Sunday, January 24, 2010

Regulation and Information--Part A

One of the things that bothers me about all the talk concerning the re-regulation of banks and other financial institutions is that it is “framed” within the context of the Great Depression and the Glass-Steagall Act, the Banking Act of 1933.

Get real people, times have changed!

We are not back in the age of the manufacturing, we are in the information age. We are not early in the 20th century, we are at the beginning of the 21st century. And, while no person commands my respect in the same way that Paul Volcker does, we do not need regulation that is in the mold of Glass-Steagall.

Finance is information. This dollar bill can be exchanged for that dollar bill. These dollars can be exchanged for so many Euros. Even more so, my set of 0s and 1s can be traded for your set of 0s and 1s: your checking account, my debit card, and her credit card.

Even individuals don’t trade in anything more than 0s and 1s these days. Finance, even at the most elemental level is just about information. And the more sophisticated that one gets, the more esoteric the information flow can become. And, that is the issue.

But, the post-World War II transformation in the financial industry began in earnest in the 1960s. The commercial banks were constrained by the Glass-Steagall Act and by geographic constraints. Yet, the world was growing. And, the banks, in order to be competitive in the world needed to become bigger and more geographically dispersed.

Three financial innovations were in place by the end of the 1960s that began to change of everything: the creation of the Bank Holding Company; the invention of the large denomination negotiable Certificate of Deposit; and the Eurodollar account.

The Bank Holding Company gave banks a freedom that they did not have when their charters limited their activity to just being a deposit taking bank. The large denomination negotiable Certificate of Deposit was an innovation that indicated that just about any financial instrument could become marketable. The development of the Eurodollar market showed that banks could raise funds worldwide and in different forms.

These three changes, when combined, turned large banks into liability managers and not asset managers. In essence, the invention of the large CD and the Eurodollar put an end to any constraints on the size of a financial institution. These instruments allowed banks to buy or sell all the funds they wanted at the going market interest rate. For all intents and purposes, by the start of the 1970s all interstate constraints on bank operations were history. And, except for capital requirements, all constraints on the size of financial institutions were history. The ability to manage liabilities ended these boundaries.

Other developments took place during this time. I will just discuss two of them. The first is the mortgage-backed security. In the 1960s politicians decided that if more housing got into the hands of the middle income classes that there would be a greater chance that they could get re-elected. They considered the mortgage, a long term asset. Then they looked at pension funds and insurance companies and saw that these institutions held long term assets. Mortgages were not quite what the pension funds or insurance companies wanted: mortgages came in sizes less than $100,000 in value when they wanted assets in the millions of dollars; also mortgages paid principal and interest whereas these funds and companies just wanted interest payments. So there were some hurdles to overcome.

As people worked with the idea, they saw that the mortgages generated and held by depository institutions could be bundled up into another form of security in order to get the size of asset needed. They also worked with the idea that the cash flow streams from the initial mortgages could be cut up in different ways so as to make individual streams of cash flows that were more desirable to the pension funds and insurance companies. Eventually they saw that securities could even be created that paid just interest (Interest Only securities or IOs) or that just made principal payments (Principal Only or P0s).

Bottom line, cash flows could be cut up (or in current terms ‘sliced and diced’) in any way that could sell! And, what is the abstract view of this? Cash flows are just 0s and 1s and 0s and 1s can be put in any form that anyone wants. These cash flow 0s and 1s could have assets behind them like houses, autos, or credit cards, or they could just be cash flows. What difference did it really make?

Of course, it could make a lot of difference. (I can’t be too ironic in what I write!)

If cash flows could just be created, why not asset values? Hence the idea of “notional” values.

Take an interest rate swap, for example. No money changes hands, the whole transaction is based on ‘notional’ values. Thus, a swap of a fixed interest payment arrangement for a variable interest payment arrangement could be achieved. Both parties are ‘better off’ and there is no real exchange of liabilities.

I could go on, but I don’t think I need to. By now you can see where I am going. Finance, today, is just 0s and 1s and people, individuals as well as institutions, don’t need real assets on which to base cash flows and cash flows can be ‘sliced and diced’ in any way imaginable so as to meet the needs and desires of those that want to acquire them. In essence, everything, all information, can be computerized and treated as interchangeable.

At least in the machines: at least ‘on paper’. But, this is the modern world of finance. That is why mathematicians, statisticians, physicists, and other “Quants” can play with this stuff. The modern world of finance is just information and information is just 0s and 1s. At the highest level, it is not people and assets and things. It is just 0s and 1s.

And, if you are concerned with this then you need to be aware of what is coming. This is the world of the future. There is a vibrant area of study that deals with information markets. The idea is that everything, and I mean everything, can be transformed into information and a market can be created for it. Robert Shiller, the behavioral economist of “Irrational Exuberance” is one of the leaders of this field.

Modern day finance is the model with the idea that this model can be extended to anything and everything. So get ready!

The fundamental point I want to make today is that the world of finance in the Age of Information is entirely different than the world of finance in the Age of Manufacturing. The 1930s are not directly transferrable into the 2010s! The rules and regulation of the modern world are not the same as the rules and regulations that needed to be applied to the world of the thirties. And the way to regulate the world of the 2010s is the subject of my next post.

Let me just close by saying that even Paul Volcker missed the point when he said that the only banking innovation of the last 50 years that was significant was the ATM machine, that all the other financial innovation contributed nothing to the age. The ATM is an ‘information age’ machine and is a part of the innovation that took place in the Age of Information. If one really understands this age then one cannot make the distinction between the ATM and all the other financial innovations that took place during this time period. Volcker has missed the point!

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