The air is heating up when it comes to the subject of banking regulation. The only advice I can offer those considering changes in the regulatory environment is “be careful.”
The main reason for this caution?
John Bogle, the founder and former chief executive of the Vanguard Group, wrote it very succinctly in the Wall Street Journal this morning: “There are few regulations that smart, motivated, targets cannot evade.” (See “Restoring Faith in Financial Markets: http://online.wsj.com/article/SB20001424052748703436504574640523013840290.html#mod=todays_us_opinion.)
Another reason for this caution comes from Mervyn King, governor of the Bank of England: “The belief that appropriate regulation can ensure that speculative activities do not result in failures is a delusion.” Andrew Ross Sorkin provided this quote in the New York Times this morning. (See “Big, in Banks, is in the Eye of the Beholder”: http://www.nytimes.com/2010/01/19/business/19sorkin.html?ref=business.)
According to these two individuals, banks cannot be prevented from engaging in the types of activities that they really want to be engaged in and there is little that supervision can do to keep them from failing due to speculative activities.
In other words, bankers cannot be protected from themselves.
Why is this?
There are two very good reasons. First, in this Information Age, almost anything can be done with cash flows and risk, and regulators will always be behind the curve in trying to catch up with what is going on in the financial sector. After the financial crisis of 2008, this type of behavior has began again in the bigger banking organizations and I would argue that the regulators are already at least three- to six-months behind what these institutions are now doing.
Second, the financial community is truly global now and the flow of money (information) is very fluid. If something cannot be done somewhere it can always move elsewhere. Discussions about what the BRICs are doing (see the week long series of articles on Brazil, Russia, India, and China in the Financial Times this week) present one picture of how the world is continuing to shrink, financially. Another picture of the flow of funds throughout the world is captured in a recent research paper by MIT’s Ricardo Caballero which is quoted in the recent article in Time magazine: “Did Foreigners Cause America’s Financial Crisis?” by Stephen Gandel. (See http://www.time.com/time/business/article/0,8599,1954240,00.html.)
I would like to make one other point: many people continue to assume that behind active governmental policy and regulation are government officials and bureaucrats that are either more perceptive and talented than their private sector counterparts, or, are less self-serving than their private sector counterparts, or, are better placed to observe how the world works than are their private sector counterparts.
In my estimation, government officials and bureaucrats are not more capable or talented than their private sector counterparts and they are certainly not less self-interested. Furthermore, in my experience in government, they are not better placed or better informed about what is going on in the world. This latter point is one that the economist Friedrich Hayek made over and over again.
There is no research that I have seen that indicates that those that work for government perform any better than those that work in the private sector. If anything, the argument goes the other way: government cannot hire or attract people of the same quality that work in the private sector. Furthermore, there is no evidence to prove, in my mind, that people that work in government service are any less greedy for advancement or personal gain than are people that work in the private sector.
Finally, in their attempt to protect the society from “bad outcomes” the government has tended to err on the side of creating an environment for greater and greater private sector risk-taking. This has come in several forms. The obvious case currently is the “Greenspan put” or the bank bailouts that have created moral hazard and greater and greater amounts of risk taking. (See the article by Peter Boone and Simon Johnson in today’s Financial Times, “A Bank Levy will not stop the Doomsday Cycle”: http://www.ft.com/cms/s/0/e118fcc2-0461-11df-8603-00144feabdc0.html.)
Another case relates to the underlying emphasis on trying to maintain low levels of unemployment. This has created an environment that encourages risk taking in terms of increased financial leverage, maturity mismatching, and financial innovation. I have referred to the whole period from 1960 to the present as one in which the government underwrote an environment of credit inflation.
Furthermore, this continual effort to stimulate the economy has tended to put people back to work in jobs that were outdated or in industries that needed change. In order to protect the worker, the easiest and best approach was to put workers back into their old jobs. We see the consequence of this policy in the problems experienced in the auto industry, the steel industry, and many other areas that formerly represented the industrial base of America.
Last, special interest programs, such as housing, although designed with good intent, have ended up with several government agencies serving as the residual lender and insurer of mortgages. Over the past several years we have focused on Fannie Mae and Freddie Mac, but it is now obvious that we cannot ignore the FHA. (See the article by Nick Timiraos in today’s Wall Street Journal, “Souring Mortgages, Weak Market Put Loan Agency on a Tightrope”: http://online.wsj.com/article/SB20001424052748704586504574654710172000646.html#mod=todays_us_page_one.) This effort has resulted in the federal government becoming biggest player in the housing market, by a long shot!
To me, regulation of the banking sector should focus on two things. The first relates to capital requirements. They should be raised.
Second, there needs to be greater transparency and openness in transactions, deals, and balance sheets.
Almost every other kind of regulation that can be put on the books, in the words of John Bogle, can be evaded. We cannot protect the bankers from themselves. But, we can attempt to protect investors and other wealth holders by giving them more information about those institutions they want to invest in. But, like the bankers, ultimately we cannot protect these investors and other wealth holders from themselves.
Showing posts with label Mervyn King. Show all posts
Showing posts with label Mervyn King. Show all posts
Tuesday, January 19, 2010
Friday, October 23, 2009
Breaking up the Banks?
Mervyn King, Governor of the Bank of England, gave a speech the other night and set off somewhat of a storm…at least across the pond. It is a discussion that needs to be heard here in America. (For a full text of the speech: http://www.bankofengland.co.uk/publications/speeches/2009/speech406.pdf.)
Not only did it get a lot of play in the press, but it elicited an immediate response from Prime Minister Gordon Brown and Alistair Darling, his Chancellor of the Exchequer. Here is an example that appeared in the Financial Times, “King Calls for Break-up of Banks,” see http://www.ft.com/cms/s/0/7056b56a-bda8-11de-9f6a-00144feab49a.html.
Let me point up an excellent commentary, written by Martin Wolf, in this morning’s Financial Times, “Why Curbing Finance is Hard to Do” (see http://www.ft.com/cms/s/0/0a8a6362-bf3d-11de-a696-00144feab49a.html). Wolf emphasizes the “artificial” division in financial institutions between “utilities” and “casinos.” He then goes on to discuss how difficult it is—or would be—to distinguish between these two types of organizations so as to set up a regulatory framework that would work.
I would like to add a little more to the discussion so as to second the points that Mr. Wolf makes. Going into the 1960s here in America, the distinction between financial institutions that were considered to be “utilities” which dealt in “debt” and those that dealt in “equities” and, hence, were a lot riskier, was very clear.
In fact, there were many jokes over the next few decades that commercial bankers were “debt” people and could not mix with investment bankers because investment bankers were “equity” people. People laughed at commercial banks going into the venture capital business when they put a “debt” guy in to run an “equity” business. Many suggested that my success in bank turnarounds (I did three of them) was because I was an “equity” guy and understood what it meant to focus on shareholder value whereas bank “guys”—ugh, “debt guys”--didn’t have the foggiest idea.
The first of two common points of understanding about commercial banking early in the 1960s was that commercial banks needed to be a monopoly—or, at least, a part of an oligopoly—within a limited geographic area. (Monopoly is “local” in either a geographic sense or a “product space” sense: for more on this see “Competition Demystified” by Bruce Greenwald and Judd Kahn, (Portfolio: 2005).) The reason for this was that they needed to have market power to exist. (In more technical terms, the banks could not operate in markets where they were price takers.) Monopoly power allowed the banks to earn an interest rate spread between what they earned on the funds they loaned out and what they paid out to depositors.
In many areas of the United States, geographic limitations on banks were very important and a part of the local culture. So we had states that allowed a bank only one office. (My grandfather was a Missouri banker and Missouri only allowed one office per bank. I really didn’t understand this, but it was like a religious truth to the people in the region.) Other states allowed limited branching. (My first banking job was in Michigan—if you don’t include the work I did in my grandfather’s bank—and Michigan allowed limited branching.) Then other states allowed statewide branching—but, you could not branch over state lines.
The second common point was that commercial bankers could not be trusted to operate in a “safe and sound” fashion and therefore had to be closely regulated. That is, commercial bankers always pushed the edge in terms of trying to earn a little more money and would push themselves into riskier and riskier loans. In other words, commercial bankers had to be protected from themselves.
Commercial banks were public utilities: they provided social capital to a society, they were very needed, yet they were potentially very dangerous—not unlike nuclear energy plants.
What changed?
Commercial banks were highly constrained institutions. Their ability to grow was severely limited to the deposit base that could be generated within their “local” area. But, like all human beings, commercial bankers were problem solvers. (Yes, commercial bankers are human beings although a not very advanced subset of the species.) The bankers found a way to escape the constraints on branching, both within a state and between states. They developed a class of liabilities that they could use to fund their banks that was not limited to the geographic area in which they resided: liabilities that could be purchased or sold in the open market.
This asset class included Negotiable Certificates of Deposit, Eurodollar deposits, and Commercial Paper issued by a bank holding company, the funds of which could be distributed to the commercial bank it owned. Liability management at commercial banks came into existence. Now a commercial bank could not only manage its cash position with the use of these instruments, it could expand its balance sheet beyond the scope of “local” branching restrictions. Limits on branching across state lines were doomed!
Now, however, commercial banks became price takers. They could buy or sell all the funds they wanted to at the going market interest rate. Commercial banking changed in the late 1960s and the early 1970s.
Commercial bankers and regulators still gave voice to the idea that the commercial banks were utilities, but, this was only lip service. It was no longer true.
Commercial bankers became “traders” and lived more and more off of arbitrage transactions. They still had markets they operated within in which they were not price takers, but, as the 20th century progressed, the number of these markets declined as a proportion of the whole. You look at bank balance sheets now and the vast majority of assets and liabilities come from markets in which the banks are price takers.
As financial innovation progressed and bank spreads narrowed, commercial banks spent more and more effort trying to generate “fees” on services that did not depend on spreads, increased financial leverage (achieved as a price taker), and greater mis-matching the maturities of assets and liabilities. The second common point mentioned above still applied: bankers always pushed the edge to earn a little more.
The “Age of Financial Innovation” changed everything. Financial innovators discovered that cash flows were just bits of information and information can be divided up in any way you like. Thus, financial instruments could be tailored to meet the specific needs of a particular investor. And, you could perform this service for a fee, meaning that you didn’t need to absorb the risk of the transaction and you didn’t need to finance it! Ain’t modern finance wonderful!
Two final points. First, financial innovation is going to continue to take place. The idea that finance is information is spreading to other markets (Information Markets) that deal with physical products, not just cash flows. As computer technology continues to advance and the idea that information can be traded spreads it becomes quite obvious that regulation cannot be put into the boxes or categories we used in the past. It just isn’t going to happen. Second, we are moving into a world in which the idea of regulation may become silly. We used to regulate, somewhat, pornography. With the Internet, control of the availability of pornography is ludicrous. Possible solutions for bank regulation: that is for another post.
Not only did it get a lot of play in the press, but it elicited an immediate response from Prime Minister Gordon Brown and Alistair Darling, his Chancellor of the Exchequer. Here is an example that appeared in the Financial Times, “King Calls for Break-up of Banks,” see http://www.ft.com/cms/s/0/7056b56a-bda8-11de-9f6a-00144feab49a.html.
Let me point up an excellent commentary, written by Martin Wolf, in this morning’s Financial Times, “Why Curbing Finance is Hard to Do” (see http://www.ft.com/cms/s/0/0a8a6362-bf3d-11de-a696-00144feab49a.html). Wolf emphasizes the “artificial” division in financial institutions between “utilities” and “casinos.” He then goes on to discuss how difficult it is—or would be—to distinguish between these two types of organizations so as to set up a regulatory framework that would work.
I would like to add a little more to the discussion so as to second the points that Mr. Wolf makes. Going into the 1960s here in America, the distinction between financial institutions that were considered to be “utilities” which dealt in “debt” and those that dealt in “equities” and, hence, were a lot riskier, was very clear.
In fact, there were many jokes over the next few decades that commercial bankers were “debt” people and could not mix with investment bankers because investment bankers were “equity” people. People laughed at commercial banks going into the venture capital business when they put a “debt” guy in to run an “equity” business. Many suggested that my success in bank turnarounds (I did three of them) was because I was an “equity” guy and understood what it meant to focus on shareholder value whereas bank “guys”—ugh, “debt guys”--didn’t have the foggiest idea.
The first of two common points of understanding about commercial banking early in the 1960s was that commercial banks needed to be a monopoly—or, at least, a part of an oligopoly—within a limited geographic area. (Monopoly is “local” in either a geographic sense or a “product space” sense: for more on this see “Competition Demystified” by Bruce Greenwald and Judd Kahn, (Portfolio: 2005).) The reason for this was that they needed to have market power to exist. (In more technical terms, the banks could not operate in markets where they were price takers.) Monopoly power allowed the banks to earn an interest rate spread between what they earned on the funds they loaned out and what they paid out to depositors.
In many areas of the United States, geographic limitations on banks were very important and a part of the local culture. So we had states that allowed a bank only one office. (My grandfather was a Missouri banker and Missouri only allowed one office per bank. I really didn’t understand this, but it was like a religious truth to the people in the region.) Other states allowed limited branching. (My first banking job was in Michigan—if you don’t include the work I did in my grandfather’s bank—and Michigan allowed limited branching.) Then other states allowed statewide branching—but, you could not branch over state lines.
The second common point was that commercial bankers could not be trusted to operate in a “safe and sound” fashion and therefore had to be closely regulated. That is, commercial bankers always pushed the edge in terms of trying to earn a little more money and would push themselves into riskier and riskier loans. In other words, commercial bankers had to be protected from themselves.
Commercial banks were public utilities: they provided social capital to a society, they were very needed, yet they were potentially very dangerous—not unlike nuclear energy plants.
What changed?
Commercial banks were highly constrained institutions. Their ability to grow was severely limited to the deposit base that could be generated within their “local” area. But, like all human beings, commercial bankers were problem solvers. (Yes, commercial bankers are human beings although a not very advanced subset of the species.) The bankers found a way to escape the constraints on branching, both within a state and between states. They developed a class of liabilities that they could use to fund their banks that was not limited to the geographic area in which they resided: liabilities that could be purchased or sold in the open market.
This asset class included Negotiable Certificates of Deposit, Eurodollar deposits, and Commercial Paper issued by a bank holding company, the funds of which could be distributed to the commercial bank it owned. Liability management at commercial banks came into existence. Now a commercial bank could not only manage its cash position with the use of these instruments, it could expand its balance sheet beyond the scope of “local” branching restrictions. Limits on branching across state lines were doomed!
Now, however, commercial banks became price takers. They could buy or sell all the funds they wanted to at the going market interest rate. Commercial banking changed in the late 1960s and the early 1970s.
Commercial bankers and regulators still gave voice to the idea that the commercial banks were utilities, but, this was only lip service. It was no longer true.
Commercial bankers became “traders” and lived more and more off of arbitrage transactions. They still had markets they operated within in which they were not price takers, but, as the 20th century progressed, the number of these markets declined as a proportion of the whole. You look at bank balance sheets now and the vast majority of assets and liabilities come from markets in which the banks are price takers.
As financial innovation progressed and bank spreads narrowed, commercial banks spent more and more effort trying to generate “fees” on services that did not depend on spreads, increased financial leverage (achieved as a price taker), and greater mis-matching the maturities of assets and liabilities. The second common point mentioned above still applied: bankers always pushed the edge to earn a little more.
The “Age of Financial Innovation” changed everything. Financial innovators discovered that cash flows were just bits of information and information can be divided up in any way you like. Thus, financial instruments could be tailored to meet the specific needs of a particular investor. And, you could perform this service for a fee, meaning that you didn’t need to absorb the risk of the transaction and you didn’t need to finance it! Ain’t modern finance wonderful!
Two final points. First, financial innovation is going to continue to take place. The idea that finance is information is spreading to other markets (Information Markets) that deal with physical products, not just cash flows. As computer technology continues to advance and the idea that information can be traded spreads it becomes quite obvious that regulation cannot be put into the boxes or categories we used in the past. It just isn’t going to happen. Second, we are moving into a world in which the idea of regulation may become silly. We used to regulate, somewhat, pornography. With the Internet, control of the availability of pornography is ludicrous. Possible solutions for bank regulation: that is for another post.
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