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High bank profits
Mark Thoma has good links and good discussion. I don't know the "inside scoop" on the bank books, but in purely theoretical terms a bit of chicanery may be socially optimal now. In general, bank moral hazard-induced-risk-taking may move closer to socially optimal, the closer banks are to insolvency. Let's say that banks are generating high profits now by, one way or the other, pursuing short run profits and "going short" on market volatility. In the long run this investment strategy will bite them, sooner or later but probably later. In the meantime they likely will become solvent. If insolvency has a high fixed cost this can be a good risk, even from the taxpayer or social point of view.
Of course one does not want for this game to continue forever and it is hard to stop once it gets rolling. But on a period-by-period basis, now is not the ideal time to stop. Now may be the time to allow such opportunistic behavior to get banks out of the range of possible insolvency. Tolerance is a kind of invisible subsidy that costs us something only stochastically or in the more distant future.
Posted by Tyler Cowen on July 19, 2009 at 11:54 AM | Permalink
Comments
How much of the bank profits, and resulting exec. compensation, reflect not just short run profits, but pure rent-redistribution? By definition, redistributing billions in rents to the bank execs makes the rest of us poorer. That's not too appealing from the taxpayer or social point of view. Maybe we should take this opportunity to try to design institutions, including our tax and regulatory structure, with better incentives on that front.
Posted by: a student of economics at Jul 19, 2009 12:56:49 PM
I have no insight into the books of large investment banks, either. However, I would point out that there is a very reasonable, relatively low-risk strategy which might explain their currently inflated profits. When they do not take or assume principal positions, investment banks are liquidity-providing market intermediaries, which make money by taking the spread on transactions conducted by investor principals. Simplistically, a bank will buy a bond, a stock, a derivative, or whatever at or near the bid price and will sell it shortly thereafter at the higher ask price to another investor. While the bank must indeed commit and hold capital against the position while it resides on its balance sheet, usually that period is quite short (sometimes mere seconds). This "market making" role, as anyone can clearly see, is relatively low risk. Since fewer banks exist now than before the crisis, one should expect that bid-ask spreads should be wider, which should mean that pure market-making is more profitable right now.
You can also see that a pure market maker should make lots more money when markets are volatile, as the volatility usually means that investors are turning over their portfolios at higher velocities than normal. Transaction volumes rise, and bid-ask spreads often widen. This, from all appearances, seems to be true now. Tons of investors are liquidating, rebalancing, and retrading their securities as the crisis continues to unravel, and leverage levels across the economy are rebalanced. In addition, the government itself is issuing vastly more debt and pumping liquidity into the markets. As intermediaries sitting at the proprietary junctions of these increased flows, one should expect investment banks to be recording higher trading revenues. This seems to be what has happened, with investment banks recording their best results this past quarter in fixed income (debt) trading.
Finally, a bank with good market knowledge can make additional money by slightly extending its risk profile to encompass longer holding periods. If a market is trending up or down, a bank will normally have the best visibility of this condition and its expected duration--since it is in the middle of most of the market transactions and chatter from investors--and therefore can extend its security holding periods from seconds, minutes, or hours to days, weeks, and even months. Again, assuming a liquid market, this risk extension should not usually be too problematic.
And, one should not forget that banks with large illiquid toxic security positions from before the crisis should be able to write up their positions as the prices for those securities improve, as many have been doing. This will flow straight through their income statements as well.
Generally, for all of these reasons, volatile markets are ideal, relatively low-risk conditions for investment banks and other market makers. The only major risk to such strategies is if liquidity in one or more important markets suddenly dries up, and the bank is caught with large trading positions on its books which transform from low-risk market making "inventory" into high-risk, illiquid proprietary investments. If banks stick to low risk strategies and markets continue to be volatile and liquid, there is no reason to suspect that banks' current profitability should not continue. Should market volume dry up, however--because investors stop rebalancing portfolios at their currently elevated velocity--we will see risk-adjusted profitability decline.
Posted by: The Epicurean Dealmaker at Jul 19, 2009 3:29:00 PM
there's not that much chicanery required for high banking profits.
because 'everyone' wants short term instruments and liquidity, the normal business of banks (alternatively known as 'maturity transformation', 'providing liquidity', or 'funding long term loans with short term instruments') is quite profitable right now.
Posted by: babar at Jul 19, 2009 7:40:51 PM
Isn't it really true that the profits have suddenly appeared now that they don't have to mark to market a lot of their bad assets?
Posted by: Yancey Ward at Jul 19, 2009 8:14:47 PM
Describing the political thuggery of forcing the prudent to subsidize the imprudent as "tolerance" is a clear sign of an addict beyond redemption. Tyler - its time you submitted yourself to a ten-step program. Maybe one for the stochastically-impaired or how about moral-hazard-aholics anonymous.
It is always a good time to stop behavior based on looting.
Posted by: Brian at Jul 19, 2009 8:24:33 PM
"Tolerance is a kind of invisible subsidy that costs us something only stochastically or in the more distant future."
Sometimes I think you haven't been paying attention over the last couple of years. Tolerance of chicanery is what got us into the mess, not what's going to fix it.
Posted by: agm at Jul 19, 2009 9:25:54 PM
Since banks borrow with a short time horizon and lend with a long one, it is truly critical that the incentives be aligned for the long term. Tolerance of anything else by the taxpayer is financial suicide.
Posted by: rluser at Jul 19, 2009 9:49:14 PM
In the meantime they likely will become solvent.
This is like hoping that your friend the gambling addict will 'likely become solvent' if you just let him go to the casino one more time. Really, what does it take to convince you that (some of) the banks' business models are broken? The trillion dollar bailout didn't offer some sort of clue that maybe this functions more like extortion via bomb threat than a conventional business?
Posted by: bbartlog at Jul 19, 2009 11:40:18 PM
"While the bank must indeed commit and hold capital ... that period is quite short (sometimes mere seconds)."
Indeed, reported times go to the sub-millisecond range, giving lie to the notion of “holding capital” to provide liquidity.
But while I am very concerned that we capital markets participants are subsidizing the banks, let's be clear: ever since the creation of the Fed, banks have assumed the role of handmaidens to our monetary policy types. Their profit margins are dictated by cost of funds (managed, if not controlled by the Fed Funds rate) and the market rates at which they can lend. When the Fed wants to expand money in circulation, they lower costs to make it more profitable, ceteris paribus, to lend. And vice versa.
The recent orgy of bailouts and subsidies are merely the result of spectacularly misbegotten policy over the last decade, under which the Fed made money so easy to get that the banks forgot that they were supposed to be rationing credit to the more creditworthy borrowers (which the Fed does not do in its historical role). Instead, under our "we're practically giving it away!!!" policy, banks were convinced that they maximized profits by maximizing volume, and they only belatedly found that only the Fed gets to give it away without worrying about individuals' creditworthiness.
We still have this deal, right? The Fed takes care of the banks, because it needs banks to carry out credit allocation while it sets the overall borrowing level. Nobody wants to pay for it, but a deal's a deal. Except that Stiglitz keeps reminding us that there are other clauses that we could be invoking for the banks' failures; those clauses are independent of any misfeasance by the Fed.
Posted by: Walt French at Jul 20, 2009 2:13:14 AM
Chicanery is actually being pushed right now, because of the idiotic Keynsian ideas that fear is what destroys markets as opposed to people doing things that are actual bad ideas.
Posted by: Doc Merlin at Jul 20, 2009 2:39:13 AM
Your post is hogwash. The profits are going to bonus pools, not to massively reduce leverage and shore up capital.
Posted by: dwinds at Jul 20, 2009 6:28:33 AM
To review- the only public good relevant here involves systemic risk.
To become solvent, the banks need to increase leverage...with good loans. The most straight-forward way to do that is to in fact retool from mass producing bad loans to restructuring those bad loans into good loans. To do that, they must want to, which they haven't shown interest, and they must survive long enough to do it. They may not want to because then they have to book the losses. That is the problem with not marking to market. However, marking to market would threaten them now. So, accounting rules have them stuck. There should be a period of accounting grace for modified loans.
Posted by: Andrew at Jul 20, 2009 7:07:40 AM
"In general, bank moral hazard-induced-risk-taking may move closer to socially optimal, the closer banks are to insolvency. Let's say that banks are generating high profits now by, one way or the other, pursuing short run profits and "going short" on market volatility. In the long run this investment strategy will bite them, sooner or later but probably later. In the meantime they likely will become solvent."
Sorry, Prof. Cowen. But this is just proof that economists who haven't bothered to study the things they're talking about should learn to say "Hey, I really don't know." rather than spouting nonsense.
You are advocating the same solution that was put into place to recapitalize banks after the Latin American debt crisis and the same solution that was put into place to recapitalize banks a decade later after the fallout from the S&L crisis. Those who know their banking history realize that we are currently experiencing the long-run effects of pursuing a consistent policy for the financial system of gambling for resurrection.
Posted by: ccm at Jul 20, 2009 1:12:14 PM
Your comment re: Mark Thoma's article about the chicanery of recent bank profits makes me think that if that's how you behavioral economists view the world, the discipline's about as useful as tits on a bull. I am amazed how intelligent people can actually believe GS and JPM profits in the most recent quarter are legitimate. Open your eyes and ears...that giant sucking sound is the collective wealth of 90% of Americans being stripped from them.
Posted by: Nik Kondratieff at Jul 20, 2009 11:05:01 PM
