bank capital

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Silicon Valley Blues

The circumstances of Silicon Valley Bank are well rehearsed by now.   The bank sat at the epicenter of the tech-bro start-up ecosystem and played a pivotal role in the collection and disbursement of all the cash that flows through that system.  It was an extremely odd bank.  Unlike the everyday banks most of us deal with it had very few deposits that originated from regular customers.  Most of its deposit base consisted of the chunky piles of cash belonging to start-ups and their various hangers-on.  That meant the average size of each deposit account was well in excess of the limit the FDIC insures.  

This odd customer base added to the strain on the bank during recent years when the combination of low interest rates and excess cash slopping about the economy led to a surge in start-up activity.  The bank benefitted from that activity — if benefit is the right word — and saw its deposits grow rapidly.

This presented the bank with a problem.  What to do with all those incoming deposits?   Because the bank had so few ordinary customers, and generated so few regular assets, it had few options.  Unwisely it chose the riskiest:  it bought long dated US treasury bonds in order to eke out the extra yield that is associated with such long dated maturities.  This is all well and good in a low interest rate environment.  Those bonds are usually thought of as being both safe and liquid — meaning that the bank can sell them easily to generate cash to pay any depositor looking to withdraw their deposits.

But as the Fed drove interest rates up to combat inflation the bank found itself squeezed in two ways.

First, the tech funding boom began to falter.  The inflow of new cash slowed and began to reverse.  Those start-ups began drawing down on their deposits.  The bank needed liquidity to meet those withdrawals.

Second, rising interest rates made those Treasury bonds lose value.  Bonds with an interest rate of 2% are worth less when rates have risen to 4%.  They begin to trade at a loss.  So when SVB started selling bonds to meet the withdrawal demands of its customers it simultaneously started to lose money.  Lots of money.

Even this would have been manageable as long as the rate of withdrawals was more a trickle than a flood.  Yes, the losses would have impaired the bank’s capital which it would have needed to replenish.  But if that had been done in an orderly fashion the bank may have survived.  

This is where the oddity of the bank became its weakness.  The tech ecosystem is a tight knit one.  As rumors began to leak out that SVB was looking to raise capital, alarm bells went off. Social media lit up with urgent warnings.  Clever people of all sorts of persuasions started to tell their friends to pull their deposits out.  Clearly, they all argued, the bank was in trouble.  It was better to be the first rather than the last to get your cash out.  Their calls for action exacerbated the very crisis they were warning of.

So a classic bank run began and the bank was doomed.

The Fed had to step in and give its backing to the depositors.  The question was to what degree that backing ought be.  Should the Fed stop at the FDIC insurance limit of $250,000?  Or should it go beyond, as it has in the past, and back the entire deposit base?

The Fed chose the latter, more conservative, approach.  All the bank’s depositors will be made whole.  Those Silicon Valley libertarians have been saved by the government.  What irony.

The panic within the tech ecosystem at the end of last week manifested itself in all sorts of desperate and unseemly calls for government bail outs.  Apparently oblivious to the obvious contradiction between their philosophy of individual grit and liberty — the stuff of the myth surrounding our obsession with “founders” and “disruptors” — and the urgency of the call for the government to protect that self-same start-up culture, literally thousands of participants in the ecosystem worked the phones to lobby for a bail out.

It worked.

Silicon Valley is now functioning happily in large measure because the Fed saw fit to extend its support beyond the mandated FDIC limit.

Now come the cries of “moral hazard”

Every time the government bails out a bank, we are told, it is sending a message to the remaining banks that they need not be too careful.  They will survive no matter what.  The Fed will backstop them.  They can play risky games to eke out extra profit for their shareholders and will never have to pay attention to the downside.  Where, once, this moral hazard extended only to those banks deemed so large that their collapse would endanger the entire financial system, it now appears the backstop has been extended down to smaller banks.  Is the entire system now protected beyond the FDIC insurance limit?  If so, how does this affect that way in which banks will behave?

There is no easy answer.  Banks are vital to the functioning of our modern economies.  They are deeply embedded in everything that goes on in the day-to-day economic activity we all take for granted.  Simply allowing the odd bank to collapse in order to avoid introducing moral hazard appears to be an easy policy.  The problem is that history suggests that this obvious answer is no answer at all.  Once one bank goes down panic stirs amongst depositors of other banks and even the strongest of banks can get swamped by a tsunami of withdrawals.  Banking is not a cluster of individual banks.  It is a system.  More to the point, it is a system built on the flimsiest of assets: public trust.  Once trust goes, they system crumbles.

So eliminating moral hazard is itself hazardous.  Banking is inherently unstable.  The essence of banking is to take risks.  Sometimes those risks will destroy the bank.  How are we to allow this natural process to unfold without it spreading panic and dysfunction beyond the bank in question?  It is always better public policy to err on the side of caution and save the depositors of a failing bank from loss.  That stems the decline in trust and the system stays afloat.

But isn’t this dangerous?  How do we punish poor bank management?  Isn’t that the essence of good old capitalism — to let banks fail is to instruct the survivors to behave in better ways.

And here we get lost in the thickets of semantics.

If we “bail out” the depositors are we really creating moral hazard?

Not if the shareholders, other investors in the bank, and its managers all lose.  They are not saved.  They all lose their money or lose their jobs.  That’s a pretty clearcut message to everyone else.  So the issue of moral hazard is avoided with respect to ownership and management.

So what about the depositors?  Ought they, too, not be punished for not being sensible and thinking about the risks they were taking by putting all their money into one bank?  Should they not lose too?

In typical bank failures of the past, uninsured depositors — those with balances of over the FDIC limit of $250,000 — have experienced a loss of around 15% of whatever their exposure was.  They don’t lose everything because even a rotten bank still likely has assets that can be sold off to raise funds to pay depositors.  That loss is not catastrophic, but it can be really inconvenient, particularly as the liquidation of assets can take a while.

From the regulator’s perspective even a rapid liquidation process represents a window of doubt.  They much prefer a more rapid solution in order to calm the banking system and reassure depositors as quickly as they can.  So the best option becomes one in which the regulator seizes control of the failing bank and then arranges its sale to another, healthy, and usually larger bank.  Typically this takes place over the course of a weekend.  The failed bank is closed on Friday, and its branches re-open the next Monday under the colors of a new bank.  The purchasing bank buys the assets of the failed bank and honors the withdrawals of its depositors as if nothing had happened.  The inconvenience is compressed into one weekend during which the depositors of the failed bank would not be able to make withdrawals.

This tried and true solution could not be put in place in SVB’s case because its book of business was so peculiar that the potential purchasing banks expressed concern about the assets they were being asked to buy.  

So when SVB re-opened the Monday after its failure it was under a new, temporary, name and under the day-to-day management of the FDIC.  The Feds keep a roster of experienced and trusted managers who can be called into run such state-run banks whilst a longer term solution — usually the piecemeal sale of assets — is undertaken.  

But back to the issue of moral hazard.  The commentariat is full of discussion this week about how the SVB wind-up affects future banking practices.  Are we now in an era of total deposit insurance?  Is that $250,000 limit now redundant?  Have we made the banking sputum more reckless?

The answer is not clear.  And that has to do with the nature of our banks.

The problem is that the business of banking is not homogeneous.  Banks are bundles of different businesses or activities.  

Some of these activities are what we call public goods — we all need a properly functioning payment system.  We need to feel safe depositing our cash into an institution that knows how to account for, manage, and move those deposits whenever we wish.  Why should any of us have to go through long winded due diligence just to deposit our cash?  Perhaps a large multi-national corporation needs to do so, indeed we should expect them to, but they all have complex cash management arrangements precisely because of this.  They protect themselves well.  If they lose money because they messed up their cash management, they do not deserve to be helped by a bail out.  

The rest of us, including small businesses and those start-ups in Silicon Valley, are not that sophisticated.  We cannot be expected to spend time and effort executing complex cash management strategies.  We look at banks as utilities providing simple, safe, and reliable services.  Banks in this regard are giant accounting functions.  They are operational.  They need an eye for meticulous detail and error avoidance.

This is a very different activity from the riskier business of assessing the creditworthiness of potential borrowers, allocating funds accordingly, and then managing the various disparate cashflows such allocation inevitably creates.  Risk taking both in calculating whether someone is creditworthy and in matching the maturity of the incoming and outgoing cashflows is a skill banks specialize in.  They often get it wrong.  Their world is a very uncertain place.  And when they make mistakes, like Silicon Valley Bank, their very existence is threatened.  It is this aspect of banking that has, historically, been the cause of bank failures. — once word gets out that a bank has made bad bets, its depositors try to get their money out quickly. 

Bank managers regularly make wrong or foolish decisions with regard to risk.  They misjudge the effects of interest rate changes.  They misjudge the ability of their customers to repay loans.  And so on.  Risk management is a central and, well, risky activity.  No one is perfect.  So banks fail.  The managers and investors in such risky activity need to pay the price when they get things wrong.  They certainly reap the reward when they get things right.  

Every economy needs these two activities.  It needs a safe payment system.  It needs someone to take credit and balance sheet risks.  But we muddle the two.  Our banks do both.

So when the risk of the second threatens the safety of the first the Fed is always forced to act.  The functioning of the public good takes priority over the disciplining of the private sector activity.  Because we need our cash to flow easily and on demand, we protect the risk activities as well as the accounting activities.  We have no choice because our banks are a muddle of both sorts of banking.

If we want to protect depositors fully, no matter what their balance, and yet we want also to punish management for making poor risk decisions,  then we need to address and sort out this muddle.

Our perpetual inability to engage in sensible conversations about the role of the government in the economy — we have been crippled in that regard for decades since the stupidity of neoliberalism took hold of our political elite in the 1970s and 1980s — prevents us from simplifying policy.  And, in this instance, inevitably gets us into these debates about moral hazard.

Private sector banking is prone to crisis and loss.  Public attitudes towards private banking ought center on our need for credit allocation and the provision of funds to the real economy.  We ought assure that the flow of funds is reliable and is not threatened by panics.  Bankers, though, will make mistakes.  As long as we think the allocation of credit should be a private sector activity we ought allow those mistakes to cost the bankers and their investors exclusively.  Perhaps they will make fewer mistakes if they know there is no cavalry coming to their rescue.  Perhaps competition will sharpen and improve the flow of funds into the real economy.  But ordinary depositors ought not be part of this equation.  They are relying on the payment system not the credit allocation system.

Since a well functioning payment system is a public good it ought to be managed separately from the provision of credit.  This would prevent errors in credit risk taking from grinding it to a halt.

If we want to neutralize moral hazard in risk taking, we need to separate the activities so the payment system can happily chug along regardless.  There ought be no risk associated with making a payment system perform.   In other words we need two banking systems not one.  If we want to utilize market “discipline” then make sure it is deployed in a market.  The provision of funds and the taking of credit risk is such a market.  A payment system is a utility not a market.  It doesn’t need discipline.  It needs rigorous operational attention to detail and effectiveness.  It needs administration.

As I said: we need two banking systems.  But I won’t hold my breath

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Techno Babble

What is about technology?  It’s either a panacea for all our ills, or it’s the cause of all the aforesaid ills.  Why can’t we make up our minds?

This morning’s Financial Times is, sort of, a good demonstration of the confusion we are in.

On the one hand there’s any article about cryptocurrencies.  On the other there’s a rather less techno-centric article about bank culture.  In both cases technology looms large.  In neither is technology really mentioned in detail.  It just forms a context and provides the framing for the problem being discussed.  After all cryptocurrencies are the archetypical modern techno fad and banks were early adopters of hi-tech bookkeeping and analytical tools.  It’s all about ledgers.  Which means, in my mind at least, that it’s all about information.

The entire crypto-craze is a fascinating example of how technology is seen as a solution to a problem.  No matter that the problem doesn’t really exist.  It is also roiling the financial world which is how the two articles intertwine.

First:  Brook Masters gets into the weeds of cryptocurrency regulation.  She is prompted by the recent UK Financial Conduct Authority decision vis Binance.  The techno-folk who are deeply into cryptocurrencies seem to confuse the various so-called “coins” for actual currencies.  Up until now they are speculative assets.  Not that currencies are immune to speculation.  Of course not.  But, so far, the main purpose of cryptocurrencies appears to have been to create a digital asset that can be bought and sold on exchanges in the same manner as gold or silver.  Binance is one such exchange.  It is one of the largest.  The FCA has taken the position, quite rightly from the public protection perspective, that exchanges doing business in the UK need to show proof of their anti-money laundering activities.

Since criminal activity is commonplace behind the shrouds of cryptocurrency exchanges — this is hardly disputable — it is not unreasonable for national authorities to seek to rein such illegal activity in.  I can speak from experience when I say that it is devilishly difficult for an intermediary like an exchange or a bank to tell what’s legal and what’s not.  The volume of daily transactions is immense, the payment system has to function in the public interest, and it’s quite easy for criminal activity to slipstream through along that river of activity.  Which is why the banks invest so much time and effort into detection.   They would prefer to avoid the cost, but the regulators insist.  Correctly.  So why should the crypto-world be any different?  It shouldn’t.

The problem for the techno-folk and enthusiasts in the crypto world is that the very basis of their technology, especially the distributed ledger and the anonymity is seeks to confer, attracts nefarious players.  Combine this attraction with the recent rapid expansion of the crypto-world and, naturally, the authorities want to crack down.  It is the secrecy feature of crypto that fascinates its fans the most, they abhor “government” which they view as irretrievably corrupt, but then they build something that is almost exactly what the criminal class would have built had they planned it.  So the first age of crypto is ending.  The free-wheeling days are past.  We are entering the next stage which will be dominated by regulation and the entry of more traditional players like the big banks.

Second: this gets us to the second article that caught my eye.  Simon Samuels, a consultant to banks, talks about the value of institutional memory in banking.  He uses the commercial real estate cycle as an example of how important it is for banks to remember their losses in prior cycles so that they can avoid pitfalls in future.  This, surely, is blatantly obvious.  But, like the detection of money laundering, it is devilishly difficult to do.  Banks, as we all know, are thinly capitalized.  That’s the nature of banking.  Some of you think it ought not to be, but before you argue for change, think through the ramifications for credit creation.  Balancing between making credit available and ensuring bank safety and soundness always attracts advice from outsiders.  Everyone, it seems, is an expert on how to run a bank.  Only Minsky is worth reading.  And public provision of finance does nothing to alter the essential dynamics of risk taking.  Banks exist to assess and take risks.  That’s their function in the economy.  This will, inevitably lead to mistakes.  We can question how to mop up after those mistakes.  And we can question who ought to benefit from the profit generated by risk taking.  But, in a world of endemic uncertainty, risk taking is inevitable.  It cannot be eradicated.  Let’s not confuse uncertainty with risk — that’s a different conversation.  Meanwhile, educated guesswork, what banks call credit analysis, is the order of the day.

Which gets us back to that second article.  The gist of which is that banks ought not exploit modern technology and adopt a hybrid work environment post pandemic.  No, they need to get back to the office so that those awful memories of the losses of yore can be passed along in person.  Apparently they cannot be passed along in any other way.  So, this reasoning suggests,  technology is totally inadequate as a form of transmitting memory in an institutional setting.  This is not true.  What’s lacking is not the capacity of people to communicate across a technological context.  It is the cultural and imaginative capacity to do so.  Let’s face it: the record of the banks is not spectacular when it comes to institutionalizing risk aversion.  There will always be too strong an impulse towards risk taking.  Someone will devise new and attractive methods of taking risks.  They will, most likely, drape these new methods as risk-mitigating.  Which is exactly how the derivative driven Great Recession began.  None of the banks now so keen to get their people back into the office and to learn from past mistakes has done a very good job of such learning.  The profit motive clouds their various memories too much.

That’s all fine of course.

But what I wonder about is how the banks really learn from their past mistakes.  Is it true that such learning cannot be done on a technologically enabled distributed basis?  Is our technology that bad?  Are we?  Are the banks so inept that a process that appears to have worked so well for the past year or so, has to be chucked over for a return to the “old ways”?  I think not.  I imagine that there a a few AI developers who could institutionalize the right learning for the banks were they asked.  The urge to get back to the office is not an indictment of the technology, it is an expression of fear.  The profit-induced pressure to take risks in banking has created an environment of fear: management needs to patrol not educate.  It needs to control in order to check the rogue behavior before it accumulates into existential danger.

To end with an example:

The first article talks about the allure of cryptocurrencies.  The “big players” we are told are beginning to dabble in the market.  Some notable names are building their own crypto platforms.  This is why the regulators are getting nervous.  Why?  Because those big names are exactly the same folk who got into derivatives.  Dabbling in the new technologies and the new ideas is something that institutional memories cannot evaluate or warn against.  Which is why they have the allure they do.  They are new frontiers for profit, they are new horizons to explore.  No amount of personal interaction can overcome the difficulty of assessing the risks of something that is completely uncertain.  Indeed collecting a bunch of eager young, bonus driven, and over-educated people into a small space is precisely the atmosphere in which speculative crazes take root.

As I said, our attitude toward technology is confused.  It gives us new frontiers to explore.  And it creates new risks.  It allows us to communicate.  And it is no good, apparently, for the adequate communication of institutional memory.  It opens up the space of problems to solve.  And it provides the solution.  It adds complexity.  And it simplifies.  It empowers.  And it limits.  It enables both decentralization and centralization.  It adds a veil of secrecy.  And it encourages universal surveillance.  It both opens up and forecloses on opportunity.  It augments labor.  It replaces labor.  It does work and is that basis of modern leisure.  It is indispensable, but sometimes we need to get rid of it and meet face-to-face.

Ever since the first great machines allows us to solve the ancient economic problem we have looked at technology as our long term savior.   Somehow, we imagine, technology will provide the answer.

Sometimes I wonder though: do we ask the right question?

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Jobs; Trade; Banks … Ho Hum And Bun Fights

This is getting dull. Really dull. The economy refuses to shift gears. Wall Street twitters on about nothing in particular. Central Bankers are even more confused and surly than usual. Businesses are sitting on piles of cash and complaining that no one cares about them. Banks are in a snit over being asked to play nicely. Consumers have all but disappeared. Government policy makers wring their hands and smile at the same time. The dark clouds of currency wars have rolled into view. And we go nowhere fast.

Welcome to the crisis part 2.

Oh: the very slightly good news is that new claims for unemployment assistance fell again last week. Whoopee. The drop was by 11,000 all the way to 445,000, which, in normal times, would be viewed as hopelessly inadequate, or a mere blip not worth mentioning, but was the reason that Wall Street roared briefly to life this morning. We exist – I won’t dignify our current state by using the word “live” – in such diminished times that even the most modest step in the right direction can be viewed as a triumph of the first order. Our era has so perverted our language that we no longer can use the word “modest” without feeling slightly apologetic. Personally I blame corporate America for its incessant hyperbole that has undermined the value of words that used to mean something.Modest used to mean, well, modest. Now it means a mix of useless and wimpy. Thus when we run into a putrid performance we have and reach for a proper descriptor we are apt to bring pablum out of our bag. This ends up confusing everyone, and allows the incompetent folks who buy and sell stocks for a living to justify anything. Thus today’s new claims data, which can only be described as the greyest of greys, is greeted in the manner once reserved for the returning Caesars of Rome.

My advice: ignore the hoopla. The claims number represents one of a long series of indifferent and indistinguishable data points, none of which tells us much other than that our malaise continues. Allow me to repeat: we need that claims number to be under 400,000. Better yet, we need it to drop to the mid 300,000 range before we reach for the celebratory fireworks.

Meanwhile ignore Wall Street. Remember they are the folks who trashed the place in the first place. The one fact we have at present is that they know nothing worth our learning.

In other news we are reading a great deal about the brewing trade and currency wars about to blight the world.

The reason is simple: practically every government facing a domestic crisis has written into its escape plan that it will grow out of crisis by pumping up exports. Those of you with an eye for detail will notice that there is a slight problem with this. Someone has to import. Not everyone can export. Whoops. In the old days the game was extremely simple. Japan, Germany, and China exported. The US and the UK imported. That meant that German, Japanese, and Chinese workers lived below their means while Americans and Brits lived above theirs. A better way to look at this is that the Germans, Japanese and Chinese exported unemployment by deliberately under-consuming goods that they made. The surplus was sent abroad. Further: the spare cash that this generated for those economies was recycled back into the US and UK where it pumped up asset prices. This “surplus” of savings on world markets created by the deliberate under consumption in the exporting nations was a major factor in the real estate bubble. At least that’s one theory doing the rounds. Bernanke is a leader of that train of thought.

Now, in the depths of crisis, the importers need to rebalance their economies and reduce the import inflow. But that implies the exporters have to adjust as well. Therein lies the source of tension. The exporters do not want to change their game. Too many local jobs depend on trade. In the case of China, whole industries depend on it, which means millions of recently displaced agricultural workers do too. That’s a big social problem waiting to burst if exporters have to change course. China’s middle class is insufficient to buy all those goods. At least not yet. So they need to keep on exporting. To us.

Which is why they rig their currency and try to play beggar-thy-neighbor with the rest of the world, and particularly with the US. If China were to allow its currency to float by unfixing its relationship with the dollar, it would be revalued upwards. That would make Chinese goods more expensive in foreign markets like the US and would thus reduce their exports. The displaced goods would have to be sold internally within China or those factories would have to close down. Either way the adjustment could be difficult. It would cramp Chinese growth which has averaged 8% a year for a while now. A slowdown from that pace would – potentially – hit their agricultural and poor workers the most since it would remove their opportunity to earn higher wages. The result? Civil unrest. The entire structure of the Chinese elite would feel the strain. It has already been hit by waves of strikes as workers lobby for better conditions and wages. Add in the loss of export industry jobs and the country gets shaky quickly.

Hence the current stand off.

Of course this scenario is being played out across the globe as countries seek to devalue their currencies to dampen Chinese and other exports and boost their own. It is particularly acute in Europe where the German refusal to rebalance their economy is weighing heavily on places like Spain. Since Spain and Germany use the same currency the poor Spanish cannot devalue. They have only one option which is to throw themselves into massive austerity programs. The Germans meanwhile preach such austerity, apparently oblivious that their failure to boost domestic demand created the excess cash that blew Spanish real estate into its bubble – all those German second homes on the Mediterranean coast, not to mention the tourists and their wads of Euros – and is now exporting unemployment along with those BMW’s.

I won’t mention the dire straits the poor Irish are in. Suffice to say that they make the Icelanders look like amateurs when it comes to self destruction.

So, all of a sudden, attention worldwide is on how to rebalance the flow of trade so that excess cash doesn’t slop about creating bubbles, and the exporting nations don’t foist unemployment on everyone else. The recipe for a full blown trade war is nearly complete. Which is very worrisome, since one of the factors that made the Great Depression truly “great” was the trade war of the 1930’s.

And, finally, on a more comical note: the banks are at it again.

This time they are all in a huff over the new capital regulations introduced by the folks in Basel, which is where the organization that dictates these things is based.

The banks argue, rightly, that higher capital implies less credit available. This is correct because capital is held in proportion to assets. So if that proportion is forced higher, the banks have two choices: they can raise more capital and not deploy it as loans; or they can keep their current capital, and reduce the amount of loans from where they now are. Either way the level of lending will drop. The entirely neutral analysts at Goldman Sachs tell us that the drop could cut about 1% off of GDP over the next few years. Conveniently we are not told how much GDP was destroyed by the excess lending of the last few years – that would mess up the story. In any case, the bleating from the banks is now very loud. Fewer loans means lower profits. And we all know what that means: lower bonuses. So I think we can ignore the warnings of lower GDP and cut straight to the one thing we know they care about: that fifth New York apartment. Or: how awful that they might have to forgo the Hamptons home and the Aspen retreat. How mean spirited of us to force such choices on the poor dears. Now this is a true national policy issue.

Not really.

A cursory review of Hyman Minsky and his financial instability hypothesis tells us that less lending is a very good thing. It reduces long run volatility because more of the economy’s wealth relies on equity funding and not debt. That makes it less susceptible to the swings of interest rates and thus more stable. This is good. Very good. The cost for getting this stability is that we will generate less wealth on paper. GDP will, indeed, grow less quickly. But, as we recently learned, wealth that relies on debt is often an illusion – just as illusory as Lehman’s asset values were.

Frankly we could do with less illusion and more reality. Hence we should gird ourselves to ignore the weeping and wailing of Wall Street, even if they have a technically correct point. After all our economy is not theirs to play with. It’s ours.

Not only that, but we want it back.

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Bank Profits: An Illusion

A friend of mine pointed me to research by analysts at JP Morgan who have developed a ‘doomsday scenario’ for the banking industry that assumes all current regulatory suggestions and then calculates their impact on profitability. It doesn’t take much imagination to see that the return on equity will be massively reduced: not only are the banks limited in what activities they can generate profits from, but their ability to ramp up leverage would be significantly reduced also. It would be the perfect storm of profitability reduction.

Which is a good thing.

And exactly what I would hope happens.

The curtailment of ROE opportunities in finance would force investors to search elsewhere for profitable places to deploy their capital. As a society we need this result. As long as the returns offered in finance are higher than those in the ‘real economy’ capital will disproportionately flow into the banks, and away from activities like manufacturing where new jobs could be created. So slashing bank returns is a good thing for the rest of us, although bankers whose bonuses would suffer probably will object.

The research also supports my point made a couple of days ago: banks are conglomerates of businesses with a melange of ROE’s that average out to whatever we see reported in their financial reports. If bankers were truly upset over the drop in their overall ROE’s they could break their banks up and expose the range of returns within the prior conglomerate. Some of the new and smaller banks would have very high ROE’s and could still attract capital. Others would be exposed as loss makers that need either to be closed up or managed back to health. This transparency of returns is socially beneficial in that capital can then be allocated by the market to better opportunities. Right now capital going into our banks gets allocated internally and a process that may not be efficient. All the evidence of the last two or three years tells us that bank mangers are very poor at capital allocation: they poured money into activities that generated huge losses. They should not trumpet their ability to allocate capital – they lack one.

Everyone except the bank managers benefits from the regulation the JP Morgan analysts decry. Yes bank returns would drop. That’s good. We need the capital is more useful places thank you. Plus those low returns might actually inspire some real innovation amongst our banker friends – innovation that creates profits that are more sustainable than the gambling they currently rely upon. Shareholders would benefit from breaking the banks up since the range of ROE’s they could choose from would expand thus allowing them to match their own risk/return requirements instead of having to rely on the faulty judgement of bank managers. Customers would also benefit since the smaller banks would be more focused on individual lines of business in which they have to find profit: this would spur innovation and competition, which would result in higher values for customers. Those faux innovations could become distant memories.

We can dream can’t we?

Remember lower ROE’s do not mean lower profits. The banks will still make big profits, but because their leverage is much lower those profits will represent less ROE. We need lower ROE’s to force capital away from the banks and into industry. So the larger message is that lower bank returns on equity are a good thing.

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Too Big To Fail

Of all the issues facing the economy one stands out as having potential to throw the economy back into crisis. Yes, the lack of consumption may make us fall into a second recession, but that is not a crisis – we know how to deal with it. No, the lack of long term safety and soundness in our banking system remains as that potential trigger. Specifically the damage that could be done by banks that are deemed ‘too big to fail’ [TBTF]

I have sounded off on this plenty of times so I will not repeat myself: I think we need a mixture of breaking up the big banks and much more rigorous regulation on their activities, especially on their trading accounts.

The debate on how to manage these behemoths is no getting up a head of steam. Today Barney Frank weighed in with his proposal to institute a tougher regulatory regime. I don’t agree with his proposal since it leaves the big banks whole, but at least we now have something to shoot at or argue over.

The central component of the Frank idea is to establish a central authority comprised of representatives of various regulatory agencies with the power to wind up the mega banks in a relatively painless way.

One of the bug stumbling blocks we have at present is that, while shareholders stand to lose everything in bankruptcy, bondholders and, crucially, counter-party creditors are protected by the taxpayer safety net. This extension of safety to sophisticated creditors, rather than just to ordinary depositors, has vastly complicated the winding up process of banks and made the cost to taxpayers extremely high. This ongoing, and implicit rather than explicit, guarantee by the taxpayer sits behind the willingness of creditors to continue to lend to big banks even when the bank’s leverage has reached dangerous levels. As I have said before: this implicit guarantee needs to be made explicit. The banks should either pay for it or give it up. Since they cannot operate any longer without the taxpayer safety net they’d have to pay. That would hammer their profits and strip away their delusions of grandeur.

But Frank doesn’t go there. Instead he simply seems to advocate a more efficient bankruptcy process that would foist losses on the bondholders as well as the equity holders. This means that in an extreme event the guarantee would disappear for the bondholders at least. But for an ongoing bank taxpayers would still be on the hook and creditors would be willing to lend at lower rates than would be otherwise prudent.

Lest this sounds arcane I want to point out that the implicit guarantee does not extend to smaller banks: those we have let fail. The implication of this is that smaller banks are at a constant competitive disadvantage: their cost of borrowing will be higher, this means their margins and profits will be lower. The big banks will be able to gobble up even more of the business. they will get even more TBTF.

I have no problem with having aggressive bankruptcy plans available to the regulators – the whole Lehman and AIG mess suggests such plans are long overdue. But tightening control must go beyond that.

As George Shulz has said: too big to fail means too big to exist.

Break up the banks.

Addendum:

I have a good friend who works at one of the regulators. His view from the inside is much more nuanced than mine and, in some ways, more pessimistic. The point being that there seems to be a total lack of political will to attack the issues presented by mega banks. Amongst these issues are:

  • International conformity of regulation – right now the big banks simply move business around the globe to countries with less strict regulations. When they go bust this leaves a trail of legal recrimination, confusion, and indecision. This ‘regulatory arbitrage’ needs to be stopped.
  • The entire mess of derivatives needs to be curtailed. The big banks have conjured up ways to package and sell things that boggle the mind. Just the names of some of the corners of Wall Street tell it all: ‘dark pools’ where trades take place away from public scrutiny; synthetic derivatives, which are derivatives based upon other derivatives; and, of course my favorite, sovereign credit default swaps – which only have value if the US defaults on its debt, at which point I would wager the banks trying to collect will have deeper problems than US treasury default.
  • Capital rules that need to be adjusted to rein in off balance sheet assets and take away the lower capital requirement for securities.
  • Risk management techniques that are self evidently fatally flawed: the collapse of the banks last year was less a capital adequacy problem than a liquidity problem. The entire fabric of risk management failed: from the fancy math right through to the inability to sell assets to raise cash. We all need to understand that markets fail. Without accepting that central premise everything else doesn’t matter. When markets fail no one can sell assets – there are no active buyers, that sends asset values crashing well below any reasonable floor, panic ensues, and banks suddenly lurch from being safe and sound to bankrupt because what they thought was a source of cash is no longer available.
  • Compensation reform. This is less easy than it sounds since it requires re-wiring the way we all think about finance. A few years ago no one paid anywhere near the attention to daily stock market gyrations as we do now. The emphasis on quarterly earnings reports needs to go away. This relentless short term focus forces managers to take risks beyond that acceptable long term. Since bonuses tend to be tied to the short term the entire focus of business needs to shift to the long term view. Only then will pay structures be easy to reform.
  • Lastly the rating agencies, whose complete lack of objectivity drove them to insanely poor analysis, need to be forced into a totally reconstructed and neutralized way of business. Those who rated what became toxic assets as triple A need to be removed from the industry permanently: they obviously were both clueless and probably corrupt.

One last thing on liquidity.

Another good friend of mine with military background used to tell the tale, suitably sanitized of course, of US military planners constantly failing to recognize the logistical bottlenecks represented by limited troop availability. Each sector commander assumed that the ‘cavalry’ was available to him to deal with a crisis is his designated area. What they all missed is the effects of a systemic crisis: clearly the same cavalry cannot be in two places at once fighting two separate crises. This is analogous to bank liquidity: banks who make liquidity plans built upon the assumption that they alone will be looking for cash miss the point. A systemic crisis means everyone will be trying to raise cash. That will flood the markets and destroy asset values. Risk management has to be systemic. How we do that and preserve bank independence is another matter.

Big bank war games perhaps?

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