The Fourteenth Banker Blog

May 28, 2010

Simple Primer on Why There Must Be Regulation Reversing Deregulation.

Filed under: Running Commentary — thefourteenthbanker @ 9:50 AM

These are excerpts of excerpts. While the original article, linked at the bottom, goes into more depth, I wanted to just pull some highlights out that relate to the simplicity of the basic banking system and its use of Public Goods. There is a lot of talk these days about Public Goods, particularly with the destruction of Public Goods with the BP debacle. Banking really cannot be separated from deposit insurance and other implicit guarantees for the Too Big To Fail institutions. Much more is available also in this link from a Federal Reserve Board conference. The different paragraphs below are in order but there are paragraphs deleted to cut down the length.

The essence, or the genius of banking, not just now, the last century or the century before that, but since time immemorial, is that the public’s ex-ante demand for assets that trade on demand at par is greater than the public’s ex-post demand for these types of assets. Let me repeat this, because this is a first principle: The public’s ex-ante demand for liquidity at par is greater than the public’s ex-post demand. Therefore, we can have banking systems because they can meet the ex-ante demand, but never have to pony up ex-post. (14 here-what he is saying is that the expectation of the depositor is liquidity, but in practice, absent a pure bank run, that liquidity never has to be provided to the entire deposit base at once. It is in fact a relatively stable funding source) In turn, the essence or the genius of banking is maturity, liquidity and quality transformation: holding assets that are longer, less liquid and of lower quality than the funding liabilities.

Banking is a really profitable business. In its most simple form, think in terms of a bank issuing demand deposits, which are guaranteed to trade at par because they’ve got FDIC insurance around them and also because the issuing bank can rediscount its assets at the Fed in order to redeem deposits in old-fashioned money, also known as currency.

In fact, let’s take a look at the $1 bill I am holding in my hand. It says right at the very top, “Federal Reserve Note.” It also says right down here, “This note is legal tender for all debts, public and private.” This is what the public ex-ante wants: the knowledge that they can turn their deposits into these Federal Reserve Notes. And if the public knows they can turn them into these notes, they don’t. With me here? If I know I can, I don’t.

Now, this is a unique note. This is a Federal Reserve liability. And, actually, it’s really cool. It’s missing two things. It doesn’t have a maturity date on it. So, it’s perpetual. And it doesn’t have an interest rate on it. I would love to be able to issue these things. It would make me very, very happy to issue these things. But it would be against the law! But, in fact, that’s what banks did in the 19th century. They issued currency. After the creation of the Federal Reserve, it was given monopoly power to create currency, which I think was a pretty bright idea. But demand deposits issued by banks are just one step away from a Federal Reserve Note.

Conceptually, demand deposits have a one-day maturity. I can write a check on it, and it goes out at par tomorrow, if not today. Demand deposits, conceptually, have a one-day maturity. But in aggregate, they have a perpetual maturity. So, therefore, banking can engage in maturity, liquidity and quality transformation: a very profitable business. Banks can issue, essentially, perpetual liabilities – call them demand deposits – and invest them in longer dated, illiquid loans and securities, earning a net interest margin. It’s a really, really sweet business.

In the early years of the Quiet Period (14 here-after the depression and institution of deposit insurance, when few banks failed), we regulated that really sweet business. I think that was a really bright idea. In order for that business not to be prone to panics and, therefore, financial crises, you needed to have deposit insurance. Deposit insurance, by definition, cannot come about as if by the invisible hand. Deposit insurance cannot be, cannot be a private sector activity. It is a public good. The deposit insurer must be a subsidiary of the fiscal authority. And in extremis, the monetary authority can monetize the liabilities of the fiscal authority. I’m not saying that pejoratively. I’m not being pejorative at all. Just descriptive. Bottom line: Deposit insurance is inherently a public good.

Access to the Fed’s balance sheet is also inherently a public good, because the Federal Reserve is the only entity that can print currency. So essentially, banking has two public goods associated with it. Therefore, naturally, it should be regulated.

That was the Quiet Period Model. And regulation took the form of what you could do, how you could do it and how much leverage you could use in doing it. And, as was mentioned by Paul Volcker a number of times earlier this afternoon, the regulatory burden that has historically come with being a conventional bank has been actually quite high. During the early years of the Quiet Period, however, banking was nonetheless a very profitable endeavor.

There was a quid pro quo, which actually led to the old joke – which was actually said about the savings and loan industry – that banking was a great job: Take in deposits at 3, lend them out at 6, and be on the golf course at 3. 3-6-3 banking was a pretty nice franchise. So, therefore, bankers had a pretty strong incentive not to mess it up. Essentially, there were oligopoly profits in the business. I think Gary Gorton is actually right on that proposition.

The invisible hand, however, naturally wanted to get the oligopoly profits associated with banking while reducing the impact of some regulation. Thus, the Shadow Banking System came into existence, where the net interest margin associated with maturity, liquidity and quality transformation could be earned on a much smaller capital base.

And, in fact, that’s what happened starting essentially in the mid-1970s, accelerating through the 1980s and 1990s, and then exploding in the first decade of this century.

14 here-fast forward to the financial crisis, TARP, unlimited transaction account insurance, etc.

Concurrently, the FDIC stepped up to the plate, doing two incredibly important things. Number one, they totally uncapped deposit insurance on transaction accounts, which meant that the notion of uninsured depositors in transaction accounts became an oxymoron. If you were in a transaction account, there was no reason to run. And then the FDIC effectively became a monoline insurer to nonbank financials with its Temporary Liquidity Guarantee Program (TGLP) allowing both banks and shadow banks to issue unsecured debt with the full faith and credit of Uncle Sam for a 75 basis points fee. No surprise some $300 billion was issued.

So, bottom line, you had the Fed step up and provide its public good to the Shadow Banking System. You had the FDIC step up and do the same thing with its public good. And as Paul Volcker was noting this afternoon, you had the Treasury step up and provide a similar public good for the money market mutual funds, using the Foreign Exchange Stabilization Fund. It was a triple-thick milk shake of socialism. And it was good. Again, I’m not being pejorative. I’m being descriptive.

Banking is inherently a joint venture between the private sector and the public sector. Banking inherently cannot be a solely capitalistic affair. I put that on the table as an article of fact. And, in fact, speaking at a Minsky Conference, I know I’m preaching to the converted. Big bank and big government are part of our catechism. And, in fact, that’s exactly what came to the fore to save us from Depression 2.0.

Let me draw to a few conclusions. How should we re-regulate the financial landscape – as President Bullard was calling it today – to make sure this doesn’t happen again? We must, because the collateral damage to the global economy has been truly a tragedy.

And I think the first principle is that if what you’re doing is banking, de jure or de facto, then you are in a joint venture with the public sector. Period. If you’re issuing liabilities that are intended to be just as good as a bank deposit, then you will be considered functionally a bank, regardless of the name on your door. That’s the first principle.

Number two, if you engage in these types of activities – call it banking, without making a big distinction here between conventional banking and shadow banking, as Paul Krugman intoned this morning – in such size that you pose systemic risk, you will have higher mandated capital requirements and you will be supervised by the Federal Reserve. Yes, I just told you who I think the top-dog supervisor should be. You will have tighter leverage and liquidity restrictions: You will have to live by civilized norms. In fact, a great deal of what is on the regulatory reform table right now proceeds precisely along those lines. If you’re going to act like a bank, you’re going to be regulated like a bank. That simple. And maybe you just might find the time to go back to working on your golf game at 3. That is the core principle.

There truly is a devil in the details, because it’s quite natural that non-bank levered-up financial intermediaries don’t want to be treated like banks. I wouldn’t either. But the truth of the matter is if you’re going to have access to the public goods associated with banking, then you’re going to be treated like a bank.

The banks are working furiously to obscure these simple realities. The truth is that all big banks were bailed out. They can squawk all they want about “We didn’t really need the money…”, but the domino effect would have brought down every big bank. TARP was only one piece. Unlimited deposit insurance was another. Guarantees of Money Market funds was another. Any unchecked runs would have brought down even the “Flight to Quality” banks, in my opinion, because their interbank loans, hung investments, mark to market impacts, and counter party risks would have swamped confidence. While leverage is down somewhat, this is still the case. le Were it not, would the Treasury and Fed be making hundreds of Billions available to the European banking sector after so much bad publicity from Bailout One?

So in the Conference Committee, the bill must be made stronger rather than weaker. The people cannot afford to give away public goods.

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