Friday, January 22, 2010

Bank Reform

Maximum Leader has come out with tentative support for banking reform.

I'm in favor of banking reform. The implicit guarantee has created too much moral hazard. Bankers have lost sight of reality. The reason they are supposed to be so well compensated is because they are taking risk, but in reality it is the American taxpayer, not them or their companies, that is taking the risk. Yet, many of them seem legitimately shocked that people are pissed at them. Also, they seem to actually believe they deserve all that money. Until two years ago, I would've agreed. Now, however, it is clear they screwed the fucking pooch and don't deserve what they are getting. That said, I'm concerned about some of the talk coming out.

The primary purpose of a financial system is to allocate capital from savers to borrowers.

There are four ways that banks make this happen:
  • Maturity Intermediation - If I have money to lend for 6 months, then that doesn't help somebody who wants it for 1 year. Banks can smooth these discrepancies out.
  • Diversification - If I make a loan, I'm more at risk because I'm only making one. The law of large numbers allows banks to determine and mitigate some of the risk of lending.
  • Cost Reduction - They do this in many ways, but generally speaking they can specialize in the knowledge required for making loans and investments, which reduces costs.
  • Payment Mechanism - Banks take the difficulty and risk out of the movement of money, which reduces frictions in the allocation of capital.

(There may be others, but they don't come to mind at present.)

There are two predominant financial systems -- bank-based and market-based. Bank-based means that bank deposits are relatively larger as a percentage of GDP and the market capitalization is smaller than market-based systems where the converse is true.Broadly speaking, Continental European financial systems (notably Germany and France) and Japan's are bank-based. Anglo-Saxon countries (Britain and the US) and to some extent commonwealth and former colonies, like Singapore, are more market-based. In the UK and US, companies generally go to the stock and bond markets to get capital. In Europe and Japan, they go to a bank for a loan. There are a variety of reasons for the differences: the relative timing of Industrialization (US and UK industrialized first), civil versus common law, cultural reasons, and others.

The World Bank has a paper with the results of a multinational comparison of bank-based versus market-based financial systems:
A clear pattern emerges: 1) Banks, other financial intermediaries, and stock markets all grow and become more active and efficient as countries become richer. As income grows, the financial sector develops. 2) In higher income countries, stock markets become more active and efficient than banks. Thus, financial systems tend to be more market based. 3) Countries with a common law tradition, strong protection for shareholder rights, good accounting standards, low levels of corruption, and no explicit deposit insurance tend to be more market-based, even after controlling for income. 4) Countries with a French civil law tradition, poor accounting standards, heavily restricted banking systems, and high inflation generally tend to have underdeveloped financial systems, even after controlling for income.

Getting back to financial regulation, a lot of what I hear from Democrats, and frankly concerns me, seems to be a desire to shift to a more bank-based financial system or doesn't seem to understand either what banks do or the role they play in our market-based financial system.

I can understand why Dems like the idea of shifting more toward a bank-based financial system. Banks making loans to specific individuals can be more narrowly regulated than market transactions. Political preferences can be encouraged. Also, less cynically, a bank taking deposits and then loaning them out is easy for people to understand, including regulators.

Securitization has gotten a bad rap because of the mortgage-backed security's role in the crisis, but it does have many benefits. The pricing mechanism of the market is good signal of information, and I'd argue that a market determination of an interest rate for a corporate bond is better than a big bank running credit analysis and offering the loan themselves.

Market-based financial systems allow for more innovation, but at the cost of greater risk and uncertainty. Both type of financial systems can have panics, but markets are more prone. Nevertheless, as the excerpt above makes clear -- "In higher income countries, stock markets become more active and efficient than banks."

Getting back to the reform idea, the demagoguery that comes from the Left that describes the market as a casino bothers me. Even the evil speculators, out for short term profits, provide information to the market. But to call market finance a casino misses an important point. A casino game is rigged, the market, if full information is available, isn't. The problem arises when some people are in a position to have more information than others, also called asymmetric information. That's why we have insider trading laws.

The key for me is to allow the market-based system to be creative and innovative, but require sufficient capital and some other protections that losses can be privatized, i.e. banks can fail.

Jim Manzi put it well:
If you want to have a safe, secure banking system for small depositors, but don’t want to make risky investing illegal (which would be very damaging to the economy), the obvious solution is to not allow any one company to both take guaranteed deposits and also make speculative investments. This was the solution developed and implemented in the New Deal. We need a modernized version of this basic construct, and as far as I can see, this is what President Obama has proposed.

The New Deal construct, Glass-Steagall, created a bright line between commercial/ retail banking and investment banking. The bank you put your money in was regulated and guaranteed. Banks in the more risky market end were not guaranteed. But this line didn't recognize the changing nature of the financial system. As I mentioned above, the market is more efficient in allocating capital in wealthier nations. Various derivatives, interest rate and currency swaps for example, allow banks to mitigate risk cheaply and efficiently. Keeping commercial banks in too tight a box, one that bans them from trading in derivatives for example, might not be helpful. Also, securitizing loans has benefits. If we keep a bright line between investment banks and retail banks, then this may be hindered or distorted. The financial world today isn't 1933. Information technology has made new products possible that commercial banks may find helpful in diversifying or mitigating their loan risk.

So, there's the nature regulation, which I looked at a bit above, but another question I have is the feasibility. This morning I was listening to BBC's Wake Up To Money. A commentator mentioned how Goldman Sachs sold mortgage-backed securities to customers, only to short them in their proprietary trading. He was saying that the Obama reform would step in to stop this. For those of you who don't know, proprietary trading is when the banks make trades for themselves rather than customers.

I had two questions. First, if the US gets too restrictive about trading, what's stopping them from moving to Switzerland or the Caymans or wherever? Second, can we devise regulation that differentiates between market making, trading for clients, and proprietary trading?

Banks make markets. They buy and sell currencies, securities, etc as part of this. Furthermore, they act in the financial markets in all sorts of ways on behalf of their clients. I find it hard to believe that given the fungibility of money that bankers can't find a way to make proprietary trades no matter what the regulation says, even if they aren't called proprietary trades.

So, what does that all mean? I'm not opposed to the regulation in principle and many of the key aspects I'm hearing about I could support. (But notably I don't support a new agency tasked with "consumer protection" and anything with the words "vanilla product.") The devil really is in the details though. Given how the health care thing has gone, I'm not hopeful.

Sorry if this post was an impenetrable, incoherent mess.

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