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

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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.