Toward a run-free financial system
John H. Cochrane
April 16 2014
The financial crisis was a systemic run. Hence, the central regulatory response should be to eliminate run-prone securities from the financial system. By contrast, current regulation guarantees run-prone bank liabilities and instead tries to regulate bank assets and their values. I survey how a much simpler, rule-based, liability regulation could eliminate runs and crises, while allowing inevitable booms and busts. I show how modern communications, computation, and financial technology overcomes traditional arguments against narrow banking. I survey just how hopeless our current regulatory structure has become.
I suggest that Pigouvian taxes provide a better structure to control debt issue than capital ratios; that banks should be 100% funded by equity, allowing downstream easy-to-fail intermediaries to tranche that equity to debt if needed. Fixed-value debt should be provided by or 100% backed by Treasury or Fed securities.
1. Introduction and overview
At its core, our financial crisis was a systemic run. The run started in the shadow banking system of overnight repurchase agreements, asset-backed securities, broker-dealer relationships, and investment banks. Arguably, it was about to spread to the large commercial banks when the Treasury Department and the Federal Reserve Board stepped in with a blanket debt guarantee and TARP (Troubled Asset Relief Program) recapitalization. But the basic economic structure of our financial crisis was the same as that of the panics and runs on demand deposits that we have seen many times before.
The run defines the event as a crisis. People lost a lot of money in the 2000 tech stock bust. But there was no run, there was no crisis, and only a mild recession. Our financial system and economy could easily have handled the decline in home values and mortgage-backed security (MBS) values—which might also have been a lot smaller—had there not been a run.
The central task for a regulatory response, then, should be to eliminate runs.
Runs are a pathology of specific contracts, such as deposits and overnight debt, issued by specific kinds of intermediaries. Among other features, run-prone contracts promise fixed values and first-come first-served payment. There was no run in the tech stock bust because tech companies were funded by stock, and stock does not have these run-prone features.
The central regulatory response to our crisis should therefore be to repair, where possible, run-prone contracts and to curtail severely those contracts that cannot be repaired. "Financial crises are everywhere and always due to problems of short-term debt" is a famous Doug Diamond (2008) aphorism, which we might amend to "and its modern cousins." Well, then, let us purge short-term debt from the system and base regulation on its remaining truly necessary uses.
When they failed, Bear Stearns and Lehman Brothers were financing portfolios of mortgage-backed securities with overnight debt at 30:1 leverage. For every thirty dollars of investment, every single day, they had to borrow a new twenty-nine dollars to pay back yesterday's lenders. It is not a surprise that this scheme fell apart. It is a surprise that our policy response consists of enhanced risk supervision, timid increases in bank capital ratios, fancier risk weighting, macroprudential risk regulation, security-price manipulation, a new resolution process in place of bankruptcy, tens of thousands of pages of regulations, and tens of thousands of new regulators. Wouldn’t it be simpler and more effective to sharply reduce run-prone funding, at least by intermediaries likely to spark runs?
In this vision, demand deposits, fixed-value money-market funds, or overnight debt must be backed entirely by short-term Treasuries. Investors who want higher returns must bear price risk. Intermediaries must raise the vast bulk of their funds for risky investments from run-proof securities. For banks, that means mostly common equity, though some long-term or other non-runnable debt can exist as well. For funds, or in the absence of substantial equity, that means shares whose values float and, ideally, are tradable.
Banks can still mediate transactions, of course. For example, a bank-owned ATM machine can deliver cash by selling your shares in a Treasury-backed money market fund, stock index fund shares, or even the bank's own shares. A bank can originate and sell mortgages, if it does not want to finance those mortgages with equity or long-term debt. Banks can still be broker-dealers, custodians, derivative and swap counterparties and market makers, providers of a wide range of financial services, credit cards, and so forth. They simply may not fund themselves by issuing large amounts of run-prone debt.
If a demand for separate bank debt really exists, the equity of 100 percent equity-financed banks can be held by a downstream institution or pass-through vehicle that issues equity and debt tranches. That vehicle can fail and be resolved in an hour, without disrupting any of the operations or claims against the bank, and the government can credibly commit not to bail it out.
I argue that Pigouvian taxes provide a better structure for controlling debt than capital ratios or intensive discretionary supervision, as in stress tests. For each dollar of run-prone short-term debt issued, the bank or other intermediary must pay, say, five cents tax. Pigouvian taxes are more efficient than quantitative limits in addressing air pollution externalities, and that lesson applies to financial pollution. By taxing run-prone liabilities, those liabilities can continue to exist where and if they are truly economically important. Issuers will economize on them endogenously rather than play endless cat-and-mouse games with regulators.
The essence of this vision is not novel. Proposals for narrow banking or equity-based banking have been with us about as long as runs and crashes have been with us. The "Chicago Plan," discarded in the 1930s, is only one of many such milestones
Here a second theme emerges: Modern financial, computational, and communication technology allows us to overcome the long-standing objections to narrow banking.
Most deeply, "liquidity" no longer requires that people hold a large inventory of fixed-value, pay-on-demand, and hence run-prone securities. With today's technology, you could buy a cup of coffee by swiping a card or tapping a cell phone, selling two dollars and fifty cents of an S&P 500 fund, and crediting the coffee seller's two dollars and fifty cents mortgage-backed security fund. If money (reserves) are involved at all—if the transaction is not simply netted among intermediaries—reserves are held for milliseconds. In the 1930s, this was not possible. We could not instantly look up the value of the S&P 500 (communication). There was no such thing as an index fund, so stock sales faced informational illiquidity and large bid-ask spreads (financial innovation). And transactions costs would have ruled out the whole project (computation, financial innovation). Closer to current institutions, electronic transactions can easily be made with treasury-backed or floating-value money-market fund shares, in which the vast majority of transactions are simply netted by the intermediary. When you buy something, your account loses an electronic dollar and the seller’s account gains one, and no security actually changes hands.
On the supply end, $18 trillion of government debt is enough to back any conceivable remaining need for fixed-value default-free assets. Three trillion dollars of interest-paying reserves can easily be $6 trillion of reserves. We can live Milton Friedman's (1969) optimal quantity of money, in which the economy is awash in liquidity. This optimal quantity will have financial stability benefit far beyond its traditional elimination of shoe-leather costs. Again, technology has fundamentally changed the game: instant communication means that interest-paying money is now a reality, so we can have the optimal quantity without deflation. Our government should take over its natural monopoly position in supplying interest-paying money, just as it took over a monopoly position in supplying nineteenth-century bank notes, and for the same reason: to eliminate crises, which have the same fundamental source.
The quantification of credit risk, the invention of securitized debt, long-only floating-value mutual funds, and the size and liquidity of today's markets mean that financial flows needed to finance home and business investment can come from everyday saver/investors who bear risk rather than hold traditional deposits.
So, the most fundamental objection is met: that society "needs" a large stock of money-like assets, more than can be supplied by other means, so banks must try to "transform" maturity, liquidity, and risk, both to supply adequate assets for transaction-type needs and to provide adequate credit for real investment. I treat a wide range of additional common objections below.
1.3 Current policy
Our current regulatory response to financial crises is based on a different basic vision that evolved piecemeal over more than a century. In order to stop runs, our government guarantees debts, implicitly or explicitly, and often ex-post with credit guarantees, bailouts, last-resort lending, and other crisis-fighting efforts. But guaranteeing debts gives the borrowers (banks and similar institutions) an incentive to take on too much asset risk and an incentive to fund those risks by too much debt. It gives depositors an incentive to ignore bank risks when lending. So our government tries to regulate the riskiness of bank assets and imposes capital requirements to limit banks' debt funding. Then banks game their way around regulations, take on more risk, and skirt capital requirements; shadow banks grow up around regulations; and another crisis happens. The government guarantees more debts, expands its regulatory reach, and intensifies asset regulation.
Less heralded, but no less important, this regulatory approach demands strong limits on competition and innovation, even before banks try to capture it. If regulators let new institutions circumvent regulated ones, the problems erupt again. Too big to fail means too big to lose money, and too big to lose money means too big to compete.
Thus, Dodd-Frank regulation and its international cousins are not a radical new approach. They are just a natural expansion of a longstanding philosophy. Each new step follows naturally to clean up the unintended consequences of the last one. The expansion is nonetheless breathtaking. Beyond massively ramping up the intensity, scope, and detail of financial institutions and markets regulation, central banks are now trying to control the underlying market prices of assets, to keep banks from losing money in the first place.
The little old lady swallowed a fly, then a spider to catch the fly, a bird to catch the spider, and so on. Horse is on the menu. Will we eat?
The insight that the crisis was a systemic run, that we can fix runs by fixing and removing run-prone financial contracts, and that new financial and communication technology addresses the classic objections, liberates us from this Rube Goldbergian (or Orwellian?) regulatory project.
We do not have to fix every actual and perceived fault of the financial system in order to protect against future crises. We do not have to diagnose and correct the sources of the crisis, Fannie Mae and Freddie Mac, the community reinvestment act, so-called predatory lending, no-documentation loans, perceived global imbalances or savings gluts, Wall Street "greed," executive compensation, perceived bubbles (whether thought to be caused by irrational speculation or too-low interest rates), and so on. We do not have to fix credit card fees, disparate-impact analysis, student loans, or hedge fund fees. We don't need to micromanage over-the-counter versus exchange-traded derivatives, swap margins, position limits, the bloated Basel bank regulation mess, the definition of risk-weighted assets, the internal process and regulatory designation of S&P and Moody ratings, the treatment of off-balance-sheet credit guarantees, and on and on and on. The thousand pages of the Volker rule alone can start a nice bonfire. If a crisis is a run, and we can remove or fix run-prone securities, none of these steps is either necessary (whew) or sufficient (ouch) to stop a future crisis. A narrower regulatory approach that can stop runs, and hence crises, without requiring these Herculean (or Sisyphean?) tasks, no matter how desirable each one might be, is much more likely to succeed.
If financial institutions’ liabilities no longer can cause runs and crises, we don't have to try to micromanage institutions' asset choices or the market prices of those assets. Nor do we have to stop entry by new and innovative institutions. Rather than dream up a financial system so tightly controlled that no important institution ever loses money in the first place, we can simply ensure that inevitable booms and busts, losses and failures, transfer seamlessly to final investors without producing runs.
Zero cost is not the standard. The financial crisis was, by most accounts, a hugely expensive event. Dodd-Frank regulation and its international cousins are not cheap, either. The challenge is only to show that my vision, which narrowly focuses on eliminating the poison in the well—run-prone assets—stops crises more effectively and costs less than these alternatives.