Arnold Kling  

Financial Regulation: Three Confirmations

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First, Paul Romer confirms some of my views when I wrote "The Chess Game of Financial Regulation." That is, eventually, all fixed rules will be gamed. He calls this "Myron's law" in deference to Myron Scholes.

Second, Sheila Bair says that big banks are not more valuable franchises. She points out that, if anything, there are diseconomies of scope. The idea that a "financial supermarket" is a great thing was promoted by Citigroup for years. But Bair points out that the more valuable franchises are focused shops.

Finally, concerning a centralized exchange for derivatives, Manmohan Singh writes,


In the most extreme scenario, where a temporary liquidity shortfall at a central counterparty has the potential to cause systemic disruption or even threaten the solvency of a central counterparty, it is likely that central banks in major jurisdictions will stand ready to give whatever support is necessary (and recent regulatory proposals suggest that the Fed and ECB will do so). However, such an arrangement creates moral hazard - and a roundabout way for derivatives risk to be picked up by taxpayers.

Pointer from Mark Thoma. Read the whole thing. There are folks whose claim to expertise in finance is that they advocate a centralized exchange for derivatives. Long-time readers of this blog know that I think that it is a futile idea. Centralized exchanges deal in options that are close to being at-the-money. Derivatives are deep out-of-the-money options. These behave quite differently from market-traded options, and the fact that so many self-proclaimed expert regulators do not understand that is frightening.


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COMMENTS (9 to date)
Edward Muniz writes:

I am not sure I agree with the notion that "all fixed rules will be gamed." I do think we have a too big to fail problem in our finance sector.

Still, wasn't a big part of the problem the repeal of the Glass-Steagall act?

Somebody on the media recently made the point (which I presume to be more or less accurate) that Glass Steagall was something like 34 pages in length, whereas Dodd Franklin was something like 1,400 pages.

It is as if we repealed a very basic regulation that had worked and made a lot of sense, only to find that we had a disaster as a result. Instead of going back to the orignal act, a complicated set of rules and regulations were then instituted. Is it not the very complexity of these regulatations that allow them to eventually be gamed?

It is like trying to insist that the stars revolve around the planet. You can construct a highly sophisticated and extremely complex system based on that premise. Still, it is a simplifying assumption to declare that the earth revolves around the sun, and that the sun is just another star in a certain location.

Simplified regulations that have a desired effect would seem to make a lot more sense than complex regulations that avoid dealing with a central problem: allowing FDIC assets to be utilized for highly speculative purposes.

Adrian E. Tschoegl writes:

I am sympathetic to the issues of diseconomies of scope. The management strategy literature had long lost interest in the topic of "span of control", where the long-ago research showed that span of control, the number of people that one manager could supervise, declined in the difference in tasks between the subordinates, the complexity of tasks of each subordinate, and the physical separation between subordinates. A CEO of a firm with a few, highly related businesses will have an easier time managing than a CEO of a worldwide financial supermarket. (Notice, how often financial debacles in a firm take place in some obscure unit doing something supposedly low-risk (and so ignorable) and fairly remote from the parent's main lines of business?)

However, the diversification discount that some researchers have found may reflect cognitive limitations of analysts more than diseconomies of scope. That is, analysts are siloed and have difficulty evaluating complex firms. Even if a firm has real non-financial economies of scope, the analyst is outside the firm and cannot see them. As a result, the analyst applies an estimation discount on those lines of business they do not understand.

Methinks writes:

In the decades I've spent in the financial industry- mostly on the trading side - I've never met a financial regulation that had the intended effect or one that hasn't been gamed (or where attempts to game it haven't been made). I've also never seen regulators evenly apply any of the regulatory rules. Large and/or politically connected firms can do whatever they want and competitors are tortured.

Edward Muniz,

I'm afraid your assertion that the financial crises resulted from the partial repeal of Glass-Steagall is unadorned by evidence.

How would the continued separation of investment banks and commercial banks have prevented the credit and housing bubble?

Shayne Cook writes:

To Methinks:

"How would the continued separation of investment banks and commercial banks have prevented the credit and housing bubble?"

It wouldn't necessarily have prevented the credit and housing bubble, but it would have compartmentalized the damage from it - and probably attenuated the magnitude of the bubble in the first place.

Note that the immediately prior bubble - the "dot-com" bubble - took place in a Glass-Steagall enforced world. The collapse of the "dot-com" bubble did roil financial markets, but did NOT collapse the entire financial system - the "Commercial" banking system (defined by Glass-Steagall) were left largely unscathed.

I suspect that Glass-Steagall was precisely the sort of "meta-rule" that Romer is alluding to in his essay. It was a "meta-rule" that proves more effective in limiting damage than a super-sized block of "micro-rules" that becomes obsolete almost immediately upon implementation. I also suspect it supports Dr. Kling's assertion that making a (financial) system "easy to fix" is superior to attempting to make it "hard to break".

rpl writes:

Shayne,

Do you think that a "compartmentalized" investment banking sector could have been allowed to fail? The way I remember the crisis, even institutions that were purely investment banks were regarded as "too interconnected to fail". We were talking bailouts well before the crisis touched any commercial banks. In particular, the commercial paper market depended on the investment banks, right? Could we have allowed that market to collapse? If not, then Glass-Steagall wouldn't have prevented the crisis.

It's also worth noting that we had bailouts and "too big to fail" long before the repeal of Glass-Steagall. LTCM, the Mexican Peso bailout, and others all happened while Glass-Steagall was in force.

I question your claim about the dot-com bubble. The dot-com bubble was different from the financial crisis in at least two important ways:

1) Stocks were always regarded as risky and institutions held capital accordingly.

2) Financial institutions didn't multiply the effective size of the dot-com market by writing huge piles of derivatives.

I don't think point #2 can be overstated. If financial institutions' long position in subprime mortgages had been limited to the actual size of the subprime market, this all would have blown over. However, between the CDS, CDO, synthetic CDO, and CDO-squared positions, financial institutions' long exposure to subprime mortgages was many times the size of the market itself. Combine this with point #1, and you have a recipe for disaster, with or without Glass-Steagall.

Shayne Cook writes:

To rpl:

Several questions here ...

First, to reiterate, I don't believe Glass-Steagall framework would have prevented the housing bubble. It obviously didn't prevent the "dot-com" bubble.

As to the prior examples of the Fed engaging in "bailout" activities of investment entities prior to 2008, I agree. But I and most economists agree that those were rather "adventurist" activities, outside the scope of the Fed, and probably mistakes. And I think the Fed would have intervened in investment banking sector collapse. But I suspect its actions in doing so would have been more constrained.

As to my "dot-com" bubble claim, I guess I would use your Point 1. as an explanation for your Point 2. Those formerly Commercial banking entities had been precluded from "risky" capital holdings, such as stocks, derivitives, etc. under Glass-Steagall precisely as you note in Point 1. But once Glass-Steagall was repealed, many formerly designated Commercial Banks either purchased or developed Investment Bank subsidiaries in order to enhance profitability. Those risk-laden activities and instruments were the one's that failed when the housing bubble burst. But in the combined-entity institutions, such as Citi, Wamu, etc., the entire financial entity failed as a result.

Note that there were large "Commercial" banks that stayed solely (or primarily) "Commercial" (and conservative) in their operations even after 1999 - as a matter of choice. JP Morgan Chase (under Jamie Dimon) being the most notable example. Bank of America also largely eschewed "Investment Banking" operations and risk until the Fed, Treasury (Hank Paulson), Geitner (New York Fed) et.al. basically coerced Lewis into using BAC's "Commercial" viability and standing to purchase Morgan's problems at inflated prices.

In short, the Glass-Steagall "meta-rule" would have precluded the "Commercial" banking sector from from being involved to any great degree in the "Investment" banking failures. That's the "compartmentalization" I was referring to.

rpl writes:

Shayne,

First, to reiterate, I don't believe Glass-Steagall framework would have prevented the housing bubble. It obviously didn't prevent the "dot-com" bubble.
Noted. I don't think that it changes anything, though. We're talking about preventing the crises induced by collapsing bubbles, not the bubbles themselves.
As to the prior examples of the Fed engaging in "bailout" activities of investment entities prior to 2008, I agree. But I and most economists agree that those were rather "adventurist" activities, outside the scope of the Fed, and probably mistakes.
They used all the same rhetoric about "too big to fail" and "systemic risk" to justify those bailouts. (NB: the phrase "too big to fail" was coined in 1984 in the wake of the Continental Illinois bailout). Why should we be convinced that the rhetoric was just a smokescreen prior to Glass-Steagall but is genuine this time?
As to my "dot-com" bubble claim, I guess I would use your Point 1. as an explanation for your Point 2. Those formerly Commercial banking entities had been precluded from "risky" capital holdings, such as stocks, derivitives, etc. under Glass-Steagall precisely as you note in Point 1.
Your theory doesn't account for all of the facts. Investment banks in the dot-com bubble were not precluded from holding those instruments, but nevertheless, they did not collapse in the wake of the dot-com bust the way they did in the wake of the subprime bust. Therefore, the salient factor was not the separation between investment and retail banking, since that would have had no effect in the dot-com bust because the investment banks didn't fail.
Note that there were large "Commercial" banks that stayed solely (or primarily) "Commercial" (and conservative) in their operations even after 1999 - as a matter of choice. JP Morgan Chase (under Jamie Dimon) being the most notable example.
You are mistaken in the second part of your statement. JP Morgan Chase has both investment and retail banking operations. It is exactly the sort of entity that would have been prohibited under Glass-Steagall. Indeed, JP Morgan and Chase bank merged in 2000, shortly after the Glass-Steagall repeal. So, JP Morgan Chase would seem to serve primarily as an example that a merged investment-retail bank can be operated safely.
In short, the Glass-Steagall "meta-rule" would have precluded the "Commercial" banking sector from from being involved to any great degree in the "Investment" banking failures. That's the "compartmentalization" I was referring to.
I understand, but where is the evidence that it would have mitigated anything in the crisis? Specifically, you dodged the question of whether we could have afforded to allow the investment banks to fail, even if retail banks could have been sheltered from the fallout. We were told that had we let the "shadow banking system" fail (the contagion had not yet spread to retail banks) commercial paper and trade credit would have "frozen up," companies would not have been able to make payroll, and merchants would not have been able to buy goods to stock the shelves of their stores. Was this true? If so, then Glass-Steagall wouldn't have helped us.

In summary, the entire argument that Glass-Steagall could have saved us is premised on the assumption that the "shadow banking system" is expendable, and therefore could have been allowed to go under. All the evidence (at least that I'm aware of) suggests that premise is untrue.

Shayne Cook writes:

Apologies for having "dodged" any questions - it wasn't my intention.

"Specifically, you dodged the question of whether we could have afforded to allow the investment banks to fail, even if retail banks could have been sheltered from the fallout."

At the risk of sounding like Bill Clinton giving a deposition, it depends on your definition of "we". As a matter of fact, it is the widest definition of "we" that is at the center of the problem - "we" affording the investment banks failures includes the operations of Commercial banks. That wouldn't have been the case had they been specifically precluded from "affording" those problems under Glass-Steagall.

And "we were told ..." a whole variety of things during that 2008 period and subsequently, most of which I don't believe for one moment. I do believe there would have been a substantial clog-up (for lack of a better term) in the Investment banking financial markets. Also, probably resulting in a mild[er] recession.

But the basic (conservative) financial services afforded to the economy explicitly by the former Commercial banking sector - most commercial paper, trade credit, short-term lending to small, local firms to "make payroll" and finance inventory, etc. that you note - WOULD NOT have been impaired by "investment banking" excesses and failures. That is the point. Most conventional day-to-day financing demands of the economy could have been met by an unimpaired Commercial banking sector.

There is no doubt that any given financial institution can operate conservatively and safely absent Glass-Steagall. JPM is an example. But the fact remains that most/many did not, and were not compelled to, after the repeal of Glass-Steagall.

Again, I make no argument that "Glass-Steagall could have saved us". I make no assertion that the absence of Glass-Steagall "caused" the housing bubble or the resulting financial sector turmoil. I do assert that Glass-Steagall provided a statutory framework for survivability of a Commercial banking sector - to provide all the basic financial services to the economy that you note - completely independent of the excesses and failures of the Investment banking sector. As a matter of fact, that was its original intent back in 1933.

Methinks writes:

rpl,

The LTCM was not bailed out in any meaningful sense - it ceased to exist. Furthermore, the action taken was by private actors - it was not at taxpayer's expense. I have no problem with private action.

Shayne,

The partial repeal of Glass-Steagall did not allow commercial banks to take more risk. It only allowed the same holding company to own both a commercial bank and an investment bank. The two entities remained otherwise separate.

The list of stand alone commercial banks that went bankrupt in the financial crisis is very long. Why? They made bad loans. Since when is making large loans for the purchase a single illiquid asset to people who had no chance of paying them back considered "conservative"?

The investment banks that went under bought too many of the loans commercial banks made or got stuck with inventory during the underwriting process when the crises hit. The list of failed stand-alone commercial banks that had nothing at all to do with any "investment banking excesses" (as you put it) is very long.

I don't understand your distinction of "primarily a commercial bank". Either it's a holding company that owns both commercial and investment banks or it's not. JPM Chase is not "primarily" a commercial bank. It is a bank holding company which owns both an investment bank (JPM) and a commercial bank (Chase). It's no different in that way than Citigroup.

Your compartmentalization argument doesn't hold water. Commercial banks are compartmentalized even if they are owned by the same holding company. That's as silly as saying that if you owned shares in both a commercial bank and an investment bank, the two would no longer be separate entities. Furthermore, banks are each other's counterparties in many transactions - including overnight lending, swaps, etc. They are far more tied to each other than you imagine with our without Glass-Steagall.

Glass-Steagall would not have prevented the crisis, as Edward implied, nor would it have compartmentalized anything.

You seem to hang your entire argument on the incorrect view that commercial banks were acting conservatively while investment banks weren't. Even if that were true (and it's not), being owned by the same holding company doesn't make any difference at all.

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