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What to do
Megan McArdle ponders. I'll again mention one suggestion: make sure that financial institutions cannot use off-balance sheet activity to escape standard capital requirements. Many people asked about this in the comments but my view is simple:
1. As long as the Fed and Treasury are providing a safety net, insisting on capital requirements is entirely reasonable and it lowers moral hazard. If you're going to bail out your friend in a poker game, you can ask him not to bet too much beyond his chips.
2. When the "shadow banking system" does not have capital requirements, normal financial activities, as regulated by the Fed, are inefficiently taxed and too much of an economy's leverage ends up in the unregulated shadow banking sector.
3. If you are anti-regulation on this issue, make the capital requirement relatively low but still impose it symmetrically across financial sectors.
4. Ideally capital requirements should be adjusted for risk. That probably implies higher capital requirements for shadow banking activity, not lower requirements.
5. Regulatory issues aside, market participants are less sure of themselves in the shadow banking sector. Derivatives are non-transparent, for a start. That's another reason not to push too much financial activity into the shadow banking sector.
6. A final solution to excess risk-taking and leverage has to come from shareholders; regulation can only do so much and of course capital requirements are only a small part of regulation. But in the meantime I think the case for more symmetric capital requirements is a strong one, recognizing all the usual comments about horses and barn doors, etc.
Posted by Tyler Cowen on March 25, 2008 at 10:37 AM in Economics | Permalink
Comments
make sure that financial institutions cannot use off-balance sheet activity to escape standard capital requirements.
One question I have is why this sentence doesn't end with the word "activity." We seem often to find the phrase, "off-balance sheet" somewhere in the rubble of financial disasters. Maybe that merits attention.
Posted by: Bernard Yomtov at Mar 25, 2008 12:25:24 PM
I agree with Bernard. Hiding liabilities by taking them off the balance sheet seems to fundamentally invalidate the reasons for having public financial statements, audits, analysis, and everything else that valuations are based on. It's always struck me as a bit of a shell game.
In a libertarian world, shareholders would demand to know what management is hiding from them, but that seems to be the real underlying problem: a lack of shareholder advocacy on boards and committees. Too many boards are held captive by secretive and imperialist CEOs.
Posted by: bartman at Mar 25, 2008 12:35:38 PM
I agree with Bernard. Hiding liabilities by taking them off the balance sheet seems to fundamentally invalidate the reasons for having public financial statements, audits, analysis, and everything else that valuations are based on. It's always struck me as a bit of a shell game.
In a libertarian world, shareholders would demand to know what management is hiding from them, but that seems to be the real underlying problem: a lack of shareholder advocacy on boards and committees. Too many boards are held captive by secretive and imperialist CEOs.
Posted by: bartman at Mar 25, 2008 12:36:55 PM
Sorry about the double post.
Also, it seems to me that the cashflow structure (and needs) of these investment banks has gotten to be a bit of a Rube Goldberg machine in which every one of a million interlocking pieces has to be working perfectly or the whole thing comes to a grinding halt. In other words, the very complicated way in which the companies are structured introduces a lot of risk that is probably not priced properly.
Posted by: bartman at Mar 25, 2008 12:41:39 PM
"In a libertarian world, shareholders would demand to know what management is hiding from them..."
In a libertarian world there would be more diversity in how firms are incorporated and run, but there is no silver bullet. The costs and difficulties of shareholder management do not go away. So although innovation would likely improve things in many ways, it won't eliminate all Enrons, Bear Stearns, Countrywide, etc.
Posted by: John Kunze at Mar 25, 2008 12:47:29 PM
Bear Stearns had capital requirements and got into trouble, so the requirements were too low, right? No, they got into trouble by having too much of their asset base concentrated in one type of asset -- mortgage-backed securities. MBS's had been very profitable to them and they got cocky about it. They failed to diversify.
Perhaps asset concentration rather than low capital requirements or off-balance sheet activity is the problem today.
Posted by: John Kunze at Mar 25, 2008 1:10:36 PM
"If you're going to bail out your friend in a poker game, you can ask him not to bet too much beyond his chips."
First, I'd tell my friends that they should be investing, not gambling.
Second, these people aren't my friends. I agree with John Kunze. It was the job of the risk assessors to assess risk and they couldn't even do it. How is the Fed or, god forbid, Congress going to set these prior restraint limits a priori.
We take our shots and suffer the losses when we lose. Not these guys. As I said, these people aren't my friends, anyway. They are my enemy, in the financial sense. Most of these financial products are superfluous at best. They can't add value, so they come up with new risky scams and call it financial innovation. Every few years, they blow up, the Fed bails them out, debases my hard-earned, value-added money.
The only financial product I need is improved corporate records that help get to the truth of what companies are doing and help me interpret it so I can better allocate my capital to individual companies. This would also help with governance.
Their financial innovations crowd out the real work of finance. Rational capital allocation. Friends, hmmph.
People fall back on the notion that if the system were allowed to collapse, everybody would be hurting. I think the pain would be short, like taking out a splinter.
Posted by: Andrew at Mar 25, 2008 1:23:30 PM
Tyler,
The capital requirements imposed by the OCC/Fed are the primary cause for liquidity crises in the first place. All banks follow Basel II, which sets capital requirements based on Value-at-Risk measures. When there's a large movement in the markets, and almost all large movements are in one direction, down, then volatility is recorded as being higher and VaR shoots up.
This causes a vicious cycle because right when the market goes down and institutions should be buying capital requirements are tighter and more selling happens. Not only does this keep pushing prices down but it dries up trading because a lot more market makers than speculators fall under Fed control, and they can't afford to hold the securities to make markets.
It's funny that what you describe as the "shadow banking system" ie financial institutions outside the Fed purview basically include hedge funds, sovereign wealth funds, individual investors and private equity have all fared much better than the highly regulated banks.
Posted by: Doug Colkitt at Mar 25, 2008 1:31:46 PM
Doug Colkitt notes "the "shadow banking system" ie financial institutions outside the Fed purview basically include hedge funds, sovereign wealth funds, individual investors and private equity have all fared much better than the highly regulated banks."
Maybe. Maybe not. Risky investments will tend to look better than safer investments -- unless they crash.
How well have the sovereign wealth funds' investment in financial institutions in the last year done so far?
Posted by: ZBicyclist at Mar 25, 2008 1:45:01 PM
Since more than 90% of the money supply is created by private banks, I wonder where the corresponding seigniorage goes. And is the "shadow banking system" able to get part of it?
If the answer is yes :
1) Banks are regulated because rent-seeking through credit expansion results in an unstable financial system. With SIVs and the like, shouldn't the same symptoms require the same treatment?
2) Another possibility is to outlaw rent-seeking credit activities, but that wouldn't leave much of today's system.
Posted by: Stephane at Mar 25, 2008 2:07:05 PM
It seems likely to me that in a "libertarian world" the banking system would be unrecognizable to us. The ills of credit expansion (and collapse) would be internalized by the banks and individuals who chose to use a certain currency. The entire system would likely be far more complex, and I doubt anyone would be able to understand it in full any more than anyone can comprehend the IT industry now. But we aren't going to live in a libertarian financial world any time in the foreseeable future.
Some new legislation is going to come out of this fiasco. Given that our banking system seems to largely be centrally-planned, what I'm wondering is if the new legislation will be better than the old?
Posted by: Grant at Mar 25, 2008 2:29:19 PM
Quite a lot of experts expected the Spanish banking system to be particularly hard hit when the crisis broke. It is relatively untroubled in large part because the Bank of Spain had insisted that banks setting up SIVs and conduits needed to put up 8% capital - so they were not set up.
Posted by: David Heigham at Mar 25, 2008 3:33:58 PM
"Banks are regulated because rent-seeking through credit expansion results in an unstable financial system."
With stability like this, who needs rollercoasters? Instability, inflation, recession, regulation AND bailouts all at the same time. Is there anything else bad we could throw in just for kicks?
I think banks are regulated because they are under the protection racket of the Fed, just like Tyler says. And they want to be able to multiply the money supply. And they can make acceptable profits on lower interest rates than someone can lending only what's in reserve, crowding out responsible financing.
Posted by: Andrew at Mar 25, 2008 4:44:06 PM
I'll come at this a different way. What Congress needs to do is eliminate the Nationally Recognized Statistical Rating Organization status that Moody's and others have and eliminate the same ratings agencies Regulation FD exemption. Much of the cause of this mess is a combination of Basel II and the ratings agencies. Basel II requires minimal capital be held against AAA assets, allowing the banks to leverage them up tremendously. The NSROs - primarily Moody's, S&P and Fitch - rated hundreds of billions of dollars in securities AAA that were in no way comparable to the credit of Berkshire Hathaway, Johnson & Johnson, Exxon Mobile, the US Treasury, etc... But the ratings agencies, and to be fair almost everyone else on Wall St., used flawed models with limited historical data and the fatal assumption that home prices would never decline. As CDO after CDO was pumped out, with up to 70-80 percent rated AAA despite the underlying collateral being BBB- tranches of MBS backed by subprime mortgages, banks held less than 1% capital charge against the supposedly "super senior" tranche of these CDOs. In some cases they've now been marked down 50-60 percent or more, against an initial reserve of less than 1%, as allowed under Basel II. My other complaint is that the NSROs are exempt from Reg FD, meaning they get access to non-public information. This is both unfair to investors who must actually purchase the securities as well creates a moral hazard of people believing too strongly in the rating because of the perceived knowledge advantage. To some degree this happened in the boom as people essentially outsourced their due diligence to the ratings agency and basically accepted that AAA meant AAA.
I agree with the off balance sheet ideas. But one area that certainly needs reforming is the ratings agencies, both in their protected status by SEC and in their exemption from Fair Disclosure rules.
Posted by: joe at Mar 25, 2008 8:54:26 PM
Some of the issues regarding capital requirements for off-balance-sheet deals are influenced by the company's optional response. Some businesses that set up the Structured Investment Vehicles did not have a legal obligation to support the instruments, but felt either a moral obligation or a long-run interest in doing so. Should that imply a capital requirement?
Consider a non-financial case that is essentially the same. A car company sells a car with a three year warranty. Their balance sheet reflects a liability for warranty costs. The car company builds a car that has a major failing on many cars at 3.5 years of age. The company has no legal obligation, but may feel a moral or business obligation to go beyond its warranty. Should their books have reflected this additional liability? Should the books of all companies reflect liabilities for service that the company never anticipated, but may at some point, under some unforseen circumstances, feel obligated to pay?
More importantly, can I deduct on my taxes the cost of funding an unspecified reserve for future non-legal liabilities I might want to pay? (My CPA says "no" but I don't think he's aggressive enough.)
Posted by: Bill Conerly at Mar 25, 2008 11:18:00 PM
joe,
How many of the AAA securities have defaulted? I'm not sure it's fair to judge the efficacy of something by what the market price does (which isn't what the ratings are there to evaluate. Judging a whole class of investments by a fairly limited derivative index isn't a good tool of evaluation.
I agree that Basel II's effective exemption of capital for anything rated AAA should go, as should the rating agencies protected status.
If I could only fix one thing, it would be to smooth banker/trader pay to long term performance of their decisions. I'd bet if every banker/mortgage broker's only revenue source was the BBB tranche of every piece of business they wrote we'd have a whole lot fewer problems.
Getting rid of off balance sheet activities is nigh impossible. How would any insurance company issue public financial statements? How would Cisco? They are effectively an off-balance sheet manufacturer (all their factories are held by third parties).
Posted by: nelsonal at Mar 25, 2008 11:25:39 PM
Doesn't off-balance-sheet activity render things less transparent and lead to less efficient markets?
Why would that be good?
Posted by: ZBicyclist at Mar 26, 2008 12:53:55 AM
Leverage: Bear Stearns was more than 30X leverage. Say what you will, but with that amount of leverage,
when things go bad, they go very bad. Yes, investment banks hve always had tremendous leverage, but over
the last several years, and decades, banks, investment banks, nearly all financial players at an individual
level, and collectively, have increased leverage dramatically. The Fed bailout has bascially said that the
system, being so interconnected, is only as strong as the weakest link, so when one firm is highly levered
and poorly managed, it's a problem for everyone.
Run on the bank: very little one can do about this. Bear wasn't able to sell assets fast enough to overcome
the severe liquidity drains. This really could happen to just about any bank.
Marked to market: accounting convention has these firms marking to market securities, even if the market values are significantly below economic value. In this case, when liquidity goes away and the only price quotes are at distressed valuations, the amrking down of values paints a worse picture about the capital
position of many banks. I'd bet they'll be write-ups of higher quality securities over time.
IMHO, the off balance sheet issue is actually pretty small compared to the other problems. One big one is that managements just don't understand these products at all. They don't know where their firms' profits are coming from, and they don't udnerstand the risks involved. Not that they're dumb, they're just clueless. There's little or no opacity anymore to these businesses; and the firms themselves didn't have a clue when they in trouble, or in the case of Bear Stearns, out of business.
Posted by: glenn at Mar 26, 2008 2:39:10 AM
I'm not sure the off balance sheet issue and the knowledge issue are unrelated.
If management can't know the risks of these financial instruments (and if there are computational limits to the ability to assess risk) then maybe the safest choice is regulating the leverage-to-capital ratio. Correct me if I'm wrong, but it seems that some of the loss of trust associated with the liquidity crisis would be fixed if investors could count on something like a reserve requirement for credit.
Posted by: sarah at Mar 26, 2008 7:39:21 AM
@ Andrew : "With stability like this, who needs rollercoasters?"
My point was not that regulation results in a stable financial system.
I wonder where seigniorage - aka monetary revenue - goes under a private banking system based on fiat money, and whether SIV's and other conduits could be in a position to catch part of it. Any thought on the subject?
Posted by: Stephane at Mar 26, 2008 3:21:14 PM
Very few (if any) triple-A rated mortgage-backed securities have actually defaulted. The problem is that the rating agencies downgraded so many of these securities from triple-A to junk so quickly that the market lost confidence in the ratings and the market for these products was so thin, and the understanding of their respective cash-flows so low, that it sparked a liquidity crisis. The mark-to-market accounting "problem" is really just a symptom. U.S. GAAP mark-to-market accounting allows companies in illiquid situations to use the underlying cash flow of the securities to derive a valuation ("mark-to-model"). However, the supposedly sophisticated investors buying these products were relying entirely on secondary market valuations and did not have the systems in place to model the underlying cash-flows of these complex securities. Consequently, when the market disappeared, they were left high-and-dry and are now complaining that mark-to-market accounting is requiring them to account for these securities "far below economic value" -- which, of course, begs the question of how they know the economic value of the security and why they don't justify whatever model they are using to "know" this information as U.S. GAAP allows. As Warren Buffett once said, never invest in a business you cannot understand.
Posted by: M.D. Fatwa at Mar 30, 2008 5:10:38 PM
Posted by: china at Mar 31, 2008 9:36:42 AM
