norms in support of that principle, rather than try to come up with fool-proof regulations.

4. Break up the top 10 banks into 40 banks. I think that is the best solution to the “too big to fail” problem, although there is no perfect solution to Minsky-type financial cycles.

5. Replace capital requirements with systems that put senior creditors in line to lose money in a default. Let them discipline the risk-taking of financial institutions.

6. Define priorities for creditors in a bank bankruptcy. I think that the solution to the social value–or lack thereof–of derivatives and other exotic instruments can be handled by the priority assigned to them. I would assign them a low priority. That is, first ordinary depositors get paid off. Then holders of ordinary debt. Other contracts, such as swaps or derivatives, come after that. I think that this would provide all the incentives needed either to curb derivatives or lead them to be traded on an organized exchange. I don.t think that getting them onto an organized exchange should be sought after as an end in itself.

7. Get rid of the corporate income tax, which encourages excess leverage. If the private sector, including banks, had lower debt/equity ratios, the financial system would be sounder.

8. Develop emergency response teams and backup systems that can ensure that the basic components of the financial system, particularly transaction processing, can survive various disaster scenarios, both technological and financial.

The overarching principle I have is that we should try to make the financial system easy to fix. The more you try to make it harder to break, the more recklessly people will behave. By reducing the incentives for debt finance and for exotic finance, you help promote a financial system that breaks the way the Dotcom bubble broke, with much lesser secondary consequences.

[Postscript:

1. I took four books to the meeting, and I got autographs from their authors.

2. We are not supposed to talk about what was said.

3. I did not hand anything out. I requested to be called on at one of the discussions, but my time came just as people had been promised a coffee/bathroom break, so I did not receive very much attention. I tried to say that it is futile to try to make the financial system hard to break. Crises come from surprises, and you cannot outlaw surprises. I suggested instead the approach of making the system easy to fix. Have backup systems to keep ATMs working (Paulson and Bernanke claimed that without TARP the system would have been so frozen that ATMS would have run out of cash. That was a sales pitch that the “common man” needed TARP and I think it was probably a lie, but in any case a backup system would be a good idea.); backup systems for settlement and clearing of transactions on exchanges in case a financial derivatives exchange blows up; and changing the tax bias to favor equity rather than debt.

4. A commenter says that eliminating the mortgage interest deduction would be a blow to the middle class. Actually, if you assume an across-the-board tax cut so that the change is “revenue neutral,” it probably helps the middle class. The benefits of the deduction go mainly to the rich. In fact, you could just cap the deduction at a low level and leave the middle-class borrower alone, and still get most of the revenue from it. But for me, the point of getting rid of the deduction is not to get revenue, but to change the incentives on leverage. So I do not want to cap it. Instead, I would prefer to have it phase out over a period of 5 or 10 years for people who have mortgages.]

Banking vs. Transparency

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Tri Vi Dang, Gary Gorton, Bengt Holmstrom. and Guillermo Ordonez write,

banks produce private money because they can keep the information that they produce about backing assets secret. By being opaque, banks can produce bank money more efficiently. Opacity makes it prohibitively costly for an expert investor to find out information about the details of the bank’s balance sheet, eliminating the expert’s informational advantage. Opacity also mutes the effects that public information may have on the value of the bank’s assets. By keeping information symmetric among traders, opacity makes trading in bank money liquid.

All of this was explained in chapter 6 of From Poverty to Prosperity, the book that I wrote with Nick Schulz in 2009 (later re-issued as Hidden Wealth). On p. 224-225, we write

the assumption of complete transparency, in which any individual knows all of the risk being taken by everyone in the economy, is not merely unrealistic, it assumes away the reason for financial intermediation in the first place. . .a lack of complete transparency is built into the basic function of financial intermediation.

In my admittedly biased opinion, the narrative description in that chapter is much richer than the “model” that the four authors (including the most recent Nobel Prize winner) develop. Information about risks is not a binary phenomenon in which it is either public or not. People and the institutions that employ them have different access to information and different skills in processing it. That is what makes financial intermediation in the real complex–more complex than any model can capture.

Empirical Public Policy

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James R. Barth and Stephen Matteo Miller write,

Testing whether it is good policy to increase bank capital requirements from 4 percent to 15 percent requires calculating and comparing the benefits and costs of such a change. Across all tested cases, it becomes clear that the benefits of increasing the capital ratio from 4 percent to 15 percent equal or exceed the costs.

This is an interesting example to discuss.

1. I am very confident that I could find problems with their methodology. This is an area in which empirical analysis is much less definitive than the authors suggest. I would say that their abstract is an example of lack of humility.

2. Nonetheless, I am very sympathetic to their conclusion.

3. In fact, many economists, left and right, are sympathetic to their conclusion. It would be hard to find a prestigious academic economist who is opposed to higher capital requirements for banks than what we have now. Unless these guys count.

4. But I bet that in fact capital requirements for banks will remain low, almost surely with obscure loopholes that make them even lower than the stated levels. It would not surprise me to find that capital requirements are so low that they are not binding, meaning that many banks will maintain capital ratios well above the minimum.

5. Speaking of my opinions, in Specialization and Trade I claim that government intervention in markets generally consists of subsidizing demand and restricting supply. This is inconsistent with any optimal intervention to address market failure.

6. Another presumption of mine is that housing policy will be dysfunctional. In addition to subsidizing demand and restricting supply, it will discourage saving and instead encourage indebtedness.

My claims in (4) -(6) might fall under the heading of “empirical public policy.” That is, what sorts of public policies can we expect? These questions are under-researched. On the other hand, economists over-research the topics of market failure and optimal policy solutions.

Implicit in this research imbalance is a very optimistic view of government intervention. It helps ingratiate economists with people in power. In effect, the economist says to the politician, “You are a wonderful public servant. I, the wise technocrat, am here to help you in your benevolent endeavors.”

Thus, the empirical policy economist is both obsequious and self-flattering. What gets lost is the opportunity to provide the public with a realistic comparison between the political process and the market process.

Finance: Practitioners vs. Economists

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Pablo Fernandez writes,

If all investors had identical expectations,
A) Trading volume in financial markets would be very small. However, the trading volumes of many markets are
huge.
B) All valuations of the shares of a company should coincide. However, there are huge differences in stock
valuations (analysts, investment banks, consultants, financial companies …)
C) The return required for the shares of a company should be identical in all valuations.
D) The expected cash flows of the shares of a company should be identical every year in all valuations.

Since our world is not characterized by any of the four above characteristics, how can one even insinuate the
hypothesis of homogeneous expectations?

My thoughts:

1. I think that the models developed by financial economists have some value, unlike those of Keynesian macroeconomists.

2. However, the fiction of the “representative investor” is problematic for some of the reasons that the fiction of the “representative agent” is problematic in mainstream macro.

3. Economists tend to assume that the conflict between financial practitioners and financial economists should be resolved in favor of economists. To some extent, this has happened, as index funds and Black-Scholes option pricing became important in practice. But as Fernandez points out, financial practice still differs sharply from what models say that it ought to be, and the economists seem to be unwilling to explore why this is the case.

Reframing Financial Regulation

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That is a new compendium from Mercatus. I wrote one of the essays, on risk-based capital.

The way I see it, the main purpose of central banking and financial regulation is to try to allocate credit to uses favored by political leaders. These leaders want credit to be cheap and available for government borrowing and for residential mortgages. So we should not be surprised that risk-based capital requirements are used to reward banks that put money into those assets.

In the essay, I explain why risk-based capital regulation has not served the intended purpose of reducing financial risk.

Did SarbOx concentrate wealth?

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Marc Andreessen points out,

Microsoft went public in 1986, valued at $300m. It went to $300bn. Public shareholders got a thousand-time rise. When Google went public in 2004, it had about a $30bn valuation and went to about $300bn. Investors got about a 10-time rise. Facebook went public at about $100bn. It’s now $200bn, so public investors have had a two-time rise.

Pointer from Tyler Cowen.

Why is more value being captured in the pre-public phase than in the post-public phase? My guess is that Sarbanes-Oxley and the hostile environment to public corporations in general probably accounts for some of it. The consequence is that ordinary Americans capture a smaller share of wealth creation from growing companies than they used to.

Freddie, Fannie, and so-called Privatization

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The WaPo reports,

Steven Mnuchin, President-elect Donald Trump’s nominee to lead the Treasury Department, said Wednesday that privatizing Fannie Mae and Freddie Mac is “right up there on the top-10 list of things we’re going to get done,” setting off a buying frenzy among investors.

I am very leery of this. My preferred approach for getting the government out of the mortgage market is the following:

1. Immediately stop any government support for cash-out refinances, second mortgages, and investor loans. Restrict support to owner-occupied purchase mortgages or refinances that lower the rate and term of the mortgage without the borrower taking out equity. Leave all the other mortgages to the private sector.

2. Gradually lower the maximum loan amounts for government support. As you do this, the private sector will have to fill in. If somebody steps up to issue mortgage-backed securities, fine. If instead what emerges is a model with banks holding the mortgages they originate while using long-term funding methods, then that is fine, too.

If you were to suddenly “privatize” Freddie and Fannie, you might end up restoring the status quo prior to 2008, with these institutions enjoying “too big to fail” status. They can use that status to borrow cheaply in credit markets and behave like hedge funds. I can remember when they were doing exotic things involving securities denominated in foreign currency that had nothing to do with their supposed “mission” of helping housing. These exotic transactions did not cause the firms to blow up then–because they blew up on credit risk instead.

I really detest the model of privatized profits and socialized risks. If you are going to privatize Freddie and Fannie, then you have to figure out a regulatory scheme to avoid socializing the risks. It’s not easy.

The Minnesota Plan for Big Banks

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Neel Kashkari explains,

Today, banks can enjoy their explicit or implicit status as being TBTF potentially indefinitely. In contrast, the Minneapolis Plan puts a hard deadline on Treasury: Certify banks as no longer TBTF within five years, or else that bank will see dramatic increases in capital requirements. We believe the threat of these massive increases in capital will provide strong incentives for the largest banks to restructure themselves so that they are no longer systemically important.

Pointer from Mark Thoma. TBTF is, of course, too big to fail.

I endorse this approach. However, instead of the threat consisting of dramatic increases in capital requirements, I think that the threat ought to be to have the Treasury break up the banks. In effect, the government would be saying, “Either you break yourselves up, or we do the break-up for you.” I am confident that every large bank would come up with a divestment plan.

Keep in mind that the top financial institutions all grew through mergers and acquisitions. It is not as if any of them just naturally grew larger because of some unique ability to serve customers. As a result of these agglomerations, the largest institutions are too complex to be managed effectively. My guess is that breaking them into “smaller” units (I put smaller in quotes, because even after divestment these institutions would still be gigantic on a world historical scale) would not result in a large loss in total market value. It might very well result in an increase.

I should emphasize that smaller institutions are not necessarily less risky financially. But when they do fail, there are many feasible alternatives to bailouts. When a financial giant is about to fall, no Treasury Secretary can sleep at night unless there is a bailout.

Trust and Banks

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Erika Vause writes,

No institution more clearly relies on trust than the bank. That is precisely what makes banks a lightning rod for suspicion. From the time modern banking emerged, it has been the subject of intense misgivings. Many of these suspicions are with us still.

This issue gets much more attention in Specialization and Trade than it does in standard economic textbooks, but reading Vause’s essay makes me think that there is even more involved. The role of materialism is one example. That is people, including most economists, want to see value reduced to tangible properties of things, such as capital and labor input. A prerequisite for understanding finance is a willingness to acknowledge the large intangible components of value, including the components that consist of trust and financial intermediation.