Tuesday, November 6, 2018

State of thought on financial regulation

I'm at a conference on "Financial cycles and regulation" at the Deutsche Bundesbank. Beyond the individual papers, I find the conversation interesting.

Groups of researchers develop a common language and a common set of assumptions. This is productive -- to push a research frontier we have to agree on a few basic ideas, rather than argue about basics all the time. I, as an outsider, parachute in, and learn as much what the shared assumptions are, as I do about particular points in elaboration of the program.

Here,  it is pretty much taken for granted that there is such a thing as a "financial cycle." It's in the conference title, after all! That means a "cycle" of credit expansion, usually "unwarranted," "excessive," or an "imbalanced," followed by a bust. It is also agreed that it is the job of financial regulators to manage this "cycle."

In his Keynote speech, Claudio Borio of the BIS described a sort of Taylor rule, in which monetary and financial policies should respond systematically to the "credit gap." Jan Hannes Lang described a model for estimating that "credit gap." Marco Lombardi applied Jim Stock's time-deformation models to characterize the "financial cycle." Michael McMahon showed a very elegant model in which banks over-lend and hence society over-invests in good times. The government bails out in bad times, so the discount factor for investment excludes bad-time outcomes.  (All paper titles at the above program link, papers aren't posted yet but you can google them.)

I parachute in from the outside. Understanding this language and shared set of assumptions is important.  I'm a bit skeptical, of course. Yes, there is regression evidence that large debts and high prices forecast crises. But there is always supply and demand in economics, always the possibility of a boom rather than a bubble. "Large" is not always "excessive." And the passage from an interesting set of historical correlations to structural understanding to something stable enough, and without unintended consequences, for policy exploitation seems to have passed while I was napping. As McMahon pointed out, credit controls in the 1970s were not a huge success. But these are just the skeptical questions of a newcomer. I come to conferences to listen primarily.

My own view is that the crisis was a run, and the central way to stop runs is with lots more capital and lots less short-term debt. Then you can have booms and busts without runs. I note ruefully that capital is under attack in the US, and that 10 years after the crisis, so much for those countercyclical buffers. Karsten Müller presented some nice regression evidence that governments typically loosen regulations just before elections, as the US just did.  Systematic countercyclical capital remains remains a dream in the eyes of many writers especially at the Fed, BIS, and other institutions. Monetary and "macro-prudential" policy that successfully and systematically lowers house and asset price volatility is even further away. How much nicer if the financial system were run-proof and did not require so much management.

At least though, this little discussion reflects a large agreement that capital is the central buffer and so much else in current regulation is not very useful.


  1. John Cochrane's solution to institutional financial instability is very simple and thus is probably very good.

    My question is, why does the financial industry resist the Cochrane solution?

    1. I assume the reason is that the Cochrane solution would make lending and borrowing a bit more difficult, and thus cause a finite contraction of the bank industry. However, the bank industry has expanded a whapping TEN FOLD relative to GDP in the last fifty years in the UK, and I assume much the same goes for the US. (See p.3 of Mervyn King’s “From Bagehot to Basel” paper.)

      Our bloated bank industry has given us liar loans, house price bubbles, and bank crises which cause ten year long recessions. Thus a contraction of this industry would not be the end of civilisation as we know it, seems to me.

  2. I have seen job postings from the Fed in recent months wanting people who are good with Big Data and ML. Sounds to me like they're wanting to utilize a lot of computing power to build better models, unleashing AI and ML upon it all. You see the same trend in Wall Street as they're opening up their cash hoards to hire DS and AI/ML engineers, but for different reasons.

    MIT also has developed a huge data eating project that attempts to give inflation data and price levels in real-time. It's not prediction, it's real time stuff.

    All of this is very interesting. I'm wondering how much it will change the positive and normative analysis in economics or if these models will just confirm what's already known - general principles and contours.

    Predictive modeling and classification are THE things in the world of ML. But, it's brute forcing versus inference. Maybe it all can help find better markers/predictors for booms and busts. I'm all for better tools, you see, especially if it can help CB's eliminate recognition lags. Maybe even help investors, too.

    This all speaks to the business of efficiency in management.

  3. Clearly John Cochrane’s “run” point is valid. But even if banks never suffered runs, there is another a fatal flaw in letting private banks fund their “borrow short and lend long” activities via deposits. It’s thus.

    Depositing money at (i.e. lending money to) a bank is no different to depositing money at (i.e. lending money to) a non-bank corporation. E.g. buying bonds issued by Exxon which have two months till maturity is no different to putting money in a two month term account at a bank. But bizarrely, taxpayer backed deposit insurance is offered for the latter but not the former: a glaring inconsistency. Plus depositing money at a bank with a view to the bank lending on the money so as to earn interest is no different to depositing money at a stock-broker, private pension fund, mutual fund etc with the same objective: earning interest / dividends.

    The solution to that inconsistency comes from the widely accepted principle that it is not the job of taxpayers to rescue COMMERCIAL ventures which fail: that is, people who want a bank to lend on their money should not be given taxpayer backed protection because they are into COMMERCE. In contrast, everyone is entitled to a totally safe method of storing and transferring money, and where that is all someone wants, they are entitled to a totally safe account which earns no interest because relevant monies are not loaned on.

    And what do you know? That equals full reserve banking, which I think is pretty much what John Cochrane supports.

    1. I guess what I don't appreciate is the costs/consequences of what you call full reserve banking. The benefits are very easy to understand, even for a layperson like myself: no more runs (and thus less severe recessions), remove the perverse incentives created by FDIC, etc., etc. This all sounds great so far...

      But there must be some cost of removing ~92% of the funds in my checking account from productive investment and dumping them into a big pile in a vault. The trouble for me personally -- i.e., someone who is not an expert in this field -- is that I have zero context of the scale of this cost. Is it a mountain or a molehill? Or maybe there is no cost at all, due to some counter-intuitive secondary effects?

    2. full reserve banking means you are lending the government. We know they need it given the deficit but where then will the private sector get its funding now the government has monopolized deposits? Also why is that risk free? Even the US is no longer AAA and in many other countries the government is worse. What about counties like Singapore where the government does not have net debt. It is not a general solution.

  4. Valter Buffo, Recced, MilanNovember 7, 2018 at 6:15 AM

    Quote: But there is always supply and demand in economics, always the possibility of a boom rather than a bubble. "Large" is not always "excessive." And the passage from an interesting set of historical correlations to structural understanding to something stable enough, and without unintended consequences, for policy exploitation seems to have passed while I was napping. End quote
    A lot of interesting and useful things in few sentences.
    * there is always the possibility of a boom: right, and for the same reasons, the possibility of a bust 2009-style; worth the bet?
    * large is not excessive: and who knows more? The Federal Reserve? Goldman Sachs? Larry Kudlow?
    * structural understanding was missing ... there and I would say everywhere
    My intuition remains the following: an adapatation of the FTPL to financial markets (that price stocks of things, instead of acting by the rules of demand, supply and individual utility) in a RNP setup

  5. "[T]he central way to stop runs is with lots more capital and lots less short-term debt."

    A question from a macro finance novice: how do we accomplish this? Is the idea that the key features of bank debt are liquidity and convenience -- not "zero" risk -- so people will happily convert their bank debt into equity investments so long as they can still auto-pay their monthly bills, take cash out from the ATM, etc.? Or is there something else I'm missing?

    The overall argument makes intuitive sense to me -- more equity means no runs, and runs are the thing we need to focus on avoiding -- I am just struggling with the mechanics of how you get the new equity...

  6. "Monetary and 'macro-prudential' policy that successfully and systematically lowers house and asset price volatility is even further away"

    That may be true, but the Fed is now applying both "tools" to financial volatility - Jerome Powell clearly intends to reverse 30 years of no bubble-popping policies.

    That reversal may be obvious to many, I'm not sure, and it may or may not prove "successful and systematic," but just in case it went unnoticed I compared Powell's statements on financial stability to those of his predecessors here:


  7. Markets employing derivatives are much more efficient than regulators at ameliorating these cycles. Interest rate parity relies on spot/forward FX rates to maintain equilibrium in global rate trades.

  8. I agree entirely that making finance run-proof is the best and simplest solution. But why does that need capital? you can hedge any risk with capital even fire risk but fire insurance is simpler and more direct. Making banks run-proof only requires matched maturity funding to eliminate Maturity Transformation (even its name which is simile for "Time Travel" reveals its weakness as a concept) and that is possible if we update the archaic structure of debt instruments (particularly deposits) and make them truly floating rate (not LIBOR fake floating) and tradeable at par.

  9. When you quite often discuss all equity bank, one key question is if a bank if financed by 100% equity, then to obtain a 10% return (not high) on its equity, it requires at least 10% interest rate on its loan, that's hard to reconcile.


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