Saturday, February 12, 2011

Facile Positions That Bug FLG

The other day, FLG was reading a post by ED Kain that contained a passage that expresses a common enough sentiment:
there’s no reason investment banks and traditional banks should be operated under the same roof. For another, there was still a stock market and trading and growth long before we undid Glass-Steagall. The last time we had a largely unregulated banking sector we fell into the Great Depression. This time it’s the Great Recession. If curbing some of this “growth” coming out of the financial sector leads to a Great Stagnation, well that strikes me as a better fate than either of the other two. Smaller, less leveraged banks and separate traditional and investment banks is likely the best option we have to prevent another financial meltdown and return banking to its sleepier, less risky former self.

FLG understands this sentiment, but the analysis is pretty much all wrong. At the time, FLG wanted to post about it, but first he wondered if Nadezhda (a commenter over at LOG who is sorta like the Bizarro FLG but smarter, more informed, and probably better educated) had said anything in support of this idea in the comments over there. In the process, FLG got distracted by another commenter who was spouting off bullshit.

Anyway, getting back to the issue at hand. Let's go line by line:
there’s no reason investment banks and traditional banks should be operated under the same roof.

Okay, what does that have to do with anything? Is there a reason that they shouldn't be? The nominal issue ED was addressing was that "We’ve given too loose a rein to the wild speculators at the top of the economic ladder, and rewarded them with unsustainable riches for their unsustainable risks." How exactly does keeping the wild speculators only in the investment banks do anything about this? This alone doesn't stop wild speculation. They'll just be in commercial banks. And would do absolutely nothing about how the financial class is supposedly screwing everybody else. Again, the investment banks would just be screwing people. So, this recommendation doesn't do shitall about that. Oh, but FLG, then we'll be able to isolate the risky, bad stuff and the cowboy bankers in the investment banks. Uh, okay. But let's not forget that Bear Stearns and Lehman Brothers were PURE FUCKING INVESTMENT BANKS. Yet, when they almost failed and failed, respectively, the entire financial system was pretty fucked. So, this plan of separating them, at least in isolation, doesn't do jack shit about financial stability, moral hazard, or the supposed middle class squeeze by greedy banker speculators.

For another, there was still a stock market and trading and growth long before we undid Glass-Steagall.

Rather than refute this with a long paragraph, let FLG just say this: People still traveled before the invention of the steam ship, car, and airplane. So, obviously, it would be so much better if we went back to them. Seriously though, the question is not whether there was growth or not growth. The question is about opportunity cost, which boils down to whether the risk-adjusted return from repealing Glass-Steagall was/is positive. Now, ED could reach that conclusion, and seem to have, but whether or not there was growth under Glass-Stegall isn't a valid metric. It's whether we can have more growth without it, adjusting for any additional risk.

The last time we had a largely unregulated banking sector we fell into the Great Depression. This time it’s the Great Recession.

FLG will agree we need regulation, although he isn't sure this correlation is compelling. However, just because we need regulation doesn't automatically mean a return to Glass-Steagall. To steal a metaphor from Paul Krugman -- if you run somebody over, then the answer isn't to throw the car into reverse.

If curbing some of this “growth” coming out of the financial sector leads to a Great Stagnation, well that strikes me as a better fate than either of the other two.

This is about the only statement that makes logical sense. Given the scare quotes, he obviously considers the growth due to GLB ersatz. Therefore, he'd rather have the previous regime.

Smaller, less leveraged banks and separate traditional and investment banks is likely the best option we have to prevent another financial meltdown and return banking to its sleepier, less risky former self.

FLG agrees that smaller, less leverage banks would be great for limiting systematic risk. However, this doesn't have much to do with separating commercial and investment banks. To be honest, FLG thinks that the most important cause of this issue wasn't knocking down the wall between commercial and investment banking, but lifting the limits on the interstate banking. When you could only operate in one or two states it was difficult to grow too big to fail.

But, all things considered, FLG thinks this is wishful thinking. This just ain't gonna happen. Not because of political reasons, although FLG admits there are strong political interests, but because the world isn't the same.

Technological change has had two major effects on banking. First, it increased the speed and size of linkages. Trades on a millisecond basis. Money flows instantaneously. FLG thinks the benefits of this are pretty intuitive to people. Funds can flow where they can, hopefully, be most effective. However, with this quick access, banks will naturally relying upon these connections. This means that a failure in one institution will have immediate and broad repercussions. Even if we separate investment banks from commercial banks, and a pure investment bank fails, it's going to have knock on effects.

Second, and more important for these purposes, technology has made new financial products possible. FLG has mentioned this before. Before computers, we had various financial products -- insurance, loans, equity, bonds, mutual funds, etc. Computers led to the advent of products, derivatives, that have aspects that are hybrids of these.

Look, these products are out of the bottle. They aren't going to be disinvented. Perhaps you are saying, "Okay, FLG, but these risky derivatives are like bets. They serve no useful purpose. If we are going to have them, then let's separate commercial and investment banks and leave them in investment banks. Commercial banks shouldn't be casinos."

Well, let's imagine a bank has a bunch of fixed rate loans and is worried about interest rate risk. So, it wants to shift to adjustable rate loans. It could go out, find another bank, let them do their due diligence and analysis, and then sell those loans. Then, go out and write or buy more adjustable rate loans. OR It could just go buy interest rate swaps. Which one do you think is cheaper and faster? Right, the interest rate swap. But it's an evil, risky derivative.

That's the thing here. The pretty much the entire point of derivatives is to shift risk. It can be used to hedge existing risk or take up risk. Do we really want to prohibit commercial banks from hedging risk cheaply and quickly? Maybe we say that it's too difficult to determine if the banks are hedging existing risk or taking on additional risk, and so we don't want to let commercial banks even get involved. Okay, but that is an explicit inefficiency that we would be imposing. Maybe it's worth it, FLG isn't so sure, but that's certainly up for debate.

But the simple fact of the matter is this -- Glass-Steagall's repeal didn't make the financial crisis happen. In fact, as far as FLG can tell it only helped in the midst of the crisis because commercial banks bought up the pure investment banks that were failing, thus mitigating a full on apocalypse.

Glass-Steagall was repealed because the investment/commercial bank distinction just didn't make much sense anymore. Computers have allowed the creation of products that blur the distinction between previously separate financial functions -- insurance, securities, bonds, etc. Moreover, it dramatically increased the size and speed of the linkages banks. Therefore, the old distinctions between investment/commercial banks is less relevant. In fact, the distinctions between all financial institutions have been seriously blurred. AIG, for example, was an insurance company who was more like an investment bank.

Anyway, to wrap up, FLG still hasn't heard a compelling case for reconstituting Glass-Steagall.

6 comments:

nadezhda said...

I'm not sure who Bizarro FLG is (an alter-ego perhaps?) but I'll take your remark as a compliment. Can't recall whether I pontificated on Glass-Steagal at the League, so I'll go ahead and leave some remarks on history here.

You're absolutely right that G-S repeal had diddly-squat to do with the financial crisis. G-S was already dead when it was repealed. The segmentation of the financial system which G-S instituted in the 1930s had been steadily eroded from the 1960s with the creation of the Eurobond market and then the dismantling of Reg Q (rise of money-market funds, interest on quasi-demand deposits, etc).

Disintermediation out of depository institutions into the capital markets was what killed G-S. That's why when the shit hit the fan in 2008 we didn't have a run on the banks, we had a run on the money markets. But the stage was set for a money-market run before G-S was repealed because of the extent of disintermediation by the 1990s.

The first huge US casualty of disintermediation was the S&L industry, which became effectively obsolete since its business depended on regulatory segmentation. Unfortunately, Congress tried to pretend the dodobird was still alive instead of sending it to the taxidermist, so a fairly normal boom-and-bust real estate cycle got fuel added to it and turned into the S&L crisis.

The expansion of inter-state banking you mention wasn't a major factor in eroding G-S, though it did make consolidation of the US banking industry a much easier process, which produced some astonishingly poorly-managed behemoths. However, large money center banks already operated both inter-state in the wholesale and corporate markets and internationally. Frex, IIRC First Chicago was technically a one-branch bank which complied with Illinois' draconian branching restrictions!

FLG said...

Thanks. I think we're pretty much in agreement.

Re: Bizarro.

I'm not familiar with Frex, IIRC First Chicago.

BTW, my point on limiting inter-state banking was that it acted as a sort of inefficient cap on size.

nadezhda said...

Now as to the impact of G-S repeal on individual financial institutions. The dream of some (eg Sandy Weil) when G-S was repealed was full-service Financial Institutions, including insurance, to exploit cross-selling opportunities, etc. That turned out to be a bust, because full-service financial supermarkets were found to not make a whole lot of sense.

Among the reasons is that banks use their balance sheets in different ways than investment banks, which differ from insurance co's, which differ from investment managers, etc etc. By the time you've assembled a bunch of separate balance sheets with different revenue streams, cost structures, use-of-capital logics and risk profiles within a holding company, you don't have 'synergies', you have a dog's breakfast.

The big banks tried to get into the investment banking business but, other than when they acquired a decent niche firm, tended to get into new product lines in a big way late after they'd been commoditized. As a gross generalization, they're not nimble enough, tend to want to scale up product lines rather than move quickly to new products, and tend to think in terms of margins and term structure, whereas IBs are very chary of deploying their capital for any length of time.

So expanding into investment banking in a big way has usually been a bad move for anyone but JP Morgan, which as a bank without a retail focus already had an IB mentality.

By contrast to the banks, the leading IBs stayed away from the universal model. As you note, the blow-ups that triggered the final meltdown in 2008 were IBs, not universal banks, which suggests there were advantages to keeping the IB business separate. Instead of acquiring or building banking ops, the IBs tended to go public and started playing with OPM on their prop trading desks, unfortunately leveraged to insane heights with the acquiescene of the regulators. Again, JP Morgan,with its acquisition of Chase, is the only noteworthy example of successfully combining important IB with a big-time banking op.

nadezhda said...

[con't]

In the 90s, the German model of "universal banks" was thought to be the way of the future to address the disintermediation problem. That was one (of many) rationales for officially dismantling G-S. But the German banks themselves ain't what they used to be, and their balance sheets and management no longer fit the previously acclaimed "universal bank" model.

People who promoted the German model ignored the very special historical connections between German industry and finance, and the cross-holdings, etc. As the German banks have taken advantage of the (poorly regulated) EU single market in financial services, the quasi-EU guarantee of their too-big-to-fail institutions, and joined the globalization race, they've run into all the same difficulties of the Anglo-Saxons.

I'm hoping that the business logic of banks focusing on banking and IBs sticking to their knitting will return once the dust settles. It wouldn't surprise me if Goldman eventually gets rid of its banking license. Disintermediation has forced the banks to be able to play in the capital markets, both to fund themselves and serve clients. But few if any will be able to replicate JP Morgan's model successfully, and they shouldn't try.

Eventually, share prices ought to reward those institutions which return to a quasi-Glass-Steagal-style of better focused business lines and more coherent balance sheets. But given how disintermediation has blurred, both legally and practically, many "banking" functions from "investment banking", trying to reimpose a regulatory firewall would be both undesirable and impossible IMHO.

nadezhda said...

FLG wrote: BTW, my point on limiting inter-state banking was that it acted as a sort of inefficient cap on size.

Absolutely. Quite inefficient. And it was the retail, not corporate, customers who paid for much of that inefficiency.

That's not to say, however, that we shouldn't come up with more efficient limits on size. With the pace of consolidation, we're moving from the unacceptable too-big-to-fail to the increasing nightmare of too-big-to-save.

Furthermore, I'm convinced that there are decreasing returns to scale after some point, and the quality of customer service declines as well. The market (both customers and stock markets) ought to be punishing the poorly-managed behemoths.

nadezhda said...

Re First Chicago (you're making me feel old).

First Chicago was the leading money center bank of Chicago along with Continental Illinois. Illinois was a "unit banking" state -- that is, prohibited branch banking, so First Chicago's big headquarters was its sole "branch". Yeah, I know. Very weird.

First Chicago disappeared in the wave of consolidations: it first merged with National Bank of Detroit, then was acquired by Banc One, which was in turn acquired by Chase (JP Morgan).

 
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