One of the many reasons I am depressed

Barry Ritholtz writes:

I believe the brain trust behind the Obama White House has made a huge tactical error.

As Rahm Emmanuel likes to say, one should “never waste a crisis” — and the White House has done just that...

There was widespread popular support for a full reform of finance. What the White House should have pursued was: 1) Reinstatement of Glass Steagall; 2) Repeal the Commodity Futures Modernization Act; 3) Overturning SEC Bear Stearn exemption allowing 5 biggest firms to leverage up far beyond 12 to one; 4) Regulating the non bank sub-prime lenders; 5) Continuing high risk trades to be compensated regardless of profitibility; 6) Mandating (and enforcing) lending standards, etc...

Instead, we have a White House that appears adrift, and the most importantly, may very well have missed the best chance to clean up Wall Street in five generations.

I agree with the conclusion: and it is deeply depressing for those of us who have devoted a lot of energy to arguing for reform.

Ritholtz's prescription isn't quite mine: I am less convinced about the benefits of a Glass-Steagall style split, not least because many European banks managed to be universal without being dangerous; rather I would prefer to see action to split up too big to fail institutions, combined with increased regulatory capital requirements that really constrain leverage for all systemically important risk takers. But the details don't really matter: doing something does.

Robust finance

John Kay in the FT comments on a theme that is central to this blog:

Any engineer will tell you of the importance of making complex systems robust. You need inspections to prevent failure, to be sure: but since failures are inevitable it is equally important to try to ensure that the consequences of such failure are contained.

This observation is as relevant to economic and financial systems as to technological ones. Designing them with components too important to fail is a prelude to disaster, as we know. In the financial sector, the problem of disruptive linkages between components has become known as the problem of systemic risk... the main source of systemic risk is within large financial conglomerates themselves.

Kay gets the solution wrong though. He suggests that the risky component as he sees it - investment banking - should be isolated from the rest. That's foolhardy on two grounds. First, it wasn't investment banking that caused the crisis. Derivatives weren't the problem, after all: it was mortgage lending. The lesson here is that the risk often isn't where you think it is, and so isolating the risky part of the business is not straightforward.

Instead we should accept that any component might fail, and thus to keep the linkages between all components sufficiently loose that no failure can bring the whole system down. That involves increasing capital and liquidity requirements, decreasing counterparty exposure, and taking a particularly conservative view of systemically important institutions.

A small town in Switzerland, part 3

Glorious, glorious, glorious is the day: yet more Basel. Here's a key passage from BCBS158:

Factors that are deemed relevant for pricing should be included as risk factors in the value-at-risk model.

If you took the committee at its word, here, no one would have a VAR model. Just consider an equity derivatives book on underlyings in the Eurostoxx. There are 50 underlyings, 50 dividend yields (more if you consider the term structure of dividend yields), at least 20 interest rates in Euros, and as many implied volatilities as you have (strike, maturity) pairs for your options. A decent sized book will have many hundreds, perhaps many thousands, of risk factors. No one has a VAR model with all of those factors in it. So, what is a bank to do? Let's turn back to the committee:

Where a risk factor is incorporated in a pricing model but not in the value-at-risk model, the bank must justify this omission to the satisfaction of its supervisor.

Ah lovely. So if you have a tolerant supervisor, perhaps because you are in a small country, or because you are a national champion bank, all is well. If not, you will have some hoops to jump. This provision in short is a charter for regulatory arbitrage. The next part is even worse:

In addition, the value-at-risk model must capture nonlinearities for options and other relevant products (e.g. mortgage-backed securities, tranched exposures or n-th-to-default credit derivatives), as well as correlation risk and basis risk (e.g. between credit default swaps and bonds). Moreover, the supervisor has to be satisfied that proxies are used which show a good track record for the actual position held (i.e. an equity index for a position in an individual stock).

If this doesn't make players with big trading books redomicile to somewhere small, low tax and friendly, I don't know what will.

Shape of regulation summary

FSA gets medium rare

Medium rare being of course far from tough. From the Times:

The City regulator said some fines could treble in size as it seeks to address concerns that penalties thus far have not proved much of a deterrent in improving company behaviour.

It also announced proposals for a minimum fine of £100,000 for individuals found guilty of market abuse offences such as insider dealing. Up to 40 per cent of an individual's salary and benefits could be taken, it said.

Why not 100%? Why not 'all their assets'? Drug dealers have all of their assets seized - are we really saying that selling grass to make thousands is completely evil, but insider trading for millions is only 40% evil?

Counter-cyclical capital

I flatter myself that I was one of the first bloggers (although far from the first academic) to comment on the need for anti-cyclical capital rules. Three years later, this is becoming accepted wisdom. People still seem to think that identifying the cycle is difficult. I'm sure it is not, and I identified a number of indicators that could be used to set capital levels in my book. Now the BIS annual report has reviewed several possible indicators: credit spreads, changes in real credit provision, and a composite indicator that combines the credit/GDP ratio and real asset prices. And, rather unsurprisingly, they all work to a reasonable degree.

Shotguns and blowups

From Mark Gilbert on Bloomberg:

If the aftermath of the credit crunch is a financial landscape featuring fewer banks, each even bigger than before because of government-engineered mergers and opportunistic takeovers of weaker brethren, then we should all be very afraid. That, though, is exactly where we are headed.

The whole article is spot on: I recommend it.

Seriously antiquated

FED, OCC, OTS, FHFA, CFTC, SEC, FDIC, NAIC, ...

It seems that Obama and co. do not have the balls to sort out the alphabetic mess that is US supervision. Even the obvious targets - the OTS, who supervised AIG (yes, technically AIG was a Thrift), the SEC's regulatory capital regime, which did such a good job there are zero out of five large firms left on it - may be left to waddle on. Antiques may have an attractive patina, but sometimes you need something that is fit for the modern age. We won't get it, though. I am very tempted, like .the Epicuran Dealmaker, to give up on this crap

The loneliness of the long distance regulator

Lord Turner, a decent, thoughtful regulator, told the Treasury select committee yesterday that

there should instead be a "tax on size" by requiring the big banks to set aside more capital when they expanded beyond a certain size.

Quite right too, and nice to see an idea I championed being mentioned in such august circles. The bad news is that

Turner also warned the MPs that the radical changes to regulations needed in the wake of the banking crisis may not take place because of the emergence of green shoots of recovery and "exhaustion".

Regulatory reform is a marathon not a sprint and I share Turner's doubts that we have the stamina to do a good job at it.

Cash up front please

The Telegraph reports an idea of Paul Tucker's: making the banks pay to clean up their own mess:

The banking industry could be told in advance that, if ever there was another crisis, the ultimate cost would come from banks themselves. In the midst of a crisis, that would not be possible. A government would have to pump in new equity. But when the dust had settled and the government had sold its shares, the loss (if any) could be calculated - and then collected from the industry via a levy.

This isn't a bad idea. But there is a better one. Make them pay before the crisis.

There are various ways to do this. One is to take cash from the banks, via a beefed up version of the way the FDIC works. In order to be a financial institution, you need an annually renewable license, and the license should be expensive.

A more intriguing one, though, is to make the banks hand over each year not cash, but one year call options on their stock. The regulator would then hedge these options. The bank's shareholders would only be diluted if the stock went up, sugaring the pill for them, while the hedging process would ensure the regulator made money whether the stock went up or down. Indeed, as the position is long gamma, a big fall would be particularly profitable to the hedging strategy.

Each way bet

One of the nice things about Foyle bookshop - despite its Waterstoneisation - is that the staff selections are still charmingly eclectic. Leonardo Sciascia's Equal Danger was one a few weeks ago. Sciascia is an oddity, a novelist who write political polemic disguised as detective stories, a stylist rather than a plotter.

Here's a nice little section. The speaker is talking about Pascal's wager. He generalises:

Today the possibility of making the wager has shifted from metaphysics to history... I would risk losing everything were I to bet against the revolution. But if I bet on it, I lose nothing if it doesn't take place. I win everything if it does.

I feel the same way about regulatory reform. If it isn't necessary and we do it properly, we lose very little. But if it is -- if failure to reform just bakes more systemic risk into the financial system - then failing to reform properly means that we lose a great deal. In this context the gutless Obama plan is worse than thin: it is a bet that may ruin us.

5% is not much

The Obama administration is proposing that originators should retain a 5% stake in securitisations. This is not enough. 20% or 25% would achieve the desired alignment of interests. 5% gives 20:1 leverage. Yet another missed opportunity.

Wasted opportunities

As weeks have dragged into months, my frustration at the lack of real financial reform has hardened into anger edged with ennui. I don't expect much to happen now, and it irritates me. Ruth Sutherland sums up the situation quite well in the Guardian:

the Obama administration in the US, which still has plenty of wind in its sails, stepped back from radical moves to downsize pay packages on Wall Street, opting instead for modest improvements to corporate governance... The credit crunch led to a recognition of the need for a deep rethink of the Anglo-Saxon capitalist model. We are, however, in danger of missing the moment as the City takes advantage of political disarray to regroup. The belief of the resurgent financial sector, as another FT headline puts it, is that the market is confounding the left. Tentative suggestions that the recession is already over only strengthen the currents pulling us back towards business as usual.

Every 'House prices rise' or even 'House prices fall less fast' headline is ammunition for people like Angela Knight, who has suggested that even FSA's current modest proposals for improving banks' liquidity do not strike the right balance.

Instead of trumpeting any green shoots, however implausible, we need a wide discussion of the issues, and we need the willingness to be bold. Back to Ruth:

There should be a proper debate about a form of Glass-Steagall Act to separate "casino banks", which would have no recourse to the public purse if they run into trouble, from financial utilities, which would continue to be backed by taxpayers.

I personally don't think that this is possible, as all systemically important financial institutions have (whether we like it or not) an implicit recourse to the lender of last resort, but Ruth is right - we should talk about it.

There should be dynamic provisioning, so that banks are compelled to build capital cushions in the good times. Another idea is a levy on the sector to cover taxpayers against the risk they will have to bail out banks in the future.

But the point is less about the specific measures than about the need to change the culture.

That is absolutely on point. This crisis has already been a tragedy for many people - people who have lost homes and jobs. It would be really tragic if we learned absolutely nothing from it, if the net result was just to carry on, with exactly the same rules and the same mindset, to the next financial meltdown.

Update. As Barry Ritholtz points out, the gap between the US administration's rhetoric and its actions is huge. Here are the principles Larry Summers laid out for reregulating the markets:

1. The government must have the authority to take over and liquidate failing nonbanking financial institutions.
2. Regulators must be able to make certain that financial institutions have enough capital to weather crises.
3. Regulated entities must not be able to choose their regulators,
4. Regulators should not have to fight each other for jurisdiction.
5. The interests of consumers must trump the interests of regulated companies.

Good foundations, those. It's a shame the Obama administration have erected a makeshift shack on them. They are poodles when we need heros.

What we need now

Less regulation of financial institutions. More leverage. After all, look how well that worked the last time... No? No. So it is rather a surprise that there is even any discussion of Goldman Sachs moving back from being a commercial bank to being an investment bank. The Reuters story is here. The regulatory regime Goldman used to operate under before the change - in the days after the collapse of Lehman - was so flawed that the SEC ended it. Given that it is not possible to be a CSE any more, if Goldman wanted to shed its bank holding company status and the regulation that goes with it, what exactly would they do?

Hoicked from the comments

In a comment on the non-classical cost benefit analysis post of a few days ago (a title, I think you will agree, of gigantic pretention), Dave said:

I agree with your conclusions: that uncertainty and moral hazard can make CBA unreliable and sometimes it is better to rely on qualitative objectives.

But I disagree with your applying these to systemic risk. Firstly, with systemic risk it is the "worst-case scenario" that is important. If regulators had used the great depression as the worst case scenario, they wouldn't have been far wrong.

Often, though, the worst case scenario can be hard to identify. The worst case scenario in much of finance for instance is that all claims are worthless and all liabilities come due immediately. We might as well all go home if that comes true, and barricade the doors. 'Plausible' worst cases have a nasty habit of turning out to be too optimistic: wasn't it David Viniar from Goldman who said that 2008 was much worse than the most pessimistic scenario they looked at?

Secondly, I can't see how systemic risk regulation would cause bankers to take greater risks. So, I don't see where moral hazard fits in.

Fair enough - bankers are not people riding bikes. (Quite literally, usually - Wall Street tends to view cycling to work as only marginally less strange than coming by elephant.) So probably bankers did not take more risk because they were regulated. Some of them did, however, take as much as they could subject to regulation, because that was the way to maximise returns to shareholders.

Thirdly, how do you take a "moral" position on systemic risk? I don't think this gets you very far.

Well, I think that the key idea of Anglo-Saxon capitalism - that the first and only duty of a firm is to its shareholders - is simply immoral. Of course, like any ethical judgement, you can disagree with that. But I also think, and I'd like to think that I can prove, that a system that has a wider burden of responsibilities, including a responsibility to the financial system, would be less likely to go into crisis, cost the taxpayer less over the cycle, and deliver slower but less volatile growth.

Finally, the main impact of systemic risk regulation would be to encourage smaller banking/trading institutions. I would think that this a good thing in itself. And I disagree with James Kwak that "countercylical measures in a boom dampen economic growth". Surely the opposite is true (in the long run).

Absolutely. We need a lot of small banks, not a small number of large ones. The hard part is how we get to there from here.

Control theory and capital

The beginnings of control theory can be summarised as 'nail it in the right place'. Suppose there's a plank over a barrel. You can keep the plank level by putting a weight in just the right place, so that it balances.

The problem with this is that any perturbation will cause the plank to swing away from the level. A gust of wind might even do it: the equilibrium is unstable. Therefore control theory 101 would suggest that you move the weight dynamically to keep the plank balanced. If one end swings up, move the weight slightly that way until it swings back.

Over the years, a lot has been discovered about how to control unstable objects moving in unpredictable environments. Modern fighter aircrafts are in some ways a triumph of control theory: without the computers which control their flight surfaces, they would fall out of the sky. And what the computers do is determined by control theory.

One of the many reasons that the current regulatory capital regime is pants (not to put too fine a point on it) is that it is stuck with static control. That is, think of a number, and that's the amount of capital that you need. In reality, the regime needs to be dynamic: the anticyclical capital of earlier discussions is one piece of this puzzle. What struck me as I walking home from a lecture last night (one which touched in passing on control theory) is that we do not even have the right inputs to develop a control theory of bank capital. That is, we don't really know what the equivalent of the angle of the plank (or the speed, pitch, yaw and so on of the fighter) is. One can think of some things that it might make sense to monitor, like credit spreads or the availability of interbank liquidity, but so far as I am aware, there has been no systematic study which discusses the indicators of health of the banking system, let alone identifies how they respond to changes in regulation. That would be the basis of a serious control theory of banking.

Scoring the SEC

The WSJ reminds us that despite the SEC's lamentable record, US regulatory reforms seems as far off as ever. How badly did they do? Here's my assessment.

• Supervisor of investment banks: 0/5. There are none left. That really does tell you all you need to know.
  
• Market supervisor: 2/5. Rule SHO didn't stop naked shorts, and the SEC's record dealing with market abuse and insider trading is not wonderful. Nevertheless, they have sometimes acted prudently in the equity markets in the past.
  
• Information gatherer: 4/5. Edgar is very useful, and Idea seems like it will be even better.
  
• Hedge fund regulator: 1/5. They could have found Madoff in 2002.

It seems to me, then, that the SEC is a great website with a deeply flawed supervisor bolted on the side. So why hasn't Geithner done anything?

Regulating small firms

The current furore over FSA regulation of building societies is interesting. A whistle-blower alleges that

A culture of apathy and complacency marked the FSA in the period of its nadir, with anyone standing up against light-touch official policy criticised for rocking the boat and branded a troublemaker.

I have no idea of the truth of this, but three points are worth making.

• In a regulator, the status of staff depends to some extent on who they regulate. The big swinging dicks are the ones who regulate the biggest banks. Building societies are not glamourous, and hence the quality of regulator here may well have been lower than elsewhere.
  
• Many regulators are really quite bureaucratic. The scope for individual staff, especially line staff, to make decisions is limited. Anything of substance is likely to go up the chain of command. Therefore if there have been failures, it is the senior people who are likely to have been responsible.
  
• Building society supervisors are likely to be a conservative lot - even more conservative than bank supervisors. What they think is dangerous may be a rather large class - and one that includes some reasonable innovations.

Bigger is worse

There is a meme going around at the moment concerning size in banking. The basic idea is that too big to fail banks are a bad idea. Various people have various ideas of what 'too big' is, with numbers like 300B total assets (a number floated in a nice post at Dealbreaker) being discussed. Interfluidity also has a good discussion here.

My own take is that limits - whether $100B, $300B or some other number - are hard to impose and liable to manipulation, e.g. through off B/S financing. Rather I would make regulatory capital a function of equity. The more Tier 1 you have, the less you can leverage it. At $1B of Tier 1 or below, say, you are allowed a Tier 1 leverage ratio of 25. At $17B, it would be 12, so the formula would be something like

permitted leverage = 20 - 0.5 x [max($1B, Tier 1) - $1B]
total permitted assets = permitted leverage x Tier 1

This formula has a maximum at Tier 1 = $20B, where it permits total assets of $200B (and of course total assets would be defined to include off B/S assets as well as on B/S ones).

What Timmy did next

The FT article is titled Geithner lays out new financial rules, but that is a little misleading. Rather our lad Timmy has laid out a framework under which new rules will be written, but we have no idea what the rules will be yet. What details there are do not allow one to form any precise conclusion. The principles seem reasonable, but the devil will be in the details (and in the inter-agency battles).