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Introduction

U.S. bank purchases, packaging and trading of mortgages and their derivatives in late-2008 resulted in the U.S. banking collapse and the global recession. European bank purchases and packaging of Greek and other sovereign debt is close to causing another global meltdown. That leads to the question posed by the title: what should we do about it. In the following article, I consider several viewpoints on what should be done.

The Bhidé and Lounsbury Suggestions

In a NYT op-ed piece, Prof. Amar Bhidé recommends:

  • Governments should fully guarantee all bank deposits;
  • Governments should impose much tighter restrictions on risk-taking by banks, and finally
  • Banks should be forced to shed activities like derivatives trading that regulators cannot easily examine.

John Lounsbury, Managing Editor and Co-founder of Global Economic Intersection has suggested:

“... the depository function of banks should be regulated as are public utilities. That public utility function is in fact institutionalized by the FDIC within the depository limits of that program. The investments associated with such deposits should be regulated to a much higher security/risk standard than many other forms of banking traditionally known as investment banking. It is only logical that the public utility should be segregated from the investment banking activities.”

Guaranteeing Bank Deposits

Felix Salmon has argued that bank deposits need not be guaranteed. He sees little change of a run on banks, either in the U.S. or Europe. I think he is crazy, particularly as it applies to Europe. I quote from one of my recent pieces:

“A bank run occurs when depositors, worried about the safety of their deposits, pull them out. This causes real problems inasmuch most banks keep less than 10% of their deposits in cash. So what would I do if I had Euros deposited in any eurozone bank? That is easy. I would pull them out immediately and stuff them under a mattress.

Why? What if Greece decides it has to get out of the eurozone and go back to its own currency? Yes, there is a way that I described in a recent article whereby you could keep your euros and they would become interchangeable with the new currency at market rates. But do I trust the Greek or any other European government to implement such a program? No.”

In my view, the danger of bank runs in several of the EUR countries is quite high. And the very last thing any country needs is a bank run: deposits cannot be covered and citizens panic. The best way to at least mitigate the chances for bank runs is to guarantee deposits.

Tighter Restrictions on Risk-Taking

Both Bidé and Lounsbury believe risks should be lowered and more tightly regulated in depository banks.

Ashwin Parameswaran and I question whether this can be done. I quote from Parameswaran:

“There are a couple of problems [here]…for one it may not be possible to effectively regulate bank risk-taking. On many previous occasions, I have asserted that regulations cannot restrain banks from extracting moral hazard rents from the guarantee provided by the state/central bank to bank creditors and depositors. The primary reason for this is the spread of financial innovation during the last fifty years that has given banks an almost infinite variety of ways in which it can construct an opaque and precisely tailored payoff that provides a steady stream of profits in good times in exchange for a catastrophic loss in bad times. As I have shown, the moral hazard trade is not a “riskier” trade but a combination of high leverage and a severely negatively skewed payoff with a catastrophic tail risk.”

I would add another reason: regulations won’t work because bank regulators cannot anticipate what is needed. For how long have bankers been working on regulations? We have had three sets of Basel Accords – I, II, and III. Each of these accords was an attempt to score the more and less risky assets held by banks. So after all this work, how was sovereign debt scored? Just as good as cash! Forget regulations: they won’t work. Instead, depository institutions should be limited to making and managing their own loans with no trading allowed.

How Do We Get There?

Two steps need to be taken:

1. Split Off Bank Trading Operations;

2. Require Banks to Make, Hold, and Manage Their Own Loans.

Split Off Bank Trading Operations

Parameswaran is horrified by this notion and does not think it can be done:

“Amar Bhide’s idea essentially seeks to turn back the clock and forbid much of the innovation that has taken place in the last few decades.”

As an aside, this comment reminds me of what Larry Summers said when Glass-Steagall was overturned. He welcomed the overturning of Glass-Steagall as “a system for the 21st Century”.

“The innovation that has taken place in the last few decades”?? Hmm. What have we gotten from these innovations? So far, two major banking collapses and a global recession that ranks 2nd only to the ’29 collapse.

Back to Parameswaran. He claims:

“There is simply no way that large banks, especially those with a large OTC derivatives franchise, can shed their derivatives business and still remain solvent.”

Parameswaran is missing the point. There is no need for them to liquidate their holdings. What would happen, as it did in the ‘thirties, is that the depository institutions’ investment banking arms would be sold off and the depository banks would get cash payments for what they were worth. The high-paid executives would leave with their products inasmuch as there would be no justification for their high compensation if they stayed behind. Let them play their “combination high leverage and a severely negatively skewed payoff with a catastrophic tail risk” games somewhere else.

Require Banks to Make, Hold, and Manage Their Own Loans

This is what banks did (before the “innovations”), and it required them to focus on the spread – the difference between what they paid to attract deposits and what they made on their loans. This was their life blood – their loans could not fail or they would collapse. Think how different the incentives are today – buy, package and sell loans – make money on the commissions – don’t worry about the quality of loans, you will be selling them off – the more you sell off, the more commissions you make.

Why did the market for mortgage-backed securities hold up so well when everyone knew there was a real estate cycle? Why was anyone buying Greek sovereign debt in 2007 when it was clear Greece was on a non-sustainable path? Because the banks did not care about risk: they planned to sell everything off and make money on the commissions.

Will this change really make a difference? I think so: the incentive change is so profound that banks will again be forced to think seriously about the quality of the loans they are making.

Parameswaran disagrees:

“Although this would seem to be a sufficiently narrow mandate to prevent rent extraction, it is not. Banks can simply lend to other firms that take on negatively skewed bets. You may counter that banks should only be allowed to lend to real economy firms. But do we expect regulators to audit not only the banks under their watch but also the firms to whom they lend money?... I outlined how the synthetic super-senior CDO tranche was the quintessential rent-extraction product of the derivatives revolution. But at its core, the super-senior tranche is simply a severely negatively skewed bond – a product that pays a small positive spread in good times and loses you all your money in bad times. There is no shortage of ways in which such a negatively skewed payoff can be constructed by simple structured bank loans."

I do not believe Parameswaran is right because of the fundamental change in incentives that holding their own loans would force on banks. But who knows? My suggestion? Try it my way. Watch it carefully. If it appears Parameswaran is right, adopt a severe public utility model and require that depository institutions limit their investments to U.S. Treasuries or in the case of the euro banks, ECB paper.

Conclusions

Some form of what has been discussed above should be adopted. Why? Because none of the steps taken to date have significantly reduced the chances of another bank meltdown. What are the chances for meaningful reforms? Not good. The U.S. and European banks’ lobbies are too strong.

Source: Global Banking: What Should Be Done?