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Whom Should We Prevent From Blowing Themselves Up, And Why?

I might have enjoyed this Andrew Ross Sorkin column, about how bringing back Glass-Steagall would have prevented neither the financial crisis nor l’affaire Whaledemort, more than most people.* Yes, the argument is pretty silly – like saying we shouldn’t have speed limits because they probably wouldn’t have prevented the Columbine massacre – but it contains an essential point that can’t be made often enough about the Volcker Rule:

But [bad sh]it often starts with banks making basic loans. Making loans “is one of the riskiest businesses banks engage in and has been a major contributing factor to most financial crises in the world over the last 50 years,” Richard Spillenkothen, former director of the division of banking supervision and regulation at the Federal Reserve, wrote in a letter to Politico’s Morning Money on Monday.

Lending: it’s proprietary! It’s risky! And yet! You can’t really get rid of it because it’s kind of what a bank is. On the flip side many crisis contributors – Bear, Lehman, AIG, I’d add Reserve Primary, you name it – were never affiliated with FDIC insured commercial banks and so also would have been untouched by Glass-Steagall or the Volcker Rule, but were both risky and systemically interesting and so worth keeping an eye on.

It’s worth pushing on why the Volcker Rule, and even Glass-Steagall, wouldn’t do much to cure modern-day financial crises. Here’s a stab at it: in 1929 there were runs on banks, and to prevent them the government created deposit insurance. To prevent the associated moral hazard, the government required insured banks to only do nice pleasing things like lend money to people who plan to pay it back, and not do scary displeasing things like flog social media IPOs to muppets, and this was called Glass-Steagall and it was good. But then over time commercial banks began to be allowed to do some scary displeasing things like sell securitizations and trade in OTC derivatives, and then in 1999 Glass-Steagall was done away with in the relevant sense that insured banks and uninsured evil investment banks could live together under one roof.

You can draw the following stylized conclusions about Glass-Steagall:

  • it roughly worked for commercial banks, in that insured commercial banks had to meet capital and asset-quality requirements that regulators were more or less equipped to monitor, though sometimes it didn’t,** and so the FDIC system has mostly worked well, but
  • it didn’t do much for investment banks, in that uninsured investment banks had lower capital and asset-quality requirements that the SEC was not especially equipped to monitor, and so all the big five independent investment banks are gone now – Lehman to bankruptcy, Merrill to BofA, Bear to JPMorgan, and GS and MS to being bank holding companies with Fed and FDIC access.

So thinking that bringing back Glass-Steagall would do much to prevent future crises requires you to basically think that non-banks don’t matter that much: that only commercial banks like JPMorgan are “gambling with taxpayers’ money” or whatever and so need to be cut off from nefarious goings-on like whatever is somewhat more nefarious than the London whale’s doings.*** And I guess there’s some case for that: MF Global managed to blow itself up without implicating much taxpayer money. There’s just not that much of a case for it: Bear and AIG blew themselves up while implicating loads of taxpayer money, Morgan Stanley and Goldman Sachs were welcomed into the warm embrace of the Fed despite having previously not been commercial bank holding companies, and Lehman Brothers … well, it’s hard to be all that cheerful about Lehman’s bankruptcy. Systemic danger seems to be uncorrelated with the holding of insured deposits.

A good person to read about that issue is friend of Dealbreaker Morgan Ricks, at Harvard Law School, who is out with a new paper this week on his theory – which we’ve discussed before – that anyone who issues short-term debt should be regulated like a bank, and that anyone who doesn’t meet bank-y asset-quality and capital standards should not be allowed to issue short-term debt. The starting point here is that short-term “money-claims” are a very risky form of financing, not only for the issuer of those claims but also for the way in which they propagate systemic risk of the sort – bank runs, etc. – that Glass-Steagall once upon a time was designed to cure. So you allow that risky financing only with a government backstop (to prevent runs), and you give that backstop only to companies with lots of capital and safe investment books (to prevent moral hazard). If you want to invest in risky things, go right ahead, but term out your funding so you can’t create a run. There would be exceptions for things like, I dunno, your personal use of credit cards.

Now, I personally don’t really like this theory because it would take much of the fun out of investment banking, which is probably a really good argument for the theory but whatever.**** The point today is that it is an effort to have a grown-up conversation about an issue about which “reinstate Glass-Steagall” is the somewhat more childish conversation. Here I drew you a picture of that issue:

That is kind of the underlying desideratum of all financial regulation: most people agree that institutions that might blow up the world should take pains not to do so, and most people agree that I can invest my tiny personal funds as foolishly as I’d like as long as I don’t expect the taxpayers to make me whole when I blow myself up. With that as a given, most of the debates are over what makes an activity safe vs. risky (whaling? prop trading?), but it’s worthwhile to think about what makes an institution dangerous vs. not dangerous too. Glass-Steagall, and most of the Volcker Rule,***** just start from the assumption of insured banks systemically dangerous, uninsured non-banks systemically safe. That really can’t be right. Is “short-term funding dangerous, long-term funding safe” the right assumption? I don’t know, but it seems like a more interesting place to start.

Reinstating an Old Rule Is Not a Cure for Crisis [DealBook / Andrew Ross Sorkin]
Reforming the Short-Term Funding Markets [SSRN / Morgan Ricks]

* My favorite part was this bit of cynicism from – Elizabeth Warren? Andrew Ross Sorkin? Anyway:

When I called Ms. Warren and pressed her about whether she thought the financial crisis or JPMorgan’s losses could have been avoided if Glass-Steagall were in place, she conceded: “The answer is probably ‘No’ to both.” …

In my conversation with Ms. Warren she told me that one of the reasons she’s been pushing reinstating Glass-Steagall — even if it wouldn’t have prevented the financial crisis — is that it is an easy issue for the public to understand and “you can build public attention behind.”

She added that she considers Glass-Steagall more of a symbol of what needs to happen to regulations than the specifics related to the act itself.

Oh, America! It doesn’t matter if you’re doing the wrong thing, as long as it gets attention.

** Like, S&Ls for one. But also, as Sorkin points out, much of the mortgage problem was caused by insured banks making bad loans whose consequences ultimately fell on their own balance sheets.

*** Because the Whale was doing things that commercial banks can currently do. But of course you could roll back to a previous incarnation of Glass-Steagall: you could say that in your conception “bringing back Glass-Steagall” includes banning commercial banks from selling securitizations or doing macro hedges with OTC derivatives. And then “bringing back Glass-Steagall” would in fact prevent the London Whale from swimming around JPMorgan, if that was the thing that you wanted to do, which, I mean, why?

**** By fun I mean things like this:

Consider the tension between the [NY Fed’s] tri-party repo initiatives and the SEC’s [money market fund, “MMF”] reforms. The repo task force report observes that “[d]ealers should lengthen and stagger the maturity profile of their financing” and “mak[e] greater use of term [repo] funding where available”—in other words, shift from short-term to longer-term repo funding. The SEC’s reforms, by contrast, preclude MMFs from allocating more than five percent of their assets to “illiquid” securities, which are defined as securities “that cannot be sold or disposed of in the ordinary course of business within seven calendar days” at approximately carrying value. In short, while the largest repo issuers are being pressured to lengthen repo maturities, the largest repo investors are being required to shorten their portfolios. The tension between these divergent regulatory objectives has already given rise to regulatory arbitrage. Large financial firms have begun issuing longer-term repo to special purpose conduits, which in turn issue overnight commercial paper to MMFs and other cash investors.

Is that not utterly fantastic and diabolical? Money market funds need short-term repo; primary dealers need long-term repo; so what you do is put an immaterial entity in between them so that dealers get to borrow long and money funds get to lend short and it all works perfectly well until IT HORRIBLY DOESN’T.

***** Except that the Volcker Rule, which basically applies to affiliates of FDIC insured banks, also can be applied to systemically important nonbanks, designated on a partly ad hoc and partly ginormous-size-and-interconnection-based criteria.

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44 Responses to “Whom Should We Prevent From Blowing Themselves Up, And Why?”

  1. Congressional Quant says:

    Maxine Waters: What is Glass Steagall and who is your CEO?!
    Elizabeth Warren: No one knows, but it's provocative, it get's the people going!
    Maxine Waters: Good enough for me.

    • guess says:

      it get us the people going?
      then again, this is about what i'd expect from Congress.

  2. Rex Ryan says:

    Matt, if you had really tried we could've gotten to ******

    -Footnote Fans Anonymous Charter Member

  3. dumb says:

    Matt nice job on the table but can we get some color in it?

  4. FKApmco says:

    I quite liked that post, Matty. But on a more pressing matter, did you find the final episode of House satisfying? I thought it was a bit rubbish.

  5. VonSloneker says:

    Whether it be Glass-Steagall, or some variant of Volker, all the principals running the "fun stuff" will go where the regulators are not.

    A few bigs spun out of the banks and loads of boutiques, rather than a few enormous desks with centralized risk management. Decentralization would yield jobs, asynchronous information (& vol)…and perhaps best of all, an opportunity for "team human" to knock the shit out of "team robot" for a while.

  6. derp says:

    We wrote loans in a riskless place.

    – Rihanna, MBA CFA

  7. Deleveraging says:

    Lending by FDIC Insured Bank = Risk Free Entrepreneurship

  8. Guest says:

    Serious response follows, my apologies to the regulars here.

    There really are only two "systemically important" activities in finance, that is, activities which directly impact the rest of the economy in a disproportionate way: demand deposits and short-term lending (i.e., revolving lines of credit). They correspond directly to the two activities that impact the rest of the economy – saving and lending – but given that they are short-term, disruptions to them can be disastrous for the economy at large (disruptions to long-term saving and long-term lending can be ridden out through short-term market movements, because, well, they're long-term).

    Is propietary trading systemically risky? Of course not – unless it's being financed with demand deposits. Are credit default swaps systemically risky? Of course not – unless they are being entered into by banks that rely on them for capitalization, and which are using their capital for short-term lending. Is market making systemically risky? Of course not – unless the market makers are financing their market making with demand deposits. Etc.

    In retrospect, Glass-Steagall only fixed one problem: it (mostly) ring-fenced demand deposits from the rest of the financial sector, but it didn't fix the problem of short-term lending (specifically, that non-financial businesses rely on the big banks for revolving credit, but the big banks are at risk of not being able to provide that credit because of other risky activities they are involved in). But solving half the problem is better than solving nothing at all. Once Glass-Steagall was gone, any number of financial institutions happily jumped into the "systemically risky" category with both feet by picking up demand deposits. Then, when their (non-demand deposit, non-short-term lending) activities blew up, the Federal Reserve and Congress felt compelled to bail them out, because, well, they were systemically risky.

    The solution, in that light, easily presents itself, and I think Matt is on the right track: separate out short-term finance from the rest of the industry, so that demand deposits and short-term revolving credit are insulated from the rest of the industry. Then, the Wall Street firms can make markets, trade their own books, underwrite offerings, syndicate big long-term loans, trade currency, write options, and do whatever they please, and be free to succeed or fail at it, because their success or failure will have little to no impact on Mom and Pop's saving account and the Mom and Pop Store's line of credit.

    – Guy who holds onto the slim hope of a serious discussion breaking out on Dealbreaker

    • UBS Risk Management says:


    • trojan_ says:

      When I see a post this long I expect geezer oil trader's tales of old… while this was quite the opposite, valid points were made.

      • gues says:

        Are you saying Geezer Oil Trader does not make valid points? If so, perhaps Geezer Oil Trader can opine here?


        – Guy who enjoys GOT's tales of old and thinks he makes very valid points

    • PermaGuestII says:

      The problem is, I could see it having the perverse affect of drying up short-term credit. There's no spread in the short end. If you're only funding short and lending short, you have to jack loan rates to generate a decent profit. If rates on short-term credit skyrocket, economic activity suffers.

      Also, think of it this way. The goal of all of these regulations is to reduce systemic risk. The solution you propose selects one activity or set of activities and decrees them risky and forbidden to certain institutions. I'd contend that any attempt to define one specific set of behaviors that will cause systemic risk in an unknowable future is futile.

      Rather than trying to do this, wouldn't it make more sense to ensure that no one institution is of such a size that it *is* systemically important to begin with? While I can't see any realistic way to enforce a regulation saying "you can not do risky things," I can certainly see a realistic way to enforce one that says "no one financial institution may own more than 2.5% of the demand deposits in the United States."

      -Guy who is in fact giving a serious answer

      • Jefferies MD says:

        Not being of such a size that you are systematically important is the NKI

      • Guest says:

        I don't think the lack of spread in the short end should be a factor – you'd still borrow short and lend long, just in the more "boring" manner that commercial banks have done in the past with the same hold to maturity and other insulation against mark to market.

        What I think "Guy who holds on…" is saying is that you would not be able to do is finance with short-term liquidity the riskier trades or assets that could cause your short-term funders to stop rolling your debt in a stressed environment, causing the kinds of problems you see today.

        – Guy who is probably missing a lot of details and is probably sounding stupid right now

        • J. Coorz says:

          What are you trying to say about people who may have a tendency to finance risky trades with short term funding, huh?

        • PermaGuestII says:

          But my point is that we have no way of knowing today what the "riskier trades or assets" will be at some undefined point in the future. What is plain-vanilla under one set of market conditions (think Municipal ARS, for instance) can become wildly illiquid and risky under another unforseen set. Once you start having the regulators define exactly what constitutes a "risky" asset or behavior you start down a road of endless regulatory adjustment as new products are introduced. I think its simpler to just cut the Gordian knot and say "all banks can do whatever they want, none can be systemic."

          And there's precedent for this. The US banking system used to be much more fragmented. Practically every major city had a "hometown" champion or two: Bank of Boston, First Chicago, National Bank of Detroit, etc. The American financial system didn't collapse when Continental Illinois Bank went under…

          • Guest says:

            One major problem with this approach is the rise of huge international corporates. Who will bank these customers? If we cut every US bank down to size, the US will lose all of that business to international competitors with different banking regimes. The biggest fish will catch all of that business.

            If it's an international anti-TBTF accord, maybe it could work, but at the cost of increased friction to do business for the big corporates and funds. AT&T got a 20B bridge loan from JPM for the (failed) T-Mobile acquisition. If every bank is small, maybe they call all do whatever they want, but none of them can provide the service that this type of deal demands.

            Maybe that's a stupid argument and some type of multi-bank syndicated bridge loan product will develop. But you'd need the international accord before that question is even relevant.

          • PermaGuestII says:

            I don't think so. Multinational corporates have been around for 100+ years and during most that time the banking system was way more fragmented. We're not talking ancient history here– the first modern multi-state bank was created by the 1984 merger of Connecticut Bank & Trust and New England Merchant's National to form Bank of New England. Like you said, large loans would be floated via syndicate (I don't have the details on the T bridge by the way but I'm willing to bet JPM didn't take the whole thing on balance sheet.)

            Besides: what's our goal here? To have bragging rights about the "biggest banks" or to have a banking system that doesn't need to get bailed out by the Feds every few years? Back in the late '80s the Japanese banks were the largest in the world, but that doesn't seem to have them a whole hell of a lot of good.

          • Serious Question says:

            Wasn't Continental bailed out, though? Perhaps "not having to bail out banks" is not the goal you have in mind, though

          • PermaGuestII says:

            You could make the case that they were bailed, yes: seized by the FDIC, depositors and bondholders made whole but the equity holders were zeroed: so it wasn't like the TARP'ed institutions. Better example would probably have been Drexel-Burnham-Lambert. Point is, though, that the FDIC and Fed were able to deal with it in a more normal course of business, w/out having to invoke obscure 1930's legislation or get Treasury/Congress involved.

      • Guest says:

        Thanks for the serious answer!

        I think you are right that short-term credit is one of the critical issues. That said, short-term interest on deposits is ~1%, and short-term rates on credit cards are roughly ~15%. I'm not sure I'm seeing how it is difficult to make money off that, even with relatively high defaults – and even if banks run into trouble, short-term credit can be securitized by financial companies who specialize in just that (e.g. Capital One), although there certainly are problems with that as well.

        But as important as short-term credit is, I think the core of the issue is demand deposits. The entire system of banking regulation was set up, more or less, to protect depositors. I will totally agree that risks are difficult to quantify and foresee, and so forth. But there is one huge, glaring risk which we have long and painful experience with: runs on banks due to fear from depositors for their cash.

        As such, I don't think I'm being all that revolutionary by calling for us to go back to what more or less worked for several decades: a strict regime protecting banks that take demand deposits, but at the cost of relatively high regulation, meaning that they can really only get into traditional lending and a few other relatively safe investments (NOT Fannie/Freddie preferreds . . . wow, what a disaster). But mainly traditional, local lending. The idea is to concentrate the risk (yes, concentrate it) into local regions by way of a large number of regional banks, so that when banks fail – and they will – they do so individually and in a way that doesn't endanger the whole economy.

        That's not the current situation, obviously, and there is no obvious path from "Too Big to Fail" to Jimmy Stewart banking. But I can identify one significant area that will have to be addressed at some point. One of the largest – if not THE largest – sources of funding for the biggest banks outside of the Fed is money market funds. MMF holdings are, in effect, demand deposits, no matter what lobbyists for the industry say – MMFs take money which they pay interest on (in effect) and return on demand, and with it they enter into financing agreements with the big banks, effectively lending to them. It's banking, again, I don't care what the industry lobbyists say. If you want to ratchet down the size of the big banks – and the risks that come with "Too Big to F6ail" – the two places to start are the Fed window and the money market funds.

        I'm actually all for taking out a lot of the existing financial regulations, which can be incredibly onerous. But the best way to make that happen is to keep depositors safe by giving them a secure area to put their money that isn't completely tangled up in the chaos of the rest of the financial sector.

        – Guy who posted the original post and really needs a permanent handle

        • Guest says:

          I missed the part where the financial crisis was caused by a deposit flight – probably because it didn't happen. Commercial banks borrow short and lend long because households lend short (we call that saving) and borrow long. Banks simply act as middle men to match borrowers to lenders (aka savers) and charge a spread for taking on the inherent credit/duration mismatch. I see nothing wrong with this, despite the systemic risk it creates by its very nature. It's like oil drilling offshore. They do it because we buy it, not the other way around. You want less leverage in the banking system? Stop borrowing.

  9. Fermat says:

    If the solution easily presents itself, perhaps you could just make a note of how you'll ring-fence short term lending in the margin here?

    Not that I'm quibbling with your general view, but I think the devil is in the details. Or, as Matt points out, in footnote 4.

    • Fermat says:

      Whoops was meant to be a reply to Serious Reply Guest, or whatever the young people are calling themselves these days.

  10. Another ex-CDO Guy says:

    On a side note, CRE loans are inherently good products for depository banks – at least until the advent of hyper leverage, liquidity and valuations changed the field. Some banks throttled down their CRE loan exposure, but all still had to maintain a presence and like most other sectors had to chase yield down the credit curve. So while G-S may not, at face value have prevented the housing bubble, i would guess that it would have prevented or controlled the leverage effect that i-banks created. For that matter Greenspan's rate policy is as much to blame as lack of proper regs.

  11. tim says:

    Maybe another good starting point would be to have some respect for one's shareholders and control risk effectively.

    – J. Stewart

  12. Guest says:

    Matt your posts are stellar. Grade A material here.

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  16. sohbet says:

    Relative game comment sounds like pr straight from ir talking points to me written by an underpaid res associate rather than an honest opinion of what matters: will financing costs for banks rise and will corporates that have stronger ratings than the banks wake up and disintermediation