A Less Coherent Post Than I'd Like About The Purpose Of Banking
Earlier this week I attended a conference hosted by the Roosevelt Institute about financial reform on the theme of: will it work? how will we know?
There were a variety of very short presentations – synopses, really, of papers included in the packets handed out to attendees – on a variety of topics including data collection, how to clear derivatives contracts, the likely impact of Basel III, the future of the ratings agencies (if any), and so forth. And the overall tone of the whole event was: we’ve fixed some things, we haven’t fixed everything, we need to maintain the political will to stay vigilant, and we need to keep Congress in the hands of the Democrats.
It was all interesting and I did learn a thing or two. But what kept nagging at me was: what do the architects of financial reform think banks are for?
That’s not a sarcastic question. The classic function of a bank is to turn savings into capital. They borrow from the public in the form of insured deposits. They then deploy this capital in the form of loans of various kinds. Their job, in other words, was to evaluate and hold risk – the risk of those loans. And for taking that risk, they earned a return.
But in the world we actually live in, banks have labored to make themselves appear to be service businesses that earn fees rather than risk-taking businesses. Indeed, risk is a bad word – and remains a bad word with the financial reformers. The new job of banks, say both the banks themselves and their regulators, is to be financial intermediaries. They don’t lend money against a house as collateral; they intermediate between a mortgage borrower and an investor in a mortgage-backed security. They don’t lend money to a business; they intermediate between a company looking to borrow money and an investor in a collateralized loan security. They don’t even take deposits; rather, the intermediate between short-term corporate borrowers and investors looking for near-cash instruments. And of course they intermediate between the various participants, hedgers and speculators, in the wide variety of over-the-counter derivatives markets.
True intermediaries, though, don’t need a lot of capital. They don’t even need a whole lot of funding. The old investment banks were intermediaries of this sort, and they didn’t retain big positions. They only needed enough money to do their next underwriting and maintain an orderly market in the underwritten security thereafter. They certainly didn’t need deposits – or deposit insurance. But the banks need a whole lot of money. They have enormous balance sheets. That’s because while they are intermediaries, they are not pure intermediaries. They’re intermediaries who retain positions. Specifically, the residual risk position created by millions if not billions of imperfectly matched trades: counterparty credit risks, dynamic hedging risks, legal risk on securitizations, and so forth.
There are, of course, rules to ensure that some capital is being held against these residual risks. But the capital rules are designed to be efficient – to require more capital where there is more risk, less capital where there is less. Where the residual risk appears to be negligible, the capital required to hold against it – even if the nominal position is in the hundreds of billions – is negligible as well.
Deposit insurance was created to prevent runs on banks, so that you wouldn’t have a pro-cyclical withdrawal of capital from the system at just the point that loan losses were increasing. Fed regulation was imposed to mitigate the obvious moral hazard created by deposit insurance. But if banks are not fundamentally in the business of lending money and earning a return for risk, then what business is being underwritten by that provision of insurance?
The business being underwritten is, in a fundamental sense, the business of modeling financial risk – the enormous pile of residual risk associated with intermediating-but-not-really. But, as we saw in the most recent crisis, modeling financial risk is, well, basically impossible. That is to say: you can model the world of normal financial behavior just fine, and you can definitely improve your risk-adjusted returns if you do it well. Fundamental changes in the state of the world, though, you can’t really model at all.
Citigroup, after all, was not bankrupted (or brught to the point of needing government assistance to avoid bankruptcy) because it made bad loans. Citigroup was bankrupted because it retained the super-senior (AAA rated) portion of risk associated with CDOs of subprime mortgage loan securitizations it had underwritten. It treated this risk as essentially nonexistent – sensibly enough given that its own models and those of the independent ratings agencies said there was none.
Goldman Sachs was not bankrupted (or brought to the point of needing government assistance to avoid bankruptcy) because it made bad loans. Goldman wasn’t even bankrupted because it happily retained the super-senior (AAA rated) portion of risk associated with CDOs of subprime mortgage loan securitizations it had underwritten. They were too clever to believe the models that said this risk was good. Goldman was bankrupted because while it retained that risk, it hedged the risk with a AAA rated counterparty: AIG FP, a subsidiary of the country’s largest insurer with a century-long track record of performance. What’s the residual risk on a AAA security hedged with a AAA counterparty? Enough to bankrupt Goldman Sachs, apparently.
What we have now is a financial system that is leveraged to risk modeling to an enormous degree, and what we’re basically doing is doubling down on that bet right after it failed in the most massive fashion. We are trying to “get the risk right” and to stop banks from taking overly risky bets in the future. But you can’t get the risk “right” – not in the only sense that matters, namely, when the next crisis will hit and how a particular book will behave when it does.
It seems to me that if we’re trying to avoid similar crises in the future, what we need to incentivize is not the elimination of risk but rather the simplification of the banks’ books. We don’t need to increase the capital charges on low-rated bonds and loans – we need to increase the capital charges on high-rated bonds with embedded derivatives, on derivatives counterparty risk, and so forth. “Proprietary trading” in the sense of highly leveraged betting on small differences in the value of similar securities or baskets thereof will migrate out of banks naturally, because it won’t be economical if the capital charges for such strategies are higher, as they would be. Derivatives businesses will either shrink or will migrate to exchanges where they will clear through a clearing corporation – which, of course, doesn’t eliminate counterparty credit risk but does massively increase transparency and provide clear policy levers for trying to keep risk from getting out of hand. Securitizations will either continue (if they make economic sense once the apparently riskless top piece cannot be leveraged infinitely to generate an adequate return) or not (if they don’t). Banks will be able to do true financial intermediation (of the sort that investment banks used to do), where at the end of the transaction the book is effectively liquidated, and there is truly no more risk. But intermediation-but-not-really as a business strategy will be too expensive in terms of capital to be profitable.
If the incentives are strong to eliminate residual risk that is impossible to measure, it will be much harder for banks to make money by pushing risk out into the tails of the distribution. They’ll have to go back to making money the old fashioned way: by lending it to the real economy. Which will mean taking risk. But it’s risk that we can see. And it’s risk that produces some social benefit, by actually turning deposits into capital. Which is what the banks exist to do in the first place.
I only understood about 9/16th of that post, but it was interesting just the same. When I think of what banks do for me, their basict function is to hold my money safely and then dole it out to me/for me through my debt card as needed. I actually pay them for this because the withdrawl fees I pay are usually more than the interest I recieve. In fact, I can’t ever remember receiving more that .5% interest on a savings or checking account. So the idea that I give the bank my money and the pays me so that they can use it, is no longer true. Unless I buy a CD I guess. So they get my money to use for loans and recieve anywhere from 4-10% (minus .5%), plus they get the debit fees (I get 12 free which is never enough) and then don’t they get they get transaction fees from the merchants? And in return I get safe and convienent digital money. Plus I’m on the hook for bailouts.
Anyway, this holding and doling out function seems like it is bound to grow as we digitize.
— cw · Oct 7, 03:52 AM · #
I still remember, some twenty years ago, when my banker explained to me that my job wasn’t to convince the bank that I could pay back the loan, but in fact my job was to fill out the loan application in a way that allowed the bank to sell the loan to someone else.
This was an important insight, and one I have profited from in the years since.
Not so sure it’s working out all that well for the rest of you, though.
— Tony Comstock · Oct 7, 01:35 PM · #
Everybody used to know what banks are for.
The problem is, all the wrong people have gotten in on my old racket and they’ve spoiled it for the little guy.
— Eddie Sutton · Oct 7, 04:12 PM · #
But the function of taking credit risks is being moved to a bond market and even distributed debt markets like http://www.prosper.com/ and to the public – DOE is funding new battery factories. So the purpose of financial reform is to keep banks from destroying the economy while they shrink. what the government should do is open a postal bank to reduce its own deposit insurance risk and divert capital from bank speculation to infrastructure funding.
— rootless_e · Oct 7, 07:04 PM · #
Cw basically is where I am. My bank, or rather, the institution I send my paycheck to every week, is basically a utility that maintains a website and some ATM machines. I really could care less about it’s interest-paying functions — if I want interest I transfer my money from the bank to a different institution that specializes in that, like an internet bank that has a high CD rate that week, or my brokerage account, or TreasuryDirect, or whatever. My criteria for putting money on deposit with a bank is: is it FDIC, can it accept ACH from my employer, does it have bill pay, and how low are the fees. I keep my cash balance at the bank as low as possible, to maximize the interest I make at the people that specialize in this.
To me it seems silly that a company that runs ATMs and does a high volume of low-balance check mailing and ACHs should be making loans— the technology has made these two completely different functions, and, if you believe what the big bankers tell you, they can quantify your risk electronically and there’s no need to ever shake hands with a Loan Officeror any such nonsense. Of course, that’s a big problem because clearly this doesn’t work right.
From my perspective a Postal Bank makes a lot of sense, because it might allow for local organizations that can specialize in local lending under local conditions without having to worry about the huge overhead of operating the sort of checking account operation that people expect now.
— jamie · Oct 7, 07:26 PM · #
I agree with Jamie (in a cycle of agreement). And I was going to say something about splitting the cash transfer business from the loan business. But then it occured to me that the cash transfer people would have this huge pool of cash they are sitting on. It makes sense that they should lend it out and put it to use. But it doesn’t make sense that they get to take all kinds of crazy risks with money that is FDIC guarenteed, or in ways that will cause the economy to collapse. So like Noah (I think) was saying (in the Finacialese dialect) it would make a lot of sense to me to separate the basic banking system that this country needs to function from investment comapanies that persue whatever kind of kind of crazy investments they want. Or to explain it another way, there should be a firewall between the kind of banking that is necessary to the economic system of this country and the kind that is just about making as much money as possible. Just like our infrastructure—telecommunications, the highways, the water and power deliverys sytems, airports, railroads, etc…—were, at one time at least, considered part of our national security, so should a basic banking system. What happened with the housing crisis was a threat to our national security. If our banking system collapses it as damaging to this country as a large military attack. But I know that our governemnt is terminally invaded by a kudzu-like tangle of special interests and that doing things that make sense to help secure the basic infrastructure this country runs on is probably imposible. The best we can hope for is small temprorary measures that fiddle with the edges of the issue.
Of course, not knowing much about our banking/investment system, maybe there is no way, or it is not a good idea, to separate our speculators from our financial infrastructure.
— cw · Oct 7, 08:56 PM · #
So you’re basically saying that Glass-Steagall worked pretty well and that the repeal of Glass-Steagall eventually led to the current financial crisis. You’ll get no argument from me on that. And let’s remember that is was those paragons of free markets like Phil Gramm that pushed that “reform” through. Why would anyone vote those people back in power?
— Steven Donegal · Oct 8, 02:38 AM · #
The “no risk” designation attached to AAA counter-parties is incredibly dangerous. Any system of regulation that maintains this fiction will fail, as banks take on as much “no risk” risk as they can. Any financial agreement includes some tail risk, and in a system as interconnected as ours, that tail risk is often highly correlated across entire classes of investment. In the 2008 crisis, our banking system was only as secure as its most reckless members, because the moment Bear Sterns and Countrywide looked shaky, everyone looked shaky, and AIG went from AAA to insolvent almost overnight as its CDSs came due.
— heedless · Oct 8, 10:27 PM · #
Great post.
It’s interesting to note that one of Noah’s prescriptions – get rid of the highly differential capital treatment between perceived-risky and perceived-near-riskless securities – is the exact same one that Per Kurowski has been suggesting for (as far as I can tell) years: http://teawithft.blogspot.com/
— Sonic Charmer · Oct 10, 12:31 AM · #
The touble with defining the issue of general financial stability as the problem of the risk of any individual bank, or financial instrument class defaulting, is that it ignores the interactions between the banks and financial instruments.
Economic Science doesn’t deal well with systemic interactions at all at the moment. Neither does financial theory. The problem created by say, a bank manager making a loan to a business associate who as a quid pro quo uses some of the money to buy equity capital instruments from the bank, thereby allowing the bank to make more loans (which is essentially what led to the Icelandic Banking Collapse), is entirely unrecognised. The immediate impact of such practices occurs when the loan in question defaults, resulting in no loss to the businessman but merely to the company which was used to take out the loan. Secondary effects on the entire population then occur, because as a result of the combination of lending and equity capital increases, the money supply is increased as well.
This creates the tertiary problem, which is that as the money supply increase is concentrated in the lending sector, ie houses, so an entirely false economic signal is created through house prices, leading to more borrowing and eventually sufficiently widespread debt defaults that the system itself is endangered. Concentrating on the risk at any given part of this cycle, badly misses the larger problem.
Feedback loops such as these are being actively researched and exploited by the financial industry on a daily basis for obvious reasons, they are extremely profitable when exploited. It will take far more than minor tinkering with capital treatment to resolve this mess.
— cargocultist · Oct 10, 12:30 PM · #
I believe this site has become infected by the borg.
— cw · Oct 11, 03:01 PM · #