Arnold Kling  

Financial Institutions, Again

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Frankly Fundamentalist... See Blindness...

Continuing this thread, which had some very interesting comments. The reason that this is important is that when this financial crisis is over, we want to know what might work to prevent another one. We know how to prevent another mortgage securities crisis, of course. But we do not know how the next bubble might emerge. If there are institutional reforms that would make the economy less vulnerable to speculative bubbles and bank runs, such reforms would be worth considering.

In some sense, Mencius Moldbug is asking "What would Mises think?" I think of myself as asking, "What would Fischer Black think?" Unfortunately, neither gentleman is alive to enlighten us.

UPDATE: for a view that runs counter to my own instincts, see John Steele Gordon. His bottom line:


the present crisis will at least provide another opportunity to give this country, finally, a unified banking system of large, diversified, well-capitalized banking institutions that are under the control of a unified and coherent regulatory system free of undue political influence.

It seems to me that European countries have banking systems with all these features, and they are even more fragile than ours.

Let us think in terms of many different fruit trees. They could be different because one is pear, one is apple, etc., or they could be different because one is in Kentucky, one is in New Jersey, etc. The point is that they are different, their values change over time, and the changes in value are not perfectly correlated.

In a simple financial market, the only securities are equity interests in each fruit tree. Each period, the value of a share in any given fruit tree changes, based on new information. How well is the tree growing? What is the weather forecast in the tree's location? What are supply and demand conditions like in the market for the tree's fruit?

The challenge for this economy is to fund the investment in fruit trees. Some people have superior expertise in the fruit tree business, but they don't have the resources to plant lots of trees. Other people have excess savings, but not much expertise. We need to get them together.

If the fruit experts issue equity shares, then the savers will not know a good investment from a bad one. I can pretend to be a fruit expert (or imagine that I am a fruit expert) and sell you worthless shares.

As a saver, you might prefer to have a debt instrument from a fruit entrepreneur, who retains the upside from the equity in the tree. This has two advantages for the saver. First, the entrepreneur's willingness to issue debt in exchange for equity is a nice signal that the entrepreneur genuinely believes in her tree. Second, it reduces the impact of the saver's lack of expertise on the saver's outcome. The debtholder gets a fixed return for a variety of possible tree circumstances, so the debtholder can rely on a relatively crude assessment of the tree's prospects.

To take another example, suppose you as an entrepreneur are going to buy an old house for $100 K, fix it up, and flip it. I as a saver don't know how well you will do, but I am willing to supply $80 K of the funds to buy the house. I am better off taking an $80 K debt instrument and letting you hold all the equity for your $20 K. If the project works out badly, and you only sell the house for $95 K, that is your problem, not mine. You're the one who needs to make a really sharp-penciled assessment of the possible outcomes of the project, not me.

Next, we can add intermediaries. One intermediary can give me shares in a diversified portfolio of equity shares in fruit trees. Another intermediary can invest in debt issued by fruit tree entrepreneurs and then offer me its own debt instruments.

Suppose that an intermediary acts like a bank. It offers me a deposit that I can withdraw at any time, but it invests in long-term debt from fruit tree entrepreneurs. The long-term debt emerges only to save transaction costs--it's a pain re-evaluating the fruit tree each time you want to renew short-term debt. The bank is counting on (a) not all depositors wanting to withdraw at once and/or (b) being able to sell its assets (the fruit-tree loans) in a liquid market.

This banking institution tends to be really unstable. Do we want it, anyway? Is there a way to stabilize it if we do have it? Those are the questions that give me a headache.


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COMMENTS (28 to date)
Les writes:

I hope the bailout kills Fannie and Freddie for good. I'd hate to see them resurrected again, so that their toxic combination of private profit and government backing could create another financial meltdown.

By the same token, I hope that legislation for mortgage downpayments under 20% is repealed, so that we don't repeat this crisis.

bgc writes:

Couple of ideas:

1. It is the problem of long term advantage but short term disadvantage. How do you get governments to pursue long term goals? Beats me - even now the US, UK and Western European govts are apparently trying to keep the house price bubble inflating. Maybe more autonomous, professionalized public administration seems more long-termist than elected govt. (I think that's what Moldbug would prefer.)

2. The problems arise where there is a 'more is better' attitude: in this instance, the more home ownership the better. Where else do we see this?

College. The general attitude has been the more people go to 4 year college the better (I have shared this attitude myself). This translates to a belief that the more years of education for more people (and educational subsidies) the better it is for the country/ the economy. So that probably means that the state-subsidies to college are creating a higher education bubble which will burst eventually.

Medical Research. Doubling funding every decade - can't last, but the system has come to depend on continually rising proportion of GDP.

AK has described others.

Isegoria writes:

As I mentioned on the previous thread, while there's a role for such an intermediary, I don't think it should be a bank promising on-demand withdrawal and set interest rates.

Yes, customers value liquidity, but promising on-demand withdrawal is practically begging for a run on the bank. Whoever shows up first gets seniority? And those funds are withdrawn from an enterprise on the verge of financial distress? That's inherently unstable.

A bond fund avoids that inherent instability, as those who have cash now can buy shares, and those who want cash now can sell shares. The bank doesn't have to unwind its investments just because shareholders want to sell their shares.

And there's no angst about "fraud" from promising on-demand withdrawals while only holding fractional reserves.

The Snob writes:

The way I think about it is thus: when a hurricane hits a populated area of the gulf coast it destroys about $2 billion of property and kills a few dozen people, while a typhoon hitting around Bangladesh will cause tens of millions in damage and kill thousands.

So we overinvest in fruit trees. When the crash hits, the guys who own the fruit trees and the bank both go bust, but the trees don't simply vanish. Of course they have to be watered and harvested, but if people really need fruit someone will come along and figure out a way to make money growing fruit.

The problem right now seems to be that a lot of the money was spent not on building houses or flying cars or what have you, but on stacking financial instruments on top of each other. When a derivative of a derivative collapses, there's nothing left to salvage, just a bunch of Excel files and last year's annual report.

Mencius Moldbug writes:

I hate to think of Mises in quite such cultlike terms. Granted, I'd say he's one of the great thinkers of the last two centuries, fully on a level with the likes of Darwin, Einstein, Mill, Popper, etc, etc. The positions I've been articulating are a pretty trivial elaboration of his thought. But when he was right he was right because he was right, and when he was wrong, which is very very rarely AFAIK, he was wrong. Just agreeing with Mises is not an automatic path to the truth. I'm sure Arnold would say the same of Fischer Black.

As for banking, I'd say the answer is to get back to the basics: what is a bank? Why do we have these things? Banks were invented for two reasons: to serve as secure custodians of money, because not everyone wants to carry around little leather bags of gold dust, and to intermediate loans.

Whether your monetary base is gold or whatever, technology has completely changed the meaning of the custodial function. We just do not need paper banknotes in the 21st century. The service of secure monetary storage - provided in gold by entities such as GoldMoney and BullionVault - is entirely orthogonal, as we programmers say, to the service of lending.

In fact, libertarian though I am, I really don't have a huge problem with making monetary storage a sovereign function. The task of converting Fort Knox into BullionVault is not, at least in the abstract, a difficult one.

When it comes to lending, all that maturity-matched accounting means is that if you want to borrow money for 10 years, you need someone on the other end who wants to lend money for 10 years. This is not a concept beyond the intellect of the average investor or even the average voter, and most of the right lending instruments - such as CDs - already exist. And there will always have to be financiers who slice and dice, diversify and amortize, audit and appraise these loans. Austrian economics, contrary to popular belief, is not a program for arresting all the bankers and hanging them after show trials.

Moreover, the world has enormous pools of long-term saving that can finance long-term investment. Ordinary people need to finance long-term purchases such as houses, and they like to do things such as saving for their retirement. Intermediating these kinds of relationships is the natural task of any financial system.

Our world also contains people who are not ordinary but in fact very rich - private banking customers. These economic royalists and decadent parasites should survive, in the Jane Austen manner, off what is basically an annuity. Actuarial construction of maturity-matched annuity investments is definitely within the skill set of the gnomes of Zurich.

From an engineering perspective, the basic problem with the central-banking model is that the central bank is a single point of failure. This just doesn't feel like a 21st-century design. It feels like a 17th-century design, which is exactly what it is. Surely we can hope for change.

TC writes:

Arnold,

Can't this whole mortgage/housing/finance crisis be traced back to this:

People who want to invest in a risky venture should be allowed to. But no one, not even the US taxpayer, should be forced to put his or her own money into a risky investment.

That's the problem with Fannie and Freddie. To a lessor extent, this is the problem with FDIC.

If you asked people if it's acceptable for a commerical bank to originate a 30 year fixed home mortage with 20 percent down from the borrower, many might say that this is acceptable. Perhaps fewer would accept a commericial bank originating a mortgage with 5 percent down.

A libertarian, free market guy like me might be tempted to say, "None of my business. Let the bank do what it wants. It's their money. They can loan it to whom they want."

But then someone points out that I, the US taxpayer, am on the hook if this bank makes too many bum loans because the bank is FDIC insured.

Business ventures go belly up all the time. But with most of them the US taxpayer isn't holding the bag. Even if a large publicly traded corporation goes belly up and all of our 401(k)s decline in value as a result, we usually don't expect the government to start buying up "undervalued" assets to corporations in similar situations to prevent them from going bankrupt or laying off their employees.

Andrew Garland writes:

A Government Guarantee Is a Blank Check On Your Account

The center of the current financial disaster is a runaway government guarantee, over many years, with the full cooperation and encouragement of Barney Frank and most of Congress.

When you guarantee something, you have all of the downside risk of ownership, often without any upside hope of profit. A guarantee is the most dangerous financial action you can take. Ironically, the more that you can pay, the greater is the danger. A guarantee should be specific, limited, and closely watched. All of Wall Street and Main Street know this. Politicians know it too; they pretend that they don't.

(continued at We Guarantee It)

winterspeak writes:

ARNOLD: Fruit trees and old houses and typhoons. Oh my!

I agree with you that we need to look beyond the proximate cause of this credit bubble (housing) and look more deeply at credit bubbles themselves. We've had a credit bubble every 5-10 years now all over the world, and each time they find a new way to manifest. Fixing housing will not prevent the next one, which the actions by the Fed and Treasury are already priming.

Maturity matched banking is actually very simple to understand: Moldbug put it well: if you want to borrow for 10 years, you must find someone willing to lend for 10 years.

This is *much* simpler than fractional reserve banking and term transformation ("a depositor puts some money in the bank, and the bank can then issue 9x that money and lend it to someone else... where does this money come from? well, it just appears. And if the depositor wants his money back, the bank needs to get it from another depositor. He can't get it back from the person he's made the loan to because that was for a 10 year mortgage, and the depositor has a checking account. etc. etc.)

Also, it's not like there isn't a ton of money out there that's looking for a long term home -- retirement savings come to mind -- and there is a ton of money needed for long term investment (factories, etc. etc.) There simply is no need to take short term money that just wants a safe place to be and transmute that into long term money. This would be true even if that magical process didn't create a system that is guaranteed to catastrophically fail for no reason at all, and potentially take the entire financial system down with it.

Deposits in vaults + CDs is not a horrible world AND it would not need FDIC insurance.

-winterspeak

David R. Henderson writes:

Arnold,
I've found myself asking, "What would Merton Miller think?"
Best,
David

George writes:

Wow, there is so much that can be written on this topic. I really think that everyone has some blame in this crisis. Greed is the foundational issue which can often work in a positive fashion but of course can come back to bite you and that it has! The mortgage companies and those that profit from them were approving people that had nothing to put down and showed no way to make even the first few payments ... insanity and now it is time to pay the piper.

guyson writes:

Andrew Garland:

You say "the government guaranteed it." My understanding was that part of the financial system, namely the shadow banking system, was not guaranteed by the government (and therefore not regulated by it either). Moreover, it was the unguaranteed and unregulated shadow banking system that imploded first, and percipitated this whole mess.

guyson writes:

Andrew Garland:

You say "the government guaranteed it." My understanding was that part of the financial system, namely the shadow banking system, was not guaranteed by the government (and therefore not regulated by it either). Moreover, it was the unguaranteed and unregulated shadow banking system that imploded first, and percipitated this whole mess.

hacs writes:

I can't understand the political wisdom that says "we are not responsible by the crisis because the financial market chose to profit on the legal opportunities we created assuring mortgage's securities". Do you understand?

stylized.fact writes:

Doesn't the tragedy of the commons provide a useful lens for understanding how regulation ought to work in financial markets? Financial bubbles are a lot like overfishing, traffic jams, or gold prospecting. The inherent complexity of economic systems more or less guarantees informational cascades, or investor herding. I've heard one suggestion that putting limits on leverage will help to curtail a future arms race, wherever it might be.

fundamentalist writes:

Kling: “This banking institution tends to be really unstable.”

Leverage makes it unstable. Banks keep less than 5% in reserves. That means that they are leveraged by 95%. One small mistake in lending can wipe out the bank’s equity. When borrowers, intermediaries and banks are highly leveraged, a sneeze will collapse the whole system. As Warren Buffet and George Soros have written, everyone was highly leveraged and they’re all trying to deleverage at the same time.

Hayek does a great job of explaining this in his “Monetary Theory and Trade Cycles.” It’s a natural result of banks keeping very tiny reserves. You could stabilize the system by increasing the reserve requirements, but I doubt that will ever happen. The next best thing would be for the Fed to target the price of gold. That would keep credit expansion and collapse within tolerable bounds.

fundamentalist writes:

To understand this crisis, everyone needs to know history better. Here is Washington Irving writing in 1819 about the Mississippi bubble in France of 1720, using it as a description of the panic of 1819 in the US:

[There occasionally arise] those calm, sunny seasons in the commercial world, which are known by the name of "times of unexampled prosperity" … Every now and then the world is visited by one of these delusive seasons, when "the credit system" … expands to full luxuriance, everybody trusts everybody; a bad debt is a thing unheard of; the broad way to certain and sudden wealth lies plain and open; and men are tempted to dash forward boldly, from the facility of borrowing.

Promissory notes, interchanged between scheming individuals, are liberally discounted at the banks, which become so many mints to coin words into cash; and as the supply of words is inexhaustible, it may readily be supposed what a vast amount of promissory capital is soon in circulation. Every one now talks in thousands; nothing is heard but gigantic operations in trade; great purchases and sales of real property, and immense sums made at every transfer. All, to be sure, as yet exists in promise; but the believer in promises calculates the aggregate as solid capital, and falls back in amazement at the amount of public wealth, the "unexampled state of public prosperity."

Now is the time for speculative and dreaming or designing men. They relate their dreams and projects to the ignorant and credulous, dazzle them with golden visions, and set them madding after shadows. The example of one stimulates another; speculation rises on speculation; bubble rises on bubble; every one helps with his breath to swell the windy superstructure, and admires and wonders at the magnitude of the inflation he has contributed to produce.

Speculation is the romance of trade, and casts contempt upon all its sober realities. It renders the stock-jobber a magician, and the exchange a region of enchantment. It elevates the merchant into a kind of knight-errant…. The slow but sure gains of snug percentage become despicable in his eyes; no "operation" is thought worthy of attention that does not double or treble the investment. No business is worth following that does not promise an immediate fortune….

Could this delusion always last, the life of a merchant would indeed be a golden dream; but it is as short as it is brilliant. Let but a doubt enter, and the "season of unexampled prosperity" is at end. The coinage of words is suddenly curtailed; the promissory capital begins to vanish into smoke; a panic succeeds, and the whole superstructure, built upon credit and reared by speculation, crumbles to the ground, leaving scarce a wreck behind…

When a man of business, therefore, hears on every side rumors of fortunes suddenly acquired; when he finds banks liberal, and brokers busy; when he sees adventurers flush of paper capital, and full of scheme and enterprise; when he perceives a greater disposition to buy than to sell; when trade overflows its accustomed channels and deluges the country; when he hears of new regions of commercial adventure; of distant marts and distant mines, swallowing merchandise and disgorging gold; when he finds joint-stock companies of all kinds forming; railroads, canals, and locomotive engines, springing up on every side; when idlers suddenly become men of business, and dash into the game of commerce as they would into the hazards of the faro table; when he beholds the streets glittering with new equipages, palaces conjured up by the magic of speculation; tradesmen flushed with sudden success, and vying with each other in ostentatious expense; in a word, when he hears the whole community joining in the theme of "unexampled prosperity," let him look upon the whole as a "weather-breeder," and prepare for the impending storm.
“Crayon Papers”

winterspeak writes:

Fundamentalist:

While it is certainly true that leverage does not make things better, it is not leverage that destabilizes financial intermediaries who term transform.

Read this thread to see why a bank that was 50% leveraged (so, assets on balance sheet are 2x equity) has the same problem with bank runs as a more leveraged institution.

And also, while I'm OK with a gold standard, it is not feasible in an MT world (as the US discovered in the 1930s). Is Federal Reserve Notes match 1:1 with gold in a vault, then what to banks lend out when they term transform? Their own scrip?

This was covered in the comments in the previous post on this topic.

-winterspeak

fundamentalist writes:

Winterspeak: "...it is not leverage that destabilizes financial intermediaries who term transform."

Why does term transformation work most of the time, but then suddenly and spectacularly fails? Because the people who own the short term assets want them back and the banks can't supply them. Why not take it out of reserves? Because they don't have enough reserves, so they must quit lending and/or call in loans or borrow from another bank. But if everyone is deleveraging and trying to gain cash, then there aren't enough reserves in the whole banking system.

I'm not advocating term transformation, but it doesn't seem to be a problem most of the time.

winterspeak writes:

Fundamentalist: How much would a bank have to hold in reserves to *guarantee* on-demand fulfillment for every depositor who wanted their money back?

If a bank has $99 in reserve, and $100 in deposits, how would you feel about being the last guy in line?

Term transformation works until it fails because there are two stable prices equilibria in a MT world for long term assets: one where MT is on, and one where MT is off. The MT-on state is precarious, as bank runs are self reenforcing, and can start for no reason.

That's not to say leverage doesn't make things worse, but things were precarious to begin with.

-winterspeak

Studd Beefpile writes:

Desirability aside, I fail to see how a ban on Maturity Transformation would be enforced. To go with the fruit tree example, say the tree farmer borrows for 3 years expecting to pay back with his first harvest, but said harvest is lousy. His only choice then is to roll over his debt for another year. How would a regulator distinguish that behavior (which is presumably acceptable) from an insidious farmer who is borrowing for a year knowing his tree won't pay off for 3 in order to get an artificially low rate?

TC writes:

How is the bank run problem (related to fractional reserve banking) related to this current financial crisis given that the problems with Bear Stearns, Lehman and AIG is what really caught our attention?

To my knowledge, none of those corporations were doing any commerical banking and were not part of the fractional reserve banking system?

At the risk of asking a stupid question (and I do it all the time)....

What is the connection between fractional reserve banking, the housing bubble and the crashing of the stock market (and perhaps collateral damage to the larger economy)?

winterspeak writes:

Studd Beefpile: For starters, you could simply rescind FDIC. There is market demand for a bank that is immune to runs, but FDIC keeps that from developing. We see the opposite happening today, as FDIC insurance is extended to more and more of the financial world.

TC: The problems with Bear Stearns, Lehman and AIG are all due to them being term transformers: borrowing short to lend long. This created the credit bubble (step 1) and has made the popping of that bubble so contagious in its effect, and broad in its impact. Basically, when the credit bubble collapsed, it triggered a bank run on the non-commercial banking world (ie. the "shadow" banking system)

-winterspeak

floccina writes:

The corporate structure is also some what of a guarantee and is to some what blame. If you listen to some of the players (http://www.thislife.org/Radio_Episode.aspx?episode=355) they new that these mortgages were junk but they new that would not be liable.

Andrew Galrand writes:

To Guyson:

You wrote:
My understanding was that part of the financial system, namely the shadow banking system, was not guaranteed by the government (and therefore not regulated by it either). Moreover, it was the unguaranteed and unregulated shadow banking system that imploded first, and percipitated this whole mess.
---

I haven't heard of the shadow banking system. I would appreciate links to the topic.

My understanding is that Fannie Mae and Freddie Mac borrowed $5.4 trillion from the credit markets under an implied government guarantee, to hold prime mortgages along with $1.4 trillion of subprime mortgages.

Fannie and Freddie collapsed when people defalted in large and growing percentages on the subprime mortages. Then the entire market in subprime (80% owned outside of Fan and Fred) dropped to 1/2 of prior value, ruining most institutions that held them.

Fannie and Freddie grew using implied government guarantees, and Congress intentionally failed to regulate them.

This is a failure of IN PLACE regulation, ignored by congressional committees who looked the other way, because it was in their political interest for Fannie and Freddie to do just what they were doing. Their motto was "So far, so good".

fundamentalist writes:

TC: “What is the connection between fractional reserve banking, the housing bubble and the crashing of the stock market (and perhaps collateral damage to the larger economy)?”
Even without term transformation, all banks are highly leveraged all of the time, meaning they have far more debt than equity. With banks the equity as a percent of liabilities is less than 5%. The investment banks and AIG were also highly leveraged. Leverage like that boosts return on assets and works fine until someone stubs their toe, that is, can’t pay the interest on debt because income has fallen below expectations. It just takes one company missing a payment and the whole structure of leveraged debt snaps back like a huge rubber band. That’s because no one has enough equity to carry them through less than perfect times, let alone really bad times. That’s what equity is for, to get you through the rough spots.
The housing bubble came about because companies borrowed huge amounts from banks to build houses, thereby stretching the credit structure of banks and themselves to the maximum. Demand was high because interest rates and credit standards were low. Someone sneezed (couldn’t make their mortgage payment) and the whole credit structure began to snap back because no one had any equity to help them through the rough patch.
The stock market often reaches its highs on borrowed money just as the housing market did. People sell stock to make margin calls, pay down debt and to escape further declines.

Libra writes:

For starters, you could simply rescind FDIC. There is market demand for a bank that is immune to runs, but FDIC keeps that from developing.

Whoahhhh. That's not for starters. That has to be the last thing you do. The second you rescind FDIC you'd have the greatest bank run of all time. First, you'd have to convert all existing savings accounts to Federal Reserve Notes (the printing press would have to work overtime for that one). Then you can retract FDIC, and put a big "buyer beware label" on all fractional reserve banks.

winterspeak writes:

Libra: You are quite correct, my ordering was wrong.

Monetize first. Retract FDIC next.

My point was that without FDIC people could pick between banks that were prone to runs, and banks that are not. I think the choice would be clear

-winterspeak

Mr. Econotarian writes:

I know what Milton Friedman would think!

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