capital ratios

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Financial Reform, Pollution, and Social Value

I can hear you all saying: ‘Huh?’

Well there’s no economic news today so I thought I would attempt to tie together a few of the broader themes that seem, to me at least, to be crucial as we get the economy going again.

That’s where what I call social value comes in.

The purpose of regulation should be to preserve or establish social value in the face of potentially anti-social private behavior. And that’s it.

The surge of deregulatory legislation – is that an oxymoron? – dating back to the Reagan years was built upon a false premise: that private interests will always be pressed by market forces to correct any anti-social behavior and, eventually, eliminate harmful activity. Alternatively in cases where that mechanism failed, the pro-market advocates argued that the mythical market would engender new forms of activity sufficient to mitigate the pre-existing bad activity.

Let me explain further by looking at the case of pollution.

First we must recognize that private entities – you, me, and businesses the world over – find it highly profitable to pollute. Yes, pollution is profitable. The cost of eliminating a pollutant from an economic process is usually quite high, and to the extent that that cost can be made external to the entity involved there is an incentive to do so. In other words it is cheaper for someone to pollute and have society at large bear the cost, than it is for that same person, or business, to bear the full cost themselves. Economists have long been aware of this phenomenon and call it the problem of ‘externalities’.

Externalities are everywhere: an obvious example being carbon dioxide pollution created by our modern way of life. None of us, individually, bears the cost of the damage being done by CO2 being dumped in vast quantities into the atmosphere, and the power companies who are the most egregious polluters certainly don’t. Yet the damage has the potential to play havoc with our standard of living at some point in the future.

So with an externality there is a social sharing of the cost coupled with an individual avoidance of that same cost.

The existence of externalities distorts the economy. Current wealth and profits are illusory because they do not include the cost of countering the anti-social behavior. Case in point: the shareholders of GE earned profits on their ownership of a business that spewed toxic waste into the river Hudson for decades. Those profits were illusory when the cost of cleaning up the toxins is taken into account. So inflated was the difference between the announced profit and the fully costed profit that GE fought for three decades to avoid having to pay for its own mess: it even went so far as to deny it was accountable.

So profitable is polluting that GE’s anti-social activity is more the norm than the exception. It is only in recent years that pressure from social activists has resulted in admission that market forces, when left to themselves, are incapable of protecting society against such anti-social activities.

And remember: it is entirely sensible and rational for businesses [and individuals] to pollute. If we accept that businesses exist to make profits, which is the bedrock assumption of capitalism, then we must also accept that those businesses will seek to offload cost onto society – ‘externalize’ them – rather than have their shareholders absorb the full cost of whatever processes they are engaged in.

Which brings me to financial reform.

Banks, by which I mean the financial industry at large, are essential to our economy. They create credit. They do this by borrowing short term money – from things like your checking account, and lending it longer term – in things like your mortgage. Simple. This is an inherently risky undertaking. Banks call checking accounts ‘demand deposits’ exactly because a customer can demand his of her money at any time. We do this all the time whenever we draw cash from an ATM: we don’t have to warn the bank, we just walk in and ‘demand’ it by extracting it from the machine. Banks try to offset this risk by gathering deposits in more predictable forms like CD’s that have certain maturity dates.

But there’s more to it: because banks have experience in predicting how much their customers will want to draw out cash they don’t just lend the exact amount they have in deposits they lend many times that. In effect banks gamble that they will have enough cash on hand to pay out to depositors on any given day. It is this gamble that allows the banks to create credit and thus help the economy grow.

Why do they do this?

It’s profitable.

But, as must be obvious, it is also risky.

There is always the remote possibility that enough customers ask for their cash back that the bank finds itself unable to meet all its commitments. It must then sell off assets to raise the needed cash or go out of business. This is why banks always keep a supply of easily sold assets like government bonds: they can be liquidated and turned into cash at short notice.

The ultimate buttress a bank has to avoid going out of business is its own capital. Capital is simply an irredeemable deposit given to the bank by its original shareholders. It is irredeemable because the shareholders cannot simply ask for it back – if they want to get their cash they have to sell their shares, which has no effect on the bank itself.

The banks can also add to its own capital by making profits and then retaining them rather than paying out dividends.

The easiest way for a bank to generate big profits is to adjust the relationship between its capital and its assets. Since a balance sheet must always balance, the only area where a bank can stretch the rules is to bulk up its assets versus its capital. This relationship is expressed as a ratio: e.g. ’10:1′ or ’30:1′. Obviously if a bank has $30 of assets for each $1 of capital, it will earn more than it would at $10 to $1. But it also entertaining much more risk because each dollar of capital has to cover the potential loss of far more assets. Conversely: when the ratio is higher and the capital is spread thinner across all the bank’s assets, the chances of the bank losing all its capital and going out of business is mush higher.

Now we can get back to social value.

Since we recognize that banking is a vital part of a modern economy we, that is to say society at large, has underwritten chunks of a bank’s balance sheet. We have, for instance, created FDIC insurance that eliminates depositor risk on certain deposits. More recently, and this is the bigger problem, we have all but announced that none of the big banks will be allowed to fail. That is an awesome cost we have lifted from their shoulders.

Notice what we have done here: we have externalized the cost of the risk. The shareholders do not have to worry about managing those deposits or capital ratios as carefully as they might were they not insured or guaranteed. So they can entertain more risk and thus make more profit for themselves. Also notice: society does not get paid for providing this insurance. The shareholders get all the benefit.

Why?

Because we need banks and the collapse of a bank is so damaging to the economy that is worth providing the insurance. Besides we can justify it by claiming that we are protecting depositors – people like you and me – who otherwise might lose our savings.

Knowing that the taxpayer is covering their backs a bank’s shareholders then act just like GE’s in the example I mentioned above: they act anti-socially in order to exact extra profits. In effect they pollute. They create toxic products and externalize the cost of any problems associated with those assets. Meanwhile the shareholders and the management benefit from the free insurance that enables the polluting behavior.

Worse: when confronted with their anti-social activity, and when the threat of regulation raises the possibility of that behavior being limited, the banks act exactly like GE did: they deny responsibility, they obfuscate, they deploy armies of lobbyists and lawyers to help prolong the period of pollution, and, when ultimately forced to conceded, they do so begrudgingly and never fully absorb the cost of the externality they foisted on society. They do all of this, naturally, while proclaiming in their media activities to be exemplary citizens.

So what to do?

It should be a simple task: force internal what is now being made external. Make the shareholders and management pay the full cost of the polluting behavior. In the case of banks this would include charging for the implicit guarantee that they would be bailed out. This is over and above the FDIC insurance which the banks fund already. We can enforce huge capital ratios that make pollution unprofitable. We can place a heavy regulatory burden on product development to drive up the cost of new products and thus raise the threshold of their profitability – hopefully this would reduce the flood of socially useless but toxic assets being created on the bank’s trading desks. We can also simply refuse to provide a guarantee for certain activities – frivolous interbank trading for instance that does nothing but inflate trading desk bonus pools. I am sure you can all add to this list.

My point in raising all this is that we are currently discussing two reforms: that of the finance industry, which has been a very depressing activity of late given the weakness of the administration’s proposals; and that of our environmental legislation. I think we can borrow from the latter to energize the former. If we can introduce ‘cap and trade’ legislation for CO2 and other pollutants, maybe we can do it for mortgage backed securities and other forms of toxic banking.

It could prove to be a lot more effective than the miserable half measures the administration is currently arguing for.

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Comments To Tim Geithner

Mr. Secretary:

Thank you for giving me this opportunity to present my comments and suggestions regarding the potential reform of the US banking and financial system.

Let me preface my comments by thanking you, your predecessor, and the Chairman of the Federal Reserve Board for the decisive and apparently successful efforts you made to remedy the crisis of this time last year, and its ramifications as they affected the economy this year. The fact that the credit markets have, with little exception, settled down, if not all the way to normal, then close to it, is testimony to that success.

But it is not enough.

My fear is that without action that some, including yourself, may consider to be radical, we are simply laying the groundwork for a new bubble – one that will have far more severe effects than the last.

I believe this to be true for the following reasons:

  1. The financial system is inherently unstable. I do not believe, as you and others do, that market forces are an adequate safety mechanism that provides us with assurance that imbalances in banking will be automatically corrected. On the contrary I think that there is sufficient evidence now to make the opposite claim: banking is immanently unstable and will, without externally imposed safeguards tend towards periodic bouts of crisis. I believe, in other words that Minsky’s ‘Financial Instability Hypothesis’ has more explanatory power than Fama’s ‘Efficient Market Hypothesis’. This leads me to believe that frequent asset price bubbles, and waves of losses based upon a subsequent correction to them, are an endemic feature of capitalist banking systems.
  2. Self-regulation is a total failure. Nowhere is this more obvious than in what used to be called the investment banking system. The explosion in marginally productive, and ultimately socially damaging, derivatives products demonstrates that the motivation to earn short term profit will always overwhelm any attempt made from within banking to impose self-regulated limits. We cannot rely at all on the goodwill of bankers to forego profit for the sake of social goals. This skepticism is amply justified: the asset leverage ratios that the banks felt capable of sustaining – and the mistakenly regulators tolerated – were primary causes of the need for taxpayer assistance. Not only was there no voluntary restraint, there were open efforts to exploit that lack of restraint for personal gain. In effect bankers robbed shareholders of capital by applying egregious economic rents to unsustainable cash flows. This has to be stopped. That, in the months since the crisis abated, such rent seeking has again sprung to the fore completes my view: bankers must be controlled as they are incapable of self-control.
  3. The regulatory system itself, as currently constituted and enacted, failed completely. I have just mentioned regulatory complicity in the build up of excessive leverage. I am unaware of attempts to penalize the banks for this level of transparent risk taking. Evidently regulators were either asleep at the wheel or so captured by the thought processes of the banks that the amassing of systemic risk passed by unnoticed until it caused the implosion last year. Without a decoupling of the regulators from the regulated we cannot expect the public interest to be well served. And, as I stated above, since the financial system is inevitably headed, by its very nature, back into excessive risk taking, it appears to me that it is essential that such a decoupling not just take place, but is enforced and policed diligently. So the regulatory system needs thorough, not incremental, overhaul.
  4. I admit here to a problem that may be difficult for you to overcome with ease: the large banks are global in nature which enables them to engage in regulatory arbitrage by moving their assets to jurisdictions with more benign regulatory regimes. You must not tolerate this. Global banks have established vastly complex and difficult to understand governance structures both to avoid regulatory limitations and to avoid paying taxes. This has compounded the systemic risk within the banking system by masking cash flows and legal responsibilities: the lack of transparency in bank governance is astounding. That this activity is openly an attempt to avoid taxation and to inhibit regulatory control at the sovereign level is, frankly, a brazen affront to the public whose money provides the safety net to the very banks who avoid their civic responsibilities. Nothing could be more insulting than a bank’s attempts to avoid contributing to the pool of taxpayers money needed to save that self-same bank form bankruptcy. We clearly lack what Justice Brandeis called the disinfectant of transparency. Global activities need global oversight and should never allow a shirking of responsibility. Nonetheless I realize this particular issue needs international cooperation for its resolution.
  5. Global organizations are also large. Size matters in banking. This feature of our system is now worse than it was before the crisis because of the loss of large market participants and the subsequent consolidation of business within the survivors. The largest banks now control excessively large market shares in all the major lines of banking activity. If we faced a problem of having banks ‘too large to fail’ last year, we now have an even more severe problem. Banks who operate safe in the knowledge that we cannot afford to allow them to fail, no matter how stupidly or incompetently they are managed are dangerous. They hold us to ransom. That we have allowed this to occur is a failure of public policy at the highest level and must be undone, and addressed urgently.
  6. Which brings me to my next point: the specter of moral hazard haunts the system as never before. Banks are continually subsidized by the presence of the taxpayer provided safety net, yet they are never charged for that subsidy. They get away scot free. This can only enhance their willingness to undertake socially problematic and excessively risky behavior. Many of the issues I have already mentioned are the result of the existence of moral hazard: leverage that pumps asset levels beyond reasonable limits is very likely not going to occur in a system where the shareholders have no ‘put’ to the taxpayers. If shareholders genuinely were the last resort source of capital to a bank it would treat them with more respect and protect itself from failure with more diligence.
  7. This leads naturally to the scale of finance. I am not the first to express alarm at the disproportionate amount of our overall economic wealth attributed to the financial system: the system has grown massively in scale and scope since its deregulation. Much of this growth is attributable to the explosion in off balance sheet and trading book activities that seem to provide little or no enduring social benefit. If the purpose of finance is to allocate capital within the economy as efficiently and as cheaply as possible, then the system we have today fails. It has just imposed an epic cost on society for which we received no particular benefit. Most of the vaunted innovation so revered by the banker’s apologists appears to have been to the sole benefit of the bankers themselves, and not to the wider economy. The inter-bank trading of incomprehensibly complex products may generate fat fees for bankers, but I am not sure it solves any social problems. And certainly is not worth the risk of a repeat melt down such as last year’s. The efficient allocation of capital can take place comfortably within a less bloated system.
  8. Finally, and following on from this, I believe the current system is too self-referential. It lacks differentiable and independent internal checks and balances. It is replete with conflicts of interest. This extends beyond the intellectual group-think that seems to have settled upon the entire industry – especially its obsession with ‘market forces’ – but is more specific: banks hold positions on both sides of a deal; they trade in CDS instruments that give them profits when the underlying security fails, even though the CDS is supposed to be an insurance against such an event; they write their own credit ratings; and have oligopolistic market power to prevent free access by non-market participants to many of the allocative features of the system. All of this must be undone if we wish to establish control over our financial markets.

This, then is my list of the more obvious problems that reform needs to remedy. Given the comprehensive nature of these kinds of issues and problems I cannot see that incremental reform can possibly be expected to secure the future. On the contrary I see tepid reform as contributing to an unsettled future precisely because it creates an aura of reform having been undertaken without establishing concrete change. In such a scenario the only winners would be the very banks whose behavior we are trying to adapt to socially responsible norms.

So what to do?

  • First establish capital ratio regulations that provide a deeper pool of protection against failure.
  • Capital as it counts towards these new and higher requirements should also be higher quality: the tendency to allow all sorts of quasi-equity structures as components of capital should be eliminated. Pure equity should constitute the lion’s share if nor the entirety of a bank’s capital as it relates to regulatory ratios.
  • Then enforce those regulations rigorously.
  • Next: establish punitive capital requirements to penalize excessive size. The larger and more systemically important the bank the more capital it should hold against its assets. The capital required should scale up rapidly against the marginal accumulation of assets such that it no longer becomes profitable to build a balance sheet beyond a certain size. That size can be determined as a function either of all bank assets, or as a function of the aggregate economy. The point being to limit bank growth.
  • Bank innovation and activity should be inhibited, or at least directed towards the true purpose of banking – capital allocation – through the adoption of regulatory oversight of product development. This can be accomplished by the creation of an approval process so that products are deemed socially useful and not harmful. The proposed agency to protect consumer interests needs to be augmented with oversight of wholesale product innovation as well. This will slow bank growth. A form of ‘Tobin tax’ could be imposed on transactions to raise their cost and hinder the unlimited trading of unnecessary products. I am not entirely convinced of the efficacy of such a tax, but in the absence of a good alternative I believe we should consider its merits more closely.
  • Banks should be limited in the scope of their activities. This could take the form of the re-introduction of Glass-Steagall style regulation. Or it could impose even more severe limits by imposing a separation of buy and sell side activities. The essential notion here being to break the oligopolistic pricing power now enjoyed by the banks. Competition is sadly lacking from the system and we should take every opportunity to introduce it by encouraging the emergence of smaller, more agile, and hungry banks.
  • Both extra competition and higher capital requirements will go a long way towards eliminating the broken bonus and pay habits of the industry, but I think we will need to address the subject of bonuses explicitly, if for no other reason than politics. The objective should be to lengthen the time period that a bonus recipient has to wait until being paid, and to change the form of the bonus from cash to some form of risk instrument such as stock. Bonuses should be risk adjusted, not risk free if we want to re-link the risk/reward structure of banker’s pay: bankers should be paid for adding to wealth not destroying it.
  • In order to address moral hazard head on banks should be forced to provide a living will that allows for their speedy and risk free winding up in the event of potential bankruptcy. In particular all the components of a bank’s governance structure must be made explicit and comprehensible – this will raise the tax cost to banks by eliminating their tax arbitrage opportunities, and will thus reduce shareholder returns – but transparency is vital for an orderly post bankruptcy deconstruction of a bank’s book of business. So transparency must be imposed. By increasing the ease with which a large bank can be wound up we reduce our fear of the consequences of such a bankruptcy. We thus reduce the hold that banks have on our ability to rid ourselves of them in the event of their potential collapse.
  • The use of off balance sheet activities should be curtailed or eliminated altogether. If a bank enters into a position that entails financial risk it should do so on the books where a capital charge can be imposed. Capital requirements aren’t worth much if they do not cover all the risk a bank takes.
  • The regulatory regime needs to be reformed. I have little confidence in the ability of the Federal Reserve Board to manage or oversee systemic risk. It is too involved in monetary policy and aggregate economic management to be a credible overseer of this aspect of the system. And its recent performance in the run up to the latest crisis leaves much to be desired. Its traditional role as an independent central bank is better preserved – as I believe it should – by putting the onus for operational risk management and the application of systemic regulatory activity elsewhere. Perhaps in a new agency built from a blend of some of the existing agencies. Having said this I believe that the exact locus of regulatory oversight is less important than making corrections to the financial system itself. Remedying the anti-social aspects of bank activity will go a long way to resolving the regulatory failure, simply because there will be less ‘bad behavior’ to worry about.

These steps form the backbone of a more radical reform than the set currently proposed. The objective should be to limit, severely, the ability of the inherent instability of finance from destabilizing and threatening the viability of the economy as a whole. And it should be to refocus banks on their proper role as mediators of capital. Profits should be shrunk and rent-seeking opportunities limited by the imposition of strongly enforced and mush higher capital requirements. Moral hazard should be addressed both by compelling ‘living will’ winding up plans and by making access to the public purse expensive – very high capital requirements can accomplish this latter task. Conflicts of interest and other opportunities to game the system must also be eliminated.

The resultant banking system should be smaller, more competitive, and more efficient. It will also be safer and less likely to create a crisis of the size and danger of that we experienced last year.

Thank you once again for this opportunity to present my views.

I look forward to answering your questions.