Eugene White on banking: regulation or incentives?

At a recent economics conference I came across a fascinating paper by Eugene White, which discussed how incentives built into banking during the National Banking Era helped reduce risk taking.  The paper changed my views more than anything else I’ve read in recent years.  Here’s a few excerpts:

The Dodd-Frank Act of 2010 exemplifies this confusion. Few observers believe that the bill will provide a lasting reform of the American financial system, and many suspect that it will sow the seeds of the next financial crisis. By focusing on the regulation of choices made by borrowers, depositors, shareholders, and bankers, the Act repeats the mistakes made by previous reform legislation. Instead, reform should focus on changing the incentives that parties face to insure that they are correctly aligned to induce the development of less fragile institutions.

.   .   .

Perhaps, the most important but least heralded change in the ten years prior to the 2008 crisis was the shift by most major investment banks from partnerships to limited liability corporations.

What is notable about contemporary reform is that there is little effort to change the incentives that caused bank executives to take the big risks and a huge emphasis on regulating their choices. The implicit assumption seems to be that incentives and the assignment of liability plays only a small role so that choices must be regulated—that is, the market cannot be made to adequately discipline banks. Could such a market-based system be devised? In this paper, I offer evidence from the American National Banking Era (1864-1913) for the ability of incentives to successfully limit losses from bank failures.

.  .  .

An essential feature of the National Banking System was double liability for national banks, chartered by the federal government. Concerned that shareholders would not devote the time and resources to adequately monitor banks’ officers, the National Banking Act of 1864 imposed double liability on shareholders. Under this rule, if a bank failed, the receiver could order shareholders to pay an assessment up to the par value of the stock to compensate depositors. This regulation provided a key incentive to shareholders to control the risk-taking activities of bank management. The results of double liability are striking—banks were frequently and voluntarily closed when performing poorly but before they failed, as shareholders sought to avoid assessments. When they did not close a bank soon enough and it became insolvent, it was typically not deeply insolvent; and depositors received a substantial partial payout.

.   .   .

The two senior officer of the bank were the president who was paid a salary of $10,000 and the cashier who received a salary of $7,000.  Some banks required a bond of the president; but Merchants National did not; however, all employees down to the messengers were required to post a bond. The cashier posted a bond of $30,000, while the messengers had to provide bonds of $5,000.

The shareholders delegated the task of monitoring the management to six outside directors (the president was a seventh director).  According to the national bank examiner’s report, they were men of “good character and standing” who met twice a week to review the bank’s discounts and loans and examined the bank twice a year, having “all its operations laid before them.”  The president and the directors all owned stock in the bank, the president 196 shares and the six directors 213, 50, 40, 20, 10 and 10 shares. Altogether, the outside directors owned 343 shares, which while it was not a large portion of the 30,000 shares, represented substantial potential individual losses if they were assessed their double liability in the event of the bank failing. For the directors owning, just 40 or 50 shares, carried a potential assessment of $4,000 or $5,000, very substantial sums in the late nineteenth century. For the president, a loss of $19,600 would have been equal to double one year’s salary. The cashier could have been assessed $6,200 or slightly less than one year’s salary; but then he had to provide a $30,000 bond. These large potential downside losses for the senior bank management (and even junior officials, considering the bonds posted) and the directors charged with monitoring them created substantial inducements to control and reduce risk taking.

It might be objected that supervision by the regulator, the Comptroller of the Currency was a more important factor in insuring the safety of national banks. However, supervision under the pre-1913 Comptroller was relatively light, relying on the market to discipline the banks.

Take the US banking system of 1864-1913, end branching regulation, add NGDP targeting, and we’d be fine.  No need for Dodd-Frank.


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59 Responses to “Eugene White on banking: regulation or incentives?”

  1. Gravatar of Major_Freedom Major_Freedom
    27. January 2012 at 07:09

    “What is notable about contemporary reform is that there is little effort to change the incentives that caused bank executives to take the big risks and a huge emphasis on regulating their choices.”

    Yes, an artificially low overnight interest rate, artificially low discount rate, implicit Fed easing, and Greenspan Put, will do that to risk takers.

    “Under this rule, if a bank failed, the receiver could order shareholders to pay an assessment up to the par value of the stock to compensate depositors. This regulation provided a key incentive to shareholders to control the risk-taking activities of bank management.”

    So did the gold standard.

    “Take the US banking system of 1864-1913, end branching regulation, add NGDP targeting, and we’d be fine. No need for Dodd-Frank.”

    We can’t have a gold standard and NGDP targeting at the same time.

  2. Gravatar of Morgan Warstler Morgan Warstler
    27. January 2012 at 07:11

    woot!

    Now Scott, the number of times where I have tried to actually use law to make banking not as profitable (fix incentives), you’ve always acted like I wasn’t being free market enough.

    It is 100% completely possible to chase the best and brightest into real company starting activities, and make the people who loan to them and invest in them, be lucky they get to sit downwind of the perfume factory.

    Glad to have you aboard!

  3. Gravatar of acarraro acarraro
    27. January 2012 at 07:14

    That’s an interesting proposal…

    But I think you are wrong. Dick Fuld had much more than a couple of years of compensation in Lehman stock. Does it make a difference if it’s a contingent liability rather than explicit? It didn’t stop the company going down.

    Plus it would be difficult to enforce actually. I just need to take the opposite position in the market and I am okay. I might need to take position in a competitor for compliance reasons (which is not ideal), but for good reasons bank stocks are very correlated. Most bank executives I know have hedging trades to their deferred stock compensation. It would be silly not to… Or I could simply salt some of the money in trusts or other vehicles…

    Plus why were the rules changed? Has it all bank lobbying? Or maybe there was some other problem? It would be very unusual for something useful to be invented and than abandoned for no reason… I guess we had the middle ages so that’s not universally true, but still…

  4. Gravatar of StatsGuy StatsGuy
    27. January 2012 at 07:19

    Scott, you cannot possibly be this naive. Do you seriously think that a law which breaks the corporate veil to penalize directors/shareholders/partners twice their annual salary could _possibly_ get through congress? It took the Great Recession just to cut their salaries 25% and shift half their bonuses to deferred compensation based on medium term results. And what, then, of international competition from other banks? Have you even been tracking the negotiations over Basle III?

    Did I mention that some 98% of economists favor a gasoline tax? Do you know what % of Congressmen favor a gasoline tax?

  5. Gravatar of ssumner ssumner
    27. January 2012 at 07:20

    Major Freeman, Gold isn’t coming back, for good reasons.

    Morgan, I have favored banking regulation, so you must have misunderstood me.

    acararro, Good point, but that’s a huge potential problem with or without White’s proposal. Perhaps the government should ban bank officers from shorting their own stack.

  6. Gravatar of StatsGuy StatsGuy
    27. January 2012 at 07:27

    @Morgan…

    “be lucky they get to sit downwind of the perfume factory.”

    Just a quick note – only the UNLUCKY get to sit downwind of the perfume factory. Very high concentrations of endocrine disruptors and allergen sensitizers, linked to all sorts of nasty things – including sperm damage. Lovely example of a negative externality.

  7. Gravatar of Morgan Warstler Morgan Warstler
    27. January 2012 at 07:42

    Stats, ok, ok.

    Reminds me of the explanation of why the east side of most cities is the poor one.

    Winds blow mostly west to east.

    BTW, externalities are built into prices. As noted above, you pay less rent when you sit down wind of a perfume factory.

  8. Gravatar of Kailer Kailer
    27. January 2012 at 07:45

    “Take the US banking system of 1864-1913, end branching regulation, add NGDP targeting, and we’d be fine. No need for Dodd-Frank.”

    And while we’re at it, legalize all drugs, create a market for kidney sales, establish mandatory Health/retirement savings accounts and emergency medical insurance, replace income and payroll taxes with a progressive consumption tax, and clean up Illinois politics. And fore Pete’s sake, could someone please do something about all these gosh-darn potholes? My poor Buick.

  9. Gravatar of Morgan Warstler Morgan Warstler
    27. January 2012 at 07:49

    1. Force FDIC banks to keep loans they write on their books.
    2. Allow one man work from home banks who can only invest within a given region (local mutual virtual) to get FDIC coverage. Expose his book in real time. Depositors get paid yearly dividends on performance.

    There won’t be any mortgages to slice and dice into CDOs. The rich will have to spread their money around in $250K deposits. Local investments will be higher. The losers will be drummed out (exposed books quickly kill of bad bet makers). The conservative long term low salary bankers will grow strong.

  10. Gravatar of SG SG
    27. January 2012 at 07:54

    Scott,

    I think I’m with acararro on this one. My understanding is that plenty of financial executives had their fortunes on the line and lost plenty as a result of the financial crisis.

    The fundamental problem of banking is that illiquid assets + liquid liabilities lead to runs on the bank, which lead to bank failures and financial panics. Even a well-managed, solvent bank can fail if enough people want to withdraw their money at the same time (see, e.g., Mary Poppins, It’s A Wonderful Life). That’s essentially what happened with big investments banks, except with repo debt instead of cash deposits, right? Even Goldman, which was solvent, could have failed without some sort of way to ease the concerns of short-term debtholders.

    How would putting executives (more) on the hook mitigate the possibility of a bank run?

  11. Gravatar of acarraro acarraro
    27. January 2012 at 07:55

    You need to ban instrument with a similar economic payout. There are so many ways to get the short exposure.

    My favorite regulation was when they had to ban short index positions in France because people were manifacturing the short by selling the index and buying all components back apart from the bank they wanted to short.

    Plus you need to outlaw CDS, options… Where do you stop? As I said, you can always go for a competitor. Do you believe bank executives don’t know each other? Are you going to stop people entering into transaction between each other? So I sell my friend stock and he sells mine and we sign a contract of some kind between each other… It would be impossible to check…

    Plus it is impossible to understand an entity as complex as a bank. Most bank officers wouldn’t have a clue. A moderm bank is many times more complicated than those old ones.

    Limited liability is a basic principle in law. Prove someone was grossly negligent or fraudlent and you have unlimited liability. Genius and stupidity are sometimes close…

  12. Gravatar of K K
    27. January 2012 at 08:28

    Introducing “double liability” is *exactly* equivalent to doubling banks’ capital requirement. Imagine that a bank is 10% equity financed but shareholders are also required to post a bond equal to the equity value. If the bank goes broke they lose their equity *and* the bond. Same as if the bank was 20% equity financed (or 10% equity and 10% sub-debt – whatever). This is just a (somewhat anachronistic and weird) proposal to deleverage banks.

  13. Gravatar of johnleemk johnleemk
    27. January 2012 at 08:54

    Scott,

    I’m pretty sure it’s illegal for employees of any public company (not just banks) to short their firm’s stock.

  14. Gravatar of acarraro acarraro
    27. January 2012 at 08:59

    One last point, the reason why banks are more complicated is that it’s actually more efficient. Small banks in the past were very dependent on the local economy, because their loans were local. A modern big bank spreads risks around. And it usually works (as it should). But sometimes it stops working… How do you decide what the optimal size is? If you think about real shocks, they are local in nature very often (like bad weather ruining harvest)… Plus you have the usual economy of scale thing…

    I think assuming there is a simple solution is a bit naive…

  15. Gravatar of Wonks Anonymous Wonks Anonymous
    27. January 2012 at 09:30

    “Take the US banking system of 1864-1913, end branching regulation, add NGDP targeting”
    There was no central bank to do the targeting.

  16. Gravatar of Jim Ancona Jim Ancona
    27. January 2012 at 09:33

    acarraro,

    Keep in mind that Scott said:

    Take the US banking system of 1864-1913, end branching regulation, add NGDP targeting, and we’d be fine.

    The reason banks in the past were very dependent on the local economy was that branching regulations prevented them from expanding or diversifying. Those restrictions were due to rent-seeking by local bankers trying to avoid competition. That’s why ending branching regulation is a good idea.

  17. Gravatar of StatsGuy StatsGuy
    27. January 2012 at 09:45

    @K

    It’s not exactly the same. It’s different depending on liquidity implications and accounting, and in the mechanism whereby you extract double liability (the implication of corporate veil on shareholders). Some examples:

    If capital ratio drops from 10% to 5%, the bank is essentially replacing 5% of its assets in secured collateral with a promise from shareholders… That promise may or may not be held in liquid collateral. Likewise, if the shareholders are themselves corporate entities with limited liabilities (holding companies, or trusts, or shell companies), it may prove nearly impossible to extract the funds.

    Shareholders posting bonds is a closer parallel, as you say, but this is very clearly different from officers posting bonds in so far as it changes the incentives for the officers (in essence, they are forced to buy and hold stock).

    But your general point is intact – that just raising the capital ratio is generally a better method than imposing hard-to-implement ownership structure regulations. The downside of simple capital ratio raises is the opacity of bank balance sheets, however – right up until its fall, Lehman was allegedly very well capitalized.

    (I would also argue it’s different psychologically, in terms of loss aversion/prospect theory.)

    The easier way to implement this today would be capital ratio increases and shifting to deferred stock-linked compensation (over a 5 year time frame, for example). These are, in fact, the types of things that are happening – the net impact, of course, is shifting the entire economy away from a credit (toward a cash) based system.

    A BETTER question to ask is: under what conditions does this maneuver RAISE the cost of capital? I would argue it _does_ raise the cost of capital, but this is contingent on certain assumptions about transmission mechanisms.

  18. Gravatar of Benjamin Cole Benjamin Cole
    27. January 2012 at 09:50

    Fascinating post.

    I often say, “If you give someone a chance to heavily leverage and make a killing, that’s that they will do–if the downside risk is only they lose their equity investment.”

    So kids behind computer screens get $1 billion and leverage100-to-1. As we saw in Long-Term Capital Management (which failed), the kids are not sent to debtor’s prison, their wives do not become sex slaves.

    Ergo, if you can leverage and bet the moon, you will. Bet right and you are set for life. Bet wrong–and go to next gig.

    Applies to banks too.

  19. Gravatar of K K
    27. January 2012 at 10:29

    StatsGuy:

    “It’s not exactly the same…”

    “I would also argue it’s different psychologically”

    I’m indifferent to holding a treasury bond and selling Bank CDS vs just holding a bank bond. But because of my own credit risk, the protection buyer is not indifferent, unless I post the treasury bond as collateral. That was the reason I suggested that shareholders would have to be required to post a bond. You can’t expect to come after grandma Millie when the bank fails. I thought it was obvious that that’s ridiculous and that that clearly couldn’t be what Scott was proposing. Which is why my proposal is equivalent.

    The real problem is how to shift principle agency back onto the risk owner. The bank bond is held on behalf of the retiree by a pension fund manager who depends on a rating agency (paid by the bank) to rate the risk. The agency is protected from liability by the second amendment and the fund manager by the fact that the rating agency said so. Fiduciary responsibility is a very  elaborate, and ultimately meaningless scam. If you want a real solution, the answer is to eliminate bank regulation *and* deposit insurance. It wouldn’t be very hard.

    “The downside of simple capital ratio raises is the opacity of bank balance sheets”

    Well that doesn’t change no matter what capital ratio you require. Banks maximize the riskiness of their assets subject to capital rules. But risk-weighted asset calculations being equal, if you double the capital requirement you get twice the default buffer.

    “under what conditions does this maneuver RAISE the cost of capital?”

    Modigliani-Miller says not at all. That’s my first order answer. My second order answer is that leverage is largely driven by unequal treatment of debt vs equity from a tax perspective (and government guarantees), which leads firms (including banks) to lever up until the expected investor dead weight losses from default balance the tax arbitrage advantage. This drives the economy to a very high level of bankruptcy dead weight loss (cost of debt capital). So my second order answer is that decreasing leverage improves efficiency and reduces capital costs.

  20. Gravatar of StatsGuy StatsGuy
    27. January 2012 at 10:42

    @K

    I think it’s more than just tax treatment – banks serve as a capital aggregation function. This could be replaced by something like investment trusts (imagine private equity firms in which shares can be purchased by small investors), but the on-demand nature of credit that matches opportunity with capital may not work as smoothly. In essence, my argument would be that (as a second order effect due to a less efficient mechanism for matching cash savings to investment opportunities) velocity decreases. If this decrease in velocity is not matched by an increase in base money (however this gets injected, I don’t know, because there _are_ distributional implications) we will see a fall in overall money supply and threat of disinflation.

  21. Gravatar of K K
    27. January 2012 at 12:15

    StatsGuy: “I think it’s more than just tax treatment”

    I agree. In the case of banks, the public guarantees are key.

    “a less efficient mechanism for matching cash savings to investment opportunities”

    You need to be very careful with the word “efficient.” What you are saying sounds more like “expedient.” Free exchange is the principal condition of the second welfare theorem. That means investors are the agents of their own capital. But when banks invest they supply their own capital as government guaranteed “savings.” These savings are not invested in the bank according to any reasonable criteria of principal agency. I.e. the public takes the risk but a very complex set of capital adequacy rules is substituted for the risk taking decision. There is no  market mechanism or other reasonable measure to assure that the risk is appropriately priced, and the bank is left to arbitrage the capital rules as it sees fit. The fact is that it’s impossible to substitute rules for personal responsibility. And worse, it’s really dumb to attempt to do so when we could easily implement systems that don’t require it.

  22. Gravatar of BW BW
    27. January 2012 at 14:44

    1. It’s not illegal for employees to take short positions in their company’s stock. They do it frequently. One example: In the late 1990s, a lot of banks and law firms made big $$ writing collars for executives who wanted to lock in bubbly-high prices. A collar is typically neutral at inception but as soon as the underlying asset price moves (i.e. immediately) it becomes long or short.

    2. Double liability is not exactly the same as higher capital requirements if shareholders are under-capitalized (as surely they would be under such rules). Hedge funds wouldn’t hold BoA stock; they would hold the BoA stock off-balance sheet in an SIV. To get to the investor, you’d have to pierce two veils. Completely unworkable.

    3. Shareholders simply do not have the needed level of monitoring ability. A lemons problem would almost certainly arise because balance sheet transparency is not readily observable (by definition).

    4. It’s hard to take conclusions from the 19th century too seriously given that the 2008 crisis was largely caused by factors that didn’t exist back then. There were, actually, contracts that functioned similarly to CDS, but the overall volume of securities issuance and trading were tiny.

    More importantly, there was no such thing as overnight repo financing, nor were the banks nearly as systemically interconnected as they are today.

    And cultural factors cannot simply be ignored, especially here when risk appetite plays a critical role in the problem and the solution.

    5. I suspect that the immediate effect of double liability for U.S. chartered banks would to to push the financial sector offshore, where it could wreak exactly as much mischief (see AIGFP, for instance).

  23. Gravatar of RueTheDay RueTheDay
    27. January 2012 at 15:06

    I do think we need to focus more on getting the incentives right in the financial sector, and that Dodd-Frankly focused on a lot of the wrong issues.

    That having been said, this statement:

    “Take the US banking system of 1864-1913, end branching regulation, add NGDP targeting, and we’d be fine.”

    is extremely naive.

    Any system with significant maturity mismatch (long term assets financed with short term liabilities) will be vulnerable to periodic runs. Likewise, any system with liabilities that commit the borrower to fixed nominal payments in order to finance assets 1) whose prices are set by the market and 2) that deliver uncertain cash flows which may be inadequate to service the debt with which they were financed is prone to periodic bouts of insolvency. In other words, Minsky was onto the core problem.

  24. Gravatar of StatsGuy StatsGuy
    27. January 2012 at 15:29

    @K

    I mean efficient in the sense of transaction costs, not agency distortions. As a simple example, a bank has significant advantages due to specialization of labor and economies of scale in pooling small shareholder (depositor) funds and making large investments. Imagine if I were to try to borrow 400k for a house. From an agency perspective, what advantage is there for investors to lend to me through a bank? However, getting 100 investors to each lend 4k (read documents, read contracts, learn how to properly evaluate a credit report, gather signatures, arrange for fund transfer) is incredibly inefficient in terms of transaction costs.

    Expedient just doesn’t mean the same thing – is there a reason efficiency needs to be reserved for pricing only?

  25. Gravatar of ssumner ssumner
    27. January 2012 at 20:10

    Statsguy, No I don’t seriously expect Congress to pass this, what made you think I do?

    I favor abolishing FDIC and the GSEs and TBTF. I also don’t expect Congress to do those things. Indeed they are even less likely, as the White proposal would piss off bankers, whereas my preferred policy was piss off bankers and depositors. So the White proposal is more likely to pass–a million to one against, vs, a billion to one against.

    Anything that does pass will of course be ineffective.

    Kailer, Those are all great ideas–especially fixing potholes.

    Morgan, Most of the problem was loans kept on bank books–that’s why so many banks failed. If they’d sold them off. they wouldn’t have gone bankrupt.

    SG, I don’t agree that liquidity problems caused the failures, it was loan defaults.

    acarraro, I still don’t agree. All the issues you mention occur with or without this proposal. But White’s proposal makes the problem smaller. Stock investors can already sell their stock short. But if you increase the liability, they will still have more on the line. Not all investors will sell short their entire stock portfolio.

    Plus it’s costly to sell short. If a bank is taking huge risks, it will be especially costly

    K. I defer to your expertise.

    Johnleemk, That’s what I thought.

    Wonks, But we have one now.

    Statsguy, Yes, my intuition tells me it can’t be quite the same. As you say, capital requirements are difficult to monitor.

    Thanks Ben.

    BW, I think it’s government backstops that have moved us away from the 19th century model. If people knew their own money was on the line, they’d be more careful. Require all bank investors to post an equivalent bond with the FDIC, or some such plan. I’m no expert, but they could make this work if they wanted to. Of course they don’t want to, so it won’t happen. That helps cover the FDIC’s losses.

    Ruetheday, Actually unstable NGDP is the core problem, turning occasional bank failures into systemic problems.

  26. Gravatar of Major_Freedom Major_Freedom
    27. January 2012 at 20:38

    ssumner:

    “Major Freeman, Gold isn’t coming back, for good reasons.”

    All hail Nostradamus!

    The “reasons” you speak of aren’t good reasons, but yes, there are reasons why some people don’t want it. In the case of the gold standard, governments and bankers are too limited when money is gold.

    It is possible, indeed likely, that in the future, enough people will come to learn that fiat money is against their interests. Fiat money has a limited shelf life. It’s been tried many times, and each time it was tried, it collapsed, not because it was abandoned, but because it doesn’t work and is internally destructive.

    If you think the economy has been “saved” by the Fed, you’re going to be in for a rude awakening. Once the world sovereign debt bubble collapses, there will be a monetary revolution. The choice after that will be either a world fiat money and world government to protect it, in which case there will just be yet another fiat collapse, and I hope I’m not alive when that happens, or there will be a return to a free market / precious metals standard.

    I personally don’t even advocate for a gold standard anyway, I advocate for a free market money standard. Every violence backed system is doomed to fail. Humans want to be free.

    “The principle that the majority have a right to rule the minority, practically resolves all government into a mere contest between two bodies of men, as to which of them shall be masters, and which of them slaves; a contest, that – however bloody – can, in the nature of things, never be finally closed, so long as man refuses to be a slave.” – Lysander Spooner.

  27. Gravatar of Morgan Warstler Morgan Warstler
    27. January 2012 at 21:41

    “Morgan, Most of the problem was loans kept on bank books–that’s why so many banks failed. If they’d sold them off. they wouldn’t have gone bankrupt.”

    Scott, that’s one of your weaknesses.

    MY PLAN negates what was in 2008.

    You can’t used what happened to argue against me – unless you are being shallow and skimming the logic.

    MY PLAN recognizes that thousands of small banks made and sold off loans in days. The argument for this is lower cost of credit.

    The reason this happened is bundling, tranches, cdos, etc.

    MY PLAN say this becomes IMPOSSIBLE. Its advantage is that it raises the cost of borrowing, reduces access to credit, and increases savings rates.

    Overnight, mortgage companies are done. Gone.

    Your silly argument is based on this:

    1. Big banks failed because they did the bundling.

    2. Smaller banks failed because they got caught up in commercial.

    But in none of my reading do I see large swaths of the small banks getting the Friday night seize – sitting on a bunch of bad mortgages…. and that’s your argument.

    So either prove your argument, or really look at the brutally simple regs I’ll put in place to chase the nation’s talent out of banking.

    A year or two ago, you made a really dumb argument about the smartest people assigning capital – this is what that’s about.

    Assigning capital is easy. Money is easy to find. The right idea and execution is what really matters.

  28. Gravatar of Mark A. Sadowski Mark A. Sadowski
    27. January 2012 at 22:16

    My Plan is that nobody listens to Morgan.

  29. Gravatar of dtoh dtoh
    27. January 2012 at 23:11

    This is a painfully simple problem.

    1) TBTF will never go away, i.e. the gov’t will always provide an implicit guarantee to banks.

    2) With an implicit guarantee, bankers will always behave “badly,” i.e. take excessive risk since they get to keep the gains while the losses are socialized.

    3) Given TBTF, there is no choice but for the government to regulate the banks.

    4) The easiest and simplest way to do this is to allow the Fed to flexibly set minimum and maximum asset/equity ratios (capital ratios) by asset class, maturity, etc.

    5) This has the added benefit of giving the Fed complete control over credit and the broader money aggregates….no more liquidity traps, no need for open market operations, QE2, twists, EOR, what not.

    There is not a single monetary or finance problem that this solution does not fix.

  30. Gravatar of Major_Doofus Major_Doofus
    27. January 2012 at 23:32

    S. Sumner:

    You’re getting confused because you don’t know how to integrate time into your economics. You view time, and thus interest, as more hindrances, or worse, intolerable phenomena that must be transcended through government force. The government must force things so that “not too much time passes” for a given dynamic market to not accommodate 100% labor. The government must force things so that “interest rates are minimized”.

    You see, the reason why you can’t understand economics is because you don’t have a rationalist philosophy that underpins the whole thing. You don’t understand time, so you view it with fear, and thus disdain, and thus you consider it violent, and so you call for violence against it, which means violence against innocent people who exist in time.

  31. Gravatar of Mark A. Sadowski Mark A. Sadowski
    28. January 2012 at 00:40

    Actually my new plan is that nobody listens to Major Anybody.

    Anybody got a problem with that?

  32. Gravatar of Mark A. Sadowski Mark A. Sadowski
    28. January 2012 at 01:17

    OK. My father was Second Lieutenant Sadowski.

    If you questioned his command he used to tell you to get down and give him ten more.

    The bottom line is suck his &!($.

    P.S. Those were the days.

  33. Gravatar of Mark A. Sadowski Mark A. Sadowski
    28. January 2012 at 01:44

    OK,very uncharacteristic of me. Allow me to post a German Christmas song. (Hey, it’s the holidays.)

    http://www.youtube.com/watch?v=OREM7kXDycc&feature=player_embedded

  34. Gravatar of mnop mnop
    28. January 2012 at 01:47

    Yves Smith made a similar point in Econned, the best book on the financial crisis:

    “These pressures drove firms to become larger, not just in terms of their operations, but also their balance sheets. That meant they needed more and more capital. And that drove the change that led to the biggest and most detrimental change to the industry, as far as society is concerned, namely the abandonment of the partnership form of organization.” – Ch.6, How Deregulation Led to Predation

    “The very worst feature of looting version 2.0 is that it has created doomsday machines. In the old construct, the CEO fraudsters would drain a business, let if fail, and move on. … But here, the firms, due to their perceived systemic importance, are not being permitted to fail. So there are no post-mortems, in particular criminal investigations to determine to what extent fraud – as opposed to mere greed and rampant stupidity – led to what would otherwise have been their end.” – Ch. 7, Looting 2.0

  35. Gravatar of Mark A. Sadowski Mark A. Sadowski
    28. January 2012 at 01:58

    Hey, you know what?

    pocałuj mnie w dupę

    So much for the holidays.

  36. Gravatar of Mark A. Sadowski Mark A. Sadowski
    28. January 2012 at 02:09

    Scott,
    Express your ideas in Polish,

    Nominalna Produkt krajowy brutto kierowania

    It goes over better.
    Thanks,
    Mark

  37. Gravatar of Morgan Warstler Morgan Warstler
    28. January 2012 at 04:11

    “TBTF will never go away, i.e. the gov’t will always provide an implicit guarantee to banks.”

    The point then is regulation done in a way that actually limits what banks can do – I prefer mine because it spins up a new modern Internet based bank under FDIC while also making banking boring…. but Glass-Steagall gets close too.

    1. The will be no political support for saving non-banks.

    2. The rule of regulation is ALWAYS to do it with the smallest public employee footprint possible.

  38. Gravatar of RueTheDay RueTheDay
    28. January 2012 at 05:36

    @ssumner:

    “Ruetheday, Actually unstable NGDP is the core problem, turning occasional bank failures into systemic problems.”

    At some level, yes, but I still think you’re focusing on treating the effect rather than the cause (though I recognize there’s some feedback going on here where effect can amplify cause).

    Take the example of the dotcom bubble. Do you think NGDP targeting could have sustained the pets.com business model forever? Now consider the fact that the bursting of the dotcom bubble was relatively mild in its macroeconomic impact, primarily because it was equity financed. Do you not think that the aftermath would have been far worse had all of the startups been financed with debt (e.g., bank loans and securitized bonds) rather than equity (mostly venture capital)? If it is the case that it would have been much worse, then it’s hard to claim that leverage is not the core issue.

  39. Gravatar of K K
    28. January 2012 at 07:10

    StatsGuy: I don’t get your point then. Investors already buy bank stocks and bonds without knowing the details of all the banks dealings. Just like people people buy Apple stock without having any idea of how to make an iPhone. All perfectly efficient. It would solve most of our problems if banks balance sheets were entirely financed exactly the same way: via issuance of securities to informed investors. There is nothing to be lost and everything to be gained compared to government guaranteed deposits which incentivize the bank to maximize the risk. That will never produce allocative efficiency.

  40. Gravatar of ssumner ssumner
    28. January 2012 at 08:55

    Major Freedom, You said;

    “If you think the economy has been “saved” by the Fed, you’re going to be in for a rude awakening.”

    Actually, this entire blog is devoted to the proposition that the economy has been wrecked by the Fed.

    Morgan, Then why did the smaller banks fail?

    dtoh, Yes, have capital requirements, but also require stockholders to post a a bond with the FDIC, so taxpayers don’t lose as much money when banks fail.

    Capital requirements can be evaded–that’s why the double liability is a nice back-up.

    mnop, Yes, and these changes took advantage of flaws in our system of bank regulation, which encouraged excessive risk taking.

    RueTheDay;

    “Take the example of the dotcom bubble. Do you think NGDP targeting could have sustained the pets.com business model forever? Now consider the fact that the bursting of the dotcom bubble was relatively mild in its macroeconomic impact, primarily because it was equity financed.”

    I think the main difference is that NGDP growth was much more stable after 2000, then after 2007. I don’t see debt as a big problem, except for taxpayers who must do bailouts.
    Eve so, I favor regulations to encourage saving and discourage debt, such as ending taxes on equity, while debt goes tax free.

  41. Gravatar of Gordon Gordon
    28. January 2012 at 08:56

    Banks were not the only corporations without a limited liability regime in the 19th century. Some had double or even triple liability. And corporations chartered or doing business in California had proportional liability for shareholders until the state constitution was modified in the early 1930s. Proportional liability is unstable given the existence of limited liability regimes in other jurisdictions, but that doesn’t prove anything about the benefits of limited over proportional liability. Defecting in a Prisoner’s Dilemma is not Pareto optimal either.

  42. Gravatar of Major_Freedom Major_Freedom
    28. January 2012 at 09:18

    ssumner:

    “If you think the economy has been “saved” by the Fed, you’re going to be in for a rude awakening.”

    “Actually, this entire blog is devoted to the proposition that the economy has been wrecked by the Fed.”

    Granted, however I don’t think we agree on why the Fed wrecked the economy (I say inflation, you say lack of inflation), nor on what the future is going to bring if you get what you want when it comes to what the Fed does.

  43. Gravatar of StatsGuy StatsGuy
    28. January 2012 at 09:52

    @K (and ssumner)

    I don’t claim to be inventing a new idea out of whole cloth (in this case, at least):

    http://www.imf.org/external/pubs/ft/wp/2011/wp11103.pdf

    Several issues at play – all relate to the financial sector as a transmission mechanism. Note there are short term (transition) effects, and long term (permanent output loss) effects. Long term effects are modeled to be quite small (I would tend to agree, particularly when one takes into account the decreased risk of financial ‘events’) however they are still there. Short term, during the process of banks building up capital reserves through retained earnings and other mechanisms (share offerings, reduction in loan portfolio, spinoffs of assets, collateral demands, etc.), the effect could be much larger.

    Modigliani Miller is only an approximation of reality. In general, I’ve favored higher capital requirements, with the proviso that CBs need to compensate in the transition. I’ve been making this argument since early 2009 at Baseline Scenario and here. I think our CBs, however, tend to like highly leveraged endogenous-money (credit) based systems, because it implies that they can exert greater control over the economy with less _real_ action (e.g. merely by making statements to change expectations). Thus, power without the appearance of exerting crude power (Krugman called this the tail that wags the dog). But below the zero bound this makes them ever so uncomfortable, because balance sheet action is visible, so they want everyone to think they have the power, but are terrified of actually using it because of the attention and political pressure it brings to the Fed as an institution. Hence the 6 month delayed response to the 2008 crisis.

    The justification for the retracement of their position favoring a highly levered system is, oops, we forgot about moral hazard and agency problems!! Moral hazard is only one of the second order effects, however – but it’s the one that economists like because it blame government subsidized risk for creating the problem.

    I think the most _interesting_ aspect of Scott’s post is not that banks worked fine prior to 1913 WITHOUT all that banking regulation (an argument that certain libertarians have made ad nauseum), but rather that we had JUST AS MUCH regulation before 1913, merely it was implemented differently.

    So, nice post…

  44. Gravatar of StatsGuy StatsGuy
    28. January 2012 at 09:56

    Oh, to follow on a bit – do note that the period of 1863-1913 (heavily regulated banking prior to the current structure) was a direct response to a TRULY less regulated system, the Wildcat Era.

    http://en.wikipedia.org/wiki/Wildcat_banking

    So I suppose that libertarians ought to be making their anti-regulation arguments by arguing that Wildcat era was dramatically superior to the post-1865 era, though there are so many uncontrolled factors between these periods that it’s a pointless argument either way.

  45. Gravatar of Gordon Gordon
    28. January 2012 at 10:28

    StatsGuy writes, “So I suppose that libertarians ought to be making their anti-regulation arguments by arguing that Wildcat era was dramatically superior to the post-1865 era”. According to the White paper, state banks with double liability were less subject to failure than state banks with single liability. What is the libertarian argument for a single or limited liability regime? I don’t expect you to have an answer for that; I’m just questioning your supposition about about what libertarians “ought” to argue.

  46. Gravatar of dtoh dtoh
    28. January 2012 at 13:40

    Scott
    “Yes, have capital requirements, but also require stockholders to post a a bond with the FDIC, so taxpayers don’t lose as much money when banks fail.”

    Problem is not the shareholders, it’s the managers. They should post the bond or else require that most of their comp be equity which vests over a 5 year period after they leave the bank.

  47. Gravatar of StatsGuy StatsGuy
    28. January 2012 at 20:27

    @ Gordon

    What is the libertarian argument for using state power to impose double liability? Or, for that matter, ANY liability? Shouldn’t the market take care of that issue for us? Consumers, seeking security, would naturally invest in banks with more transparent balance sheets, friendlier depositor policies, and stronger capitalization – so why is it necessary to legislate a strong capital position? Or, indeed, ANY capital position?

    It would seem that the wildcat era is closer to the pure libertarian position than the post-1863 era. Wouldn’t you agree? (Surely there was less government subsidization of risk then?)

    So, where are all the libertarians demanding that we return to the pre-1863 era of banking?

  48. Gravatar of Gordon Gordon
    28. January 2012 at 22:03

    @StatsGuy

    What is the libertarian argument for using state power to impose single (limited) liability? If the “pure” libertarian position is for no state-chartered corporations, then we have not double, but unlimited, liability. Or is it your view that the “pure” libertarian must advocate no legal structure at all? Even anarcho-capitalists envision market transactions within a legal system.

  49. Gravatar of StatsGuy StatsGuy
    29. January 2012 at 07:44

    @Gordon

    “If the “pure” libertarian position is for no state-chartered corporations, then we have not double, but unlimited, liability.”

    The premise here is incorrect. In the absence of state-chartered corporations, the recovery for any bank would be dictated by whatever private contract governed the bank structure. Every bank could conceivably have a different private contract, and different liability limitations.

    Prior to 1863, one would imagine that if the “efficient” market demanded deeper liability on bank owners, it would have produced such a structure as new banks were created to respond to such a demand.

    I’m not sure why my statements are controversial – many libertarians do actually want a return to pre-1863 rules, or “free banking”.

    As you might guess, I’m skeptical…

    http://www.frbatlanta.org/filelegacydocs/acfce.pdf

  50. Gravatar of Gordon Gordon
    29. January 2012 at 11:31

    @StatsGuy writes, “In the absence of state-chartered corporations, the recovery for any bank would be dictated by whatever private contract governed the bank structure.”

    Sorry, yes, for voluntary creditors, though not for involuntary, e.g., tort, creditors. I didn’t mean to suggest that your statements were controversial. I was simply trying to understand what you meant by a “pure” libertarian position, and I was thinking in terms of corporations generally, not banks in particular. My bad, as the kids say. But when you ask “So, where are all the libertarians demanding that we return to the pre-1863 era of banking?”, you seem to answer your own question, both in general (“many libertarians do actually want a return to pre-1863 rules”) and in particular with your citation (though the author of that piece might not be a libertarian and his support seems highly nuanced). Thanks for pointing that paper out, btw.

  51. Gravatar of ssumner ssumner
    29. January 2012 at 12:34

    Gordon, Good point.

    Major Freedom. No, I say lack of NGDP, not lack of inflation.

    Statsguy, Good observations.

    dtoh, That’s similar to White’s proposal, maybe better (I’m no expert.)

  52. Gravatar of acarraro acarraro
    30. January 2012 at 06:10

    There are really 2 different proposal in this and I think they should be treated separately.

    The double liability is an unworkable idea. Let me make one more objection: would it be based on the market value or the notional value of the share. It cannot be market value (since the market value will go to zero), so has to be notional value. Have you looked at the notional value of stocks recently? Usually they are a tiny percent of the market value (because of inflation, profits, etc…). Do you propose to re-index the liability? How? The entire thing is very complicated.

    Forcing bankers to take a stake in the company is a much better proposal and I fully support it. But it would be a small push in the right direction. It wouldn’t and couldn’t replace proper regulation.

    Also there is no cost in hedging. The banking sector might have a high risk premium (so the short might have negative expected value), but hedging only caps your profits. Obviously there are transaction costs, but if you are a banker and don’t know how to minize them, you deserve to pay.

    Most people are long the banking sector (mostly through your pension fund), so you just need to reduce the over-exposure rather than cancel it. The diversification benefit will trump any other concern anyway.

  53. Gravatar of Matt Waters Matt Waters
    30. January 2012 at 23:15

    I would echo StatsGuy’s observations that the private debt and deposit market could have theoretically required contracts of equity holders with unlimited personal liability. Even today, there is nothing stopping a bank from being a general partnership, which would theoretically get much cheaper debt than a limited liability corporation.

    The fact that even publicly held broker-dealers like Lehman Brothers had access to cheap funding shows that there’s deeper issues with banking and debt markets in general than corporate structure. The information asymmetry, even among bank executives relative to mid-level traders, made it very difficult to analyze balance sheets. Investors in Lehman debt should have walked away because of the information asymmetry, but because all of the previous 30 years’ experience pointed to Lehman not going down in the short-term, they didn’t walk away.

    It’s hard to say, with banking crises, whether the chicken or the egg came first. In other words, whether a crash in NGDP or a banking crisis came first. But I think all the bank writedowns BEFORE Lehman Brothers in 2008 shows that there were severe capital misallocations, and that not all the misallocations were due to government distortions.

  54. Gravatar of ssumner ssumner
    31. January 2012 at 13:57

    acarraro, I agree about “proper regulation” but one reason I like this idea is that I have no confience in our ability to produce proper regulation. The regulators were encouraging subprime loans. What makes us think “next time will be different?”

    I think the stock plan is workable. We’d have to change the current system, but that could be done. It’s no more unworkable than a Tobin tax.

    Matt, I agree that it’s hard to separate out the various effects.

  55. Gravatar of Head Head
    31. January 2012 at 15:16

    Hello, late response sorry, but i was wondering if you had the PDF saved anywhere? The link you posted above to the paper is dead and i’d love to read the original.
    Regards,
    Head.

  56. Gravatar of ssumner ssumner
    1. February 2012 at 17:14

    Head, The link still works for me. “Rethinking the Regulation of Banking” is the title–try google.

  57. Gravatar of Should we break up the large banks? — Marginal Revolution Should we break up the large banks? — Marginal Revolution
    12. February 2012 at 09:30

    [...] rest of the piece considers non-limited liability as an alternative for banking reform, and I thank Scott Sumner for drawing my attention to a recent piece by Eugene White (pdf) on this topic.   Stephen [...]

  58. Gravatar of Alex Godofsky Alex Godofsky
    12. February 2012 at 14:46

    Why do we want banks to take less risk?

    For me or you, it’s generally in our own best interests to take fewer risks individually. But why would society be better off? Assuming, for the moment, that the banks’ investments are legitimately ex ante expected value positive, what does society gain by restricting banks to only the less risky investments?

    It seems to me that “the banks take too many risks!” is just code for “I wish they hadn’t been wrong about future housing demand”. Fine, but less risk-taking doesn’t really solve that, you have to make them actually better at predicting the future.

  59. Gravatar of ssumner ssumner
    13. February 2012 at 12:00

    Alex, Becasue of external costs–taxpayer bailouts. If you end FDIC and TBTF, I’m 100% on board for unregulated banking.

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