Sunday, January 24, 2010

Correspondence

I've received some emails regarding my Glass-Steagall stance. Most are along the lines of: "I don't understand how most of this works, but if Glass-Steagall seemed to have worked since the 1930s, then that seems like a good plan to me." I'll try to explain.

The big flaw in that plan is computers.

Lots of eyes glaze over when it comes to finance, but at it's core it is very simple: Person A gives money to person B on some date(s), and in return person B promises to give money back at some future date(s). Over the years we developed lots of names for these things (mortgages, insurance, bonds, bills of exchange, etc), but what is happening is that somebody is giving money to somebody else in return for the promise of getting money later. When we worked with pencil and paper ledgers, calculation and tabulation were relatively difficult. We had, as I mentioned above, set types of financial transactions that were relatively well-defined and people and companies specialized in particular products.

Fastforward to the advent of computers and calculations become cheap. Mathematical concepts that were known but too labor intensive due to the number of calculations involved became possible. MIT PhDs used these techniques and technology to create new ways of person A giving money to person B and paying it back that had certain properties of different products. Hybrids, so to speak. These were far more efficient and cheaper than many of the old methods of doing things.

For example, interest rate swaps allow banks with too many fixed rate loans on their books basically to turn some percentage of them into variable rate loans. This helps them manage their interest rate exposure almost in real-time. Ah, but interest rate swaps are "derivatives" that "greedy speculators" use to "gamble" on the "casino" that is Wall Street.

My point here is that in the age of computerized finance it's not so simple as saying this bank can invest in a risky instrument and this one can't. New products, if understood and used properly, could help manage risk. We can't roll back the clock to an earlier era where only investment banks do risky stuff and commercial banks engage in staid, boring transactions. We really ought to focus on the composition and size of capital reserves for the different types of banks, but I'm nowhere near smart enough to figure that out.

Andrew Stevens, you haven't said anything on this front. What's your take on Glass-Steagall and banking reform?

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