The Real Weakness in the Reform Strategy for Banks

by Simon Johnson

Anil Kashyap is one of our leading researchers on banks. His book with Takeo Hoshi on the evolution of Japanese corporate finance is a must read on the twists and turns that built a great economy and then laid it low. And he has many other papers and relevant recent commentary (pdf files).

Professor Kashyap has a sharp perspective of the administration’s financial sector reform thinking, in part because he has long worked alongside key people now at the National Economic Council (the NEC, by the way, has disappointingly little transparency; even Treasury is more open).

So we should take him seriously, writing Tuesday in the Financial Times, on the importance of the proposed new “funeral plans” for banks.

Kashyap’s point is that if banks are forced to explain, in convincing detail, how they can be wound down, this will effectively limit the complexity and scale of their operations. (See “Rapid Resolution Plans” on p.25 of the regulatory reform proposals; p.26 in the online NYT version)

The notion is intriguing, if such rules are actually enforced. Essentially, banks would be required to specify the extent and nature of costs for any bailout they may require.

A key part of any plan would be the people involved. Are there critical individuals who would need to be kept on to wind down positions (as was claimed to be the case with AIG FP)? Would they therefore require large retention bonuses? How large exactly?

You can see how such resolution planning might go wrong – particularly if banks were only forced to consider whatever they now regard as “normal” risks. Remember the head of quantitative equity strategies who said, in early August 2007, “Events that models only predicted would happen once in 10,000 years happened every day for three days.”

A checklist approach is definitely not going to work (been there, done that, for countries). You need something that can simulated or, even better, played out in a war game. Bring in some difficult outsiders and try to break the bank in the messiest way possible (in a game), then follow the consequences and costs.

These banks are so large and intertwined with so many others, it’s hard to fathom how a “funeral plan” would be reassuring – unless it means that they become smaller and less complex.

And this brings up the real weakness of this approach to reform – the political economy. How do regulators of any kind press for meaningful plans regarding closing down, say, Citigroup (C) or JP Morgan Chase (JPM)? The CEOs of those firms have direct access to the Secretary of the Treasury and on Pennsylvania Avenue they are regarded as gurus and bastions of the economy. They’ll say, “look, if you let this person force us to simplify our business, there will be less credit growth and a big recession.” Which recent Treasury Secretary would be able, at that moment, to face them down – particularly as these bankers can, if pushed, go to the big boss?

On top of this, keep in mind there is no cross-border resolution authority currently on the table in the US regulatory reform proposals or at the G20 level. The Europeans say they are inching in this direction; I’ll believe that when I see it. In our next boom-bust iteration, big banks may well be regarded as having ”too many cross-border liabilities to fail”, so there’ll be another quasi-bailout with potentially huge fiscal costs.

And then someone will promise a new regulatory reform plan.

Comments

[Fitz919:]

The Government just wants to be able to say, "We did something...and it worked." It doesn't matter to the Government whether it's true or not.

Jul 02 12:47 PM

[dcb:]

Debt is capitalism’s dirty little secret
By Ben Funnell

Published: June 30 2009 19:14 | Last updated: June 30 2009 19:14

Just why is there so much debt in the Anglo-Saxon world? Bankers and regulators know well that it is in nobody’s long-term interests to have allowed borrowing to escalate to a position where the US now owes far more, as a multiple of the economy, than at the start of the Great Depression.

The answer is capitalism’s dirty little secret: excessive lending was the only way to maintain the living standards of the vast bulk of the population at a time when wealth was being concentrated in the hands of an elite.

The amount by which the elite has benefited is startling, and illustrates the problem with lightly regulated free markets: the rich get much richer while the rest do not get richer at all. According to Société Générale economists, the inflation-adjusted income of the highest-paid fifth of US earners has risen by 60 per cent since 1970, while it has fallen by more than 10 per cent for the rest. As was recently pointed out in the New York Review of Books, the Walton family, of Wal-Mart fame, is wealthier than the bottom third of the US population put together – about 100m people. These are staggering statistics, confirmed by measures such as the US and UK’s ever-rising Gini coefficients, which estimate income disparity. Another way of putting this is that the share of profits in gross domestic product is at a 100-year high, or was until very recently.

Put simply, the benefits of economic growth have gone into the pockets of plutocrats rather than the bulk of the population. So why has there been no revolution? Because there was a solution: debt. If you couldn’t earn it, you could borrow it. Cheap financing was made widely available. Financial innovations such as the asset-backed securities market aided this process, as did government-sponsored agencies such as Fannie Mae and Freddie Mac. Regulators welcomed it all while perhaps taking insufficient account of the moral hazard problem it posed: that ever-increasing leverage meant the authorities had to keep interest rates low, otherwise the debt burden would cripple consumption. This prompted more leverage, which exacerbated the problem.

A walk in any low-income area in the UK confirms this. There are BMWs in the driveways, satellite dishes on the roofs and furniture delivery vans on the streets. In both Britain and America the jobless were encouraged to buy their own homes. No one begrudges anyone else the right to own a home or buy luxury goods. The problem is that the luxuries need to be paid for out of earnings and the houses out of equity topped up with an affordable amount of debt.

The question is whether the debt load – total US credit market debt outstanding was $53,000bn (€38,000bn, £32,000bn) at the end of March, or 3.7 times GDP – is at all sustainable and, if not, how it can be lowered without sinking the economy. Those pushing extra debt in an effort to boost the economy via increased consumption point to the scale of assets backing the debt. The net worth of US households, including their houses and after counting debt, was $50,000bn in March, according to the Fed. Not a bad tally for 306m people: $165,000 each. However, the cost of servicing this debt as a proportion of income, even with record low rates, is at a 30-year high, above 15 per cent, as incomes have stagnated and the total level of debt has risen.

The debt burden has to come down, which means more saving and lower economic growth for many years to come. Along the way inflation is likely to return, probably sooner and more violently than most expect, which will prompt investors to demand a higher return and make it even harder for governments to tackle the debt. At best the debt will fall slowly over many cycles and simply trim otherwise resilient growth. At worst it could cause growth to lurch upwards before tumbling again, with all the attendant uncertainty that entails. At this point, no one can know which is more likely. I incline to the more benign view because of the size of household assets but, if the dollar’s reserve currency status should come under serious attack, rates would have to rise to defend it and that could itself cause a consumption crisis.

What can be done? First, although it is not ideal, we should not be too hasty about abandoning the capitalist model. It is less bad than any other system yet invented. But we should redouble our efforts to increase productivity through innovation and creating new markets; simply squeezing lower-income workers is a bad option, which helped get us into this mess in the first place. This requires investment in education and research. Second, we have to learn to live within our means. This means spending less than we earn, perhaps doing without the BMWs, flat-screen television sets and leather sofas. Third, we should be careful in distributing the higher tax burden that we will inevitably have to bear over the coming decade. Very high marginal tax rates did not work in the 1970s and will not work now. That said, income disparity at current levels is a political time-bomb that needs to be dealt with. Finally, we should all come to terms with the fact that these are structural issues needing structural solutions; they need to be enforced over a longer time period than any one government’s term. So we need a new political consensus, one aimed at reducing overall debt levels while reducing inequality by encouraging education, entrepreneurship and investment in innovation.

The writer is an asset manager at GLG Partners
Copyright The Financial Times Limited 2009

Jul 02 04:55 PM

[dcb:]

Dear Simon,
They’ll say, “look, if you let this person force us to simplify our business, there will be less credit growth and a big recession.”

I'd say it was credit growth that got us into the recession, so how is more going to help.

Lets face the facts they have bought and paid for their policies and the logic behind them is secondary. What gets said at meetings and to the public is spin. The spin is always "it will make things much worse". )(By the way this has been scientifically shown that you get more in negiotiations by making the other party feel disaster will happen if you don't do something. ).

Real meaning: "If we don't do things like this I won't make as much money". Has anyone besides myself noticed that each and every solution they have just happens to put more money in their pockets.

Simon, if you can't sort out the spin form reality you have been in washington too long!!!

Jul 02 05:01 PM

[TinyTim:]

"These banks are so large and intertwined with so many others, it’s hard to fathom how a “funeral plan” would be reassuring – unless it means that they become smaller and less complex."

Bingo. Plus more transparent and collateralized.

Jul 03 02:10 PM

[John Lounsbury:]

In the Old West, people survived shooting from the hip and by having only friendly folks at their back. The same credo seems to be in vogue now in the world of finance. Didn't it take a couple of generations to bring law and order to the Old West? Same for Wall Street?

Jul 03 02:18 PM