Scott Sumner  

Some initial thoughts on banking reform

Pluralism and Civil Society... Rushkoff's nostalgia...

There's a new Congressional proposal for banking reform:

NEW YORK - House Financial Services Committee Chairman Jeb Hensarling (R-TX) today unveiled details of the Financial CHOICE Act - the Republican plan to replace the Dodd-Frank Act and promote economic growth.  CHOICE stands for Creating Hope and Opportunity for Investors, Consumers and Entrepreneurs. . . .

The Financial CHOICE Act, which Chairman Hensarling said will be introduced as legislation later this month, will end taxpayer-funded bailouts of large financial institutions; relieve banks that elect to be strongly capitalized from "growth-strangling regulation" that slows the economy and harms consumers; and impose tougher penalties on those who commit fraud as well as greater accountability on Washington regulators. . . .

To end taxpayer-funded bailouts and "too big to fail," the Financial CHOICE Act will create a new subchapter of the Bankruptcy Code tailored to specifically address the failure of large, complex institutions.  In April, the House approved similar bipartisan legislation to establish a new bankruptcy process for financial institutions with assets of $50 billion or more.

"Taxpayer bailouts of financial institutions must end, and no company can remain 'too big to fail,'" said Chairman Hensarling.  As a result of the Republican plan, "some large firms will likely become smaller because the credit they now obtain will be priced according to their inherent risk of failure without implicit government guarantees backing firms that are 'too big to fail.'  As a result, failure -- when it does happen -- will be more contained."

Banks that make the choice to be strongly capitalized will be eligible for relief from Washington regulations "that create more burden than benefit," Chairman Hensarling said.  "To avail themselves of this exchange, many larger banks will have to raise significant additional equity capital.  Most community banks will have to raise little to no additional capital.  Regardless, the option remains with the bank."

The Financial CHOICE Act also includes more than two dozen measures to provide additional regulatory relief for community banks and credit unions.  While big banks have gotten even bigger since Dodd-Frank became law nearly six years ago, community financial institutions are disappearing at an average rate of one per day.  Dozens of witnesses representing small banks and credit unions have come before the Financial Services Committee to describe the harm caused to their customers by the avalanche of Washington's post-crisis regulations.

This executive summary contains much more information, as does this speech by Jeb Hensarling, although I still have a number of questions:

1. How can we be sure that this proposal will eliminate "too big to fail"? Here is some added information from the Executive Summary:

*Retroactively repeal the authority of the Financial Stability Oversight Council (FSOC) to designate firms as systematically important financial institutions (SIFIs).

*Repeal Title II of Dodd-Frank and replace it with a new chapter of the Bankruptcy code designed to accommodate the failure of a large, complex financial institution.

*Repeal Title VIII of the Dodd-Frank Act, which gives the FSOC authority to designate certain payments and clearing organizations as systemically important "financial market utilities" (FMUs) with access to the Federal Reserve discount window, and retroactively repeal all previous FMU designations.

*Restrict the Fed's discount window lending to Bagehot's dictum.

*Prohibit use of the Exchange Stabilization Fund to bailout financial firms or creditors.

*Repeal Dodd-Frank's so-called "Hotel California" provision.

Does that actually prevent the Treasury from bailing out large banks?

2. In my view, the biggest problem with our banking system is moral hazard. The bill does address TBTF, but doesn't seem to address the GSEs, and it does not seem to reform deposit insurance. In my view those are bigger problems than TBTF. I worry that special interest politics may have prevented meaningful reform in those areas.

3. On the plus side, it would seem that higher capital requirements are a superior option to the Dodd-Frank approach, which involves lots of burdensome regulation, moving in the direction of treating banks like regulated utilities. As Hensarling pointed out in his speech, the problem was not too little regulation, it's that the government is not good at regulating banks.

Dodd-Frank's false premise is that an alchemy of Wall Street greed, outsized private risk and massive Washington de-regulation almost blew up the world economy. According to their narrative, this necessitated massive taxpayer bailouts and a functional occupation of our capital markets by federal regulators.

But financial regulation did not decrease in the decade leading up to the crisis - it markedly increased. In fact, regulatory restrictions on financial services grew every year between 1999 and 2008. Financial services was, and remains, one of the heaviest regulated industries in the economy.

It wasn't de-regulation that caused the financial crisis; it was dumb regulation.

The point of higher capital requirements is to offset the bias towards risk taking produced by distortionary policies such as FDIC and the GSEs. So that part of the reform seems sensible. What are the arguments in favor of Dodd-Frank?

4. I also like the pushback against CFPB regulations restricting things like payday loans.

Repeal authority to ban bank products or services it deems "abusive" and its authority to prohibit arbitration.
CFPB regulations could push lower income borrowers toward loan sharks.

5. I also like the idea of making the Fed more accountable:

Demand greater accountability and transparency from the Federal Reserve, both in its conduct of monetary policy and its prudential regulatory activity, by including the Housepassed FORM Act.
But the devil is in the details.

Overall this seems a step in the right direction, but I'd need to know much more about the details to have a firm view of this proposal. I'm a bit concerned about all of the rhetoric in favor of small banks, as I see them as a bigger risk than large banks. But perhaps that is just politics; you need to sound pro-small bank to get anything passed in Washington. And again, I'd like to see abolition of the GSEs and reform of FDIC, but I understand that the power of the banking/real estate lobby makes that very difficult.

I would appreciate comments from people who know more about this bill than I do, both for and against.

HT: Chad Reese

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CATEGORIES: Finance , Regulation

COMMENTS (16 to date)
Khodge writes:

"The devil is in the details." Did anyone care about the details when Dodd-Frank passed? It seemed like little more than Elisabeth Warren's ranting being codified into law. From my vantage point at the time Dodd-Frank was designed solely to facilitate regulatory capture. (My company revelled in the new barriers to entry that were set up.)

Kevin Erdmann writes:

I'm not an expert on the new reform, by any means. But, I would comment that until we get over the error of blaming the housing boom/bust on regulation, we are fighting the wrong battle.

Here is a post showing relative price changes, arranged by zip code price levels. The high priced zip codes were the leading zip codes in the price decline of 2006-2007. This did not lead to substantial defaults because these zip codes are not as credit constrained. These zip codes declined first because the housing market was undermined by a series of contractionary moves by regulators and the Fed, as far back as 2003-2004.

The boom and bust in private securitizations was a lagging indicator during both the boom and bust phase. They only spiked up in usage after 2003 because the Bush administration's first move in busting the housing boom was to pressure the GSEs, and private pools, banks, REITs, etc. all expanded to fill the void. By the time the subprime crisis was pulling down prices at the low end in late 2007, homes at the high end had already dropped by 10%.

There was no set of realistic regulatory constraints or risk management in the banking industry that could have made a difference. There was a consensus to tank the housing market, and if it took sucking another hundred billion of currency out of the economy, we would have insisted upon it. If many banks fails after its main source of collateral has an across the board collapse of 25%+ in value, that's not a failure of bank management, that's a failure of systemic economic management. This is quite parallel to the problem of analyzing the Great Depression.

MikeP writes:

What are the arguments in favor of Dodd-Frank?

The only argument in favor of Dodd-Frank that I'm aware of is that it is named after the two individuals most responsible for causing the financial crisis it is purportedly designed to solve. So that's something.

Matthew Waters writes:

The big issue is there is no definition of "well-capitalized." The investment banks before 2008 were well-capitalized by weighted standards, with the AAA CDO's having low capital standards.

Capital is also not a metric set in stone. It's an accounting measure, with the issues inherit in accounting. A simple equity/assets measure is vulnerable to deteriorating quality of assets.

And I don't see "Too Big to Fail" ending. Remember the stock market's reaction to the House voting down TARP? I don't see everyone remaining so principled against bailouts when the next crisis happens.

Why did the stock market plummet when TARP was voted down? The investment banks in 2008 had de facto bank deposits, including money market funds and deposits for corporations, pension funds and hedge funds for their working cash. So corporations could have actually have had trouble making payroll.

Wherever you have a demand deposit structure, it isn't practical to quickly move billions upon billions of assets. The Fed can print money and so their discount window functions as a lender of last resort. Otherwise, you have the banking panics which occurred every generation or so. From the 90's, large deposits moved outside the banking system to shadow banks.

Lorenzo from Oz writes:

Any reform which leads the Fed in charge of prudential regulation in particular is not likely to work, based partly on past experience and also on the structure and responsibilities of the Fed. A separate, targeted authority (such as the Australian Prudential Regulatory Authority) is the way to go.

Calomiris and Haber (from memory) suggest that the Fed is left with banking regulation precisely to encourage ineffectual (or at least bank-friendly) regulation by an authority with too much other political burdens/hostages to blowback to carry.

ChrisA writes:

What I worry about with TBTF is the backlash from the inevitable bail outs. Already you can see justifications for bailing out other (not TBTF) industries because "the banks were bailed out". In that sense moral hazard is a concern, not because of the risk created by the moral hazard, but because of the impact on politics.

As people above say, personally don't think capitalization rules are a good approach, they are too easily avoided since leverage can come in many hidden ways. I would prefer a narrow banking approach myself, even to the point of making it illegal to offer bank deposits or guaranteed principle return unless all deposits were invested in the CB. Of course this approach is a political non-starter. Perhaps an alternative approach is to limit salaries (including any bonuses) for all bank personnel to less than (say) $500k if the bank is a deposit taker. There is then less moral hazard, because there is no upside for any of the people in the bank. This might be politically more acceptable.

bill writes:

I would like to see a requirement that banks have some sort of preferred equity tranche in their capital stack that automatically converts to equity if their equity falls below a certain level. And I'd like to see all bonuses (and maybe even salaries above a certain level) to bank employees get paid in a restricted form of that preferred equity (restricted in that it can't be sold for say 5 years).

Richard writes:

*Restrict the Fed's discount window lending to Bagehot's dictum.

Actually, the Fed does largely follow Bagehot's dictum in its discount-window lending. And its bailout programs of 2007-08 hewed closely to the dictum as well. The biggest deviation from the dictum was TARP, created by Congress and the Treasury, not the Fed.

Philo writes:

"I'd like to see abolition of the GSEs and reform of FDIC . . . ." Yes, and the reform of FDIC I'd like to see is . . . abolition! (Alas, politically impossible!)

As for TBTF: would it not be an adequate response to the failure of a big bank simply to pump up the money supply (rather than bailing out the bank's creditors and, to some extent, stockholders)?

Matthew Waters writes:

Narrow banking with 100% deposits at the CB is an interesting idea. It would be 100% reserve banking.

In principle, the cost of 100% reserve banking is simple. Bank balances don't earn interest. But it's not clear how that actually hurts economically. 100% reserves reduce velocity, but the CB can print enough to offset it and hit the same NGDP target.

I suppose banks reduce transaction costs by providing both money transfer services and bond investing services. For whatever reason, 100% reserve banking has never taken off with consumers even when there was definitely no moral hazard. The reduction in transaction costs must be significant. Banking and credit often go hand in hand.

My extreme version of narrow banking is both high capital requirements and requiring all assets be eligible collateral for the discount window. Truly eliminating moral hazard is difficult, unless NGDP targeting can be far more robust below the zero-bound. The stock market reaction to TARP suggests NGDP became highly sensitive to bailouts.

Scott Sumner writes:

Everyone, Lots of good comments. Regarding narrow banking, do we really need to go all the way to 100% of deposits backed by reserves? Why wouldn't it be safe enough to back them with interest earning T-bills? And how about both insured and uninsured bank deposits, with the uninsured offering higher yields, but able to be lent out.

I like the idea of debt that automatically converts to equity in a crisis.

Canada has avoided banking crises, it should not be considered an impossible goal.

ChrisA writes:

Scott - the disadvantage of allowing deposits to be used to purchase treasuries is that in times of stress treasuries can change in price. So if there was a banking panic, treasuries may be difficult to sell if the bank depositors wanted their money back. Of course the market actually went the other way in the last panic, with treasuries increasing in price due to the "flight to safety" but I don't think we would always see that. The other disadvantage is complexity - where there is money there is great ingenuity and I am sure that someone will find a way to get some extra leverage with this option. Retail banking should be extra boring, like municipal water supplies.

I see narrow banking working like this - the CB pays interest on reserves, the banks then compete with each other in terms of services and other aspects with customers with their profit basically being the difference between what the customers gets in interest and what the CB pays. If you prefer an interest rate, as a depositor, close to the CB rate, then perhaps you will choose a bank with very few branches and services. If OTH you prefer lots of ATMs, branches, services, then you get a lower interest rate or perhaps even get charged for the services you use.

These banks would always be allowed to create some investment funds if they believed they saw an investment opportunity that they would like to share with their customers. These would work like pure equity funds, the price you get is whatever someone is willing to pay, so it would be very clear that the funds would be at risk. No-one has a problem with this on the stock market, and there is many trillions invested there, so I don't believe it will depress investment that much. I would also be fine with CDs, where the term of the underlying loans matches the term of the CD.

On the Canadian banks surviving the crisis, I am not sure why they did so much better than the US. I suspect it was a multiple reasons thing including more conservative people running their banks thanks to cultural reasons, no house price crash, higher inflation etc. I think it would be hard to "retrofit" this onto the US system. Narrow banking would be possible, but politically, given the strong links between Wall Street and both major parties, impossible.

Benjamin Cole writes:

Scott- debt that converts to equity in a crisis--I think you are referring to convertible bonds. So a bank is owned by the shareholders--that is a layer of equity--and then convertible bond holders who would take over the bank in the event of a bank failure. In theory, I guess you want the depositors to take risks but given the level of financial intelligence that most depositors are likely to have this may be a bridge too far. Besides if shareholders are wiped out in a bank failure there has been plenty of consequences and to the people that have an ability to control who runs the bank.

I have no problem with bailing out banks, in fact it should probably be done rapidly and quickly in any recession (after a wipeout of shareholders and convertible bond holders).

Normally I would expect that taxpayers could actually make a profit by recapitalizing banks and selling them.

Mr. T could do that, don't you think?


Kevin Erdmann writes:

A couple of questions, Scott, if you're still checking comments:

1) Is there even a reason, in the 21st century, to have a set of financial institutions built around intermediation of maturity-mismatched assets and liabilities? It seems like a lot of systemic risk comes from this. If we built the financial sector based today's technology, it seems like there would be plenty of ways to more simply match savers and borrowers.

2) What is the public choice reason for pro-debt policies? If there were fiscal adjustments that reduced the preference for debt, wouldn't that lead to a higher ratio of currency to credit? And wouldn't that create more seigniorage profits?

Matthew Waters writes:

"Is there even a reason, in the 21st century, to have a set of financial institutions built around intermediation of maturity-mismatched assets and liabilities? It seems like a lot of systemic risk comes from this. If we built the financial sector based today's technology, it seems like there would be plenty of ways to more simply match savers and borrowers."

The history of merchant banking shows why banks handled both deposits and lending out the deposits. The first merchant banks were set up in, say, both Italy and Germany. People who shipped from Germany to Italy could only get paid by gold and silver going back from Italy to Germany. Shipping money this way was extremely dangerous and hazardous, with shippers waiting a long time for payment.

Merchant banks would instead transfer deposits on receipt of goods in both Italy and Germany. Only the net transfer of gold between Italy and Germany would actually need to be transferred between countries, lowering transaction costs.

At some point, the bankers lent out the deposits. Typically, the loans were to these same merchants who needed working capital before payment. In theory, other depositors could have withdrawn their gold and lent directly to the merchants, but the banks were already bankers to the merchants and had their business history. Like with merchant banking for trade, the transaction costs were lower with banks lending out deposits.

Even today, there's a lot of anecdotal evidence for banks reducing transaction costs. CFO's and Treasurers of companies often have lines of credit and banking accounts at the same bank, to have one contact. Getting a line of credit for accounts payable from a separate source would have more transaction costs.

Kevin Erdmann writes:

Thanks Matthew. Your examples seem like they revolve around short term assets and liabilities, which seems to be a reasonable match. These seem like reasonable core functions. But, at some point, much of banks' assets became associated with long term mortgages, which seems unrelated to working capital and deposits and creates a lot of systemic risk.

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