Finreg I: Bank capital and original sin

[This post originally appeared at interfluidity on December 11, 2009. It is reproduced here in its entirety.]

I have always flattered myself that I would someday die either in prison or with a rope around my neck. So I was excited when The Epicurean Dealmaker invited me to write about financial regulation and crosspost at a site called The New Decembrists. But my views on the topic have grown both more vehement and more distant from the terms of the current debate (such as it is), and I'm having a hard time expressing myself. So I'll ask readers' indulgence, go slowly, and start from the beginning. This will be the first long post of a series.

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Banks are not financial intermediaries. Their role is not, as the storybooks pretend, to serve as a nexus between savers with capital and entrepreneurs in need of capital for economically valuable projects. Savers do transfer funds to banks, and banks do transfer funds to borrowers. But transfers of funds are related to the provision of capital like nightfall is related to lovemaking. Passion and moonlight are often found together, yes, and there are reasons for that. But the two are very distinct phenomena. They are connected more by coincidence than essence.

The essence of capital provision is bearing economic risk. The flow of funds is like the flow of urine: important, even essential, as one learns when the prostate malfunctions. But "liquidity", as they say, takes care of itself when the body is healthy. In financial arrangements, whenever capital is amply provided — whenever there is a party clearly both willing and able to bear the risks of an enterprise — there is no trouble getting cash from people who can be certain of its repayment. Always when people claim there is a dearth of "liquidity", they are really pointing to an absence of capital and expressing disagreement with potential funders about the risks of a venture. Before the Fed swooped in to provide, 2007-vintage CDOs were "illiquid" because the private parties asked to make markets in them or lend against them perceived those activities as horribly risky at the prices their owners desired. There was never an absence of money. There was an absence of willingness to bear risk, an absence of capital for very questionable projects.

No economic risk is borne by insured bank depositors. We have recently learned that very little economic risk is borne by the allegedly uninsured creditors of large banks, and even equityholders — preferred and common — have much of the risk of ownership blunted for them in a crisis by terrified governments. The vast, vast majority of bank capital is therefore provided by the state. Prior to last September, uninsured creditors of US banks were providing some capital. Though they relied upon and profited from a "too big to fail" option when buying bonds of megabanks, there was some uncertainty about whether the government would come ultimately come through. So creditors bore some risk. During the crisis, private creditors wanted out of bearing any of the risk of large banks. Banks were illiquid because private parties viewed them as very probably insolvent, and were unsure that the state would save them.

For Every Action ...

[This post originally appeared at The Epicurean Dealmaker on December 10, 2009. It is reproduced here in its entirety.]

Christopher Columbus: "Hello there, hello there. Heh, heh. Ahh ... We white men. Other side of ocean. My name ... Chris-to-pher Co-lum-bus."
Indian chief: "Oh? You over here on a Fulbright?"
Christopher Columbus: "Hah? Uh, no, no. I'm over here on an Isabella, as a matter of fact. Which reminds me: I wanna take a few of you guys back with me in the boat to prove I discovered you."
Indian chief: "What you mean, discover us? We discover you."
Christopher Columbus: "You discovered us?"
Indian chief: "Certainly. We discover you on beach here. Is all how you look at it."
Christopher Columbus: "Ah, I never thought of that."

— "Columbus Discovers America," Stan Freberg Presents the United States of America, Vol. 1: The Early Years

It looks like Alistair Darling is going to have a quiet Christmas.

The UK finance minister unveiled a nasty Christmas surprise for bankers in the City yesterday: a 50%, non-deductible tax on discretionary bonuses in excess of £25,000 (or $41,000), to be levied against their employers' net income. This scurrilous government attack against chalk stripe suits, Soho strip clubs, and London property values landed with a sickening thud in Old Blighty. Many a banker's wife summarily cancelled their holiday plans and started contacting real estate agents in Geneva.

Today, Nicolas Sarkozy of France had the unmitigated gall (Unmitigated Gaul?) to pile on with a parallel policy proposal for his country's budget and an editorial in The Wall Street Journal, co-authored with famously dyspeptic Scot Gordon Brown. The fact that France agrees with the UK and is proposing a similar policy is proof positive that either La Republique has been secretly taken over by a stunted Englishman pretending to be French or the UK's Labour government is so desperate to retain power that it's turning Gaullist. Probably both.

In any event, the policy—as do all new tax policies at the end of the day—has triggered a desperate surge of scurrying about by bankers and banks, as they attempt to discover ways out of the trap. Their prospects do not look good.

London contacts report senior investment bankers stacked three deep on the pavement outside advisory boutiques' offices this morning, banging on the custom paneled mahogany doors to get entrance for interviews. One Vice President remarked he hadn't seen that many bespoke suits in one place since he stumbled into Gieves and Hawkes' basement storeroom on Saville Row by mistake. I predict independent UK advisors will quintuple their headcount by Christmas.

Build It, and They Will Come

Mike Konczal over at Rortybomb¹ has weighed in this morning on my reformist manifesto. For the most part, he does not seem to have disagreed with me overmuch, which is either a sign that I am on the right track or that Mike is too much of a gentleman to reveal to the world that I am a hopeless idiot. I prefer to believe the former, despite all evidence to the contrary.

Anyway, he specifically comments on a handful of my proposals. While I do not disagree with the substance of his remarks, I thought it would be useful to respond in this forum with a few clarifications and comments of my own. He repeats my proposals in bold and comments below:

2) Narrow and focus the role of the Federal Reserve…3) Render Fed actions and deliberations transparent.

To me this is an either/or. If the Fed wants to be the systematic risk regulator and use its 13 (3) privileges in an expansive manner going forward, there needs to be a change in the way they are monitored. I understand 13 (3) goes back 70 years, but given that the Fed will use these privileges more aggressively in the future then they need to be monitored in an equally aggressive manner. Removing these regulation powers to outside the Fed (as the Dodd Bill currently proposes), means that there isn’t quite the same need for transparency (though the way appointments are made could stand to be reformed either way).

I think we really agree here. My proposal is to narrow the Fed's mandate to its core responsibility for monetary policy and price stability but add "responsibility for monitoring, controlling, and managing systemic financial risk." If we commission the Fed to act as our overall systemic regulator, as I suggest, of course we should increase legislative oversight of it. It is exactly the sort of non-monetary policy decisions like the Fed made in the case of AIG and others recently that must be examined in retrospect under a clear and searching light. Just reassign the Fed's other responsibilities for consumer protection etc., which it has sadly neglected, to other parties. Monetary policy, as far as I am concerned, can remain largely unexamined and protected from political interference in the deep dark hole where it has resided for decades.

Cap This!

Lest we forget that the recent financial crisis has imposed real costs on the real economy, Simon Johnson of The Baseline Scenario reminds us, at length.

He claims that bailing out financial institutions considered too big or too connected to fail was the principal vector in the recent contagion, and he asserts we will have fixed nothing if we do not fix this:

9) At the heart of every crisis is a political problem – powerful people, and the firms they control, have gotten out of hand. Unless this is dealt with as part of the stabilization program, all the government has done is provide an unconditional bailout. That may be consistent with a short-term recovery, but it creates major problems for the sustainability of the recovery and for the medium-term. Again, this is the problem in the U.S. looking forward.

And in Europe, too, a point which Mr. Johnson makes as well.

His solution? Explicitly limit the size of financial institutions through the imposition of hard caps: