I’ll provide a post-mortem on my appearance at this panel on whether or not to break up the banks after I’ve had more time to reflect.
Prior to the panel, I Googled one of the other panelists, and I found that he had hopes for the Volcker Rule, which would try to keep banks from doing proprietary trading. I am not a fan of the Volcker Rule. In fact, in recent years, I have not been a fan of Paul Volcker, because I think he has what I call a low geek quotient.
What I call Geek Finance has emerged over the past thirty years. It is used extensively in derivatives markets and in mortgage finance. It involves very complex probabilistic simulation models that are used to assign values to long-term, deep out-of-the-money options. Some thoughts.
1. Is Geek Finance a good thing? On the one hand, I would say that we need some rational way of valuing these sorts of options. On the other hand, it is important to be aware of the assumptions that go into such models and not to have too much faith in their precision. In the case of mortgage default risk, for example, it matters whether you assume that house prices across different locations are highly correlated or nearly independent. It matters whether you assume that a large nationwide house price decline is practically impossible or just somewhat unlikely.
2. Shortly after the financial crisis, Robert Merton, who shared the Nobel Prize for developing option price theory, gave a lecture in which he suggested that many top corporate executives did not really understand what was being done by the practitioners who worked for them. I termed this the Suits vs. Geeks divide. Many CEOs, and also many top officials in Washington, had low geek quotients.
3. Whether you love or hate geek finance, whether you want to tolerate it or would seek to get rid of it, you have to understand it. I think that Suits with low geek quotients are dangerous.
4. In 2003, Freddie Mac’s Board ousted a CEO with a high geek quotient and replaced him with a CEO with a low geek quotient. The main change that resulted from that was that Freddie Mac greatly increased its exposure to risky loans.
5. In 2006, Goldman Sachs lost a CEO with a low geek quotient. Subsequently, and this may have been purely coincidental, Goldman was relatively good at reducing its exposure in the mortgage market.
6. The original idea of TARP, which was to use government funds to buy toxic assets, had a low geek quotient. As a geek, I did not think it was workable. Of course, this idea was never implemented. Instead, the TARP money pile was used to inject capital into banks, to restructure GM and Chrysler, and ….well, whatever the President and Treasury Secretary felt like spending it on, it seems.
7. Back to the Volcker Rule. I don’t think it can fly. My prediction is that they will get it off the ground to save face, then it will wobble at low altitude for a bit, and within a few years you will find it resting on the ground. I imagine a sequence of conversations going something like this:
Volcker rulers: Banks, you cannot touch securities.
Banks: But you do want us to hedge our risks, don’t you?
Volcker rulers: Hmmm. OK, but you have to hold your hedging instruments until they mature.
Banks: But when interest rates change, you do want us to rebalance, don’t you?
Volcker rulers: Hmmm. OK, but…
etc., etc., until there is no rule left
So low geek quotient CEOs were more trusting of bamboozling con-men with a risky venture? You are scaring me.
Arnold:
To begin with, I concur completely with all 7 of your listed observations – including the applications of your Suits/Geeks conceptual framework. And I’m looking forward to your “post-mortem” comments on this panel, paper and the question of breaking up the “big banks”.
The question I have, that I’ve not seen addressed by those who favor breaking up the big banks, is: How would it be done? More explicitly, along what lines should a large financial institution be broken up? By global versus domestic operations? By conventional commercial operations versus investment operations? Or some other “line of demarcation” that hasn’t been defined yet? I’d really like to see/hear breakup advocates explain that and their justifications.
On “The Big Bank Theory: Breaking Down the Breakup Arguments” …
I downloaded and began reading through this paper, and frankly found it misleading to the point of being comedic. The extent to which it propagates the myth the “taxpayers” will somehow be “protected” by the new regulatory regimes, OR by breaking up the large financial institutions for that matter, is the comedy.
To wit: “Title II of the Dodd Frank Act established the Orderly Liquidation Authority process to allow a major bank to be put through bankruptcy or an alternative insolvency proceeding. Under this mechanism, losses suffered by financial institutions are to be borne by its shareholders and creditors, not taxpayers.”
(I guess “shareholders and creditors” are not “taxpayers”. Indeed, according to this, “taxpayers” and “shareholders/creditors” are mutually exclusive groups. Didn’t know that.)
And this gem: “Whether the total increased regulatory cost borne by large banks is $20 billion, $30 billion, or $50 billion annually will be difficult to determine.”
(Whatever it is, I’m sure glad it’s going to be the “large banks” that bear the costs of these new regulatory burdens – and not us “taxpayers”. So now I guess we can add “depositors” to the list – with “shareholders/creditors” – of folks who are exclusive of the group “taxpayers”.)
> The question I have, that I’ve not seen addressed by those who
> favor breaking up the big banks, is: How would it be done?
> More explicitly, along what lines should a large financial
> institution be broken up? By global versus domestic operations?
> By conventional commercial operations versus investment
> operations? Or some other “line of demarcation” that hasn’t
> been defined yet?
By “parts that are obscure enough that no one will notice when we require it to be sold off at a discount to our friends” vs. other parts? My tongue is only partly in my cheek, because the public choice issue is big.
Max L.
I don’t envision officials breaking up banks, but rather providing enough of a penalty for size that banks choose to spin off some of their operations. I will say more in subsequent post.
Perhaps if the creditors, shareholders and management of the financial institutions were made to suffer the loss of excessive risk taking, they would be inclined to demand prudent behaviour and insolvency would be less likely.
It also seems unfair for all the benefits to accrue to the subset of taxpayers who are creditors, shareholders and management but the losses be imposed on all taxpayers indiscriminately.
Finally, if there is an incentive for financial institutions to demerge, I am certain they will find profitable ways to do so. The implicit subsidy from ‘to big to fail’ has certainly encouraged mergers in unwieldy and seemingly unmanageable behemoths.
Hi Lindsay:
It might surprise you to know that I completely agree with you. Both as to which sub-group of taxpayers should (and do) bear most of the costs of failed risk-taking, and that if benefits accrue only to the sub-set of taxpayers who are creditors, shareholders and management, they are the sub-group who should bear the costs of imprudence.
But I would ask you to consider that the subset of taxpayers who are shareholders and creditors of large financial institutions is vastly larger than you might think. They aren’t just the bad old rich fat-cats. They are any taxpayer (or non-taxpayer) who owns shares in a mutual fund, or who has a pension account, or a 401K account, or even retired folks who own Certificates of Deposit (CD’s) as a means of supplementing their income. The vast majority of those investment vehicles are invested in large financial institutions such as J.P Morgan Chase, Citibank, Bank of America, etc.
I would venture a guess that you either own shares in or are a creditor of – at least indirectly – in those “big banks” if you have any sort of pension account, 401K, CD, or even a savings account.
So it turns out that a very large subset of taxpayers bear the costs of imprudence – and rightly so. My point in my original comment is that the folks who authored this paper seem to want you to believe “taxpayers” are protected not only from the costs of imprudence/excessive risk-taking, but also from bearing the costs of the new regulatory regime.
The paper propagates the notion that it will only be the “big banks” that pay the seemingly inestimable, but very large ($10B to $50B, per year) ongoing costs of the new banking regulations. And that “taxpayers” are somehow protected from those regulatory costs. That isn’t just misleading, it is an out-and-out lie – for at least the reasons I alluded to above.
There is one other reason I would ask you to consider. The increased regulatory costs are inestimable at this point in time, but are legislated and will become reality at some point. When they are fully implemented and the U.S. financial system assimilates, adapts and writes the checks to pay for the new regulations, I suspect it will not be the subset of taxpayers who are just shareholders, management and creditors who bear all or even the majority of those costs. Applying a few economics principles, I suspect it will be depositors and borrowers who bear the majority of the regulatory costs – depositors by way of marginally lower interest rates on savings, and borrowers by way of marginally higher charged interest rates.
So if we include depositors and borrowers into our vastly larger group subset of taxpayers who are shareholders, creditors and management, I suspect pretty much ALL taxpayers – and many folks who aren’t taxpayers – are going to be picking up the costs of the new regulatory framework. And that, completely irrespective of whether the “big banks” are broken up or not. Or whether the new costly regulatory regime lives up to its promise of precluding another financial system “meltdown” or not.
Frankly, I’d prefer a $350B “taxpayer bailout” event every 20 (or more) years to an additional $50B per year perpetual regulatory cost burden. That preference is because I’m a taxpayer (as well as being a depositor, borrower, saver, creditor and shareholder.) And I consider the 2008 “bailout” one of the most abhorrent events in U.S. financial system history – but probably not for the reasons other people do.
Geek finance has an important role to play, but it has been used in the past to obfuscate rather than clarify. Copulas and CDOs for example.
I would add that the most important ideas should be within the grasp of low-geek quotient folks. Regulatory arbitrage. Too big to fail. “If it [expected return] looks too good to be true, it probably is (securitization and fake AAAs).”
Arnold: “I think that Suits with low geek quotients are dangerous.”
Or is it Suits who don’t realise they have low geek quotients who are dangerous?
I think I remember one Suit banker saying something like: ‘They tried to explain that stuff to me, but I didn’t understand them, so we didn’t buy it.’ Don Drummond at TD maybe? (Though maybe Don is semi-geek.)
The Suit vs Geek divide is (presumably) also present in Canadian banks. And they have not been, in general, more tightly-regulated than US banks. But they very rarely fail. I don’t know why.
The problem is that all banks practice modern risk management techniques now. When everyone does it, it doesn’t help any more. It just makes it impossible to see when the problems are building.
“[W]e need some rational way of valuing these sorts of options. On the other hand, it is important to be aware of the assumptions that go into such models and not to have too much faith in their precision.”
We may need a rational way to value them. That doesn’t mean we have a rational way to value them. Assessing the probability of rare events using unverifiable assumptions about initial conditions is augury with math, no matter how deep you go into the Greek alphabet to write the equations in your model.
It seems to me a trifle hypocritical to accept a gig as Chief Fortuneteller for the Emperor, knowing he will move his armies according to your forecast, and then to sniff that the Imperial Suits didn’t read the fine print about exactly how wrong you might be about this stuff when deciding to deploy their assets to follow one of your strategies, and throw up your hands. The Street’s a den of bookies, the gig is to set the lines.