Archive for the Category financial regulation


The only real solution to Too Big To Fail

In a recent post I suggested that higher capital requirements might be called for if policymakers were unwilling to bite the bullet and remove moral hazard from our financial system.

The FT has a new article discussing a Treasury proposal to end Too Big To Fail, by setting up a new type of bankruptcy for big banks.  I wish them well, but remain skeptical.  In my view, the only way we’ll ever be able to remove moral hazard is with monetary policy reform.  If we can get to a policy of NGDPLT, then policymakers will no longer have to worry about the consequences of the failure of a big bank.  Unfortunately, that’s likely to take many decades, as we first need to implement the policy, and then see how it does during a period of financial distress.  Only then would policymakers begin to feel comfortable rolling back TBTF.  (And even then, special interest groups will try to keep it in place.)

PS.  The NYT has a new post showing that historians view Trump as being the worst President in American history.  That’s also my view.  Some people judge presidential performance by how the country is doing.  That’s about like judging my blogging based on how monetary policy is doing.  A couple posts I’d recommend are Yuval Levin explaining why Trump is not actually the President, in the conventional sense of the term.  He’s not qualified to be President, so day-to-day decisions are made by others.  Thus the GOP “deep state” wisely vetoed his recent attempt at crony capitalism, which would have re-regulated the coal and nuclear industry as a backdoor way of bailing them out.  The outcome was good, but Trump’s specific input into the process was destructive.  Matt Yglesias also has a good post, explaining why Trump is much more corrupt that even lots of left-of-center reporters assume.

PPS.  I have a new post on budget and trade deficits, over at Econlog.

A very depressing interview

David Beckworth has an excellent interview with The President and VP of the Minneapolis Fed.  I did a post on the portion of the podcast that interviewed Neel Kashkari, over at Econlog.  Here I’ll address the part where David interviewed VP Ron Feldman, mostly on banking regulation.  I’ve always thought that eliminating moral hazard is the only way out of this mess.  Feldman says that’s politically impossible:

I think you just need to look at what happened with Fannie Mae and Freddie Mac. This was in a prior regime. People used to talk about what’s called subordinated debt, but it’s the same idea, that they would be forced to issue debt that would be very junior, so it would get converted, and there would be no problem.

Now, flash forward. You’re in a crisis, and what people are worried about is, am I going to lose my money? You’re in the middle of a crisis, and you’re telling me that the solution to making people feel comfortable, not freaking everybody out, is that you’re going to impose more losses on more people. It just seems implausible.

The only active creditor in the US where we have a record that we do impose losses on them is equity holders. We do treat equity holders differently from fixed income holders, depositors, or bond holders. I think CoCos and bail-in debt, it’s very elegant. If it worked, I think that would be great. But we have a record of it here.

I should just add, in Italy and other places, they’re using the same idea. Last year, they were confronted with this issue: what are they going to do about the bail-in debt of the Italian banks that are in trouble? They said, “We want a special exception. We’re going to need to protect those folks.”

I think that’s the history. We talked about, is the five-year delay credible? The thing that’s not credible is that in a crisis, a government is going to want to impose more losses on debt holders.

Just to be clear, I don’t think it would be a problem doing this in a technical sense.  Crisis or no crisis, there’s no reason why bonds can’t be converted to equity when a bank gets into trouble.  But I suspect he is right about the politics, at least in highly corrupt countries like Italy and the US.  (Perhaps it would work in the Nordic countries, or Canada.)

I find this to be profoundly depressing, and pushes me toward reluctantly supporting tighter bank regulation, especially higher capital requirements.  The Minneapolis Fed has developed a plan that calls for a 23.5% capital requirement for large banks:

We would require banks to fund themselves with equity that would be equal to 23.5 percent of their risk-weighted assets. Risk-weighted assets means there’s a bigger weight that’s put on something, an asset that’s risky, and a lower weight that’s put on something that’s safe, like a Treasury bill.

I actually think the main problem is reckless smaller banks.  That’s where our tax dollars go.  I’m much less worried about the bigger banks, where moral hazard is less of a problem.  Unfortunately, it seems like higher capital requirements are just as politically infeasible as reducing moral hazard through convertible bonds:

The capital ratio rose from 10.5% before the crisis to 12.7% after, but has since slipped back below 12%.  A 23.5% ratio sounds great, but only if applied to all banks, not just large banks.  Unfortunately there’s probably almost zero political support for doing some something like this.

As with healthcare reform, as with zoning reform, as with FAA privatization, as with a hundred other issues, there’s simply no interest in banking reform.  In either party.


The problem with deposit insurance

I’ve always thought that the 2008 financial crisis was basically tight money plus moral hazard, with the latter factor playing the biggest role.  I’m no expert on banking, but I’d guess that these three factors increased moral hazard (in order of importance):

1.  FDIC (deposit insurance)

2.  The GSEs (Fannie and Freddie)

3.  Too Big to Fail

I’ve already spent a lot of time discussing the role of tight money, but I also believe that deposit insurance is a massively underrated problem.

A new NBER working paper by Charles W. Calomiris and Matthew S. Jaremski relied on rich set of panel data for banks in states with and without deposit insurance. They found that states that created deposit insurance during the early 1900s tended to see faster than normal rates of deposit growth, and then higher than average levels of bank failures after WWI:

First, we are able to show that deposit insurance increased insured banks’ deposits and loans, and lowered their cash to asset ratios and capital to asset ratios. Second, we find that deposits flowed from relatively stable banks to risky banks. Deposit insurance increased risk by removing the market discipline in the deposit market that had been constraining erstwhile uninsured banks.  .  .  .  Deposit insurance encouraged banks to increase their insolvency risk because doing so did not prevent them from competing aggressively for the deposits of uninsured banks operating nearby. In fact, increasing risk was necessary to fund the higher interest payments that presumably attracted depositors.

The extent to which insured banks attracted deposits away from uninsured banks, and used those funds to expand their lending, depended on the risk opportunities available in their local economic environment. Variation across in counties in the extent to which they produced commodities that appreciated during the World War I agricultural price boom explains between one-third and two-thirds of the observed effects of deposit insurance on deposit growth, loan growth and increased risk taking by insured banks. The fact that a large part of the moral hazard associated with deposit insurance is dependent on the time-varying and location-specific opportunities for risk taking has important implications for empirical analysis of the consequences of deposit insurance in other contexts. The potential costs of deposit insurance may appear low in environments that are relatively lacking in risk-taking opportunities, but those costs can appear much higher when greater risk taking opportunities present themselves.  (Emphasis added)

That’s final sentence is a warning not to become complacent.  Just because deposit insurance didn’t cause many problems in the decades after WWII (when borrowers were bailed out by higher than expected inflation), doesn’t mean that it could not do so in the 1980s or 2000s.

They also show that voluntary insurance systems were less destabilizing than mandatory insurance systems, presumably because they created less moral hazard.

Their paper ends with a warning:

The history of deposit insurance in the United States and internationally has been a process of increasing systemic risk in the name of reducing systemic risk. 

Will the GOP will bring back the 2007 era bank regulatory structure?

I.e. the regulatory structure that gave us the mid-2007 to mid-2008 banking crisis (the late 2008 crisis was also on the Fed.)

That’s what I infer from this letter sent to the Fed from an important GOP Congressman.

I have been a big critic of Dodd-Frank and wouldn’t mind seeing it repealed.  But only if other simpler and more effective regulatory changes are made.  Those might include higher bank capital requirements, getting rid of Fannie and Freddie, and/or reforming FDIC.  But as far as I can tell, the GOP is opposed to all of these actions.  Indeed the letter warns that higher capital requirements will slow economic growth.

So it looks to me like the GOP favors the regulatory system that led to the 1980s banking crisis and the 2007 banking crisis.  Am I wrong?  (I hope so.)

PS.  The letter is hard to quote from, as it’s a photo that’s difficult to copy.  But the gist of Congressman Patrick McHenry’s letter is, “Give banks liberty, or give me death.”

HT Lars Christensen

Update:  You heard it here first.  Trump will replace Mike Pence with Noam Chomsky in 2020—a better fit for his views:

When Fox News’s Bill O’Reilly challenged Mr Trump in the interview, saying “Putin’s a killer,” the president replied: “There are a lot of killers. We have a lot of killers . . . What, you think our country is so innocent?”  .  .  . ” I do respect him [Putin].”

How many times have top GOP figures had to totally disavow the embarrassing statements made by Trump over the past 12 months?

Greg Ip on monetary policy

Where does all the time go?

I just noticed that I’ve fallen behind on the set of podcasts by David Beckworth, so I will work through the ones I’ve missed, starting with the Greg Ip, one of our best economic journalists.  Here’s my favorite comment by Ip:

And it actually may be better to have lots of small financial disruptions than one big financial disruption.

In Greg’s recent book he discusses this idea in more detail.  In the interview, Greg uses analogies such as the danger of continually preventing small forest fires, and thus building up fuel for a catastrophic fire.

Over the past 50 years the government has prevented financial crises about every decade or so, by either bailing out depositors of large banks, or arranging assistance in the case of LTFC (1998).  And this had the effect of storing up fuel (moral hazard) for an even bigger crisis in 2008.  But I would go much further that Ip, who approves of FDIC.  It’s not politically possible to abolish FDIC, but perhaps we could create a two-tier system where insured deposits are backed by safe assets, so that taxpayers are not put at risk.  Deposits used for lending to businesses and homebuyers would not be insured, but would offer higher interest rates to depositors.  Let bank depositors choose how much risk they are willing to take.  Ip also is appropriately critical of the regulatory overreach of Dodd-Frank. BTW, banks would hate my FDIC reform proposal, but it could be combined with the complete repeal of Dodd-Frank.

There are also a few areas where I disagreed with Ip.  At one point he wondered why there was so much discussion of the need for monetary stimulus. After all, unemployment in the US and Japan is relatively low, and the unemployment rate in the eurozone is now declining at a decent clip.  This is a good argument, but I think he’s also missing something important.  Monetary policy must be judged as a regime, not in terms of day-to-day considerations of macroeconomic stability.

For better or worse, central banks now focus most of their effort on inflation targeting, with some attention also paid to keeping unemployment close to the natural rate. Recall that the natural rate hypothesis predicts that the public will eventually adjust their expectations to match any inflation rate, and unemployment will eventually move back to the natural rate.  When viewed from this perspective, I think what Greg’s really asking is what difference does it make if the Eurozone has 1% inflation, or 1.9% inflation, as long as it is reasonably steady and as long as unemployment seems to be adjusting back to the natural rate.

I see two problems with the ECB allowing 1% inflation to be the new normal:

1.  If this were to occur, the public would lose faith in the ECB’s inflation promises. This would make ECB policy less effective in the next crisis.  If central banks are going to set inflation targets, then those targets should mean something.  If they decide not to target inflation (as I’d prefer) then it’s essential that they set some other target, such as NGDPLT.

2.  If 1.0% inflation, rather than 1.9% inflation, becomes the new normal in the ECB, then nominal interest rates will move to a permanently lower track.  And since real interest rates seem to be entering a new normal which is well below the rates we saw in the 20th century, a lower trend rate of inflation would mean that the ECB will be stuck at the zero bound for a much greater percentage of the time.  Indeed financial markets are already quite pessimistic about the future course of eurozone rates, especially for safe assets like German and Swiss long-term bonds.

Notice that points 1 and 2 relate to each other; both make it more difficult for the ECB to achieve its goals in the future.  So there is real value in taking an announced inflation target seriously, and trying to hit it.  BTW, the US is doing much better than the eurozone and Japan on the inflation front, but just today Kocherlakota warned that even the US is likely to fall short of 2% inflation going forward.  (I’m a moderate on this question—I think they’ll probably fall a bit short, but perhaps not as much as Kocherlakota and some of my fellow MMs believe.  I see something around 1.8% as the new normal.)

At one point Ip asked David the question of what should the Fed actually do to implement an NGDPLT policy regime.  I hate these “concrete steppes” questions, but we need to face the fact that this is what everyone wants to know.  The reason why I hate these questions is because I know the sort of answer people are looking for:

Desired answer:  Some big bazooka of a monetary policy instrument that is so powerful that it can clearly move NGDP to the desired policy path.

My answer:  NGDPLT is the big bazooka, and once implemented you merely need to do tiny little OMOs, like we did back before 2008.

And I know that this answer won’t satisfy anyone.  They think money has been very easy, and if we’ve fallen short then we must need very, very, very easy policy.  We MMs think money has been tight, and that a NGDPLT target could be hit with the sort of moderate policy we had before 2008.  In other words, if 5% NGDPLT were adopted in 2007, or right now, the policy would look pretty much like what you saw in Australia after 2007, or what you see in Australia today.  Positive interest rates.

But yes, you do need a big “instrument” bazooka lurking in the background, just in case.  That makes the system credible, so that you don’t actually have to use it. For David the big bazooka is the Treasury, promising to do a coordinated fiscal/monetary expansion if the Fed runs out of ammo.  For me the big bazooka is a Fed promise to buy any and all financial assets, anywhere in the world, until market expectations of NGDP growth are equal to 5% (or whatever the target chosen.)

And the other point I always make is that the lower the NGDP target (i.e. the lower the trend inflation rate) the bigger the Fed balance sheet as a share of GDP.  If NGDP growth is so low that nominal rates fall to zero, then the Fed balance sheet can get very large.  If the NGDP target rate is set high enough where rates stay above zero, then the Fed balance sheet stays small.  I prefer a small Fed balance sheet.

Inflation or socialism?  It’s your choice.