Economics rightly comes in for a lot of stick for failing to
appreciate the possibility of a financial crash before 2007/8. However it is
important to ask whether things would have been very different if it had. What
has happened to financial regulation after the crash is a clear indication that
it would have made very little difference.
There is one simple and straightforward measure that would go a
long way to avoiding another global financial crisis, and that is to substantially increase the proportion of
bank equity that banks are obliged to hold. This point is put forcibly, and in
plain language, in a recent book by Admati and Hellwig: The Bankers New
Clothes. (Here is a short NYT piece by Admati.) Admati
and Hellwig suggest the proportion of the balance sheet that is backed by
equity should be something like 25%, and other estimates for the optimal amount of bank
equity come up with similar numbers. The numbers that regulators are intending
to impose post-crisis are tiny in comparison.
It is worth quoting the first paragraph of a FT review by Martin Wolf of their book:
“The UK’s Independent Commission on Banking, of which I was a member, made a modest proposal: the proportion of the balance sheet of UK retail banks that has to be funded by equity, instead of debt, should be raised to 4 per cent. This would be just a percentage point above the figure suggested by the Basel Committee on Banking Supervision. The government rejected this, because of lobbying by the banks.”
Why are banks so reluctant to raise more equity capital? One
reason is tax breaks that make finance using borrowing cheaper. But non-financial
companies, that also have a choice between raising equity and borrowing to
finance investment, typically use much more equity capital and less borrowing.
If things go wrong, you can reduce dividends, but you still have to pay
interest, so companies limit the amount of borrowing they do to reduce the risk
of bankruptcy. But large banks are famously too big to fail. So someone else
takes care of the bankruptcy risk - you and me. We effectively guarantee the
borrowing that banks do. (If this is not clear, read chapter 9 of the book here. The
authors make a nice analogy with a rich aunt who offers to always guarantee
your mortgage.)
The state guarantee is a huge, and ongoing, public subsidy to the banking sector. For large
banks, it is of the same order of magnitude as the profits they make. We know
where a large proportion of the profits go - into bonuses for those who work in
those banks. The larger is the amount of equity capital that banks are forced
to hold, the more the holders of that equity bear the cost of bank failure, and
the less is the public subsidy. Seen in this way it becomes obvious why banks
do not want to hold more equity capital - they rather like being subsidised by
the state, so that the state can contribute to their bonuses. (Existing equity holders
will also resist increasing equity capital, for reasons Carola Binder summarises based on the work of Admati and
Hellwig and coauthors.)
This is why the argument is largely a no brainer for economists. [1] Most economists are
instinctively against state subsidies, unless there are obvious externalities
which they are countering. With banks the subsidy is not just an unwarranted
transfer of resources, but it is also distorting the incentives for bankers to
take risk, as we found out in 2007/8. Bankers make money when the risk pays
off, and get bailed out by governments when it does not.
So why are economists being ignored by politicians? It is
hardly because banks are popular with the public. The scale of the banking
sector’s misdemeanours is incredible, as John Lanchester sets out here. I suspect many will think that banks are
being treated lightly because politicians are concerned about choking off the
recovery. Yet the argument that banks often make - holding equity capital
represents money that is ‘tied up’ and so cannot be lent to firms and consumers
- is simply nonsense. A more respectable argument is that
holding much more equity capital would translate into greater costs for bank
borrowers, but David Miles suggests the size of this effect would not be
large. (See also Simon Johnson here, John Plender here and Thomas Hoenig here.) In any case, public subsidies are bound
to be passed on to some extent, but that does not justify them. Politicians are
busy trying to phase out public subsidies elsewhere, so why are banks so
different?
There is one simple explanation. The power of the banking lobby (and the financial industry more generally) is immense, from campaign
contributions to regulatory capture of various kinds. It would be nice to imagine that the UK
was less vulnerable than the US in this respect, but
there are good reasons to think otherwise. [2] As a result, the power and
influence of banks and bankers within government has hardly suffered as a
result of the Great Recession that they played a large part in creating.
So to return to my original question, would it really have made
much difference if more mainstream economists had been fretting about the position
of the financial sector before the crisis? I think they would have been ignored
then even more than they are being ignored now. The single most effective way
of avoiding another financial crisis is to reduce the political influence of
the banking sector.
[1] The optimum amount of equity is not 100%, in part because
some (subsidised) borrowing does increase discipline on bankers. For a good
discussion of other measures that might reduce the too big to fail problem, see this speech from Andy Haldane. An alternative
to the state picking up the bill is to inflict losses on depositors, but the
economic problems with this are pretty obvious. Nicolas Véron discusses the difficulties the Eurozone has
got itself into with this following the Cyprus crash: see also Simon Johnson here.
[2] In Europe, we had what Mark Blyth describes as the biggest bait-and-switch
operation in modern history, where a banking crisis involving private sector
debts was turned into a public sector debt crisis. While I would be the last
person to defend
the macroeconomics status quo, I also think there is an element
of bait and switch in the ‘macroeconomics in crisis’ idea. Macroeconomic theory
tells us a lot of useful
things about how to get out of the recession, if only politicians would
take some notice.
“So why are economists being ignored by politicians?” Another answer to that question is that politicians suffer from Rogoff/Reinhart deficit-phobia: an ailment that also afflicts the IMF and OECD. That is, politicians favour ANY FORM of stimulus that doesn’t increase the deficit or national debt.
ReplyDeleteThat’s why they want banks to lend as much as possible and why they favour QE. The fact that QE subsidises the rich and destabilises developing economies is just brushed under the carpet.
They need a bigger brush.
DeleteSo to return to my original question, would it really have made much difference if more mainstream economists had been fretting about the position of the financial sector before the crisis?
ReplyDeleteIf they had done it in they way they usually do indeed. You donot sell Eskimos snow you have to sell the heating.
The problem should be simplified and brought via politics to the public attention and you would have had a proper chance. As said earlier no use to convince fellow lefty academics with or without beard for issues like that. You need the public a plan that works and a simplified version that everybody can understand. If you have had these three public's attention a plan that works and a version that the general public understands you likely would have succeeded.
Piece of cake for the banks now, get the speed out of the process by all sorts of technical problems. Until the public has lost interest (and subsequently politics). After that it is business as usual.
The politicians were part of the problem. They phased out the Glass Steagal Act with GLBA and allowed too many players (mortgage companies) in the banking arena, while neglecting the changes that were taking place in the industry (the way bank's were supervised including capital requirements). Bank risk profiles changed completely after the GLBA dismantled Glass Steagal. And, regulators were competing for the opportunity to supervise the big banks while the whole industry was shrinking.
ReplyDeleteAt the same time, non-bank companies were growing and were not being regulated. These mortgage companies did not play by the same underwriting rules as the banks and were not properly supervised. If you tracked down most of the failed FNMA/Freddie Mac securities that were collateralized by mortgages and probably paid a high yield, I'll bet you that they came from unsupervised mortgage companies.
Bank of America's losses came from Countrywide Mortgage, yet no one on the regulator side criticized the underwriting (that we know of)before the acquisition. I wonder why?
Beth Pitzer
Yeah, Baby!
ReplyDeleteThis shows how much more progressive taxation, and regulation, can start a virtuous circle, which I had a post on, which was in Mark Thoma's links:
http://richardhserlin.blogspot.com/2011/09/sharply-progressive-taxation-virtuous.html
Before we are too quick to demonize Banks we should remember that the classic reaction of the politicians, whenever a Bank gets into trouble, is to get another bank to buy it, each time guaranteeing that the average size of Banks increases slightly. Barings was bought by Ing, which itself got into trouble later. Countrywide and Merril were bought by BoA, and BoA got into trouble.
ReplyDeleteThere is plenty of blame to go round here, but we are all still suffering from BDS - Banker Derangement Syndrome - and it's just a bit too trite and a bit lazy to go looking for white hats and black hats.
My view of the financial crisis is that it's a sub-case of what Minsky wrote about. After a long period of steady growth and falling inflation and interest rates, everyone reaches for yield and they adopt financial methods, sources of funding, levels of leverage, and even staff incentives that work until they don't work. And when they stop working, you go through an inflection point, a Minsky Moment, that isn't symmetric. No matter how slowly and gradually you approached the inflection point, the other side involves a drop into chaos.
And of course, anyone who was buying Tech stock on Margin in 2000, or who was flipping and re-financing houses in 2007, was doing exactly the same thing. And haven't individuals bought stocks on margin, or flipped houses before? And haven't authors written many books pointing out the dangers, only to be ignored the next time a nice gradual expansion began?
The point is that bubbles would not get as big, and the consequences of bursting would not be as serious if banks were required to have reasonable equity buffers.
ReplyDeleteAt $85 Billion a month, the drip-feed rate is way beyond what a gradual expansion would entail and the risks keep shifting to the main street; with a minuscule equity buffer, the banks chase brick and mortar companies, who cannot make a disruptive growth happen over months. The real risk is always borne by the real economy. The worry is that at this pace the equity buffers would be waning for the main street as well.
ReplyDeleteBarry Eichengreen asked a few months ago is his column, 'Why No Glass-Steagall II?'.
ReplyDeleteIncumbent politicians and journalists generally have largely shown themselves to be hirelings, but at least Paul Krugman and Joseph Stiglitz have come out as one and two in the WSJ list of most influential economic commentators (Krugman blog, July 3, 2013, 'Nobody Pays Any Attention To What I Say'), surely because they can point to having spotted the housing bubble before it popped.
Samuel Johnson in 1758 wrote this of journalism and history (Of the Duty of a Journalist):
"A Journalist is an Historian, not indeed of the highest Class, nor of the number of those whose works bestow immortality upon others or themselves; yet, like other Historians, he distributes for a time Reputation or Infamy, regulates the opinion of the week, raises hopes and terrors, inflames or allays the violence of the people. He ought therefore to consider himself as subject at least to the first law of History, the Obligation to tell Truth. The Journalist, indeed, however honest, will frequently deceive, because he will frequently be deceived himself. He is obliged to transmit the earliest intelligence before he knows how far it may be credited; he relates transactions yet fluctuating in uncertainty; he delivers reports of which he knows not the Authors. It cannot be expected that he should know more than he is told, or that he should not sometimes be hurried down the current of a popular clamour. All that he can do is to consider attentively, and determine impartially, to admit no falsehoods by design, and to retract those which he shall have adopted by mistake."
I wonder where economists would and should fit into this schema?
Thank you for an interesting post. Do you follow the work of Bill Black at Missouri? He has a decidedly worrying take on events of the last few years but one which seems to me broadly consistent with the general thrust of your views as expressed here.
ReplyDeleteI will follow your posts in future.
Simon, you say: "Why are banks so reluctant to raise more equity capital? One reason is tax breaks that make finance using borrowing cheaper. But non-financial companies, that also have a choice between raising equity and borrowing to finance investment, typically use much more equity capital and less borrowing. If things go wrong, you can reduce dividends, but you still have to pay interest, so companies limit the amount of borrowing they do to reduce the risk of bankruptcy. But large banks are famously too big to fail. "
ReplyDeleteI disagree.
Is it only banks that are too big to fail? What about GM?
Is it only banks that use debt in preference to equity? What about Enron?
How many rights issues do most PLCs ever undertake to raise cash for investment? And how many go to the large investment banks instead?
It is not only banks that get tax breaks for debt interest. Private equity uses it on an industrial scale. So why not simply change the rules of tax relief?
http://cantab83.blogspot.co.uk/2013/05/tax-avoidance-2-gsk-loan-trick.html
The fact is large multinationals behave just like banks. It is only some of the small family firms that are debt-averse and worry about bankruptcy because the livelihood of the owner depends on its survival. As soon as you separate management and ownership then you create a conflict of interests.
Simon, you said: "The larger is the amount of equity capital that banks are forced to hold, the more the holders of that equity bear the cost of bank failure, and the less is the public subsidy. "
ReplyDeleteIf you really want to eliminate the government bailout liability then you need to restructure banks. It isn't enough to just separate retail and investment. You need to separate low interest, low risk, instant access current accounts from high interest, high risk, time-locked deposit accounts. That is the only way you will resolve the triangular paradox of allowing banks to fail while avoiding bank runs and state bailouts. See:
http://cantab83.blogspot.co.uk/2013/05/the-right-way-to-regulate-and-rescue.html
As for the equity issue, it is about leverage and profit. Increasing equity requirements increases both a bank's leverage ratio and its Tier 1 capital adequacy ratio. This reduces the amount of lending it can provide, not just for a given level of bank equity, but also for a given amount of base currency in circulation.
In the past banks were protected by two measures: reserve requirements and capital adequacy. Capital adequacy was supposed to be insurance against bad loans. The reserve requirement was supposed to protect against bank runs, but it failed in times of crisis. So the result was it was abolished and replaced by the Fed discount window, or rather in the US it wasn't abolished but was replaced by the discount window, whereas in the UK it was abolished but wasn't replaced by the discount window - hence the Northern Rock bank run.
However, the reserve requirement also limited lending. The ratio of M4 money to M0 or M2 could never exceed a set multiple set by the reserve ratio and it tended to that limit over time asymptotically as (1 - exp(-a.t)). But as reserve money is deposits that are "dead money" (it can't be lent out) it was abolished, and it supposedly replaced by the equity used for capital adequacy. Unfortunately, this does not have the same stabilizing, self-regulating effect on the M4/M2 ratio. The ratio blows up and is inherently unstable over time.
So perhaps, rather than increasing equity, it is the re-introduction of reserve requirements that we need. Alternatively, if we regulated house prices then that would limit bank lending and bad debt as well. See:
http://cantab83.blogspot.co.uk/2009/10/how-to-control-house-prices-guide-for.html
I agree that we need to “…separate low interest, low risk, instant access current accounts from high interest, high risk, time-locked deposit accounts.” An increasing number of people and groups are now advocating that. E.g. see:
Deletehttp://www.bloomberg.com/news/2013-03-27/the-best-way-to-save-banking-is-to-kill-it.html
and
http://www.positivemoney.org.uk/wp-content/uploads/2010/11/NEF-Southampton-Positive-Money-ICB-Submission.pdf
But there might also be good reasons why bank equity is too expensive (from society's point of view).
ReplyDeleteIn particular, we've known since Townsend (1979) that if the owners of a firm are unable to verify the payoff of a project, then management can extract some of the payoff for themselves. The optimal (non-stochastic) financial contract in this case is risky debt, not equity.
In the case of banks, it's not unreasonable to think that the owners of the bank's liabilities (either debt or equity) are unable to value bank loan books properly - they require bank management to do it. This might give the opportunity for bank managers to extract a higher share of profits than is optimal (e.g. through setting larger bonuses). Fixed debt repayments would stop this.
"The state guarantee is a huge, and ongoing, public subsidy to the banking sector"
ReplyDeleteIncreased equity capital to help insulate society from excessive risk taking by the tbtf seems obvious. Arguments against it bear a lot of resemblance to a bunch of brats screaming when you take away their candy.
Why does it seem the one sector of our economy which should be promoting capitalism seems to be doing everything possible to make sure it isn't applied?
1. The banks are a dysfunctional part of the economy. By far the largest one in the business sector.
ReplyDeleteNext to the government in general and some groups like the aged and the bottom of the labour market.
leaving the last mentioned aside as they are also voters, reorganising these 2 gives some room to keep the standard of living at the same level when there is no growth and real wages are not rising.
2. The banking sector is also the by far the largest sector where reorganisation might be practically possible. SMEs are already heavily taxed, probably too heavily even. While taxing international business more is an illusion. A quoted company wil never accept a tax rise (and a massive loss in value of its shares) and likely react by partial or complete moves and taking jobs with them.
Banks however are are not able to move a substantial part of their activities by the nature of their business is local.
3. Profits=subsidy. And what is even worse is that real profit<bookkeeping profit. Banks have all sort of rules that allow them to hide losses and regulators accept that. So at the end of the day the sector is at this moment likely lossmaking while getting a huge subsidy via cheap borrowing.
4. You rather see snow in hell than the European bankingsector being able to bring their capital at a proper level This would involve 100s Bns probably Tns no way that it realistic even if they would want that.
Even made more difficult by the fact that a lot of the present banks still in business are a) bust and b) unable to function properly anyway (for several reasons).
5. In the South banks are used to keep the state afloat. Pensionfunds eg in Spain are already 'robbed'. With banks they were the 2 groups of institutions that kept the state from falling down. Re banks the structure is as follows:
-Banks buy sovereign debt;
-Give as repo/collateral to especially ECB for new loans.
Massively helped by the fact no capital is required for this set up as even semi bust states are deemed riskfree. And cuts in the collateral are low.
Nice carrytrade and with little downside risk for the banks. They are bust anyway and kept alive by the state. If the state would go bust they would be bust the next day.
6. It all opens the question if this is the right time to tackle the problem. A proper businesslike bankingsector would mean:
-Especially Southern banks, but also a lot in the North, would be bust;
-South (PIGGS belt) is bust the next day (better minute);
-Lending to the private sector would take a massive hit, with all sorts of consequences for the economy.
7. What the Dutch example shows is that:
a) countries have a truckload of unbalances (or similar problems);
b) only a relatively small part can be solved at the present time without making economic recovery totally impossible.
The Dutch adressed quite alot of unbalances and as a consequence have negative growth now. But eg still leave most of the aging problem unsolved anyway. The UK had at least as much problems but didnot let the RE bubble burst and is now in slightly positive territory.
8. Imho better to get the economy going again and if it runs attack the unbalances left one at the time. Will not work in practice of course as soon as things are going again all unbalances are likely to be forgotten again until they create the next crisis.
As solving unbalances will require a lot of financial means making the banking sector more efficient would be one of the possibilities to keep the standard of living for the majority of the population.
For the part of the bankingsector that is not adding much in making society function better while at the same time massively increasing risk in the banking system. next to open the sector up for real competition. The organisations are simply very slow in reacting to new developments (as the whole sector does that); coststructure way too high (wages are much higher for similar functions in unsubsidised sectoirs, no of 'shops' (and subsequently staff) is ridiculous seen the way things are done at present etc).
How to attack this issue (or a lotof similar issues) effectively.
ReplyDeleteNow it is basically done via specialised non mass media in a rather academic way and getting the pressure off during that process. While the other side is working effectively via lobbyist into the other direction.
Just some loose thoughts combine them yourselves:
1. Politicians main objective is to be reelected. They might get away with minor stuff which is forgotten at election time but no at the end of the day with the larger longer taking issues.
Look at EU; look at immigration if traditional parties donot react new kids on the block will arise (aka as populists).
The issues are very important for large groups of voters and permanently in the news. If the traditional parties donot react and pay attention somebody will jump in that (marketing)hole.
So to get this solved it would have to be an issue of the same or slightly less magnitude as immigration or the EU/Euro.
The issue is however very technical and complicated to get mass attantion it needs to be simplified and related to the economy (and via that way to people's wallet).
2. To appeal to the masses it has to be simplified so people understand it and the way if affect them (and their wallets).
At the end of the day the subsidy could otherwise have been used for Granny Johnson's medication, schoolfees for Mr and Mrs Peterson's kids. That kind of stuff.
Make it personal and make it an own wallet issue.
3. Keep the pressure on especially close to electiontime.
4. Come up with a total plan not just a rough idea. Not for the general public btw. But politics are clearly simply not able to do that themselves. One of the reasons at present the sector is winning on a lot of fronts.
5. Look at the Krugman example. Voted as the most influential economic commentator (by some idiots imho). It is of course important to keep your own supporters awake and informed. However the main mistake it is completely usueless if you have only 40% and do that in a way that pulls the other 60% off. You need 51%. In a nutshell Krugman's standard mistake.
At the end of the day it is not about media attention (Krugman does very well) it is about getting things done your way (Krugman is probably counterproductive).
Go for the groups that can make the difference and bring you to 51%. Otherwise it is practically useless. A nice academic exercise without any practical result.
And adjust the way you communicate to those groups to make it effective. An organic soybean munching lefty is not really a great presentor if you need social conservative groups for support. And the other way around.
But especially the 70s and 80s style lefties are in the firing line in general at the moment. They are the personification what a lot of potential populist voters (and a lot of others) see as what is wrong in today's society.
6. Politicians usually move when there is something to gain. Make it an interesting proposition for them (and do most of their work).
Same with media. These havenot seen this as a major news item as it is way too technical (and they themselves donot grasp it).
"There is one simple explanation. The power of the banking lobby" - I was enjoying this post (hey it confirmed my pre-existing views, so shoot me) up until it said that because its such a rotten explanation not least because it potentially encourages a distracting sideshow focus on better lobbying legislation.
ReplyDeleteRather than viewing things in terms of bad bankers vs government or us or regulators, a better explanation stems from taking a class based approach, specifically that of the British ruling class.
Ideologically, politicians, bankers and what not (i.e. the ruling class) genuinely buy into the more capital equals less credit therefore leave them alone argument. Heck they all buy into the lets leave them alone because London is a British "success" story and we need successes argument as well (if you want a practical example of this read the Win Bischoff TREASURY report)
Practically, big banks are stuffed full of private school then Oxbridge educated(the good Prof will know this first hand, so should presumably have an opinion here) members of the ruling class intent on making the big moolah for themselves (with occasional references to "trickle down" being used to explain how this is actually for the greater good). So again don't do anything to mess with their bonuses.
And then you look at the post government careers of politicians, regulators, civil servants and what not where they build up nifty portfolios of special advisor-ships here, senior positions there and directorships allova the place - in the financial services sector!
So does the immense power of the banking lobby explain things? No, of course it doesn't because for the most part they're pushing at open doors. What does provide a much better explanation is the pre-existing beliefs of the ruling class and its own sheer self-interest. Simples.
(I write this as someone who works in banking i.e. I know what bankers actually think because I ask them . I'd also suggest reading the stuff the Prof Karel Williams lot at Manchester University are churning out because its very good on the political economy of it all give or take some unnecessary sociological waffle)