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Inevitable Bank Risk

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Tyler Cowen writes,

Bondholders don't and can't have much idea what is going on inside the trading book of a bank. It doesn't matter how financially sophisticated the bondholders are; the point is that the trading book must remain fairly confidential and a lot of risk can be put in the trading book.

On many issues, Cowen takes the position that we are more or less doomed to live with the status quo, and this is one of them. Read the entire post to see his reasoning.

I agree that financial intermediaries are likely to be too opaque for creditors to regulate. My sense is that if past performance is good, even sophisticated investors do not delve into the underlying balance sheet. If Enron fooled most of the people most of the time (and I suspect that even inside that firm few, if any, executives there understood that they were Picking up Nickels), then so can any bank.

Cowen alludes to and dismisses "corporate forms other than limited liability." I continue to believe that if we do not have prison terms for bankers who take excessive risks, then the asymmetry between the potential gains and potential losses will be too high.

Cowen thinks that big government needs big finance, a position that any reader of Niall Ferguson would understand. That in turn implies that bankers will have political leverage, so that the idea of prison terms is off the table.

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COMMENTS (13 to date)
mark writes:

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Daublin writes:

I can't speak to your conditional, but do we really want to live in a country where you can be put in jail for "taking excessive risk"?

That sounds horrible. Whenever an effort fails, everyone says, in hindsight, that the risk was too great.

I would rather drop banking than put businessmen in jail. Jail should be for people who are a strong risk to society if they are let loose.

Jeff writes:

Markets are better at institutional design than Cowen knows. Traditionally, investment banks obtained much of their funding from short-term borrowings like commercial paper. Creditors kept them on a short leash by refusing to roll over the debt when the banks engaged in activities that made the lenders uncomfortable.

There is a lesson here about how economists are too quick to spot market "imperfections" and then call for government intervention when they don't actually understand how particular markets work.

Publius 10 writes:

Jeff is spot on. The economists demanded bailouts for the big banks, in part, because they don't understand the rules of bankruptcy. Energy trading firms with huge books of energy derivatives have been through chapter 11 without disrupting the energy markets. And yet, the economists wailed that bailouts were necessary for the big banks.

Mercer writes:

" but do we really want to live in a country where you can be put in jail for "taking excessive risk"?"

No, but I do want to live in a country were peoples personal assets can be taken away when they engage in risky trading. Having limited liability corporations is not a God given right. They are a creature of man made law and the laws should be changed if the corporations are used to create moral hazard.

eccdogg writes:

A correction unrelated to the general point.

Enron did not collapse because of picking up nickles or any other trading strategy. Its Energy trading book was the profitable part of the business.

Enron collapsed because it wasted money getting into businesses it never should have been in the first place (Broadband, Water, Building Power plants in India,etc). And then it used accounting tricks and fraud to hide the losses before the final blow up.

The point still stands however that many inside the company had no idea how grave the situation was (though many suspected).

Publius 10 writes:

Daublin doesn't understand the facts. You had banks telling people they had flat, square books of customer trades, when in fact those books were intentionally taking on inventory risk. You had banks telling regulators they didn't have risk with respect to off balance sheet vehicles, when in fact they had risk under liquidity puts and other instruments.

It is very, very likely that many bank executives made intentional misrepresentations or omissions in their securities filings to shareholders or in their disclosures to regulators, that is fraud. And that needs to be punished with jail time.

However, much bad behavior was fully and fairly disclosed, and in those cases, Daublin is right. But that is demonstrably not all cases, not even close. We can have an empirical argument about what level of fraud was going on, but there is clear and convincing evidence of a great deal of fraud that hasn't been punished by plaintiff attorneys or prosecutors. Mainly because Bernanke, Paulson, and Geithner did widespread and poorly structured bailouts, which deterred the litigation necessary to find out who broke the law and dish out appropriate civil or criminal penalties.

fundamentalist writes:

Keep in mind that the securities that brought down the banks were MBS's, which had received glowing praise from Greenspan, the IMF and most mainstream economists as tools for reducing risk to individual banks by spreading risk to more people. No one considered them risky at first and they worked very well for about a decade. Then a few people notices the concentration of investment in MBS's and saw the risk in that. But regulators knew of the MBS investments and approved of them. They were not considered risky by economists or regulators. Bankers did not think they were engaging in risky behavior.

Yes, jail time for taking risk would put a chill on the economy. What's needed is better (Austrian) monetary theory and less criminalization of bankers and innovators.

Publius 10 writes:

fundy: The fact that the Fed failed to enforce the rules doesn't mean there weren't rules. If the police fail to catch murderers, that doesn't make murder legal. Cops don't have that authority. Neither did the Fed.

fundamentalist writes:

Publius, what rules did the Fed fail to enforce? Also, the Fed had been pumping money into the economy like crazy for years. Had they succeeded in preventing that money going into housing, it would have gone into another industry and we would be talking about a bubble in it. When the Fed floods the economy with new money that new money goes somewhere, just like a dam bursting. It will create a bubble in some industry.

Doc Merlin writes:

"If Enron fooled most of the people most of the time (and I suspect that even inside that firm few, if any, executives there understood that they were Picking up Nickels), then so can any bank."

You do realize however, that it was students and not regulators that spotted the errors. They were clearly there for all to see, right on the open books.


Actually, the Fed makes most of the rules.

You are absolutely correct.

Tom West writes:

In the end, I think Tyler is correct, the status quo is the status quo for a reason, and it takes a huge effort to change it because those reasons tend to remain.

In this case, there may well have been malfeasance on the part of the banks, but the real problem is innovation. The reality is sometimes it blows up, and many times that blow-up comes 10 years after use.

There will be people who recognize when an innovation is dangerous, but they'll be indistinguishable by people who recognize when an innovation is dangerous when it turns out not to be.

The real trouble is that innovation is now adopted so quickly that by the time an innovation proves itself dangerous (10-20 years), the whole world has already adopted it.

There are arguments that the financial world needs *less* innovation rather than more. Much of the Canadian bank's success during the crash was lack of innovation, a source of bitter criticism for years. It was only the anti-market parochialism of the Canadian government that prevented them from being bought out by the far more successful innovators to the south. (Anti-market regulation prevented Canadian retirement funds from deserting the Canadian banks for their American counterparts).

In a truly global world, you either join the innovators and pray, or get bought by them when your investors desert you for the innovators.

So, yes, Tyler's correct, we pretty much have to live with the status quo, nudged a little here or there as we can.

Brendan writes:

Forcing banks to make a sizable chunk of their bond debt mandatorily convertible to equity when certain capital thresholds are violated, seems almost a panacea to me. Can someone explain this policy's problems to me? I'm sure my lack of understanding is the problem here.

I understand the claim that banks' cost of funds will rise a bit, but I doubt it would be significant. During 2009, holders of preferred stock jumped at the chance to convert to equity at 50-70 cents on the dollar when tenders were offered by Citi and BoFA among others. I understand preferred stock is different than bond debt, but it still seems obvious that there are many situations where automatically convertible debt could be a win for both the bank and the debt holder.

Any insight appreciated.

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