Tuesday, September 21, 2010

Bank reform: the debate is the message

This article is part of a series:
Part I: Banking Reform: The Debate is the Message You are here.
Part II: Banking Reform: Simplify

What would banking reform look like? Following is a synopsis of opinion and alternatives. It does not really matter where we begin.

Simplify Banking

Let's begin with the assertion that Lehman's Balance Sheet, like all bank Balance Sheets, can not be measured.
“Large complex financial institutions” report leverage ratios and “tier one” capital and all kinds of aromatic stuff. But those numbers are meaningless. For any large complex financial institution levered at the House-proposed limit of 15×, a reasonable confidence interval surrounding its estimate of bank capital would be greater than 100% of the reported value. In English, we cannot distinguish “well capitalized” from insolvent banks, even in good times, and regardless of their formal statements...

... On September 10, 2008, Lehman reported 11% “tier one” capital and very conservative “net leverage“. On September 25 15, 2008, Lehman declared bankruptcy. Despite reported shareholder’s equity of $28.4B just prior to the bankruptcy, the net worth of the holding company in liquidation is estimated to be anywhere from negative $20B to $130B, implying a swing in value of between $50B and $160B.
Subsequent investigations by examiners found no illegality in Lehman's original valuations. Waldman's solution is to simplify bank structure so we can understand them and minimize the risk.

Higher capital requirements

Are higher capital requirements the answer? Giethner believes increasing capital requirements is better left to Basel because Congress isn't smart enough. Except we were relying on Basel in the first place, weren't we? How is that working out for us? In fact, Canada avoided financial collapse at least partly because they did NOT rely on Basel.

To be fair, the issue with capital requirements, apparently buttressing Waldman's assertion, is that many technically well capitalized banks quickly exhausted their reserves due to exposure of troubled assets. To Waldman's point, we do not know they are troubled until they are troubled (Just as most of us laymen, including Bernanke, do not know there is a bubble until it is bursting). The IMF cited study stipulates that retail deposits (over wholesale sources of capital) are the best predictor of bank survival in the crisis. In other words, banks that stuck to traditional banking came out ahead. Canada's regulation forces this outcome.

Increase regulation and regulatory power

The existing banking reform relies on even more sophisticated regulation and more powerful regulators. It is hardly surprising that government bureaucracy finds more government bureaucracy the answer. But there are gargantuan issues with regulation and regulators:
The problem with resolution authority is that it is like a nuclear bomb: it causes a lot of damage and you don't want to haul it out except as a last resort. So the default position for regulators is always going to be the same as it is for the banks themselves: do everything they can to avoid using it.
Well, there is that. And of course we're haunted with the specter of Bernanke telling us, even as the sky is falling, that everything was going to be just fine and dandy. Giving the Federal Reserve and the SEC even more power seems kind of irrational and silly given that they denied the issue the longest in the first place, but that is exactly what we have just done.

As Obama repeatedly says, Wall Street's main issue was greed. He uses the same argument with the oil industry. The general theme is that the inherent evil of capitalism left unchecked results in unscrupulous practice and devastation. Smart, empathetic bureaucrats can act as a watchdog to protect consumers.

The argument goes something like this: the issue with previous regulation was that lobbying had tilted the legislation in its favor. Now, armed with more regulation and power, the government will get it right. The government just has to keep trying. It is all that protects us from a society that is inherently unjust.

Control risk and simplify regulation

In response to the obvious incongruity of heaping even more nuanced regulation on top of a fortified, more powerful failed institution, experts like David Merckel suggests cleaner, simpler, 'dumber' regulation. His suggestion is to basically treat banks like insurance companies where regulation strongly inhibits any risk, and size is inversely related to capital requirements to combat the multiplier effect of a failing larger institution.

'Simple' and 'intensely risk averse' are attractive adjectives when it comes to regulation and banking. We do not want people playing with Grandma's nest egg. And given the inherent multiplier effect of banking due to their monetary role, their mistakes ripple through the economy in destructive ways that even economists arguably do not understand. Banking can not be where the risk takers of our society roost, especially since unlike any other industry, banking structure is inherently leveraged.

Except that is what is happening now. The 'smartest', most aggressive people gravitate to banking and use ever more sophisticated instruments to exact profits from the economy. Assuming that no one intentionally burns down their own house regardless of who will pay to rebuild it, the financial collapse attests to the fact that not even the the architects of such instruments understand their true exposure.

Merckel's argument then, is a powerful one. If we're going to have fractional reserve banking, make it simple and very boring. That approach works well in insurance. It can work well in banking.


The only experts likely to applaud current financial reform are the big government pundits. Even some of those pundits are left nonplussed; we are still left with 'Too Big to Fail' institutions and their dissolution is now institutionalized. To many, that sounds like a preservation of the collapsed system, not a major revision of it. Also, Fannie and Freddie have been institutionalized and any further reform delayed.

And Basel III does not significantly increase capital requirements even while it delays implementation until 2019. By then, the economy will have have made up its own mind regardless of the effectiveness of any reform.

All of these arguments, including the above alternatives, are technically reasonable and at least begin with a kernel of truth.

And they all suffer from the same hubris. Their initial premise is incorrect. Their message all makes the same mistake. And they are all a statement of the fundamental issue with the economy as designed.

They are all doomed to failure. We are attempting to make a silk purse out of a sow ear.

We shall critique each argument in subsequent posts.

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