More on financial reregulation

After reading the comments at the Wall Street Journal (some in response to
my earlier post), and listening to various commentators on the boob tube today,
I have some additional thoughts. Many of the responses to the president's
proposals (and my original comments) have been along the lines of we need
to fix the things that caused our current state of affairs -- they then go on to
point out how many of the elements of the president's plan do not correctly
address this or that participant; or this or that situation that contributed to
the current mess. Many of the pundits have correctly pointed out that the Obama
team is in fact making two proposals: one to put a "firewall" between "risky"
activities, and those with little risk; the other is to attempt to limit the
size of "big" Banks. The Obama administration apparently is of the opinion that
the "too big to fail" issue is a problem (that needs to be addressed/prevented)
rather than an unavoidable fact of life in the financial world of
21st-century.

Whether an activity contributed to the current financial
disarray or not, the essential policy issue here is whether we have effective
regulatory mechanisms in place to deal with systemic risk. As I stated in my
earlier post I am broadly in agreement with the attempt to segregate "risky"
activities from non-risky ones (and that would be in all financial
intermediaries whether classified as a bank or not; and "all" risky financial
transactions -- no matter who originates them -- a lot of commentary on the
financial TV channels was spent discussing abstruse things such as SIVs). We
need to foster going forward two kinds of financial intermediaries: those with
the appetite for, and the ability to manage, risk; and those who engage in more
mundane, less risky retail banking activities. I believe these two kinds of
entities need to be kept separate: one, because (in the past) internal "Chinese
wall" approaches have not worked very well, and two, because at base this is
mainly an issue of "corporate culture". You cannot create an entity (I believe)
that can accommodate at the same time pro-risk and anti-risk cultures within a
single organization.

On the other hand I find the proposal to limit the
size of "big" Banks distasteful, and wrong-headed. In the globalized world in
which we live, large financial intermediaries are a fact of life, and if we wish
to remain globally competitive (and to keep a sizable fraction of financial
services jobs in the US), then we must have entities of sufficient size and
expertise to compete on the global playing fields. We have already seen the
deleterious effects of Sarbanes-Oxley in the migration of parts of the financial
services industry to places like Hong Kong and London. In the 80s and 90s New
York was the financial center of the universe; today that is no longer the case.
If we attempt to limit the size of large investment banks, New York will be
relegated to becoming a financial backwater. "Too big to fail" is not something
that needs to be "fixed". Rather, it is an unavoidable consequence of the
globalized economy, and we should -- as a matter of public policy -- figure out
rational ways of handling the situation when a "too big to fail" entity gets
into trouble.

Cheers,
Ed

Financial Reregulation

After reading this article in the Wall Street Journal:  Obama Moves to Restrict Big Banks , I decided to put in my two cents for whatever they may be worth (certainly not as much as when a dollar was a dollar ).

 

At last, Obama has done something that I actually can agree with. In my time I have worked for the exchanges, a large investment bank, a large "money center" bank, and a mergers and acquisitions-oriented "merchant bank". Most working in financial services today probably have forgotten what the financial landscape looked like back in the early to mid 70s.

Essentially there were four entities: brokerages which sold financial products (mostly to the public), investment banks (specializing in proprietary trading of various sorts), investment banks (specializing in underwriting and mergers and acquisitions), and commercial banks. Commercial banks offered checking accounts (at cost), savings accounts (on which the interest offered was strictly regulated by Reg Q.), and commercial loans of various sorts. Commercial banks (except for the five large "Money Center" Banks) were small, and mostly limited to operations within only one state. Commercial banks engaged in a generally low risk, modestly profitable business in which they obtained funds relatively cheaply (through checking account deposits, and Reg Q.-limited savings deposits), made some money playing the "float" (of several days duration), and made some more money from the interest charged on the commercial loans and mortgage products which they offered. Risk was low, risk appetite was extremely aversive, and compensations and profits were moderate. Across the street in the investment banking community risk was high, appetite for risk was large (with numerous mechanisms of a highly technical, quantitative nature in place to help manage risk), and compensation and profits (in most years) were large. If an investment bank made a mistake, and lost money they took their lumps, ate the loss, and moved on.

All this started to change as the economic and technological background to all this began to evolve. Two events stand out in my mind: NOW accounts, and cash machines. Now accounts (offered primarily by brokerage firms) represented a direct threat to the income streams of commercial banks because they could offer returns on deposited funds above that offered by the reg Q-limited commercial banks. In general there was pressure to "speed up" the flow of money throughout the economy. Interest offered on deposited funds had to be increased, and the "float" periods were narrowed; cash machines made deposited funds "more available" to depositors as well.

Commercial banks responded by asking the government to eliminate Reg Q., and allow them to enter into "brokerage" businesses. Meanwhile across the street at the investment banks, they were inventing new kinds of financial products to meet the needs of an ever more complex and international financial marketplace. One of these "new" products: mortgage-backed securities, helped to lower the interest rate charged on housing loans, and as a side effect did some social good in eliminating such pernicious practices as "redlining". However, they also over time in effect removed a traditional income stream from commercial banks; commercial banks became the originators and "servicers" of the loan (for which they received a fee), but in general they no longer received the interest paid as the loan was repaid. Somewhere along the way restrictions on interstate banking were reduced, and then effectively eliminated, and large transnational entities began to emerge.

This set the stage for the final result: large multinational banks engaged in both traditional commercial banking as well as the more risky brokerage and investment banking businesses. With the recent meltdown in the housing marketplace, it has become apparent that some of these institutions are literally "too big to fail" because they are intertwined in every facet of the financial landscape across essentially the whole world -- such that a failure could possibly lead to a "domino effect" widespread financial disaster that would have dire consequences not only for our nation but many others as well. Many of these institutions have evolved from corporate cultures that have little understanding of the risks associated with the high profitability of some of their products -- leading to an over reliance on them in contributing to the bottom line.

I think, therefore, that a return to some form of "Glass-Steagall" is going to be necessary. Certain activities are vital to the day in day out functioning of our economy, have risk profiles that are relatively low and manageable, and need to be supported as a matter of public policy to foster financial and political stability. On the other hand the riskier, high profit transactions are also vital in the new highly fluid, technologically advanced, "global" economy. We need to foster both kinds of activities and protect them as well as we are able. Separating high risk from low risk activities seems to me to be a good idea. In addition I think we need a mechanism somewhat akin to the FDIC which would include a fund to bail out institutions engaged in high-risk activities -- especially institutions that are regarded as "too big to fail". Institutions in the "too big to fail" category should be charged an ongoing fee to ensure that this fund is adequately provisioned. In addition should an institution be a member of the "too big to fail" club they would be subject to additional "emergency" levies should the money available in the "too big to fail" fund be inadequate to cover a particular failure.

Our efforts here need to be "ex ante" rather than "ex post" -- we need to get away from this notion of "punishment" for bad behavior and rather recognize that these activities are necessary, yet nevertheless require some exposure to risk, and that there will be from time to time failures that will need to be accommodated. Further, we need to recognize that the analysis and management of risk, and the willingness to undertake risky transactions are highly complex and technical activities that require higher than normal compensations. The notions that certain "bonuses" are out of line need to be set against the highly skilled and risky nature of the transactions these people engage in.

Obama's proposal appears to me in general to be headed in the right direction; at least Paul Volcker understands the environment and the relevant history.

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