Russ Roberts

Admati on Bank Regulation and the Bankers' New Clothes

EconTalk Episode with Anat Admati
Hosted by Russ Roberts
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Anat Admati of Stanford University talks with EconTalk host Russ Roberts about her new book (co-authored with Martin Hellwig), The Bankers' New Clothes. Admati argues that the best way to reduce the fragility of the banking system is to increase capital requirements--that is, require banks to finance their activities with a greater proportion of equity rather than debt. She explains how debt magnifies returns and losses while making each bank more fragile. Despite claims to the contrary, she argues that the costs of reducing debt are relatively small for society as a whole while the benefits are substantial.

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0:33Intro. [Recording date: March 21, 2013.] Russ: Your new book, The Bankers' New Clothes is now one of my favorite books on the Crisis, and I've read quite a few. What the book does is it takes you step by step through how debt works, for an individual, for a bank, for a nation. And one of the things you learn even if you know something about debt is that debt is tricky. You talk a lot and very clearly about the incentives that debt creates, the side effects of debt, the fragility of debt. So if you find balance sheets confusing, or 'equity' a scary word, this is a great book for you. And even if you already understand these things, you'll get a better understanding. So what we're going to do is we'll go through some of the basic ideas of the book to start with in the podcast, and then we'll get into some of the policy applications that you also deal with in the book. So, I want to start with what a bank is. Now, a commercial bank--and you use the example in the book of the Bailey Savings and Loan from It's a Wonderful Life,--what a commercial bank does in its simplest form is it takes in deposits and it lends out that money to people who don't have enough. So, people who have extra money, savers, put that money in the bank. The bank then lends the money to people who don't have enough, say, for a downpayment or--excuse me, not for a downpayment but for cash to buy a house outright--they need to borrow some of the money. So what a bank does in that simplest of stories is they are just an intermediary. They take my money as a saver--and then I become a lender to the bank. The bank then lends that money to someone else. And I don't want to have to find those people. I don't want to have to find people who want the amount that I want to lend. I don't want to have to vet and check the credit risk of the people I would lend to. So in that story all a bank is is just an intermediary. It finds borrowers for the lenders who put their deposits in the bank. And of course the bank makes a profit. It takes a little bit from the borrower, a little bit from the lender. That makes sense. I'm still better off; I still get interest on my deposits. The person who borrows for the house still has to pay his own interest back, but not as much as they would if--or at least get to buy the house. There's competition among banks that keeps the spread--the amount that they borrow at and then lend at--small, to cover their costs and a little for profit. And that should be the end of the story. Banks are just intermediaries. But it's not the end of the story. Why are banks fragile? Why does that simple business model of transforming my loan into someone else's loan, my savings into someone else's mortgage--why does that become complicated? Guest: Well, they have fancy ways to talk about banks, and we try to unpack those. They talk about maturity transformation, liquidity transformation. What that means is really that the depositor, the people who lend to the banks, often time want their money quickly, especially demand deposits. But when they invest it, they kind of invest it longer term and in less liquid things. So there is a sort of imbalance between the money that they use to fund and their investment in the sense of the length of time until something has to happen and also the speed with which they have to pay versus get paid. And so that mismatch creates fragility by itself, which also means for example if all of us run to the bank at the same time then the bank may not be able to cover all of that. Even if it technically would be solvent, it has everything, that's kind of an inefficient run that you could have, in principle. So basically the banks tend to run a little bit more than other people into liquidity problems. You could say that, just, I have the money but I didn't go to the ATM kind of thing--I can pay you back but we're going to have to find a liquidity solution, sort of a rolling back my debt. Their funding is kind of fragile almost by definition because of the way it comes and the way people can come back for their money on short notice or any time they want. So that's part of the funding. And the investments are not as liquid or longer term than that. Russ: But of course as a depositor, in the absence of deposit insurance, if we imagine a bank just coming into creation but in the abstract, in a world that doesn't exist right now but did exist in the past. In the past, when I put my money in the bank, I was aware of the fact that it could go broke. There might be not enough assets backing up my deposits, so that I might not be able to get my money back if I didn't get in line early enough. So, how did banks, in the pre-deposit insurance days, how did banks reassure people that they would get their money out when they wanted it? Guest: Banks, way back before there were a lot of ways they were supported to pay back their debts, such as deposit insurance and other lenders of last resort-- Russ: Access to the Federal Reserve [the Fed]-- Guest: Right, the Fed and central banks, they had a lot more equity. And their equity funding, the owners' equity, didn't even have limited liability. The owners were personally liable. It was like a partnership, a private business with unlimited liability. And that's what depositors needed to trust the bank with their money. So, in the 19th century, it was 40, 50%; it kind of started declining, and as banks became only limited liability, really in the United States, after deposit insurance was introduced even through the Great Depression, there was increased liability for bank owners and at much higher equity levels, it still wasn't enough in the Depression. And then there were basically still losses, even with bankruptcies of owners, they were not [?]. But yes, the banks used to have a lot more equity. It may not have been enough, and banking was fragile for other reasons. So our view is it was never fully efficient. They always wanted to live slightly more on the edge than was efficient. But they certainly had a lot more equity than they have now, and that was kind of the way that depositors had to have it or they couldn't really trust the bank.
7:18Russ: Now we could spend the rest of the hour very carefully as you do in the book looking at what equity is, how it works, how different levels of equity affect returns, riskiness, fragility--and again, I really recommend the book for that. It's not as riveting as Stephen King--I'm not a big Stephen King fan, so I'll say Charles Dickens. It's not as riveting as Charles Dickens, but you will get a lot smarter when you are done. It's not boring; it's not dreary. It's just steady and straight and clear. But in the meanwhile what I do want to talk about is this word 'equity.' So, let's try to--as you point out in the book, one of the biggest problems with talking about this is that people can confuse capital and equity. And they use them interchangeably. But let's talk about equity first; and then we'll talk about why that confusion arises. So, if I am a bank, and I get together with a group of people and I want to start a bank, in the old days before deposit insurance, I couldn't just say to people: Hey, put your money in my bank; I'll give you 3% interest, and I'll be lending it out--that's how I'll be raising the money to cover your interest because I'll be getting these mortgage payments back; let me cover that interest that I'm going to owe you; and so, just give me your money. People would rationally say: Well, what if some of those mortgages go broke? Or: What if a bunch of people who lend you money, put in savings, suddenly want it at the same time? And since bankers knew that, and depositors knew that, to get people to lend to your bank, to deposit money in your bank, you had to have your own equity tied up with it. So let's take an example of 50% equity. So, with 50% equity, I would collect a million dollars from depositors, say; I would put up a million dollars of my own money, or the partners in the bank--before limited liability we would each put up enough money to raise a million of our own; we'd take a million from depositors. And that would give us $2 million that we could potentially lend out. And if we lent that out, let's say, and all the lenders wanted their money back--or a better example would be, a bunch of the mortgages went broke, say, half of them, so I had half as much money coming in, I'd still have enough money to pay back my depositors. Correct? Guest: That's right. Russ: And if I had, say, 30%--let's say I took in $700,000; well, let's try and keep the numbers the same--$1.4 million in deposits and I put up $600,000 of my own money, the owners of the bank--then we'd have 30% equity. Thirty percent of the total assets and liabilities of the bank would be coming out of our own money rather than borrowed money from depositors. Why would that be better than the current world? Guest: Well, in the current world they don't have anything like the numbers you are talking about. You are talking about 30, 40, 50% equity. The numbers that banks have right now are in the single digits, and sometimes very low single digits. And you don't have to look very far to see that. Look at the crisis in Cyprus right now. You have banks in Cyprus taking in a lot of deposits from all over--from Russia, too, and their own people. Actually, as it turns out, promising to pay them 4 or 5%, which is above a market riskless rate. And so how were they trying to deliver that? Well, obviously they had to take risks to try to deliver 4-5%. However, they had almost no equity to speak of. Very little. They may have even been in compliance with the regulations that are so insufficient and flawed. And we can talk about that later. But right now, when they incurred losses, there is nowhere to turn. And they all of a sudden need a bailout to somehow tax their--or whatever they call it--to default, basically, on their depositors. Russ: So, in the recent crisis in the United States and other parts of the world, of which Cyprus is just the latest variant, as you said, equity as a percentage of total liabilities was not just single digits: typically less than 3%. And I think it's important to remember--we've talked about this on the program but it bears repeating: For every $100 that I invest as a bank, if $2 of the $100 is mine and $98 comes from borrowing--and it's not just depositors, the way we think of savings; these are people who lend money. And the only important thing to remember is that a borrower is somebody who gets a fixed return. They don't share in the up-side. They only get the down-side; and they are promised a fixed amount on their bond. Guest: A legal promise. Russ: It's a legal promise. So, if I put in $2 of the $100 myself and $98 comes from borrowing, which is a 45-to-1 ratio--now that's very normal, unfortunately, in the modern world. That means, and this is the cool part--not so cool, it turned out--that means that if the assets that I invest that $100 into, if they depreciate, if they fall in value by more than 2%, that means that the implicit collateral to pay back those loans is now worth less than the promises I've made. Guest: Underwater, basically. Russ: I'm under water, and I cannot keep my promises. And I'm bankrupt. Guest: Well, you might not go bankrupt quite, because you might not default. You might be insolvent but not bankrupt yet. That's exactly where the sort of blurry line comes in for the banks. They might remain in the state of insolvency. We've seen that and in fact we probably see it around us, that they somehow manage to live but they are actually very distressed or insolvent, very weak.
13:46Russ: So your solution, and it's one I would be happy with--we'll talk about some different solutions later--your solution, then, is if you want to have a stable financial system, it's pretty straightforward. What do you have to do? Guest: Well, you need to reduce dramatically this indebtedness and you need to increase dramatically the reliance on equity funding. Which is basically the way other corporations in the economy fund for the most part, without having to regulate them. Russ: Now, when we talk about equity funding, earlier in our little example, the bank example, was the owners put up their own money. That's one form of equity. Of course, you can also issue stock. Guest: Corporations, yes. Russ: And that stock is a different kind of promise than debt. Stock is: You share in the future profits of the company, but there's no guarantee, no fixed amount you are promised. It just depends on how probable or unprobable the company is. Guest: The point about equity is there isn't really that promise. There is the upside, but you only get that after you pay your debt. The equity has returns and it has risk and the return is supposed to be compensating for the risk on average. And that's how these markets work. The economy funds itself with plenty of equity all the time. Among the best way for corporations to grow and invest is first and foremost to invest their profits. That's equity right there. It is basically if you have a good thing to do with the money--that's how Warren Buffett funds some of his investments; he never pays them out. He just keeps investing. Russ: Or you could issue stock. Guest: Yes, or you could issue stock. In other words, corporations do not need to borrow in order to invest. And many of them don't. They do some borrowing, and there is some [?] to borrowing, or maybe we can tell some stories. But basically equity is a fine and useful way to fund, and in the United States we have very nice, working equity markets that most corporations, especially the publicly traded ones, use happily. Russ: So, the claim then-- Guest: Except the banks don't like them. Russ: The banks don't like them. Now, that's the fascinating question. It's sort of the centerpiece of your book--the bankers will claim: We're different. We're not like Apple Computer. Apple doesn't borrow any money; in fact they are sitting on a lot of cash; and that's part of their equity. And the bankers say: No, no, you don't understand. Our industry is different. And if you make us have higher equity levels, we won't be able to do our job. That's their claim: We won't be able to be as effective; it's not efficient for banks to have to have the high equity levels that other corporations have. Is there any truth to that? Guest: No. It's just the types of things they would say if you press them on this vary from absolutely nonsensical to just flawed, in the context of the policy. Basically, they don't like equity for reasons that we explain in the book. There are a number of forces that make them not like equity. But when you step back about how we want them to fund, there is absolutely no reason that they should not fund with a lot more. And they would be a lot more productive for the economy and a lot safer. So, everything you can think about with them funding with more equity just removes distortions and corrects distortion and everything about it is like 10 good things. And everything that they say that's bad about it is just the way that this particular funding works from their narrowest perspective, from where they are right now and given the subsidies they are given when they borrow and the way they are compensated--all these things that have nothing to do with their ability to function or their ability to do things that are appropriate, in a cost design[?] economy.
18:00Russ: High levels of leverage--that is, high levels of debt relative to equity--it seems to be good for bankers, but not good for banks necessarily. Or the rest of us. Guest: There are very few people who benefit. It's almost like they are addicted to it, and it's almost like we would help the industry, except for the subsidies, which maybe they pass on but there is not a huge amount of evidence that they do, but even if they do, it's distorted; that somehow if you correct that, that something would be bad. It starts with this confusion that you kind of hinted at, and you almost slipped into saying 'hold' capital, because that's how they use the word. And that sort of sends you to the wrong side of the balance sheet. Because it sounds as if what we are talking about is cash reserves. And some people would tell you that we are talking about a rainy day fund. But that's not what we are talking about. It's not about cash sitting idle. It's about the way you fund your loans. Russ: So, people, when they hear the phrase--and I have to confess, I used to misunderstand this as well; we did talk about this in our first podcast together. And I've gotten a little bit smarter since then. I've read your book, I've thought about it a lot more. Someone it makes more sense to me. But the idea is, when you hear the phrase 'higher capital requirement' it makes it sound like you have to set money aside in case your, say, assets lose value. Guest: It's not cash. Russ: Right. But that's not what it is. Explain what it is. Guest: It's just basically your assets minus your liabilities. The amount that's not committed to borrowed funds, as a fraction of your assets. That's equity, basically. Capital [?] is a whole other can of worms; it allows some other things to be counted as loss-absorbing. But it's meant to be the part of your funding that can absorb losses. Russ: So, for example, if we required in the United States or other countries required their banks to have, say, a 25% equity requirement, that is not 25% of your assets have to be set aside. It means that for every $100 of investment you make, $25 has to either come from your own money or money you raise through stock; or cash, if you have it. But it doesn't mean it's sitting around. Now, I think the key for me--and tell me if I'm wrong--the key for me in understanding this is that the reason bankers like leverage--obviously isn't what they say, which is: The money would be tied up if we have equity. Guest: Taken away from the economy, they tell you. They say it's socked away, taken away from the economy somehow. Russ: That's clearly-- Guest: Nonsense-- Russ: --not true. What it seems to me is true, and I think this is the reason they don't like it, is the bank would be smaller. Guest: Well, if that's true then it's only because right now it's too bloated with subsidies. Because really the only way it would be smaller, the total funding of the bank would only increase by the removal of subsidies that are associated with equity. So that's all. If the size of the bank or the banking industry would go down, it would go down to the right size. Russ: Right. To me, smaller--that's a feature, not a bug. Guest: So from their perspective, they might be compensated in such a way--and there are many ways in which this manifests itself--but the ways bankers themselves are compensated encourages them to rely more, to magnify the upside. And we go through that in great detail. And they only want to think about the upside. And of course, with more risk comes more return on average. Maybe they don't even compensate their equity holders enough relative to the risk. But obviously the smaller the base, the higher the magnification on the upside. And also the average, because risk and return are tied. So they like the upside and they can live in that world. And in addition, their borrowing is subsidized so they get to borrow at slightly lower rates than they would have been if they were not enjoying the guarantees. So it's easier to pass that. So, when we have the example of explaining how guarantees work, we have basically your aunt guaranteeing your loan on your mortgage, and then you get a cheaper interest rate from the bank, and the bank doesn't care if you have equity. So their creditors are not normal creditors in terms of what they demand.
22:29Russ: I hear that a lot. I think that misses the other important point. When I read your book I was waiting for it. And you do mention it. But I don't think you emphasize it enough. So let me try to make this point. So, what you are talking about now is: If I go to buy a house, and I have a rich aunt who has got a much better credit rating and history than I do, I'm going to be able to get a better interest rate if she guarantees the loan than if I try to use my own credit rating. And that's one part of the subsidy that the guarantee of large financial institutions allows them to borrow money at a lower rate from their creditors than they otherwise would, when they issue bonds. So, Fannie Mae is a great example of this. Fannie Mae, which was not guaranteed explicitly, but implicitly was; and then did get it actually--its bondholders did get all their money back--Fannie Mae paid a slightly higher rate than Treasuries. But not much. Slightly higher, because there was some chance that the Federal government wouldn't stand behind them. But they were like Treasuries with a higher rate. So, a lot of people found that appealing. The Chinese government bought a lot of that. My Dad helped, as I have often mentioned on this program--Fannie Mae bonds. And those people got their money back, because of the promise. So, as a result, Fannie Mae could borrow money relatively cheaply. But the other part, it seems to me, which is much more important--and maybe I'm wrong--is the size, of how much I can borrow. So, if I'm buying a $200,000 house and I'm borrowing $160,000 of it, and I'm putting 20% down, putting $40,000 down, then yes, when I borrow the $160,000, my rich aunt's guarantee lets me pay a lower rate of interest. But the cool thing about a rich aunt is now I can buy a $1,000,000 house and put a very small amount down, that a bank would never let me do; and lenders would never lend to Goldman Sachs and Bear Stearns and Lehman Brothers if there only is a 3% equity cushion unless they thought it was guaranteed. Guest: Well, it depends whether you use the same amount of money. If you have to do more and put more of your own money, then again, if it's shareholders' money, they would potentially just let it sit as a fraction. If you can have very little of your own money and keep borrowing and borrowing, then of course that would be like higher leverage, and you'd definitely have an incentive to do that. Which really goes the heart of what makes banks hate equity so much. So, you will tell your aunt that equity is expensive. You don't want to put your own money at risk because it's much nicer to get the upside and be protected on the downside. You can go invest it in Treasuries and never lose, and then you get all the upside and magnified. So it's great. Russ: And my understanding--again, correct me if I'm wrong--is, no debtor, no lender, no creditor would give money to a bank under fixed income conditions with a 3% equity cushion, an inadequate cushion, unless they were pretty sure--not 100%, but pretty sure--that there was a rich aunt. Or a rich uncle. Uncle Sam, in this case. Guest: Right. You didn't mention when you said, people get smarter--we tried so hard to make it entertaining to read, where we had these cute epigraphs and all of that, right. And so we have the aunt, and then the banks, and Uncle Sam, cute little rendition. One of the things that we point out also is there is a sort of maturity rat-race phenomenon which is written about, by Markus Brunnermeier, other people [?] there are the papers about that. It's part of the sort of dark side of borrowing. And in banking what happens is they have this ability to borrow in all kinds of ways. So, for example, people like to talk about repos [repurchase agreements] as sort of the new form of deposits. Well, it's a trick to borrow; and the trick is: Here's a, JP Morgan, trillions of dollars, really, depending on the accounting system maybe $4 trillion goes through that fortress, supposedly. And among the numerous ways that they borrow, this repo means basically that I sell you an asset overnight, the collateral, and I promise to buy it back. So, my promise is basically the promise that I'll buy back that asset from you, and the interest is sort of folded into that. Russ: I don't buy it back at the same price. Guest: Right. Russ: That's how the interest gets folded in. Guest: But the trick there is that this arrangement, since very recently, actually, just since I think 2004 something, in the United States is exempt from stay in bankruptcy. So, should I, in the imaginary scenario that I actually can't buy it back from you the next day, you could just walk off with it, out of the courts, out of the frozen-from-bankruptcy process, out of the priorities. So essentially you jumped ahead of everybody, because you own that collateral overnight. So, this is among the many ways in which they manage to get the creditors to agree to lend them and basically think they are safe. So, the depositors feel that they have deposit insurance; some of the creditors have all kinds of collaterals; or they have the belief, as you said, of implicit guarantees, especially in the case of the largest banks. But even in all the cases of the entire system, somehow or other there is a belief that they will be paid. It's not true for the junior debt of a small bank, because actually the Federal Deposit Insurance Corporation (FDIC) might impose losses on them, maybe. But of course if they become systemic then in the Crisis even that was supposed to absorb losses never did. Russ: Just like in a foxhole there are no atheists, in a banking crisis, everybody's systemic; or at least everyone claims they are. There is always going to be an incentive to explain why my bank is so crucial to the future of the country. Guest: You have to pay all my creditors. From then on, my creditors are nice and allow me to borrow under terms that some other people in the economy or corporations cannot borrow, and therefore they don't.
29:29Russ: So, to go back to my question: Do you believe that if banks had larger equity requirements--let me phrase the question differently. I believe that if banks had larger equity requirements, they would be smaller. And it would be much more difficult for executives in banks to make as much money as they make today. Because I think--I understand there are formulas that determine their pay that are based on returns on equity, and so they have an incentive to magnify that artificially, and accounting tricks, etc. But I believe that if we had high equity requirements, they would change their compensation structure. But even if they did, the banks would be smaller and they would not make as much money. Guest: So, the key here is governance, really. In our corporations--in most other corporations, really, the governance issue is between shareholders and managers. In banks, there are so many creditors that you almost find the governance problem really resembling more of a creditor-borrower problem, because it's kind of managers and sort of narrowly-defined shareholders against kind of creditors and deposit insurance: who gets the upside and the downside? So, precisely as you said, one of the corrections that would happen if they had more equity is the equity would bear more of the downside, and then they might care more about the downside. And therefore they might then not allow managers to be compensated in the ways that encourage risk-taking. Russ: That's exactly right. Because right now--I always point out, and I got this I think from Gary Stern's book, Too Big to Fail, who we interviewed a long time ago--but generally, the debt holders are the people who care about the downside because they don't get the upside. So, they're the ones to make sure that banks don't act too recklessly. And if you take out their downside, there's nobody else. Guest: So, no creditors are helpless, with their dispersed [?] they have no governance role. In other corporations they would just walk away, but in the case of the banks, somehow they are agreeing to be there and the banks like it that way. Russ: Some people, when I make this claim, they say: Well, shareholders care about the downside; they don't want to be wiped out. And that's true. But they don't mind if firms take risk. We are not talking about someone who steals their money. We are talking about a firm that takes risks; the shareholders get the upside; they diversify, so that they have a lot of these. Guest: Yep. Right. But still, my claim to shareholders, and I've written about this, too, is that the system really works only for managers and very, very narrowly defined shareholders, because diversified shareholders end up losing from financial instability. So, how did the S&P 500 [Standard and Poor 500 Index] perform as a result of the crisis? So, the banks managed to maybe squeeze subsidies out of the rest of us. But then we all paid. Dearly. Russ: Yeah, it stinks. Russ: So, just to clarify. What do you think, if you imagined a conversation between the executives of a bank and the executives of a non-bank, say, a manufacturer or service provider--would the bankers say: Hey, guys, you are missing out. This debt's great; you ought to borrow more. What would the "regular corporations" say in response to the bankers' encouragement to borrow more? Guest: Well, they would say that borrowing becomes really tough on the borrower, and the creditors would have all kinds of consequences for the borrower when it gets to heavy levels. And that in fact the debt contracts don't allow them to continue borrowing, don't allow them to pay out; and the creditors are very nervous people when they lend them, and so they would put covenances in, they would tell them they can't do things without creditor approval. They would behave like the creditors that worry about the downside. And so they would tell the bankers: You are lucky because your creditors nicer to you than our creditors are to us. Russ: So, we've been talking about commercial banks. And of course they are nicer because they have this implicit guarantee. I assume. That's been my theory from Day 1. I try not to fall prey to too much confirmation bias but I don't know what the alternative argument is.
33:47Russ: But it raises the question: We've been talking about commercial banks. If we talk about investment banks, meaning Bear Stearns, Lehman Brothers, Goldman Sachs--and parts of the commercial banks, Citibank and others have investment bank parts--these are folks who took the money and they didn't put it in mortgages, directly. They put them into assets--some tied to mortgages. They put them into other types of speculation. They invest the money in a very different way than a commercial bank. Who is lending to them? Who are the net lenders to the investment bank sector? How is it that all of these banks are running leverage levels of 98:2, 45:1, 97:3? Who is providing the liquidity for the investment banks that allow them to run wild with that money? Guest: Well, at the end of the day, it's all linked together and within itself. In other words, there's a lot of interbank lending and borrowing. And this goes back to--the people think of separations but it's very hard to separate. Because we give money to money market funds, and money market funds lend to the banks. And so here you have the depositors' money going some directly to the bank and some to the money market fund, and the money market fund then funds the banks. And it funds the investment banks, the trans-European banks, they fund each other. So there are many ways in which they borrow and then there are many ways in which they invest, as you said. And some of these investments--they also come back to the mortgages. The mortgages were securitized, they were made into marketable securities; and not all of it is bad. Because diversification of risk is good. So, to a point all of this creates what we want the system to do, which is to spread the risk around and lower funding costs and allow productive investments in the economy to be funded. And all of this there is a role for a financial system. But the system gets very distorted because they have incentives to get very complicated and very complex and all knotted up. And globally, too. So that they become kind of very difficult to resolve or to fail. And then gives them more ability to continue growing like that. Inefficiently. Russ: But if I look at the balance sheet of, say, Bear Stearns in March of 2008, or of Lehman Brothers in September of 2008, when they were both in severe crisis--I thought Bear Stearns should have been allowed to go bankrupt; I think then Lehman would have been different. But who knows? Hard to say. But if we look at the creditors, the people who were involved, a lot of them were the other large banks. Right? Guest: Exactly. But that's okay. You can have that. You can have the banks grow, owing and lending to one another. This is where we can see the counterparties. We go through the book, for example, on 'netting.' Netting on derivatives basically means that I owe you and you owe me. In market value, not in the same contract. We netted out. We just pretend that the part--I you $150 and you owe me $100, and we just erase the $100, and it's just my debt to you of $50. And the balance sheets don't show that. If we didn't net, we'd have bigger balance sheets like they have in Europe, and we show for JP Morgan that snapshot is $1.8 trillion dollars, which is almost double the size of the bank, really, assets and liabilities, which means that its equity is that much less as a fraction. Just that is with the same counterparty. In other words, that just shows you how interconnected they are. When we come to regulate counterparty exposures they scream that having an exposure to the same counterparty of no more than 10% of their total equity, their capital, that that's terrible. That's amazing. If 10% or more of your equity is exposed to the risk of 1 counterparty failing--meaning if they don't pay you, you could lose 10% of your equity--that's incredible interconnectedness. Right there. So there's an enormous amount of interconnectedness in this system. And that's partly why we have the systemic risk, that it's sort of like a set of dominoes standing one next to another. Through various mechanisms, it's sort of they all end up failing at the same time. Or the failure of one triggers a huge problem. And that's really why it's really important to reduce that fragility. And why it's also hard. And also why making individual banks a lot safer makes the system so much safer. Russ: But we incentive through policy. We incentivize that complexity. We gave them an incentive to create it. Guest: That's what's so perverse about the situation. We are feeding the addiction to something harmful. We are subsidizing pollution of the system through excessive [?], does nothing good but just is sort of people in the system have incentives to take. And it's not productive risk at all. I'm all for productive risks being taken and when the banks say, Oh, we invest long term; we do this and that--the real productive long term investments are made right here in Silicon Valley. And they are funded with long term funding, equity funding, and they can fail. And they do. Russ: And it works great. Because every once in a while they hit a home run and the world is a better place for it. Guest: You want to take risks, for innovation. I don't have a problem with risk. What I have a problem with is excessive risk that does nothing but is a leverage risk, a financial risk, that's packed on to of the risk of actual investments. Russ: Yeah. Take risks with your money. Not mine. Guest: Exactly. Russ: Unless I agree. If I agree to it, I'm okay. Guest: Exactly. Other people's money is also equity money. But the borrowed money comes with that legal commitment and it is hard to untie that commitment. And that's the problem with it. So they should just do much less of that. They should fund less with that and their incentives are to only promise, promise, promise. Legally. And when it doesn't work out, it's somebody else's problem.
40:05Russ: Now, I like your story. And listeners know that I agree with it. So let's try to challenge it a little bit. Let me ask the following question. Now, since the Crisis--since 2008, 2009--the biggest banks are bigger than they were before, I think. I assume leverage is about the same, if not more. Guest: It depends how you measure it. All these things, really that's a whole can of worms, how you measure. Russ: But nobody's prudent. I wouldn't say anybody's gone out and said: Gee, we really were irresponsible; it was terrible what we did to the American people; we're going to raise our equity to 10%. Guest: They don't have incentives. Russ: Right. Guest: It needs to be the whole system, they have incentive to compete to lever more. Russ: Correct. So, given that's your story--and it's my story, too--why haven't we had another crisis? Why would banks be prudent at all? Why did banks buy credit default swaps? Why bother with that? Why not just be reckless and collect a lot of money when things crashed and keep going and enjoy the upside and avoid the downside? Why is there any prudence in the system whatsoever? Guest: One of things that's stopping it a little bit is we do have regulation in place. This is recognized that in banking you must have regulation to maintain the depositors' funding and to prevent--ever since we had deposit insurance we do have supervision regulation by the FDIC and other regulators. And banks are regulated in every country. The problem is that--so it's the regulator's job, because creditors want to be safe, and the depositors in particular want to be safe, what you have is it falls on regulators to contain the risk in this system. The credit default swaps were part of the attempts to pacify the regulators. To tell them the risk is gone, and then therefore we don't have to worry about it. Except the risk all went to AIG. Russ: Yeah, well, I like it. When I was explaining to someone that AIG was a bad thing, someone said: Well, but people made those--people were insured. Thinking people were insured--JP Morgan Chase? Lehman Brothers? You're right. They went through the motions and it does matter whether your insurance company is solvent. Guest: Exactly. This insurance company ended up accumulating all these default risks which then nobody also cared to monitor in terms of credit-worthiness. Which reduced the quality of loans, too. So in this process a lot of it built up in AIG, and these regulators didn't keep track of the risk to where it was going, and allowed all kinds of entities in the shadow banking system to be backed up by regulated banks. All kinds of build-up of the risk that ended up coming back to haunt all of us. So, there was a regulatory failure before, which of course they now want to start the story where they saved us from all these disasters. But the story really goes back to how they failed to contain this risk in the beginning and how they are continuing to make the same mistakes now. Russ: So, explain that a little further. How is it that credit default swap purchases by banks--which, I always hear them say: We were prudent. We weren't reckless. We had insurance. My response is: since everybody insured with the same person, or too many of the same people, it didn't work. You're telling me that some of that credit default swap purchase, that insurance, was for the purpose of complying with regulations. Guest: Yes. Russ: How is that? Explain that. Guest: Because the regulators would want them to have some equity backing, but they told them the risk is gone, therefore they don't need it. So, it was basically allowing the regulators to think that they didn't have any credit risk any more on their balance sheet; it was gone to AIG, and they were all safe then. Russ: Which is the same argument they made with Triple-A. We have Triple-A-- Guest: Exactly, exactly the same. They would say, Look, we invested in something safe. Now, the regulation allows European banks, with no backing by equity at all, to invest throughout the Eurozone pretending that all that is in the Eurozone is safe like cash. That is saying that the Greek debt that is paying 20% is as good as cash. And you can back it up totally with borrowing. Russ: Well, that's because the Martian Central Bank will bail them out eventually. That's what I'm counting on. Guest: But this shows you how crazy and political some of these regulations end up being. And they always, so the banks would have those incentives. And this is actually how we blame some of this structure of this regulation with interconnectedness, because they all tend to go to where the regulations use it as safe, but it's not actually safe and it pays a little bit more return. And then they can scale that up. So if the regulators all say, Oh, the risk is gone. Oh, fine, then you can do lots more with borrowed money. Then, all of a sudden, AIG needs a bailout. So, they replaced basically the default risk of their creditors with the default risk of AIG itself. Russ: Yeah. Great.
45:29Russ: So, what can be done about it? Let's first talk about your proposals. I'll give you some others to react to, but what would you suggest we do to stop this from happening again? Guest: Well, there are just some really simple, obvious things to do. Which is, first of all, we are very concerned about the weakness of many banks. So there are claims and there are signs that some banks, especially in Europe but even in the United States are really weaker than they appear. And all these stress tests don't impress me very much. Because they focus on accounting numbers and they allow risk weights and they use all kinds of models that I don't believe. And they don't actually take into account the collateral damages and a lot of interconnectedness. I am not sure of all the details; when I start looking at them I feel kind of numb; but to me it's obvious that where we are, I know where to go, from here. Which is to, if I had to put them to a test, I would tell all the banks to go raise some equity. But equity, common equity, not from Warren Buffett with promises of 9%, but common equity. If somebody cannot raise equity at any price, although not at a price they like, but any price, there is a flag about that. They are either too opaque or too risky, or insolvent. And we want to know that now. So if we knew now who is weak then we would actually be dealing with them and kind of remove them from the system. Because sick banks tend to lend to unhealthy borrowers and maintain bad loans on their books and not make new loans. They are just a drag, basically. That's like Savings and Loans were allowed to, with forbearance, to stick around too long. And that could actually also clean out some excess in this industry. And then, the viable banks should be strengthened by retaining their earnings, first and foremost--that's equity dollars that are already there. So allowing dividends is like completely favoring very few banks-- Russ: Insane. Guest: Completely insane. There's no benefit to that at all. And then they tell you they can't lend. I mean, they are not even lending their deposits, let alone these retained earnings. They want to do something else with them than lending. Of course they like to threaten that they won't lend. But in any case, they should be strengthened right away, and we should aim for much, much, much higher--we've got plenty of time to figure out when to stop. We know what to do now, which is to strengthen this system. That's what we suggest, and we suggested the targets that Basel III set and the structure of that regulation is entirely insufficient and entirely flawed and doesn't learn the obvious lessons from what just happened. Russ: Basel III is the latest round of international banking regulations. I always find it funny when people say, Well, we need international regulations because that way there's a level playing field. First of all, I don't care about a level playing field. If other countries want to subsidize their banks, that's their problem. But when people say they want an international system, what they really mean is they want a system that's far away, with limited oversight from the domestic population, so that the insiders can write the rules. And so I assume that Basel III, the people who are most concerned about it are the banks. And I assume they spend a lot of time trying to influence it. Guest: Oh yeah. This is the politics of banking on which we have one chapter in the book. There's no talking about banking without talking about politics. It's very highly political. And basically, in Basel you had governments coming in with their bank lobbies, together, to impact international agreement, which ends up being a race to the bottom, really. With very few people fighting for safer coordinated effort. And the reason you would--what you really want to coordinate is you want to coordinate the resolution mechanisms if we have any hope of allowing banks to fail, global banks. So that's super important. But that's not the solution to the problem. The solution to the problem is, as you said, that every country makes sure that its banks are safe. And we have a little bit of a race to the top. When somebody tells me that they would move their money to French banks, I say my heart goes out to the French taxpayers. Russ: That's right. Good for you. Guest: It's really crazy. Russ: Yeah. Help yourself. Guest: They also end up winning against other industries. Because if you bloat them with subsidies then they end up taking people who might be productively employed elsewhere. We just don't know any more what's right because it's all distorted. Russ: Well, it's worse than that. I've said this many times; I'll keep saying it many times: The other result is that we allocate the capital that we do have towards, say, too many houses. Instead of better medical care, better cars, better gas mileage. Guest: We subsidize so that's what [?] is saying, the way we subsidize, in fact borrowing, for housing maybe we have too much housing; and certainly the way banks behave left a lot of empty buildings around the world.
50:40Russ: So, I think it was the late 1920s or early 1930s, certainly before 1932, Franklin Delano Roosevelt, when he was governor of New York, said that Federal deposit insurance can't work, because inevitably banks will take too much risk and then depositors won't have to be careful because they are backed by the government, so it will spiral out of control. He was onto something there. He eventually supported it when he was president. But this whole idea of insurance, which starts off as a nice idea--small depositors don't have to worry about whether the banks are safe--somehow gets extended to people who lend money to Bear Stearns overnight to buy stuff that's highly risky. And so the question is: What's feasible to stop that from happening? Your solution is to raise equity requirements. Richard Fisher, the head of the Dallas Fed, has a proposal where he says: If you lend money to an investment bank, when you do that you have to sign a piece of paper saying that you are aware of the fact that that money is at risk. Now, I'm not sure that is going to make a difference. It's an interesting idea. My preference would be we don't bail anybody out at all. Period. Which of these do you think have the highest political chance of passage? Which of these might actually be supported by the American people and make its way into some real world solution? Guest: Well, I know what I would prefer and I can argue why that's better. So, you say not to bail out. The problem with that is the collateral damage [?]. So in other words, what happens when a bank fails and what are the stock choices? It depends where you want to leave the regulations in terms of trying to prevent that before we get to failures, or even to distressed by my book. So even if you don't bail out--we didn't bail out Lehman and it just has collateral damage. So financial crisis, should that happen, tend to linger in terms of their interaction with recessions and other variables. So that's what Reinhart and Rogoff show, and other people. Russ: I'm not sure I agree with them. But keep going. Guest: I don't know. But in any case, I favor deposit insurance to a point, because runs can be inefficient, and runs can start like in the movies. It's true, even in the Depression, we make this point in the book, usually depositors know which banks were healthy or not. But I favor explicit deposit insurance to a point, but I favor effective regulation after that to really contain the safety net so that it's not needed as much. What Richard Fisher is saying is that we need to have loss absorption. So, we all kind of agree on that. It's a question of what form it takes. If you say that I want the creditors to agree that they would suffer losses, again we go back to who they are, the creditors; and if banks lend to one another, what's the worth of the piece of paper that they sign this if they themselves are going to become weaker, and then we'll care about that. So, it's a question of who can absorb losses. What we are saying is basically that there is a lot of risk capital in the economy and that banks should just approach that investment community much more than they want to. And so the regulation should focus on making sure that they deal with investors that really know they will bear the downside. Much more. And do much less of any kind of signing of any kinds of pieces of paper. Triggers and promises and all of that, that we have fewer promises. Russ: So, what level of equity would you want to see? Guest: Well, people always ask about the numbers. And I'm very happy to have people like John Cochrane and Eugene Fama say: Oh, 50% sounds good to me. Because then I sound so sane when I say 20-30%. I'm such a moderate. Russ: That's right. And the bankers say: 3%. So that's good. Guest: What Cochrane said was: Until it doesn't matter. That is, until there are no more bailouts, they can stand on their own feet. So, we said, sort of as a starting point, at least 20-30%, because it's a matter of allowing the equity dynamically to absorb losses and not always working to a number. So we want a range, a conservation buffer. Because equity is there to--what happens when you lose is equity is supposed to absorb it to a point. But then you should bail it out, you shouldn't pay and all of that. So that's the concept of a conservation buffer. So, we talk precisely about how to make it work. And we kind of throw out the 20-30%, but we know and point out that the big can of worms is who puts the numbers on both sides of that balance sheet. And is it market values, is it book values--exactly what do regulators look at to tell them what's going on in terms of the dynamics of it. Because balance sheets, accounting balance sheets come every three months and they tend to lag, and there are all kinds of accounting conventions there about how you account for losses, and there are lots and lots of issues there, about what's the value of your assets, what's the value of your liabilities? Therefore how much equity you have. That's a whole discussion that needs to be had. We just kind of wanted to stake our position as a lot more than what they are talking about right now. A lot more. Russ: But you do raise the problem, which is: Measurement is a lot trickier than it sounds. And I think, fundamentally, it's a political problem. As you point out, you can't avoid the politics; the bankers are very politically powerful. I think till the American people demand that they be treated differently, which we're getting to, we're getting there. I was very depressed in the last Presidential election in America that neither candidate, Obama or Romney, felt that this was a central issue. Until a candidate makes it a central issue, it doesn't really matter. Because the banks will manipulate the regulations, manipulate the system. To me, it has to come from the politicians saying: No more. And they are not going say no more until we say no more. Because they have another voice that says: More. Guest: That's precisely why we wrote the book. Because you just couldn't penetrate this unless you got a little more political pressure that something is not quite right. That we don't want to wait for another crisis. And we already have a crisis in Europe that could implode and affect us more over time, we don't know. But there's no reason to maintain this inefficient system, crisis or not. Every day it's not an efficient system. And so indeed both parties are reluctant to do something, but we have a little more noise right now and the noise is good. Bernanke admitted yesterday that he agrees there is a problem. That's a big step. Because they've been in denial about this all the time and they refuse to engage. Russ: Well, he knows where his bread is buttered. It's your quote, right--didn't you say--what's the quote? You have a quote from Upton Sinclair. I can find it. Guest: There are multiple quotes. Russ: This one. Guest: The quote is you can't teach somebody something if your salary depends on not understanding it. Russ: I've got the exact quote right here: "It is difficult to get a man to understand something when his salary depends upon his not understanding it." So, it takes Ben Bernanke a while. Guest: Also for the politics on banking, there was a quote from an Austrian playwright that said: The king is naked but under such splendid robes. Russ: Yeah. Well, that's very apt.

COMMENTS (29 to date)
Steve writes:

I'm still scratching my head about the creditor question that Russ asked. Who is lending the investment banks so much money?

Admati didn't really seem to give an answer. She essentially says that it's all very complicated, and a lot of the lending comes from other banks. I'm sure that's true, but if they're all so leveraged, they are net borrowers, despite the loans they've made. So other institutions must be net creditors.

Greg G writes:

Among those lending to highly leveraged investment banks are garden variety FDIC insured banks. Through the purchase of investment bank bonds, more heavily regulated banks can take on the kind of risk they could never underwrite on their own. It's a crazy system.

Steve Sedio writes:

I can understand why the bankers, politicians and regulators try to keep this nonsense out of the public view.

But what ever became of investigative journalism? Can I suggest the money financial institutions spend on "advertising" serves the dual purpose, of promotion, and silence?

Gudmundur Karlsson writes:

Can you or Dr. Admati comment on Full Reserve Banking as described here:
http://en.wikipedia.org/wiki/Full-reserve_banking
and here:
http://www.positivemoney.org/

I ask because the Icelandic parliament is currently evaluating this option, and the largest political party which is likely to win in the upcoming election in late April has it on its agenda.

Would it be wise for Iceland to become the first country in the world to implement Full Reserve Banking?

Thank you,
Gudmundur

Guest: Exactly. This insurance company ended up accumulating all these default risks which then nobody also cared to monitor in terms of credit-worthiness. Which reduced the quality of loans, too. So in this process a lot of it built up in AIG....

You and Your guest need to better inform yourselves about AIG. Somebody very much did care about the risks of credit default swaps at AIG; Hank Greenberg.

It wasn't until Eliot Spitzer decided that that company was a convenient vehicle to use to advance his political career, which ended up forcing out Greenberg (and destroying AIG's AAA credit rating in the process) that AIG became the ticking time bomb. The tragic tale is well told in The AIG Story.

You ought to get Lawrence Cunningham (the co-author) on to relate that incredible tale.

Greg G writes:

Thanks for the discussion given here to the way repo is treated in bankruptcy. This is one of the most important and under reported stories in economics today. I would love to hear an entire podcast on the topic.

Repo is used to fund some of the most speculative and systemically risky lending. It ought to be at the end of the line in a bankruptcy but it is legally at the front of the line. Talk about perverse incentives. Meanwhile a teenager who takes on a college loan has assumed the debt treated most harshly in bankruptcy. The common denominator in both cases is that the law is written just the way a bank lobbyist would have written it.

Russ, you were right on the money when you criticized calls for international banking regulations to "level the playing field." The motive here is primarily to escape domestic oversight as you pointed out.

Chritian L writes:

The six part series from positive money tells the story about how banks create most of the money in the system. Its a UK based story but checked it out in Australia (where I reside) and talking to bankers here it looks like it works the same. If this story is true then there is 3 sources of funds for lending. Depositors, equity from shareholders and out of thin air (sort of like quantum foam).

Here is the first part:

A writes:

Russ and Anat discuss how higher capital requirements were at one time a happy symptom of good incentives: savers understood their roles as lenders to banks -- with the concomitant potential for loss -- and they therefore demanded that banks compete on safety.

So far so good. But then Russ and Anat suggest the big fix is just to legislate the symptom! Aaaack! If you want the symptom, provide the incentives for it to appear. No regulator is as scary as hordes of demanding savers who want to keep their money safe.

Bogart writes:

There are at least 3 superior alternatives to the management of banking institutions via the Federal Reserve Cartel that I can think of:
1. Stop fractional lending on demand deposits and offer contracts that allow the bank to risk part of the depositor monies.
2. Less possible under current politics: Allow anybody to open up an unregulated bank. That is they can get some cash and loan it. There could be plenty of web sites that will allow this. Then we can skip all of this foolishness with this banking cartel and deal with people we trust. What if Walmart loaned money to its customers for mortgages and other loans? Do you think that this would get the other banks in the Fed Cartel to become more responsive to consumers? Would it make them more responsible to their depositors? What if Walmart offered superior terms to depositors?
3. Most superior, but will never happen in the current political climate although with Bitcoin it might happen regardless of what the Fed Banking Cartel wants and what Washington wants. That is to allow competing currencies. At this point the Fed would have a diminishing pool of marks from which to steal their money via inflation. That would very quickly destroy the whole cartel.

Adam Baum writes:

While the podcast initially made me think it was going to delve deeply into tecnicalities, such as the distinction between equity and capital.

Unfortunately, it sort of drifted off. While analyzing the forces that make banks fragile, (correctly, in my opinion) the author seemed oblivious to the fact that government faces similar forces that makes it incompetent.

At one point she used the term "regulatory failure", without any thought that most regulation fails, because it's conditioned on a faith in the regulatory state as the sponsor of dispassionate and incorrupt expertise.

Can it be that Professor Buchanan's lesson of viewing politics without romance is being lost this quickly after his passing?

Michael writes:

This was an interesting podcast, and any economist with a plan that gets praise from both John Cochrane *and* Simon Johnson is worthy of consideration. This suggestion makes a lot of inuitive sense.

One thing I wonder about, though, is whether there was something of a contradiction between Admati's ideas and Steve Hanke from an earlier podcast.

I think Hanke suggested that the increased capital requirements imposed by Basel III have been a bad thing. (Although I am not clear on whether Hanke and Admati mean the same thing when they talk about "capital".)

However, here is another view, from a recent Josh Hendrickson blog post that seems to be in line with Hanke:

http://everydayecon.wordpress.com/2013/03/19/how-much-capital/

"To the extent that one believes that the transaction asset shortage is significant, policymakers face a difficult decision with respect to capital requirements. While imposing stronger capital requirements might lead to greater financial stability by imposing greater losses on shareholders, this requirement can also exacerbate the shortage of transaction assets. Banks and other financial institutions will then have a strong incentive to attempt to mitigate this shortage and will likely try to do so through off-balance sheet activities.

This is not meant to be a critique of capital requirements in general. However, in my view, it is not obvious that they are sufficient to produce the desired result. One must be mindful of the role that banks play in the creation of transaction assets."

While not opposed to the idea of capital requirements, Hendriskon suggests that there are other issues at play here.

Jeff Boyd writes:

Enjoyed the podcast but something that wasn't discussed is what would happen if credit collapsed as a result of requiring banks to carry more capital. Maybe the pain of say a 50% collapse in real estate prices, nationalization of banks, etc. would be worth the pain in the long run but isn't that going to be the result if we require banks to carry 20-30% equity cushions?

John Berg writes:
Russ: Basel III is the latest round of international banking regulations. I always find it funny when people say, Well, we need international regulations because that way there's a level playing field. First of all, I don't care about a level playing field. If other countries want to subsidize their banks, that's their problem. But when people say they want an international system, what they really mean is they want a system that's far away, with limited oversight from the domestic population, so that the insiders can write the rules. And so I assume that Basel III, the people who are most concerned about it are the banks. And I assume they spend a lot of time trying to influence it.

Russ can generalize this thought to make it an issue of Federalization. The Progressive individual always prefer federal regulation to state regulation to ensure the absence of accountability to voters. Currently we seem to prefer no accountability by having civil servants execute our laws. How does one determine the proper level at which laws are to be held accountable?

How are corporate managers held accountable by shareholders?

John Berg

John Berg writes:

GUEST: It's part of the sort of dark side of borrowing. And in banking what happens is they have this ability to borrow in all kinds of ways. So, for example, people like to talk about REPOs [repurchase agreements] as sort of the new form of deposits. Well, it's a trick to borrow; and the trick is: Here's a, JP Morgan, trillions of dollars, really, depending on the accounting system maybe $4 trillion goes through that fortress, supposedly. And among the numerous ways that they borrow, this repo means basically that I sell you an asset overnight, the collateral, and I promise to buy it back. So, my promise is basically the promise that I'll buy back that asset from you, and the interest is sort of folded into that.
RUSS: I don't buy it back at the same price. GUEST: Right.
RUSS: That's how the interest gets folded in. GUEST: But the trick there is that this arrangement, since very recently, actually, just since I think 2004 something, in the United States is exempt from stay in bankruptcy. So, should I, in the imaginary scenario that I actually can't buy it back from you the next day, you could just walk off with it, out of the courts, out of the frozen-from-bankruptcy process, out of the priorities. So essentially you jumped ahead of everybody, because you own that collateral overnight. So, this is among the many ways in which they manage to get the creditors to agree to lend them and basically think they are safe. So, the depositors feel that they have deposit insurance; some of the creditors have all kinds of collaterals; or they have the belief, as you said, of implicit guarantees, especially in the case of the largest banks. But even in all the cases of the entire system, somehow or other there is a belief that they will be paid. It's not true for the junior debt of a small bank, because actually the Federal Deposit Insurance Corporation (FDIC) might impose losses on them, maybe. But of course if they become systemic then in the Crisis even that was supposed to absorb losses never did.

Like any "kiting" scheme, the "borrowed asset" need only stay 24 hours ahead of the auditor.

John Berg

MG writes:

This was an OK guest, advocating a generally sensible position. I have some synpathy for the proposals, but I think I could have pushed back a bit on the consequences of tightening capital requirents and I would have challenged her claim that banks have done little to adress this since the crisis.

Coincidentally, today I came across this discussion of the (it is argued, negative) consequences of tightening capital requirements, especially if accompanied by the usual perversions that the regulatory system ends up pushing through alongside.

http://www.aei.org/article/economics/the-cost-of-capital/

A couple of quotes:

"A rule of thumb suggests the impact of tight regulations on lending is massive. Over the past five years, banks have increased Tier 1 capital — the core measure of safety from a regulator’s point of view — by nearly 30%, from $991 billion to $1.26 trillion, the highest in history. This increase in capital alone represents nearly $2 trillion in forgone loans or, presuming an average mortgage size of $200,000, about 10 million home mortgages.

To top it off, when banks do lend, regulators apply “capital punishment” through a process called risk weighting. Regulators assign risk weights to bank assets based on their perceived riskiness. The higher the risk weight, the more capital the bank has to hold against that asset. The joint notice of proposed rulemaking from the Federal Deposit Insurance Corporation, Federal Reserve, and Office of the Comptroller of the Currency on Basel III is a perfect example. Home mortgages are given a risk weight of up to 200%, meaning that banks must hold a lot of additional capital if they want to be in the mortgage lending business. Meanwhile, sovereign debt for E.U. countries is given a 0% “risk weight.” Yes, this includes Cyprus.

To be sure, capital is essential to safety and soundness. It buffers banks against unwelcome and unexpected future shocks. However, increasing capital requirements is also a surefire way to keep banks from lending, and that’s exactly what we are seeing today."

Douglas Tree writes:

MG,

I'm not in banking or finance, so take this with a grain of salt, however aren't you confusing the exact point that Russ and Anat make at the beginning of the podcast? In other words, as I understand it, your linked article argues that banks are being required to hold cash, not increase their equity share.

For instance it says: "Capital on banks’ books is like money under a mattress. It cannot be used for profit-oriented activity, like loans."

I think this was directly addressed in the podcast (near 18:00). As I understand it, Anat doesn't argue that banks must hold more cash, but rather that they must have 20-30% equity. In other words, they must play with a larger fraction of their own money (i.e. smaller fractional liabilities or a smaller leverage ratio).

Doug

Frank Howland writes:

MG:

I think you are missing the point of the podcast. The article you cite says this a few sentences before the part you quote: "Capital on banks’ books is like money under a mattress. It cannot be used for profit-oriented activity, like loans. Because banks can leverage loans, an old industry rule of thumb is that each additional dollar of capital restricts lending by $7 to $10."

The first two sentences are simply not true, as Admati points out in the podcast and her excellent book. If I attract $1 billion in equity, that has the exact same effect on my ability to make loans as if I attract $1 billion in deposits or if I borrow $1 billion. Capital is not put into some reserve which cannot be used for loans.

The last sentence of the above quotation bears some relation to reality, not the exact numbers, but the implication that equity is harder to attract than debt. Institutions are more willing to make very short term loans to banks than to buy equity. But reliance on debt finance makes banks much more prone to shadow banking type runs. Furthermore, the reason debt finance is cheaper than equity is the fact that the default risk on debt is being partly borne by the taxpayer for too-big-to-fail banks.

Frank Howland writes:

MG and Doug,

Sorry, I didn't notice that Doug had made a similar point in response to MG, but I endorse what he says.


FH

honeyoak writes:
Guest: But when they invest it, they kind of invest it longer term and in less liquid things. So there is a sort of imbalance between the money that they use to fund and their investment in the sense of the length of time until something has to happen and also the speed with which they have to pay versus get paid.
This is not true. See covered bonds in Denmark or how the repo market engages in reverse liquidity transformation. Nothing stops banks from investing exclusively in t-bills or structuring their liabilities to be less liquid than cash.
MG writes:

Frank and Doug,

The sentence both of you (rightly) disdain I would have edited out of the article. (Actually, I did!) I think it undermines the main point of the article which is that the impact of requiring instititutions to fund their portfolios with a higher percentage of equity (the simple residual of portfolio assets minus liabilities) is either (a) not to raise additional equity but to de-risk the asset side (by lowering amount of risk based-assets or their riskiness or to raise additional equity and (b)to raise the lending rate on the asset side to ensure that the return on (less leveraged) shareholder equity is consistent with the market's hurdle rates. (This does not rule out also seeking to lower the operating costs of bank lending or to turn a good deal of the banker's compensation portion of these costs into equity financing.)

For many banks in the real world, this process does end up looking like what the article oversimplifies: "risky assets" are replaced by "riskless government bonds" (another form of cash in the mattress, except on the asset side), because this is what the capital calculations would say reduces leverage or increases risk-weighted capital most (or easiest). Or new discretionary lending (say, as opposed to relationship lending) is done at higher default-recovery adjusted lending spreads.

If you think these are features not bugs of deleveraging, I would not disagree with you. But let's be prepared to accept the moaning from those who think growth is being curtailed by deleveraging.

Harder working banks with access to equity financing will raise more equity capital (like the author wants and claims they have not done) while also doing some of the latter. I suspect that most of these institutions are keenly aware that their wieghted average cost of capital has increased, and that their business model will have to change accordingly.

Something else to consider is whether the problem with global banking is that an enormous range of asset side riskiness (including the usual few black swan assets) should be funded out of a homogeneous equity + liability structure (capital in the broad sense). We have only talked about tweaking the equity side by deleveraging, but could not the debt side also use more price tiering and the assumption of real renegotiation risk?

Stephen H writes:

On the question of how to add real equity back into the system.

Well another option that 'seems' to be getting some traction is to slowly unwind the interdependence (banking and politics) and specifically move toward the removal of the retail guarantee. How? Government grantee deposits in commercial retail banks, and they own a couple of big chunks of banking (UK). So why not create a public bank and move the guarantee to that alone...

http://www.bbc.co.uk/news/business-22094308

The removal of this single incentive should encourage enough away from the big retail banks. Then hope they downsize or fail (who cares they can all go and pee in their own closed pool and let nature take its course). Then denationalize when the system is more stable.

Let's hope they do it!

[broken html fixed--Econlib Ed.]

John Berg writes:

In the cited
"FDR and FDIC," by Russ Roberts at Cafe Hayek, December 2, 2008.
is the interesting 2008 comment

Mr. econotarian December 2, 2008 at 3:50 pm "He also promised to uphold the gold standard, while on the campaign trail."

I think that pre-1933, the feeling was that the gold standard could not be touched because of many debt contracts written with explicit "convertible in gold" clauses on repayment. (Hoover explicitly said he would not leave the gold standard because of gold clauses).

In 1933, Congress passed the "gold clause ban" that negated all contracts with gold convertible repayments. After that, going off the gold standard was much easier!

If all contracts can simply be negated, in one go, by congress and the president, what value does any contract have at any level of State or Federal?

While Anat Admati and Martin Hellwig address in their book only the banking system, I seek a wider cause for our current crisis. Did the income tax amendment to the Constitution permit the federal government to go around the states to tax individuals. Wasn't it obvious to the amenders that once the Feds had the money, they could bribe, incentivized, and control the states?

John Berg

SaveyourSelf writes:

This was a very frustrating podcast for me. Here is Anat Admati—a thoughtful, well informed, disciplined thinker who demonstrated a clear understanding of the importance incentives play in determining human behavior when she said, ”the system gets very distorted because they [the bankers] have incentives to get very complicated and all knotted up”. She also demonstrated a clear understanding that regulations create incentives when she said, “this is actually how we blame some of the structure of this regulation with interconnectedness, because they [the bankers] all tend to go to where the regulations say it as safe, but it's not actually safe.” She even demonstrated a clear understanding of the practical results caused by present day incentives when she said, “certainly the way banks behaved left a lot of empty buildings.”

Why, then, doesn’t she make the next logical conclusion that [nearly] ALL regulations will—ultimately—lead to similar bad outcomes. Why does she say, after demonstrating so much clear thinking, that her fix for the present day regulatory problem is more—albeit different—regulations.

“I would tell all the banks to go raise some equity,” she says. Furthermore, “I favor effective regulation after that to really contain the safety net so that it's not needed as much.”

So she goes from apparent understanding of the role of regulation in the modern systemic bank failure to an assertion that new regulations can not only solve the problems caused by the previous regulations, but they can also reduce the risk in the system so the safety net won’t get utilized as much. She doubles down on that assertion when she agreed with Cochrane’s position that the right regulatory requirement for bank equity is: ”Until it doesn't matter. That is, until there are no more bailouts…” She is once again concluding—in stark contrast to her own understanding of the present system failure—that it is possible to regulate the risk in the system down to zero—ie. “until there are no more bailouts.”

Looking back on the conversation, I see the cause of my frustration. It was Russ, not Anat, who was spelling out what a world with unregulated banks looks like and how it functions. I mistakenly took her agreeable comments as evidence that she understood the implications of his words, namely that a banking sector can function better without any outside regulation and that her proposals were simply attempts to move closer to the system that exists naturally in the absence of government regulation, subsidy, and insurance.

I mean no disrespect, Anat, but here is what you missed: The lowest risk model in existence—in banking or any other market—involves 2 people agreeing to trade in an environment that is competitive, well informed, and free of ALL regulations aside from the precepts for Justice. Any reduction to any of those environmental factors—such as reducing freedom by regulating equity requirements on one or both parties—INCREASES RISK for that trade. It doesn’t decrease it. It CANNOT decrease it. You don’t understand anything at all until you understand that model. And until you understand it, your well meaning efforts to improve “this inefficient system” are guaranteed to fail.

John Berg writes:

Hard-wired to be a teacher, Russ can't be faulted for wanting to use his discipline, economics, to solve this vexing problem that plagues Russ, me, and, apparently, you. Stated as simply as possible, "Why has our Constitution failed us?" We amended it to our peril before--and had to rescind the amendment. Might we have done it again? Which of our Constitutional amendments were passed during the Progressive era? Which could be expected to alter our Federalist form of government?

Putting it at another level: why is diversity wonderful for every collective problem we face but not when we consider fifty states each offering different approaches designed to be accountable to a region directly "benefiting" from that approach?

Russ's penchant for teaching has provided me personally at least four years of much appreciated graduate study far from my life's work.

John Berg

Bjartur writes:

+1 to A and Saveyourself, above.

Russ, I'm trying to understand why you're buying into the increased regulation argument on this. Don't you think the screwed-up incentives are at least mostly caused by government interference in the market? Don't you think a better response to government interference in the market is to reduce or eliminate that interference rather than treating the symptoms with additional regulations? Maybe try the thought experiment of--rather than just talking about "the banks" in the abstract--coming up with specific details of what you would actually make specific banks (JPM, Citi, Wells Fargo, US bank, etc.) do if you were an all-powerful regulator. Think of the odds of your being successful at that; then think of the odds of less intelligent and more corrupt people being successful at that.

Leigh writes:

I really enjoyed this podcast. It's great to hear interesting points of view on topical financial issues from someone who knows her stuff. More like this please.

Denys writes:

"A voice crying in the wilderness". I have been in banking for 40 years and I find it very hard to pick holes in her argument that requiring 20 pct or more equity capital will have anything but positive effects (except to bankers' bonuses!).
I take my hat off to her because I, myself, considered this argument that increased equity capital was the answer to improving the banking system. But I, unlike her, was dissuaded by all the voices around me that said such a thing would automatically, and inevitably, raise the cost of money to borrowers and significantly hurt the economy. But she has been brave and smart enough to challenge that view against almost universal and highly charged (!) opposition. Is she right! More right than wrong I believe.

Sri Hari writes:

Very informative podcast, Adnati was at her best and patiently waited for Russ to complete his comments!!

High equity is required to impose private market discipline. With wafer thin equity there was no 'real owner' of banks to oversee viability of various transactions. Bank CEO's and regulators have incentives lined up such a fashion that they are not concerned with long-term survival of the institutions. Criminal prosecution for overlooking underwriting responsibility-both by seller and buyer of loans need to re-imposed.

I am concerned that vast number of listeners including 'saveyourself' do not understand this 'human factor' and are living in the "Ayn Rand' world of self imposed private market discipline.

SaveyourSelf writes:

@Sri Hari. Your choice of wording is excellent and allows me to respond intelligently.

You wrote, "I am concerned that vast number of listeners…do not understand this 'human factor' and are living in the "Ayn Rand' world of self imposed private market discipline."

First, in a Free-Just-Competitive-Well informed market, discipline on market participants is not "self imposed." Discipline is customer imposed and also competition imposed. Importantly, within that ideal framework your concern about a 'human factor' is automatically addressed. (I assume by 'human factor' you mean the ugly willingness inside each of us to harm others if doing so makes us better off.) No market participants who are free to choose from many different sellers will choose a seller who harms them. That means the businesses who routinely injure their customers quickly run out of customers and go bankrupt. In this way, Free-Just-Competitive-Well informed markets filter and nullify sinful human tendencies, leaving only moral tendencies to prosper.

Second, Americans do not live in a Free-Just-Competitive-Well informed market. America is a socialist country. Its citizens operate in a highly regulated and Unjust albeit Competitive and Well informed marketplace. So America has some strengths that predict a moral society and a high standard of living—especially when compared to the rest of the world—but also some weakness that pull down the overall standard of living and nurture immorality.

Third, Ayn Rand got a lot right. I'll be the first to admit she didn't see everything perfectly in her world-vision, but her predictions have proven so prescient that she really needs no defending. Her work stands on its own.

Forth, I agree with you that the absence of criminal penalties following the credit crisis is concerning. People got hurt. Justice requires an accounting. I think the notable absence of a trial at any level is a clear indication that the criminals and the prosecutors of criminals now consider themselves the same people. Fannie Mae was the child of the government...and still is.

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