The core problem of focusing on institutions not activities:
The theory behind so-called systemically important financial institutions, or SIFIs, is fundamentally flawed. Financial crises are pathologies of an entire system, not of a few key firms. Reducing the likelihood of another panic requires treating the system as a whole, which will provide greater safety than having the government micromanage a number of private companies.A crisis is a run:
The risks to a system are most pronounced when financial institutions borrow heavily to finance investments. If the value of the assets falls or becomes highly uncertain, creditors—who include depositors—will rush to pull out their money. The institution fails when it is unable to find a new source of funds to meet these obligations.
Nay, a crisis is a systemic run:
A bank’s inability to pay off its creditors can be transmitted to others. The mechanism can be direct: The debtor bank defaults, and its creditors cannot repay their creditors, etc. But the mechanism can be indirect. The suspicion that similar assets held by other institutions are subject to the same downward pressure can start a run at even an unrelated financial institution.Ok, a minor disagreement here: The dominoes theory -- I fail, I don't pay you, you fail, you don't pay Joe, Joe fails, etc. -- is popular and enshrined in much Dodd-Frank rule making. It simply did not happen. Our financial crises are simultaneous runs, not failure dominoes. I fail, your investors see that and worry you might not pay them back, so they run, and so on. Companies do understand counterparty risk! And even small equity buffers multiply -- For a domino to go from A to E, A's losses must exceed all the combined equity of A, B, C, D, and E. Domino models tend to have large single counterparty exposures and no equity. But, this is an oped, and it's a story widely told, so I can't blame Lazear for passing it on as a possibility.
The stability of equity:
consider the contrast between the 2008 financial crisis and the dot-com crash in the late 1990s and early 2000s.
The bursting of the dot-com bubble and subsequent failure of many Internet-based companies had serious repercussions for investors, but not for the financial sector. That’s because the failed firms were financed primarily through equity, not borrowed money. Investors took big losses when the value of tech companies fell precipitously. But there were no runs.Floating-value liabilities also are run-proof:
Mutual funds are similar. Many are large and hold assets that may be risky, but they don’t fail when the value of their assets falls. The liabilities move one-for-one with the value of the assets because the fund does not promise to pay off any fixed amount to its investors. There is no reason for a run: Getting money out first serves no purpose to investors nor does withdrawal of funds cause significant distress. The fund simply sells the assets at the market price and returns that amount to investors.Mortgage backed securities are fine -- if held long-only in investor's portfolios. It's funding MBS by rolling over overnight debt that causes problems.
The bottom line: equity financed investment and narrowly backed deposits
These factors suggest that instead of trying to divine which firms are systemically important, banks should be required to get a larger share of the funds they invest by selling stock. Bank investment funded by equity avoids the danger of a run: If the value of a bank’s assets falls, so too does the value of its liabilities. There is no advantage in getting to the bank before others do.
deposits—the checking and saving accounts that are bank liabilities—should be invested only in short-maturity secure assets, like Treasury bills.Good news: These views seem to be taking hold. The people who run the regulatory agencies are pretty smart, they do listen, and they understand better than we do just how unworkable the plan is for them to make sure no big highly levered bank ever loses money again:
The Federal Reserve seems to be wising up, and may require higher equity capital for the SIFIs and place less emphasis on regulation
Additionally, the international Financial Stability Board announced on July 31 that it would set aside work on designating funds or asset managers as systemically important to focus instead on whether their activities or products were systemically important.The last point is especially important. There has been a little noticed effort underway to designate asset managers as "systemically important." Asset managers buy and sell stocks on your behalf. There is no fixed value promise and no run here. But there is a chorus that worries the asset managers might all sell, herd, or otherwise act with behavioral biases and they need to be regulated as SIFI. If you understand that a crisis is a run, and that the government should not try to prevent any asset from ever losing value, you see this is not such a great idea.
John,
ReplyDeletePlease explain how you convince SIFI's to finance federal debt purchases by selling voting equity.
You don't. It's mortgages, and other loans to private sector entities that must be funded wholly or to a significant extent by equity. In contrast, where depositors want their money to be totally safe, their money is simply lodged at the central bank or put into federal debt.
DeleteAs to how to "convince" SIFIs to fund mortgages etc with equity, that's easy. Split the bank industry into two halves or two types of bank, or bank department. Re the "lend to mortgagors" half, just look at the liability side of its balance sheet. That should consist entirely of equity (or X% should be equity if the law says mortgages must be funded X% by equity). And if the equity isn't there, it's fines or prison sentences for those responsible.
Ralph,
Delete"In contrast, where depositors want their money to be totally safe, their money is simply lodged at the central bank or put into federal debt."
And if depositors instead put their money in a safe or under a mattress?
The question remains - banks (specifically primary dealer banks) are by far the largest purchasers of federal government debt when that debt is auctioned. These banks are really the ones we are talking about with regard to Strategically Important Financial Institutions (SIFIs).
Why do you think any bank (more specifically it's shareholders) would lend money obtained from new share sales to the federal government?
I don't see the problem in people putting money under mattresses if that's what they want to do.
DeletePrimary dealers don't to any significant extent buy government debt by selling equity. The biggest purchasers of debt are entities with cash to spare: insurance corporations, pension funds, foreign wealth funds, mutual funds etc. The only reason SIFIs / primary dealers get involved is that government or the Fed refuse to deal with anyone other than a very limited number of large banks. In other words those banks act as agents for the pension funds etc. I.e. central banks are simply delegating administrative work to SIFIs.
Ralph,
Delete"Primary dealers don't to any significant extent buy government debt by selling equity."
Under Cochrane's full reserve banking proposal they would have to make that choice.
"The biggest purchasers of debt are entities with cash to spare: insurance corporations, pension funds, foreign wealth funds, mutual funds etc."
Uh, no. Insurance corporations, pension funds, etc. typically buy that debt second hand. At auction when U. S. government debt is sold the single largest purchaser of that debt is the system of primary dealer banks. Don't believe me?
Here is an example:
http://www.treasurydirect.gov/instit/annceresult/press/preanre/2015/R_20150915_1.pdf
Total Issuance: $19.79 billion
Total purchase by primary dealers: $13.40 billion (approx. 68%)
Under Cochrane's proposal (banks must sell equity to be able to lend), the primary dealers would have had to sell $13.4 billion in additional stock to lend the government $13.4 billion.
You still haven't answered the question - why do you think any bank (more specifically it's shareholders) would lend money obtained from new share sales to the federal government?
In full agreement here, about equity capital and more so for what the asset managers are concerned. Just to add a brief consideration about "the theory behind so-called systemically important financial institutions, or SIFIs": it might not be the whole story here. The degree of concentration in the banking and financial sector as we see today in not the product of a "natural evolution led by market forces". In the era of "unconventional policies", and "asset price targeting", it might be that a few large institutions became even larger also by acting as "transmission mechanisms". Twenty years ago, we had nothing of the sort (and not just in the US). If this would prove true, it will be even harder to reform regulation and capital requirements, and "public welfare" would not be the inspiring principle in the debate.
ReplyDeleteI think we are ignoring the demand for assets side of this exchange. All firms would like long dated (perpetual) source of funding but the risk preferences of asset holders may include need for lower risk fixed dated assets or even cash. They could rely on market liquidity to convert it into cash, but price volatility would make this unattractive.
ReplyDeleteSo in a hypothetical world even if we got rid of all these pesky banks and had only equity capital owned by asset managers there will arise an intermediary who will issue cash like liabilities with fixed maturity (or debt) and hold these equity investments. Or you are back to where you started - if it is unsecured short term debt you have a bank and if these are backed by collateral you have a shadow bank.
I can see why not having to manage cash inflows and outflows (debt repayment/rollover) can make it impossible to create problems in the functioning of the real productive economy because of runs, but the risk will remain and probably be heightened (my guess) in the financial sector where savers invest.
Sunil,
Delete"Or you are back to where you started - if it is unsecured short term debt you have a bank and if these are backed by collateral you have a shadow bank. "
One problem with collateralized loans is that the loan value is legally fixed while the collateral value is market determined. Suppose both are legally fixed?
"I can see why not having to manage cash inflows and outflows (debt repayment/rollover) can make it impossible to create problems in the functioning of the real productive economy."
Another problem with collateralized loans is that the collateral is often not easily divisible (a house mortgage for instance). It's not like a homeowner can miss a payment and forfeit a portion of the house rather than the whole thing.
But what happens when the collateral is divisible and partial defaults are simply the transfer of a portion of the collateral from borrower to lender? Does that not solve the cash flow problem?
This statement from John cracks me up:
"...that the government should not try to prevent any asset from ever losing value"
Which is funny because in several instances the U. S. Constitution instructs the federal government to do precisely that:
https://www.law.cornell.edu/constitution/articlei
"To establish a uniform rule of naturalization, and uniform laws on the subject of bankruptcies throughout the United States"
The only reason for bankruptcy law (let alone uniform bankruptcy law) is to ensure that debts are honored, that bonds do not lose value.
"To coin money, regulate the value thereof, and of foreign coin, and fix the standard of weights and measures."
Again, the Constitution gives the federal government the authority to regulate the value of money.
This comment has been removed by the author.
DeleteFrank
DeleteGood points both. My point was let's take it to the extreme and have only equity liabilities issued and all intermediaries have floating value liabilities. This ensures one important thing- no event in the financial markets will affect the real productive sector. The dot com bubble and its bursting is presented as a case study of this. All risks are assessed once during the time of capital raise and then what happens happens. All claims are them freely traded with markets reflecting new information processed and changes in expected return.
My point was that even in such a utopia you are faced with different liquidity and risk appetites of investors and intermediaries will spring up that look either like banks (providing low risk liquid deposits backed by their holdings of marketable assets but not explicitly identified with specific assets) or shadow banks who will do the same but back it with trade able assets as collateral. Or this is a one sided solution that is focused only on borrowers of capital in the production economy who face constraints from credit conditions changing but ignores the role intermediaries play in matching differing needs of borrowers and the savers who provide these funds.
I also suspect (and this is only a hunch) that leverage is a reflection of the large scale need for risk free assets. For every highly levered investor there is a provider of funds who is risk averse. The increase in leverage might just be a reflection of the large heterogeneity in risk appetites in the marketplace. If the risk pools that are risk averse exceeds the pool of risk free assets, the intermediaries are going to help create it.
Thanks again for your comments.
Sunil,
DeleteThank you for your reply.
"My point was let's take it to the extreme and have only equity liabilities issued and all intermediaries have floating value liabilities."
Let us try to define the distinguishing characteristics of debt and equity.
1. Debt is typically fixed term, equity is typically floating or perpetual term
2. Debt is legally protected (through bankruptcy law), equity has looser legal protections
3. Debt has both a traded market value and a legal redemption value, equity has a market value that is identical to it's redemption value.
Obviously there are shades of gray. You can have a security that is fixed term and is not protected by bankruptcy law (for instance a property rental contract). And so when you say - take it to the extreme and have only equity liabilities issued do you mean:
1. Issue all perpetual / floating term securities?
2. Eliminate the legal (bankruptcy) protections for all security purchasers?
3. Make the redemption value equal to the market value for all securities?
From your statement - "This ensures one important thing- no event in the financial markets will affect the real productive sector."
I am not sure which aspect of equity (if any) achieves this result. There was a recession (in the real productive economy) after the bursting of the dot com bubble. Money (and finance) can't exactly be swiped under the rug.
Unlike Friedman, I believe that money (and finance) has an effect on the real economy. Real economic growth tends to be higher in economies with a uniform medium of exchange relative to barter economies.
Frank
DeleteThanks for your patience as you let me help me think through this a little better each time.
Let us imagine a world with no debt. All claims issued are perpetual claims and assets owned are perpetuals. These may have fixed coupons or be equity like but that does not matter very much. The issuers of these perpetuals for argument sakes can buy these claims back when they have economic surpluses. I am removing the "survival constraint" that debtors have when their credit comes due and they have to either repay from accumulated surplus or refinance; for if this becomes difficult for many, it can lead to a credit crunch and disruption of economic activity.
My point was that even this economy is not feasible without a bank like financial system emerging. And there are possibly two reasons for that:
1) surplus providers may not have the same term requirement for funds that the issuers have creating a mismatch.
This term mismatch creates the opportunity for an intermediary that issues short term debt and buys these perpetual claims.
2) seen from another perspective it is a tautology that claims issued in aggregate will be collectively owned by all claim owners. The "market portfolio" will be average pool of assets held.
While this is true on average, some claim owners will be less risk averse than average and others more so. On the Capital Market Line they will use an intermediary who will issue risk free deposits to some who are risk averse and lend it to the more risk seeking investors. If the level of these exchanges are high - for example there are corporate cash pools/reserve managers that want risk free short term deposits and on the other side there are levered hedge funds, an intermediary will arise to match these two taking on matched exposures on their balance sheets (and looking like a really levered financial sector participants).
And all this is in a economy without debt based real economy. You will even here get levered intermediaries. It is easy to see that if you have borrowers in the real economy reacting to price signals, there is no getting away from loans of differing maturity even there.
For me the idea that you can somehow get rid of loans from one side of the transaction (borrowing) without considering the other side (the need for some investors to have liquid assets and be shielded from price fluctuations) is incomplete. In my mind deposit insurance brings stability to a system that cannot help but be levered and where agents can change their mind. And the need for them is proportional to how much risk appetite heterogeneity exists; for if there were none every body would hold the market portfolio and there will be no need for anything other than brokers.
I am here abstracting away from the other valid considerations about security structure that you raise.
Your point on finance impacting the economy I am completely in agreement with. Even in the toy economy I started with large price fluctuations will only make it for difficult for borrowers to borrow raising their "cost of capital" and slowing down activity. And banks also provide the ability to scale the exchange of economic surplus across time unlike in a barter society where these exchanges are bilateral. These gains are no different from gains from specialization anywhere else.
Sunil,
DeleteYour basic point as I understand it is that shadow banks or other types of intermediary will arise which will try to circumvent the rules. Doubtless they’ll try. But getting banks to obey rules is horrendously difficult ANYWAY. Banks have had to pay over $100bn in fines in the last two or three years for various crimes like fiddling Libor and laundering Mexican drug money.
Moreover, the rules of Lazear’s system (which are much the same as full reserve banking) are simplicity itself compared to Dodd-Frank, which stands at about 10,000 pages and counting. And simple rules are easy to enforce as compared to complex rules. Lazear / full reserve has just two basic rules. 1. Where depositors want total safety, their money is kept in a totally safe manner, i.e. lodged at the central bank or put into government debt. 2. Loans to private sector entities, e.g. for mortgages, must be funded just by or to a significant extent by equity.
Sunil,
Delete"Let us imagine a world with no debt. All claims issued are perpetual claims and assets owned are perpetuals."
Okay, so we are in an infinite life agent model? If all claims are perpetual (for instance credit card bills) then everyone must live forever to be able to issue perpetual claims. Assets do not depreciate, get outmoded, or simply turn to dust.
"My point was that even this economy is not feasible without a bank like financial system emerging. And there are possibly two reasons for that:
1) surplus providers may not have the same term requirement for funds that the issuers have creating a mismatch."
In an infinite life agent model surplus providers and issuers live forever. Presumably they will have the same term requirement.
Lets adjust your model and say that all claims are marketable floating term claims and that all agents / hard assets are fixed term. This creates a term mismatch. Does banking as an intermediary system solve all the problems?
That would depend on whether a system of banking (or individual banks) should be allowed to fail. Suppose bank XYZ borrows from Joe short term to lend to Paul long term. Paul offers his townhouse as collateral on the loan. Paul dies without heirs and the townhouse reverts to the bank. The only problem is the market value of the townhouse is less than the value of the loan bank XYZ owes to Joe.
If the bank can default on it's loan from Joe and stay in business, then it can continue it's business of intermediation. If it can't, then bank XYZ goes under, and other enterprises depending on bank XYY for intermediation must look elsewhere. This will likely have an effect on the real economy.
Now suppose that bank XYZ cannot borrow short term under any circumstance. To make the loan to Paul, it must sell equity to Joe - this is what Cochrane advocates. In that case, Joe absorbs the risk associated with either Paul defaulting on his loan or the value of the townhouse plunging.
The problems with Cochrane's system are fairly obvious:
1. The value of a bank's common equity is determined by more than the value of it's assets under control - things like reputation, patent rights owned, and regulatory requirements (state and federal) come into play. By making Joe buy common equity to get a stake in Paul's townhouse, a bank is forcing Joe to take on more risk than he may want.
2. Fiscal considerations - how may banks will want to sell common equity so they can turn around and lend the money to the federal government?
3. What is short term? It's one thing to say that there can be no lender of last resort function from the central bank. That still doesn't stop an enterprise from attempting to borrow short and invest long using say a short term period of 10 years and a long term period of 11 years.
4. What is a bank? Under Cochrane's proposal, banks are no longer permitted to perform credit intermediation. Okay, so Phil opens a used car business and borrows short from a pool of investors to lend long to prospective car buyers.
Ralph,
DeleteYou make a valid point that banks will rise to circumvent the rules; I was talking about them not coming into being to circumvent rules but to meet the need for near cash like instruments from asset owners in a world where the issuers of claims will want to live without having cash like liabilities. The bank would intermediate between these two non-synchronous preferences. It is in my mind a very creative response to a market need for the "product". Unless of course you outlaw the provision of this product.
The full reserve banking I do not fully understand and I should read and think about it before I shoot my mouth off. I can see the attractiveness of having all checking deposits being backed by reserves at the Fed and the rest of the bank liabilities being "equity" like. There will be two "banks" really - one part that collects deposits for the Fed and another that pools equity and invests in a pool of claims.
I wonder what the Fed balance sheet will look like though - short term deposits from commercial banks and presumably long dated assets or that Fed will now become the institution with a maturity mismatch (and so where the risk resides). I wonder what the repercussion of that would be and the cultural impact locations of this (Audit the Fed, as the losses if any will be taxpayers). But like I said I have not thought enough and so should now just shut up.
Frank,
I'm not sure if infinitely lived investors (and issuers) means that there will be perfect agreement on timing of cash flow needs between the two groups. But here again I should plead ignorance of the nuances of these models.
But good points both for me to think through. I cannot thank you both enough.
Sunil,
DeleteRe your question as to what the Fed balance sheet would look like, it would expand a fair bit because everything in checking accounts would be backed by bank reserves.
We're already there. Thanks to QE, there are more reserves than checking account balances.
DeleteRalph,
DeleteThat I get on the liability side of its balance sheet; what I do not is what assets will it own for all the reserves it issues? Treasury bills. This will become an autonomous flow for the central bank and if it exceeds the store of bills, some longer term treasuries perhaps, mortgages. You can see where this logic takes us: the Fed cannot control its balance sheet size because preference for liquidity is outside its control. And risks that we now associate with commercial banking get centralized in the central bank. Unless if the "Treasury" under law issues as much overnite debt by law as is required by the Fed so the Fed has no maturity mismatch risk or spread income. The Fee is when all is said and done a bank/clearing house that issues very safe liabilities; liabilities it traditionally issued and bought Gold, treasuries, and in more recent times mortgages and longer term treasuries.
It does seem under the set of assumptions I am making, you create a more government owned banking system and a tad less flexible. But thanks again for your response.
Sunil,
Delete"I'm not sure if infinitely lived investors (and issuers) means that there will be perfect agreement on timing of cash flow needs between the two groups."
I guess the question you need to ask is intermediation a frictionless exchange? I don't know of many banks that operate as not for profit, so my guess is that banks (and other intermediaries) charge a profit margin for performing that service.
And so, it makes sense to me that infinite life agents would bypass intermediation entirely and keep the profits of exchange to themselves. It's not like either is going to die off before they can realize the gains.
Too many zero-maturity instantly-liquid liabilities, not enough reserve asset collateral in the banking system. Something changed in 1998-2008, and it was durable enough to be a policy decision.
ReplyDeletehttps://research.stlouisfed.org/fred2/graph/?g=20RG
For the sake of banking stability, don't run up MZM without matching those liabilities with reserves in the banking system. And, don't worry now, there are more than enough reserves to stabilize banks for decades.
Too many liabilities, too few assets = too little shareholder equity. Equity is the outcome of more assets than liabilities. There may be the occasional "missing market" in the capital structure, but the real solution is boosting assets and / or limiting liabilities; e.g. deleveraging.
To encourage deleveraging, I suppose it's too much to ask for less moral hazard and more capitalism, eh?
Some people that I know - IMFers, FWIW - have argued to me that banks issuance of debt confers an externality by providing a greater stock of liquid assets that can be used as collateral in repo-like markets. If I understand correctly, Gary Gorton has made a similar observation. What do people think of this argument against banks decreasing leverage ratios? It makes little sense to me - there will still be a lot of bank debt out there if banks reduce their leverage rates from 25 to 8, but maybe I'm missing something.
ReplyDeleteI think 14 trillion of government debt is plenty for the task, plus another several trillion of government guaranteed mortgage debt plus agency securities. If more liquidity is needed, government debt can be short term or unified for greater liquidity (see
Deletehttp://faculty.chicagobooth.edu/john.cochrane/research/papers/Cochrane_US_Federal_Debt.pdf). This is not a problem that I think requires banks to issue government guaranteed deposits, then requiring all the extensive supervision and regulation of Dodd Frank.
Anon,
DeleteI'm probably repeating some of Prof Cochrane's points here. Anyway... commercial banks certainly do provide “a greater stock of liquid assets”. Put another way, they supply the economy with some wondrous stuff called “money” which obviates the inefficiencies of barter.
But there’s a problem there, which is that the mere fact of issuing short term liabilities makes banks vulnerable. As Messers Diamond and Rajan said and in reference to the liquidity / money creating activities of banks, “We show the bank has to have a fragile capital structure, subject to bank runs, in order to perform these functions.” See:
http://www.nber.org/papers/w7430
But luckily we don’t need to rely on private banks to supply dollars because the Fed supplies dollars as well, and it does so without any sort of risk of going bust. Plus the state can supply the private sector with whatever amount of dollars are needed to induce the private sector to spend at a rate that brings full employment. So what the point of those silly private bank dollars is, I’m not sure.
Ralph,
Delete"So what the point of those silly private bank dollars is, I’m not sure."
The silliness ultimately stems from the same reasons that we have three distinct branches of government (legislative, executive, and judicial) and two or more political parties (Republican, Democrat, etc.) - separation of power.
The U. S. went through periods where the central bank was integrated with the Federal Government - see First Bank of the United States (1791-1811) and Second Bank of the United States (1816-1836).
https://en.wikipedia.org/wiki/First_Bank_of_the_United_States
"Hamilton's bank proposal faced widespread resistance from opponents of increased federal power. Secretary of State Thomas Jefferson and James Madison led the opposition, which claimed that the bank was unconstitutional, and that it benefited merchants and investors at the expense of the majority of the population.
Like most of the Southern members of Congress, Jefferson and Madison also opposed a second of the three proposals of Hamilton: establishing an official government Mint. They believed this centralization of power away from local banks was dangerous to a sound monetary system and was mostly to the benefit of business interests in the commercial north, not southern agricultural interests, arguing that the right to own property would be infringed by these proposals. Furthermore, they contended that the creation of such a bank violated the Constitution, which specifically stated that congress was to regulate weights and measures and issue coined money (rather than mint and bills of credit)."
The U. S. Federal Reserve (as a body independent of government) was created in 1913 as a compromise. Note that under objections from Madison and Jefferson, the U. S. mint is an unconstitutional overreach of Congressional power.
Your statement - "Plus the state can supply the private sector with whatever amount of dollars are needed to induce the private sector to spend at a rate that brings full employment."
Not according to Jefferson and Madison.
That's nonsense. Jackson and Madison never opposed the establishment of a national government mint. That's just wikipedia gibberish. What they were opposed to was a central bank (which was privately owned).
Delete"U. S. mint is an unconstitutional overreach of Congressional power."
Nonsense, the Constitution specifically gives Congress the power to "coin Money, regulate the value thereof, and of foreign coin", as well as to issue securities and borrow 'on the credit of the nation'.
And the ability of commercial banks to create a form of money (deposits) has got nothing to do with the political separation of powers.
Phillipe,
DeleteI said Jefferson (as in Thomas Jefferson), not Jackson (as in Andrew Jackson).
Though you are correct, the link that Wikipedia provides as a cite:
http://www.mmisi.org/ir/45_1-2/westley.pdf
Provides no indication of Jefferson's or Madison's objections to a U. S. Mint on Constitutional grounds. Rather, Jefferson and Madison objected only to the creation of a national bank on Constitutional grounds.
In fact, Jefferson in 1785 laid out a groundwork for U. S. government coinage of money:
http://press-pubs.uchicago.edu/founders/documents/a1_8_5s5.html
So I am not sure where Wikipedia obtained it's information.
I meant Jefferson.
DeleteKISS--- keep it simple stupid. Good government is clear. And easy to understand.
ReplyDeleteYes, one regulation for banks: you loan only equity.
By the way, the banks could still securitize and sell loans to non-banks. Then a wave of mortgage defaults would not threaten the banking system.
And that would last until the first government bond auction failed.
DeleteFederal Government - "Hey you banks, to make loans, you must sell equity shares"
Bank Equity Shareholders - "Fine, we will never lend to you Federal Government again"
Federal Government - ???
?
DeleteThe federal government has no problem selling bonds. Remember they can sell globally. Even then, the federal government can print money.
And faced with being forced to lend equity, banks can relocate out of the United States.
Delete"Yes, one regulation for banks: you loan only equity."
Banks - "Fine, we like the regulations in Europe / Japan / etc. better."
"Remember they can sell globally."
Except that global owners do not have voting control over U. S. tax / spending policy. Fine, U. S. government resorts to selling bonds overseas. U. S. voters decide to suspend all debt repayment.
Under autarky, this is a sensible proposal because providers of equity capital to the Banking sector can just as easily invest in realty or the Corporate sector. However, if a country has a large inflow of capital from foreign countries with a chronic export surplus but little knowledge of how to invest and/or faces legal barriers from investing in (for example) Defense or strategically important companies, then Bankers can play a discoordination game (i.e. target foreign suckers) by borrowing short term to fund their own equity.
ReplyDeleteThere was once a criminal Bank called BCC which got the Sultan of Oman on the hook- he hadn't a clue how to invest his money- but it collapsed despite his deep pockets. This was a disaster for entrepreneurs from a particular ethnic community though they have since recovered because it genuinely was a case of just one or two bad apples rather than full blown systemic incentive incompatibility.
Similarly, Germany once had some of the most naive bankers in the world and they got saddled with sub-prime rubbish as well as, under the Eurozone disccordination game, Greek debt etc. This German problem has hurt the real economy of Europe which, if it contributes to the implosion of the European Union, might have real effects on the US.
Assuming information asymmetry, Banks always have an incentive to use discoordination games in a manner such that they can turn what ought to be liquidity into their own equity- in other words, they can convince suckers to buy what appear to be 'near cash' assets while showing the regulators that they have equity backing.
Discoordination games have mixed solutions featuring crises of one kind or another. Thus, even if Banks are not legeraged, still market corrections, or changes in the law re. 'money laundering' or a National Security led crackdown on particular types of asset holders, will still cause liquidity to dry up, thus requiring a bail out of some sort, to protect the real economy.
The proposal given here is a good solution to the co-ordination game of an autarkic financial system with limited information asymmetry and unlimited arbitrage because risk is distributed efficiently. However, if there are significant capital flows from abroad and there are legal/institutional/infomational constraints on some agents then the possibility of a discoordination game arises which is bound to feature Systemic crises requiring bailouts. Furthermore, the Govt has less incentive to check unethical or incentive incompatible behavior by the Banks. Indeed, if there is regulatory capture, Bankers would be better able to turn foreigners into 'suckers' by getting the Govt. to pass laws restricting their ability to access better quality assets.
Another idea is that commercial banks issue mandatorily convertible bonds. These bonds would convert to equity if certain triggers were hit.
ReplyDeleteOr just eliminate the commercial banking sector altogether. Federal government issues money without the corresponding debt.
DeleteDFA required the FDIC to set up resolution plans for large banks (seems any company that isn't a saloon). Part of the planning would be to convert certain nondeposit liabilities, e.g., subordinated debt, into failed bank capital/equity. Before DFA, these creditors would participate in the losses in bankruptcy/liquidation.
DeleteWorse is the fact that DFA was patched together by two of the people that spent decades making the late financial crisis. I don't know of one word in the what 1,300 page legislation that actually addresses the causes of the recent crisis or the proximate crisis.
has a
Its been among the best use of the sources.
ReplyDelete