bank reform

Economists sure as heck didn’t.

“Before the financial crisis, most macroeconomists were blinded by the idea that efficient markets would take care of themselves.They did not bother to put financial markets and the banking sector into their models. This is a major flaw.” Professor Paul De Grauwe, a macroeconomist in today’s Financial Times.

It is one of those oddities that I am certain most of you are blissfully unaware of, but text book economic theory has no place for banks. Go on read that again just to make sure you understand: there are no banks in the realm of economic theory. None. No Goldman Sachs, no Citibank, not even JP Morgan Chase whose eponymous founder was an economic powerhouse and involved in national economic policy for years. And, no, I am not exaggerating. If you pick up any standard text book you will find no references to finance in the models of an economy.

Yes there is a whole subject now called financial economics, but that deals with valuation of assets not with institutional structure. The notion of intermediation, which is the central essence of banking, is entirely absent from econ 101, or econ 909 for that matter.

So it always a little disconcerting to watch a panel of economists opine about the banking system. It’s a bit like having bird watchers build airplanes: they can describe what’s needed, but have no idea about what it takes to implement, execute, or actually do anything.

Nonetheless here we are: bank reform is back on the table and Congress is having its normal self-indulgent ‘fact-finding’ sessions with ‘experts’. Most of whom turn out to be economists.

No wonder bank regulation is a mess.

With that said, there seems to be some clarity appearing around what should be done to prevent a recurrence of the recent melt-down in banking. With Barney Frank leading the charge even hearings on bank reform can be fun.

First what’s the problem?

1. Some banks [and insurance companies like AIG!] are simply too big. If they run into difficulty we are forced to bail them out because we cannot afford to have them fail. A few of our largest banks now have assets approaching 10% of GDP. That’s an enormous figure and shows how much is at risk in just one of them.
2. Bailing out banks is really, really expensive, as we have just learned. So avoiding a repeat seems urgent.
3. Banks all operate with a government guarantee of sorts: FDIC insurance provides protection to deposit holders up to a limit, but that means banks can afford to be foolish safe in the knowledge that their depositors are relatively safe. No ‘market discipline’ there. Worse: now that we have shown we will bail out the ‘too-big-to-fail’ banks they can operate with complete abandon – they can be totally reckless and maximize their payoffs to employees and management knowing full well that the taxpayer will pay for the collateral damage. This is not a good idea.
4. Banking is hopelessly interconnected. Regulators presumably were aware of this but did nothing to examine bank safety from a systemic perspective. This interconnectedness was the reason AIG had to be bailed out: no one – literally – had any clue as to the consequences of an AIG failure, so the regulators had to play it safe.
5. Banks have exploited legalese to such a degree that few if any consumers know what they are signing up for when they purchase a bank service. A credit card, which is about as generic a product as can be, should not come with fourteen or fifteen pages of tiny font sized, jargon laden, and incomprehensible caveat riddled ‘terms and conditions’. Consumer protection from this ridiculous and often exploitive legalese has become vital. If you don’t believe me: try modeling the true cash flows of an option Adjustable Rate Mortgage with only the data given on the application form. You won’t get it right.

So those are the main topics we find our economists talking about. What are the solutions?

• Limit bank size. You can do this by ramping up capital requirements on assets over a certain limit – thus making those assets unprofitable. Similarly you could simply outlaw leverage of above a certain limit – leverage was a chief culprit in the meltdown.
• Bolster anti-trust legislation so as to ‘break up’ banks deemed ‘too big’.
• Develop an updated bankruptcy code that covers big financial institutions. Our current bankruptcy code is really designed for industrial companies and medium sized [or smaller] organizations. Unraveling Citibank with its labyrinthine corporate structure, counter-party risks, global presence, and derivative laden balance sheet cannot be doe within the current set of bankruptcy rules.
• Create a Consumer Protection Agency to provide and improve standards of bank products for consumers. Don’t fall for the whimpering about the damage this will do to ‘innovation’. Adding pages of legal jargon to a boring and vanilla product is not innovation. The last true innovation in consumer banking were probably the ATM and extended opening hours, everything since has been designed to bulk up profit opportunities not to provide a genuinely new product.
• Get some transparency into the arcane world of derivatives. My own view is that most derivative trading should simply be banished: it adds risk rather than mitigates it. The origins of derivatives were in the need for options and future trading for farm products like wheat. Securitizing and selling bad mortgages was not on that original list, nor were credit default swaps for sovereign debt [ a ‘bete noir’ of mine as you know!]. They either should be abolished or traded on open and fair exchanges, not behind closed doors where traders can rig bonus pools for each other’s benefit.
• Finally, we need international regulation. Case in point: the unwinding of Lehman is taking place in several countries across the globe. Each has a slightly different bankruptcy code, each has different regulators, and each has national jurisdiction over the bits of Lehman domiciled in its territory. It is already a mess and will take years. There is no way the global community could dismantle Citibank or Goldman Sachs. Plus those different standards make it easy, and legal, for a global company to move assets around the world and park them in the most relaxed regulatory environment. They can thus dodge tough standards, bolster profits, avoid taxes, and still foist the damage on their home country. This is not a time for national sentimentality: the banks are exploitive and full of lawyers. They will rip us off if they can.

So they are few points that need fixing.

Most are on the table in Congress, so reform could be substantial.

Now. Back to economics: one of the great reasons that Keynesian economics should be the standard rather than the neo-classical fanciful rubbish that they teach you in school, is that it actually does acknowledge the role of finance in the economy. The neo-classicists tried to eliminate Keynesian thinking partly because of this: finance introduces the inherent uncertainty of an economy. The neo-classical model has no room for uncertainty as it assumes that all consumption will be paid for from wages or profits. There is no borrowing in that model. Hence there are no banks.

How they get involved in fixing the recent crisis I have no idea.

They need to get out a bit. And then fix their sill models.

‘Who knew there were banks?’ is hardly a defense for the errors the neo-classicists models made.

Keynes knew. That’s who. Look it up.

Addendum, 10:50 a.m. July 22:

No sooner do I write this than I find an article in the Financial Times that includes these words:

“How to resolve this crisis in macro-economics? The field must be revamped fundamentally. Some of its shortcomings are obvious. Before the financial crisis, most macroeconomists were blinded by the idea that efficient markets would take care of themselves. They did not bother to put financial markets and the banking sector into their models. This is a major flaw.” [My emphasis]

Well duh!

The article’s author,Paul De Grauwe,is professor of economics at the University of Leuven and the Centre for European Policy Studies. He’s a Keynesian, so I would expect him to call for the overthrow of the stupidity currently known as standard economic theory.

Anyway you can imagine my smug reaction when I read his words!