Paul Volcker wants to roll the clock back and restore Glass Steagall, the 1933 rule that separated commercial banking from investment banking, but Team Obama is politely ignoring him.
Mervyn King, the Governor of the Bank of England, is giving a more strident version of the same message, calling on the biggest financial firms to be broken up, arguing that he sees no reason not to implement a Glass-Steagall type split.
But there is an interesting failure of all parties to discuss some of the real issues.
First, a quick overview of the Volcker-Administration differences per the New York Times:
The aging Mr. Volcker (he is 82) has some advice, deeply felt…He wants the nation’s banks to be prohibited from owning and trading risky securities, the very practice that got the biggest ones into deep trouble in 2008. And the administration is saying no, it will not separate commercial banking from investment operations….
The Obama team, in contrast, would let the giants survive, but would regulate them extensively, so they could not get themselves and the nation into trouble again. While the administration’s proposal languishes, giants like Goldman Sachs have re-engaged in old trading practices, once again earning big profits and planning big bonuses.
Mr. Volcker argues that regulation by itself will not work. Sooner or later, the giants, in pursuit of profits, will get into trouble. The administration should accept this and shield commercial banking from Wall Street’s wild ways.
“The banks are there to serve the public,” Mr. Volcker said, “and that is what they should concentrate on. These other activities create conflicts of interest. They create risks, and if you try to control the risks with supervision, that just creates friction and difficulties” and ultimately fails.
I think Volcker is wrong, but not for reasons one might expect. I am not opposed to separating commercial banking and investment banking (although you could achieve the same result by aggressively firewalling the depositary operations and limiting the kind of risks it could take. Having the two activities under the same roof would become pointless, indeed cumbersome, and they would over time be split up, since someone in a position to earn a deal fee would persuade management that value could be created by separating the units).
The problem with Volcker’s logic isn’t that it lacks merit, but it is not close to being the solution he imagines it to be.
The subtext of his message is that the useful social function of finance is largely served by traditional banks. He further believes that if you separate banking from investment banking, you can let investment banks fail.
Um, remind me what happened last fall?
We had a huge expenditure of effort and money to prevent investment banks from failing (at least in an disorderly fashion, Merrill was on the way to failing) because it would have taken out too much critical capital markets infrastructure. You may not like it (I sure don’t) but pretending the facts are other than what they are is not a way to get to a remedy.
The problem is that we have had a thirty year growth in securitization. A lot of activities that were once done strictly on bank balance sheets are merely originated by banks and are sold into capital markets. Think of the old model as mainframes and the new model as distributed computing.
We have now seen a lot of activity shift from banks to capital markets. And thanks to a host of factors (barriers to entry like high minimum scale, network effects, deregulation which made it easier for firms to span product and geographic markets) we now have capital markets dominated by a very small number of players. And these players are too big to fail by virtue of their ROLE, not simply their size. Lehman was considered small enough to be let go, but it was sufficiently tied to the grid so as to produce a more disruptive outcome than the authorities assumed (I am not of the view that Lehman was let go by design in a financial version of a Reichstag fire. The powers that be consistently underestimated the severity of the problems in the financial system and overestimated the efficacy of their patchwork remedies. Subprime was contained. Paulson’s bazooka would stem the need to do anything with Fannie and Freddie. The public was clearly disgusted after Bear. I said Lehman would not be rescued, it was obvious there was no will to do so. It was politically unacceptable and the Republicans were not going to go there. So everyone did a “don’t ask, don’t tell” of assuming that the system could digest the failure rather than trying to assesses the consequences in advance. Never attribute to malice that which can be explained by incompetence).
Now you could in theory go back to having much more on balance sheet intermediation (finance speak for “dial the clock back 35 years and have banks keep pretty much all their loans”). Conceptually, that is a tidy solution, but it has a massive flaw: it would take a simply enormous amount of equity to provide enough equity to all those banks with their vastly bigger balance sheets. We’re having enough trouble recapitalizing the banking system we have.
Separating commercial banks in the US out of this mix will not solve this fundamental problem. Remember, Morgan Stanley and Goldman, both pure investment banks as of last year, also nearly failed, and Merrill, Lehman, and Bear perished.
So the industry had already become so concentrated (and levered) that it had become more failure prone. So merely separating commercial banking and investment banking is not sufficient; you have to do something about the risk taking of capital market players. And sadly, the network effects in trading are powerful. Left to their own devices, the propensity is for the industry to coalesce into a format of fewer, more powerful players. And now that it is in that format, it would take a lot of intervention (Tobin taxes? barriers between products? barriers between geographies?) to not merely restructure the industry, but to keep the factors that favor concentration from reasserting themselves.
In addition, most of the key capital markets players are non-US: Barclays, RBS, HSBC, SocGen, Paribas, UBS, DeutscheBank, Credit Suisse. Eurobanks have a tradition of “universal banking,” of having combined banking and trading businesses. You might sell a variant of Glass Steagall in the UK, but you’d have a much harder time in Europe (not that this is warranted, mind you; the greater ability in Europe to use deposits to fund trading operations led to some pretty bad practices).
And the elephant in the room is derivatives. The big players have massive OTC derivatives exposures. You need a really big balance sheet to provide OTC derivatives cost effectively (recall that this is one area where the big banks were competitive players early on, and it was because derivatives “talent” would put up with nuisances of being at a commercial bank because the advantage of having a very large balance sheet was an enormous advantage). And the books are large, and most exposures are hedged dynamically.
So even if miraculously, the powers that be around the world agreed on a way to reconfigure things to make it less attractive to have a small number of integrated capital markets firm…..what are you going to do about their big derivatives books? Even if you could figure out a way to break up a business going forward, you have massive exposures, and smaller balance sheets in the new entities (and that’s before we get to possible operational and skill issues….).
Put it simply, I have yet to see anything even remotely approaching a realistic discussion of how to deal with too big too fail firms, and we have been at this for months. My knowledge of the industry is not fully current, but even so, the difficulties are far greater than I have seen acknowledged anywhere. That pretty much guarantees none of the proposals are serious, and nothing will be done on this front.
That further implies the system will have to break down catastrophically before anything effective can be done. I really hope I am wrong on this one.
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You might sell a variant of Glass Steagall in the UK, but you’d have a much harder time in Europe.
IMHO that’s just not true, Yves. You could not sell it to European bankers and their lobbies, of course. (but that’s not even fully true if you talk to detail banking network executives in private conversation…).
But most of continental Europe – saving version – is fed up! Sarkozy is certainly not alone. Either right or left wing of the political spectrum.
There are some restrictions that limit the use of depositary funds in securities operations in the US (you need a waiver from the Fed). There are no such restrictions among the Eurobanks. Operationally, that makes it MUCH harder to unwind them. And unwinding them also will make even more transparent how undercapitalized they are (again, worse than US banks, believe it or not). The powers that be do NOT want to expose that fact right now.
So the banks can run out the clock. Nothing will be done until they are looking healthier. And when they are looking less sick, the argument will be, “There is no need to do anything, see? The crisis passed and things are more or less back to normal.” I hate to tell you, it works every time.
Consider this: the Swiss National Bank was furious (and that word is not strong enough) with the mess UBS foisted on the country. A very long story, but it damaged Switzerland as a banking center and hurt the once rock solid Swiss franc.
Do you see the SNB doing ANYTHING about the TBTF problem that UBS and Credit Suisse pose? Nope. And if Switzerland does nothing, no one in Europe will do anything either.
Look at the US, the will of the people means nothing on this issue.
You cannot regulate or control someone who has a knife at your throat. The banks have the upper hand, like it or not, at least until an even bigger force moves against them. Mere public anger is not sufficient.
Daniel de Paris has a point in that public sentiment in Europe might reach dangerous, or as some would say, catalysing, levels. There is so much that could go wrong with the European economy in 2010 that it can not be excluded that there will be general strikes in several EU countries. If the financial system is viewed as the main culprit, a momentum for change could be created.
However, the extent of the problem is such, as Yves clearly summarises, that it would be difficult to know where to start. It is true that few European leaders dare staring the truth in the eyes but at least Mervyn King deserves some recognition for his belated reconversion.
The Brits are busy with the electionering, the Germans are busy getting their new coalition Government on track and Sarkozy is scoring domestic self-goals. A voir.
Thank you both for the useful clarification,
Concerning Europe, I hope – well that’s just plain hope not knowledge at this stage – that the level of sophistication and risk has been reduced in 2009. I heard that trading volume had reduced as well and that common sense was making its way back. And that some were still without work …
That’s what I hear in Paris at least. Being no banker, not even a financial expert just an Austrian-based would-be economist on the sideline, I have limited access to information anyway.
The feeling is clearly different and the political position of the banking lobbies here bear little ressemblance with the ones in London and in the US.
It definitely matters IMHO
Our government has taken great liberties with the tbtf. We all did not want the total financial failure. So how can we now deal with derivatives? What would happen if the government cancelled all current derivatives. And in the future the government would make derivative originators put up reserves for future sales.
You’d cause utter chaos. Everyone would have to cash settle their current exposures. And you’d leave customers who had used them for hedging or to manage their exposures in a huge mess (and many of them would have to make large payments which they were not prepared to do).
There are times you cannot go back. This is one. We might be able to reduce the level of derivatives over a period of years by putting rules in place that made them more costly, but a lot of end users would howl that they need them. Whether or not you buy the latter (I’d like to investigate that premise, but some are legit users), there are no Gordian knot-cutting solutions here. I’ve looked at this a bit and am convinced that this is nasty indeed.
The question is can the real economy afford to permit gambling in derivatives by public institutions? Suppose Congress required all bets to be reflected on the balance sheet at market value, registered at a central authority, and imposed a five percent excise tax on notional value? Unregistered bets would become unenforceable. This would penalize all players equally instead of waiting to see who blows up. It would also make the game less appealing for the real reason players play: tax evasion, regulatory arbitrage, manufacture of artificial earnings.
“And the elephant in the room is derivatives. The big players have massive OTC derivatives exposures.”
After I watched Frontline’s piece last night on Brooksley Born, this certainly feels synchronistic, not to mention the Cassandra flavor of Volcker crying in the wilderness. I wonder how long it will be before they muzzle him, and he resigns?
Yves:
I agree it is a tough nut to crack; but if W$ and Banks fail again while we wait for a solution, millions more people will be on the streets. That is not a pretty picture to leave us plebeians with today. I am sure you have a few thoughts on what to do.
As far as the public not having much of a say? I am off to Chicago and will join an attorney friend to visit the “Showdown in Chicago.” I am told by the sponsors, their will be 1000 on Sunday/Monday in attendance to their conferences and annother 8000 or so on Tuesday to march to the ABA convention. Lets hope there are no Days of Rage amongst the police . . . (which is why I bring an attorney with me). Maybe some pressure can be brought to bear?
Magnificent post! thank you, yves
Yves,
I’ve been saying the exact same thing (though you’re in a much better epistemic position on this stuff than I am). The culprit here is derivatives. And it will take a long time to gradually curtail the amount of leverage involved with these things. Glass-Stegall is a sideshow and salaries/bonuses–though relevant–also aren’t the elephant in the room.
Banks (standard and IBs) are leveraged via derivatives so much as to make it impossible to capitalize them adequately to avoid a repeat of current chaos. Players also are so connected via things like CDSs so that one even moderate-sized player can bring down the entire house.
Maybe the Obama Administration’s Ostrich Strategy is the only one available.
Tougher capital standards for all risk positions and all institutions is the only rational and effective solution. The rest is just shuffling chairs.
Bingo.
What should be done: Incrementally tax leverage and its consequent effect on systemic risk through differential capital requirements for different business activities and also incrementally increasing depending on the size of originating organisation.
What will be done: Nothing (Arse covering platitudes aside.)
Reason: Regulatory system capture is complete.
This is great commentary, Yves. Volcker is receiving accolades in the blogosphere simply because he is not part of the Summers–Rubin–Geithner Rat Pack and is perceived as an honest regulator. But as you so admirably pointed out, the world has changed since Volcker was at the Fed, and prescriptions which might have worked in the past are not likely to work in the future. The nostalgia for Glass-Stegall is redolent of yearning for the “good old days” and proposals for its readoption have a utopian whiff about them.
What is really needed is a committment to long-term thinking by the chiefs on Wall Street–to figure out what sacrifices they will need to make in the short-run in return for bringing stability back to the system. Instead, everyone there seems to be about grabbing theirs while they still can–and these are the “solid citizens” who no doubt deplored television pictures of the looters in New Orleans after the flood.
“The problem is that we have had a thirty year growth in securitization. A lot of activities that were once done strictly on bank balance sheets are merely originated by banks and are sold into capital markets.”
So the root cause problem is that investing in deposit-based lending is too staid compared to placing bets in the largely unregulated capital markets? Some honest tax lawyers and capital market regulators could presumably write the legislation that would fix this problem. Enormously large and boring banks under a tight regulatory regimen would be the desired result. Sounds doable in principal – confiscatory taxation and strict regulation could force capital to the desired safe harbor.
The trick would be getting the UK and EU to go along simultaneously.
“the system will have to break down catastrophically before anything effective can be done.”
Again?
Glass-Steagall?
Or, the road not taken when we went with Glass-Steagall.
1933.
We had the Fed, and we had the Crash of ’29 – exactly what the Fed was supposed to prevent.
There was a necessary fork in the road ahead.
The nation’s academic economists and those within the government supported the Chicago Plan for Monetary Reform.
-End to fractional-reserve banking.
-End to the debt-money system
-Begin government-issue of debt-free money.
-Restore monetary powers to the people.
The bankers, and the government in their pocket took the fork that went with Glass-Steagall, the FDIC, etc.
It’s exactly the difference between universal health care and the health-insurance industry.
They’d rather have insurance and regulation, than the PREVENTION of the problems.
They can ALWAYS deregulate and bailout.
Here’a a clue.
There’s another fork in the road ahead.
Which way we gonna turn?
The Money System Common.
Your reluctance for Volcker’s solution revolves around the complicated nature of the unwinding process due to securitization and derivatives. One solution is to remove the incentives that created this mess in the first place and let the industry itself unwind on their own.
When oil prices rise, we hear a universal cry for windfall profits, but no one regards GS profits and huge bonus pool as a windfall. If we introduced a graduated taxation of undesirable financial actvities, the industry itself would gradually reform and unwind. By raising the costs to these non-economically productive activities (from a jobs and growth perspective), available funds would flow into more productive pursuits. Internationally, it hard to imagine that other countries (that look for more opportunities for taxation) would be less inclined to follow our lead on this.
The US needs to get back to our real roots which is “creating” wealth by making stuff, rather than the illusion of wealth by making deals.
“The subtext of his message is that the useful social function of finance is largely served by traditional banks. He further believes that if you separate banking from investment banking, you can let investment banks fail.
Um, remind me what happened last fall?”
Yves – I disagree with the point you’re making here, though I think Volcker is also missing a piece of the picture.
We need Glass-Steagall II. Commercial banking must be walled off from the rest of finance. The part that Volcker missed is that what needs to be firewalled off is more than just demand and time deposits at traditional commercial banks. The shadow banking system (specifically, the money market funds, and by extension, the commercial paper market it supports) must also be brought into the firewall. THAT’S what last September was really about – the run on the money market brought about by the sudden collapse in value of Lehman CP some of them held. Bring the shadow banking system out of the shadows and regulate them like banks. Then, true investment banks can be allowed to fail without bringing down the entire system (though we still do need a new chapter of bankruptcy code designed to deal with the failure of large financial companies).
Yves – c’est tres bien fait!
Hooray! The problem is too big to be solved! We are all wage-slave to Goldman Sachs now! Congratulations, Yves, you have capitulated! There is nothing to be done but wait for the apocalypse (or more likely, the new state of neo-feudalism the super-rich plan to impose under Hank Paulson’s long-awaited martial law).
And once you let stuff escape the balance sheet, what’s the point of financial reporting, as the irascible IA often points out!
Get real, Yves. Volcker knows more than you do.
A question:
my reading of this post makes it seem as though Volcker is only suggesting a Glass Steagall II type program. Is this the case?
I agree fully with Volcker’s idea that we need a GS II. But I agree with Yves that this is not sufficient.
I agree that the problems appear insurmountable, (I’ve harped for years elsewhere that the CDS problem may be unsolvable). However, there is danger in defeatism. If we don’t try there will be no solution. There may be no solution anyway… so then it doesn’t hurt to try.
Yves,
did you have time to read Mervyn King’s speech?
http://www.bankofengland.co.uk/publications/speeches/2009/speech406.pdf
He agrees with you that it will not be easy; that the IB’s still pose dangers and need regulation. He explains breaking up as a necessary FIRST step.
Hoping to be able to regulate the current too big to exist (note even bigger and with less competition than before) — the Obama approach — is in his words “delusional”.
And waiting for the next (even worse) catastrophe seems out of line with the attitude exposed in this blog.
There is no need for big balance sheet to trade derivatives. It’s a myth perpetuated by big derivatives dealers, big banks. You need big balance sheet to trade OTC derivatives, but if you move everything to exchanges, only party that needs balance sheet is clearing house. It also takes almost all credit risk out of the system. In my opinion, big balance sheet is big BS.
zernda,
I have discussed at length here that moving credit default swaps to exchanges is NOT a solution. I will admit I found this idea appealing too, but if it were implemented, you’d wind up with an even more dangerous situation than now.
See this post by Satyajit Das long form treatment. I’ve also spoken at length to Das about this. He is no fan of CDS, BTW.
Because CDS are not a true derivative (prices are not derived from the price of an underlying; CDS are basically a prediction market on default), there is no way to provide for adequate margin to be posted (the Das article explains why). The result is an undercaptalized exchange, which is a concentrated point of failure, an AIG waiting to happen.
Moreover as Paul Davidson has explained, you have to have an adequately capitalized market maker somewhere. You cannot finesse that function. In fact, the fantasy that merely posting screen based prices is a substitute is part of what got us into this mess.
In addition, exchanges only succeed if you have sufficient trading volume of the instruments listed. It took years of efforts by options dealers in Chicago to get the S&P 500 contract going. Many days they traded among themselves to create a false image that there was end user demand. In other words, only products with a reasonable amount of trading are SUITED to be exchange traded. Das has said that even ex the margining issue he raised in his post, that only 50 CDS contracts are bought and sold actively enough for them to be suitable to be on a exchange. The rest would need to be traded OTC.
“That further implies the system will have to break down catastrophically before anything effective can be done. I really hope I am wrong on this one.”
You are absolutely right! Who controls the chaos and the speed of the chaos are now the pertinent variables.
Given the dynamic as structured today, and if unchanged, it will be a long controlled chaos that will end in; the decimation of the high resource consuming global middle class (which will be replaced by the much less costly and more obeisant law enforcement class), consolidation of wealth at the top into the hands of a very few elite (the vanilla greed folks attending the self serving “Showdown in Chicago” will NOT be included), and, a two tier ruler and ruled world where the ruled are constantly pitted one against the other in a pre planned ‘perpetual conflict’. This is neocon philosophy 101.
Lehman WAS let go by design in a financial version of a Reichstag fire. It was a fire doused in highly flammable competitive personality squabbling. It was a fire fueled by prior intentional, and well orchestrated, manipulation of credit access and withdrawal of regulation. This IS a global financial coup. Never attribute to incompetence that which can be explained by deception. Deception is after all the strongest political force on the planet.
Changing the dynamic is essential. Aggregate generational corruption has made the system totally non responsive to the will of the people and has produced a scam ‘rule of law’ that serves only the ruling elite few and their corporate fiefdoms.
I repeat myself here …
Change will never be made from within. The system is designed to prevent it. When you engage the scum spawn of the illegal and immoral system you give up your power and the system remains intact. Take to the streets yes! But go for the throat. Change the two party electoral process, the gate that all of these scum bags must come through. That is the key to changing the scam ‘rule of law’.
Essential to that is building a common folks mass media to counter the now deafening voice of the ruling elite. A clean and clear voice that does not daily bounce of of the established stage setting corporate media.
That will allow discussion of; organizing a new electoral process, election boycotts, voter registration card burning, debt strikes, fuck FICO rallies, calls for redeployment of troops from Afghanistan to Wall Street, etc.
And … fashion a new concept of privatization that would recognize that when ANY private venture becomes large enough to significantly affect the greater society then that privatization must become subject to the greater society. We must return the commons to the masses. In keeping with that concept the greater society has a dog in the fight of what industries will be most dominant. Banking and finance will be severely curtailed to a utility percentage and the age old question of usury should be revisited.
Yes we are to the wall. It is time to choose your chaos. Doing nothing will surely cost you your present crumb supply.
Deception is the strongest political force on the planet.
Frontline’s “The Warning” makes Ives point implicitly that catastrophic failure is all but inevitable. Without an economics background I can’t begin to understand derivatives or what most posters here are talking about (thankfully), and (apologies to FDR) it is frightening to know just enough about history to realize that without any resolution or substantive change, a bigger crash must come.
One failure begets another and another, one bubble spawns a bigger bubble amid serial manias and depressions. Just since Reagan—Oil booms, S&L, Latin debt, Russian debt, Enron utilities, Homeland Security wars (always wars!), housing, and now Golden Sacks, booms-and-busts grow monstrous. And way before Reagan—the Gilded Age, the Gay Nineties, and the Roaring Twenties—all show capitalism making great advances but then eating society and government and then cannibalizing itself. But this time it’s really bad: now the imperial taxpayer is ALL IN at the casino—no more pretenses. Only now we have no FDR; we are royally screwed . . . unless Obama grows a spine.
I am so glad Ives is going to Chicago. Give ’em hell Ives!
Yves, there is an easy solution to end TBTF and systemic risk. however, it will be hard to implement because of entrenched interests. first, all derivatives must be moved to a clearing house for settlement/collateral, etc. this will greatly reduce counterparty risk and limit systemic threats from the lehman’s or aig’s of the world. second, payments need to be separated from lending/merchant banking. the payment system is a critical part of the economy; hence, it need to be separated from risk taking activity and regulated like a utility. in the new world, payment banks cannot be owned or be affiliates of lending/merchant banks. all deposits in a payment bank would be fully insured. all liabilities of lending/merchant bank are not insured or have any other federal guarantee. these two steps would end systemic risk and TBTF.
See my comment in response to Zernda above, and in particular, the link to the Das blog. The exchange/clearinghouse idea is not a solution, in fact, it has the potential to make matters worse.
i read satyajit’s post and i do not see much there with the CCP structure that could not be overcome. yes, there are difficulties in setting collateral margins for certain products, which is not that large of a problem if it is not concentrated. yes, liquidity risk may increase because someone may have to post margin, which is actually a good thing. yes, returns will fall because of capital (margin) being posted to CCP, which will probably be a good thing as it will reduce some speculative positions. yes, CCP failure is a risk, which can be reduced by limiting their size and ownership (no affiliate relationship with major banks). another benefit of a CCP is transparency. trade terms should be published. also, since the CCP will know the counterparties, this could help with setting margins as large concentrations in certain positions could be discerned (e.g., aig cds book). lastly, if cds or other similar instrument has such margin problems, then the instrument should be banned, which btw many want to do anyway since cds is not a true derivative since it has no cash reference price.
IF the banking industry had not been intertwined with dodgy deals originating from some of those investment banks, they could have been taken down much more easily and much less risk to the commercial finanical system.
Bringing back Glass-Steagall is just a start, but an important one. The very banks that were bailed out spent hundreds of millions in lobbying efforts to have their overturned, and for good reason.
Obviously the loosening of leverage in the IB’s is the next step. But this whole argument that Glass-Steagall won’t work is on a par with the loss of competitiveness, they will just find a way around it argument.
Want to stop the destruction? Don’t let the banks we really depend upon play with matches. Let them be boring lenders, and stodgy risk managers.
Let a select group juggle chainsaws over is a field by themselves.
Yves the Gordian knot-cutting you mentioned has happened in history. It happens when societies and governments are to paralyzed to make the obvious changes to save their way of life. That Gordian knot-cutting is called the collapse of society, of the know way of life. Then a new set of rules is built as people rebuild on the ruins of once great empires. We are very near to cutting that knot once again. Many people see it. Complete and total financial collapse is the only way to unwind the position we find ourselves in.
Peston makes a similar point today:
http://www.bbc.co.uk/blogs/thereporters/robertpeston/2009/10/bank_reform_the_radical_way.html
“And it is perhaps testament to the lobbying clout of the big banks that the proposal from Paul Volcker, the distinguished former chairman of the Federal Reserve, for the separation of banks’ investing and trading functions has not been embraced by Barack Obama or Gordon Brown.
But although breaking up the banks may be a sensible and necessary reform, it’s by no means clear that it would be sufficient to correct the flaws that got us into this mess – even when combined with the recent international agreements to strengthen banks by obliging them to hold more capital and liquid assets.”
But Narrow/Limited/Utility Banking is a necessary part of the solution.
There are a few things that could be done. One would be to exclude CDS, credit insurance and credit enhancements from computations of regulatory capital, applicable to banks globally. Another would be to give community and regional banks inducements to refinance mortgages (residential and commercial) and some degree of exclusivity. Most of this fee generating business is currently going to the toobigtofail in the US and new originations are being sold to the government securitization conduits. The first is a regulatory change. The second is about where the bailout is being directed. The overall idea is to begin to shrink the balance sheets of the toobigtofail and to strengthen the smaller banks that service borrowers who do not have access to capital markets directly. Inducements to the smaller banks could be part of a program to shrink toxic securitizations to a manageable size.
Yves,
You make a very good post. I generally agree with most of your points, in fact, I most agree that if a correction is to be achieved we will have to endure a cataclysmic collapse.
Ultimately, we need to get to a reinstitution of some form of Glass-Steagell. We need to bring regulation to bear on the derivatives trade. We need to create a method for liquidating financial institutions that fail. The reintroduction of failure is a critical component of any proposed regulatory system.
As to derivatives, what will happen if the government simply passes a law that says that certain contracts are no longer enforceable? What will happen if we go back on the gold standard? What will happen if we go to 100% reserves against demand deposits?
Trading firms that chase yield with leverage are doing so because the unlevered return is insufficent to even pay the light bill. If the currency is stable and maintains purchasing power, an important inducement to chase yield is eliminated. History is redolent with financial failures that were fed by excess credit.
You raise the most critical impediment to any reformation and that is the international resistance that will arise should we seriously regulate the derivatives trade. We could offer a choice, accept regulation; or we will repudiate our debt. Some would take that as an invitation to war.
This sounds like a great argument for there NOT having been a rush to unilateral action by the Feds. In politics, every action has a massive opportunity cost. To let the issues simmer is a great strategy if you think the solution is not obvious.
Yves’s comments on yesterday’s Lehman thread about negotiation are pertinent here. Politics and policy frequently involve much more elaborate negotiations than business/finance types (including super type-A ones) conduct. It might be Team Obama is ineffective, but it also might be that they are waiting for an opportunity do something epic once the banks are lulled into a false sense of security.
The Obama Administration’s approach to derivatives is to wait them out. After all, most expire harmlessly.
It would seem prudent to begin to tax them to create a stabilization fund that can be used instead of tax revenue or government debt when (not if) the next nuke goes off. Probably best to coordinate this internationally while maintaining normal sovereign tax and funding structures, rather than trying a new international tax/fund institution.
Too simple? Oh bother.
In my opinion the Obama administration has continued the same failed policies of the previous regime. And I think that until the government sets out a plan to deal with the fundamental structural problems in our financial system of too much debt and not enough savings and capital, we will not have a sustainable recovery. So even though the stock market can stay irrational in the shorter term, in the long run I believe it will go back to reflecting the fundamentals of our boom and bust economy. And I therefore feel that for most people it is safer to remain in cash and gold. In my view the gold price will continue to rise due to a lack of faith in central banks’ policies and in fiat currencies. And there are some very interesting articles that I came across on these topics at http://www.goldalert.com/gold_news.php, which discuss the relationship between the dollar, the gold price, and gold mining companies given the Federal Reserve’s monetary policies. I thought the one called “Gold Price Up, Dollar Down – Does it Really Matter?” was particularly useful for investors to read to get a better sense of the relationship between these asset classes, and to get an understanding of the consequences of all the money printing and its potential effects on fiat currencies.
I don’t understand the issue. No one, no thing, is “too big to fail” unless someone in power simply decides that this is so. Goldman-Sachs SHOULD have been left to die. JPMorgan, Citi, BoA, all should have been left to die. Quick pain, then quick recovery.
There is no such thing as too big to fail, only too corrupt to live.
I don’t think anyone is suggesting that Glass-Steagall by itself is sufficient. It is a great barometer though to measure the seriousness of the President and Congress to reform. The fact that Volcker is the only one mentioning it and that he has been frozen out speaks volumes.
I keep a list of reforms (each just a few words in length) to fix the financial system and the economy and it runs 3 1/2 pages. So there is a great deal to be done, and most of it really needs to be done at the same time. In essence, the paper economy built on securitization, exotic financial instruments, interconnections, TBTF, and the shadow banking system has to be dismantled. It is an existential crisis. Either we kill it or it kills us.
A lot of derivatives can be dealt with by banning them in the future, nullifying some of the most egregious ones currently on the books, like naked CDS, and changing the rules on most of the others, as in accept the new rules or we nullify them. This may seem extreme. It is. We are already in extreme territory. But the longer we dither and do not restructure our financial system the extremer the measures will become in order to deal with it.
“Um, remind me what happened last fall?”
What happened last fall was the culmination of a decade-plus of deregulated activity between investment and commercial banks. If that activity is separated and commercial banks are on the hook for the loans they make, then no one blindly buys the toxic crap and fake insurance the investment banks were peddling and when/if they fail, the partners who put in their own capital lose, not the public.
Don’t look at last year’s symptoms, this has been in the works since the Clinton administration – it takes time to dismantle a wall brick by brick.
Volker is right because he sees the fundamental conflict of interest – the public and currency (represented by credit money) can’t be kept safe if they are combined with speculation and deregulation.
If we can’t agree on that principle, then all the rest is for show. What is the point of having a wall between TBTF commercial and investment divisions – you can’t combine the capital base – you want to put the entire country (everyone’s deposits) at risk for Wall Street’s next bright idea?
What if everyone took their deposits out of BofA, Citi, Wells and put it in credit unions? That would create a financial disaster? People freely choosing to put their own money where they want?
Sure, we currently have a huge hairball. The question is: do we want to unwind it and see what is there. But W$ (great abbr) wants to wind it tighter. What do you think is hidden in that hairball?
For example, if there is fraud in some mortgage securities – what law is applied, since these are unregulated? Well, it depends on the circumstances and jurisdiction, which takes forever to sort out – so the financial system NEVER goes through the necessary restructuring needed to clean up their balance sheets. We will have toxic waste sitting around for decades. And the people who know how to move it around will get it to those who don’t.
How you can take an unregulated security and link it to a highly-regulated asset (a mortgage) and expect any problems to be easily resolved is beyond me. This is what is restructuring our legal system. Because it will not be the rule of law that decides these cases, it will be whoever has the juice.
I think you are overstating the settlment problem – you don’t need to cash settle, you need to net positions and then settle, with the governments (global) as a backstop (this is the “bad bank” scenario). Instead, we don’t know whose position we are saving (speculator, fraudster or pension fund), why (what is the real impact), and how long this is going to take.
Sure, the world is global – but that’s why we have governments. Instead we are going to allow US deposits (with FDIC backstop) to serve as leverage for unregulated international deals, with NO transparency to the depositors. Brilliant. I guess it really isn’t our money, even if we work for it.
pebird,
I was assuming you’d cash settle net exposures.
Dealers claim to be fully hedged on their credit default swaps, but that isn’t fully true. They have to do interest rate and duration exposure matches related to the CDS. They have a heap of other exposures in connection with CDS that are not net flat.
For some of these complex instruments, both sides to a trade will show profits in their price movements since the contract was entered into, a clear impossibility. This should be (and in my mind is) fraud, but it is permitted under the current regs, there is that much latitude.
Simply agreeing the price on some of this stuff would be a colossal mess. And as I indicated, this would cause a great deal of pain to end users of derivatives. Let’s look at a simple example: Freddie and Fannie are probably the biggest users of interest rate derivatives to hedge the optionality in their mortgages. God only knows what the immediate impact of forcing them to settle their exposures would be, and it would force them to re-do their balance sheet management, and no doubt mortgage pricing, completely.
You also have interest rate and FX swaps. The plain vanilla versions of these products are considered benign, but many corporations enter into more customized contracts, and the dealers most assuredly have net exposures here.
There are many cases when you can’t go backwards.
OK – I understand what you are saying – so, why didn’t the bad bank scenario go forward?
Give institutions time to assess their portfolios and dump some percentage of bad assets for disposition at a discount with upside and/or backstop. The government would unwind with a reasonable haircut.
You wouldn’t need to settle all derivative contracts, the counterparty risk (allegedly a source of reduced liquidity) is reduced (in both directions, everyone gets to dump some bad debt), and creditors are provided a relatively transparent and fair process. What am I missing?
I guess the downside is that the government bailout isn’t concentrated towards 1 or 2 firms.
In a series of blogposts I argue that the solution to our current fragile, overconnected financial system is to prohibit too big to fail entities from collateralizing over the counter derivative contracts. Also all the repo related amendments to the bankruptcy code that were passed in 2005 (and 2006?) should be repealed.
AIG wouldn’t have failed if the former had been in place and Bear and Lehman wouldn’t have developed their ridiculous repo exposure if the latter had been in place.
The recommendations are here. The series is here.
Yves,
I won’t argue about the colossal problem of OTC derivatives. I don’t have the financial knowledge to do so.
But, if it is such a huge problem, how come the trading of new OTC derivatives is still allowed? Why hasn’t any government/central bank imposed a total freeze on *new* derivatives already?
I’ve missed your analysis, Yves. Great post!
Maturity windows must play a part too in any solution, hence the overwhelming importance of derivatives to the TBTF banks. Everything has moved to the short-term. Anything long-term is unloaded, or at least ownership is constantly rotated, in the search for increasing returns. While the obvious hot potatoes have been mortgages, of any type, the tactics are beginning to impact all long-term assets and liabilities. Balance sheets are becoming critically unstable–and, I’m not sure this confined to banks. With derivatives off the BS, this is difficult to see or understand clearly.
I’m concerned about the mounting consumer debt and mushrooming unemployment in this scenario. I too worry about the collapse of society.
Your comment on the difficulty of “untying the Gordian knot” is extremely apt. No matter what’s done the likelihood of another world shaking crisis seems to very probable. That leaves us with the question, “How can we mitigate the effects of the pending implosion?” If we can’t break the TBTF banks up safely, or regulate them effectively given the current global political objections to doing so, what can we do?
I can’t come up with any easy answers either. But, at least this post points to the proper things to consider first–making all derivative transactions public, prioritizing bank balance sheets (public and shadow) problem areas by those most leveraged by outstanding derivatives, creating programs to help those groups of individuals globally most affected should further BS areas implode–using bailed out TBTF banks’ executive bonuses for funding …
I am disappointed to see Yves calling for a solution that is more with these times.
These, of gargantuan, monoloithic institutions.
They refuse to fail, without taking out the rest of us.
And, then, Yves, it’s their ROLE in the economy-financial system that worries you.
A ROLE that makes them indispensible to the lifeblood of our nation’s well-being.
They’re like the IMF of those little guys.
Play by our rules, or no game.
Sorry, Yves, it is their ROLE that is the problem that you are trying to resolve.
Volckers incremental steps back into regulation are fully appropriate, but infortunately inadequate.
The question becomes who owns the responsibility to solve the problem of too big to fail.
The bankers, or the government?
It should be the role of the government to provide the circulating media that provides for exchange within the economy. Ask Friedman.
And the need for a stable circulating media trumps all that TBTF bs.
The Money System Common.
joebhed,
You chose to misconstrue my point. All the ideas (and they hardly rise to the level of being ideas) are not adequate solutions, and some have the potential to make matters worse. I am saying the TBTF measures now proposed will come to naught because they are insufficient and misguided.
To come up with a solution, you need a realistic appraisal of the situation. And unfortunately, any REALISTIC remedy cannot be implemented quickly, but is probably a 5-10 year program. This is like disarming not a single bomb, but a mesh of bombs. Trigger any one by mistake, and they all go boom.
You are basically shooting the messenger because you do not like the message.
Thanks for the reply.
I can’t imagine how I misconstrued your position, and I would hope that being disappointed with your very learned position is not equal to “shooting” the messenger. It is with trepidation that one questions the best blogger on the scene.
Note that we agree on the inadequacy of re-introducing Glass-Steagall, for somewhat differing reasons.
My position is that GS never went far enough to PREVENT risk to ordinary depositors, needing the complement of the FDIC. Therefore leaving us open to financial deregulation.
And here we are.
The proposal of the Chicago Plan economists, ending both the private power of $USD money-creation, and requiring full-reserve banking of government-issue circulating media, is exactly what was required back then. Now that they deregualted their way back to 1920’s, it is again needed more than ever.
Backing up – yes, it was the separation of the banking functions of deposit and investment that prevented much of the risk-taking made so avant-garde by Greenspan, etc.
I agree on the five-year solution, it will take that long to get to full-reserve banking across the spectrum. And I think the American Monetary Institute’s proposals for monetizing(?) ALL debts is very much akin to what you call for, correctly recognizing the need for VOLUMES of equity- infusion.
Even if you are correct that the system MUST implode, and I think that depends, then we still need to have a plan of reconstruction.
Mine is clearly to PREVENT this shit from happening again.
And that will not happen with private money creation and banks lending money that does not exist.
Be they commercial or investment.
Respectfully.
BTW, there was an interesting NYFRB staff report (No. 276) issued in 2007 by Beverly Hirtle that examined the relationship between banks’ use of credit derivatives and the supply of bank credit. Here’s the PDF link.
A few of her findings may throw some light on the activity shift from banks to capital markets and why they’re dominated by so few players.
1. The benefits of increased credit derivatives protection are relatively narrow.
2. The benefits of derivative protection seem to accrue mainly to large firms.
3. The success of credit hedging via derivatives seems to depend on non-credit hedging, or complementary derivatives based on non-banking portfolios like corporate stock and bonds.
Food for more thought. The more credit derivatives you have, as a major bank/market dealer, the more non-credit derivatives you need. Could this have cascading market effects?
Surely, even without FX and rate impact (and the media/political propaganda), one can’t be faulted for questioning the soundness of recent market movements. If we also add in price inflation/deflation and eroding purchasing power, all financial fundamentals become suspect.
I’m still with you, Yves. Reinstating Glass-Steagall will solve nothing. Any large firm, bank or otherwise, involved in heavy derivative hedging is part of this global house of cards. Focusing on derivatives is the place to begin for seeking potential solutions.
Yves,
I also want to argue that manual intervention is preferable to catastrophic failure. There is so much that is not known about the derivative situation except how dangerous it could be. It seems to me to be prudent to not allow more to be issued without getting a better handle on the situation…..stop digging down to catastrophe.
An ounce of prevention is worth a pound of cure.
Yves,
Excellent post. What do you think of Lynn Stout’s (UCLA Law Professor) idea of effectively refusing to enforce contracts which include naked and OTC derivatives, and forcing the market to police and enforce the “contracts”? Stout believes that the market will adapt to require more private mechanisms of enforcement, such as higher capital requirements, and shift to fewer high-risk derivatives contracts.
Further, requiring other derivatives to be traded over exchanges, and only enforcing derivatives if one party is hedging, would reduce the incidence of two speculators engaging in a derivatives contract.
Nick
http://dealbook.blogs.nytimes.com/2009/10/07/dealbook-dialogue-lynn-stout/