Thursday, June 6, 2013

Two on financial reform

I recently read two interesting items in the long-running financial regulation saga.

First, a very thoughtful, clear, and succinct speech by Philadelphia Fed President Charles Plosser titled "Reducing Financial Fragility by Ending Too Big to Fail." It's interesting to see a (another?) Fed President basically say that the whole Dodd-Frank / Basel structure is wrong-headed. Two little gems:
 There is probably no better example of rule writing that violates the basic principles of simple, robust regulation than risk-weighted capital calculations.
...
Remember that Title II resolution is available only when there are concerns about systemic risk. Just imagine the highly political issue of determining whether a firm is systemically important, especially if it has not been designated so by the Financial Stability Oversight Committee beforehand....

...Creditors will perceive that their payoffs will be determined through a regulatory resolution process, which could be influenced through political pressure rather than subject to the rule of law
No surprise, I agree.

Second, Anat Admati and Martin Hellwig have an addition to their "Banker's new clothes" book (my review),  23 Flawed Claims Debunked.  Don't miss the fun footnotes.  Anat and Martin get some sort of medal for patience in wading through dreck.

9 comments:

  1. I think some of the claims of Admati and Hellwig are to strong.

    I worry about pro-cyclical nature of fixed capital ratios. The purpose of capital is to serve as a buffer. When a firm loses money, its capital should fall, and perhaps more than in proportion to its assets. Requiring that the firm sell new shares when it is suffering losses only seems "easy" when there is perfect information.

    Also, it is true that monetary liabilities are debt, and so a bank that issuing these liabilities is different than another institution. A 100% equity funded bank could not offer any checkable deposits. If the equity requirement were 99.999999.....% then the required equity for a single dollar of deposit could be more than total wealth.

    Admittedly, ratios like 15% or 20% don't have these sorts of absurd consequences. Commercial banks fund remarkably little of the asset portfolios with checkable deposits.

    On the other hand, if the past wink and nod version of regulation were replaced with something stricter, then the amount of "official" checkable deposits might look more like MZM than M1.

    I think more capital for banks is a great idea, I am just skeptical about using regulation to impose fixed ratios.

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  2. Tom Braithwaite ‏@TBraithwaite

    Obama says he believes in 'a light touch when it comes to regulations' at Silicon Valley fundraiser

    Obviously, the string theorists are correct and we live in multiverse with different forces of gravity.

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  3. Hi prof Cochrane,

    I dont do research in Macro, but I was thinking that if the problem of fiscal policy is action lag, and if the automatic "fiscal stabilizers" are desirable as some sort of insurance. What would you think about a paper that develops a model in which the government has variable (automatic) tax rates for times of recession and growth?

    For instance, marginal tax rates at 10% if the year was "bad", and 30% when years are good?

    This would not generate any of the moral hazard problems with the unemployment insurance and etc that we see, no? So later we can end with these insurances... It is still fiscal policy, but from tax cuts, instead of increasing spending for the guys who like "stimulus". It might also help to have a smaller state in the end, and it would be an improvement for all risk averse agents in the economy, I guess. (Apart from the ones that actually lose their jobs in case we extinguish the unemployment insurance...)

    Anyway, just some ideas...

    All the best!

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  4. It’s easy to make it impossible for banks to fail. Laurence Kotlikoff has explained how. It goes like this.

    Depositors have to choose between two types of account. First there are 100% safe checkable accounts which pay no interest because nothing is done with the relevant money: it’s not loaned on or invested. Second, where a depositor wants interest and they’re prepared to forgo instant access, they buy into a mutual fund (perhaps administered by their bank). The money in the safe accounts is 100% safe because it is lodged at the central bank till it’s needed. As to mutual funds, they cannot fail because if their assets fall X% in value, then their liabilities fall by X% as well.

    What commercial banks CANNOT DO is accept $X of deposits, promise to return the $X and lend on or invest the $X. The latter loans are inevitably less than 100% safe, and that’s why banks have failed regular as clockwork ever since Roman times.

    There you are: problem solved in 150 words as compared to Dodd-Frank’s 10,000 pages which fail to solve the problem.

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    Replies
    1. I agree entirely, with one additional option. Banks or money market funds that invest entirely in short-term treasuries or interest-paying reserves can offer interest as well.

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  5. Why is it desirable to make it impossible for banks to fail? Isn't there some upside to creative destruction? Won't markets do a better job than governments at determining what the appropriate levels of equity and debt are?

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    Replies
    1. It's not just about markets being a better source of determining appropriate levels of debt and equity Jason. Isn't there also an argument about basic fairness here as well? Big banks are able to raise capital much more cheaply then smaller financial institutions because of the implied government guarantee, which of course is ultimately backed by taxpayers. If investors believed that the big banks really would be allowed to fail, there cost of capital would - presumably - go up and create a more level playing field. I am not an economist, and maybe I am saying this in the wrong way, but it just seems the gov't guarantee is really creating an artificial advantage for the bigger guys?
      Peter Thompson

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    2. Allowing banks to fail wouldn’t matter if depositors accepted the consequences, i.e. that they lose their money. But depositors often refuse to accept the consequences: they demand that government protect them. And if government does, then that equals a subsidy of banks.

      The solution is to allow government protection where money is lodged in a near 100% safe fashion (i.e. where government protection has little real effect). As to depositors who want to make a fast buck by having their money used in a riskier fashion, they should so*ding well carry the downside risk if they want the upside profit. That way the bank as such cannot SUDDENLY fail. However, under the latter arrangement a bank can certainly shrink, or shrink to nothing over a period of time.

      But that doesn’t matter: it’s the SUDDEN failure of banks that causes the harm.

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  6. It seems to me that if you accept all of their premises then there's no tradeoff at all on the 0%-100% capital requirement continuum. They tear into essentially all "lower requirement" arguments from the simple ones to the complicated ones. If higher requirements yield stability and no downsides, why not go full equity banking?

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