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Notes to myself, possibly of interest to others.
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Monday, October 29, 2012

Sheila Bair - Five steps to fix Wall Street (+Gary Gorton)

Source. HT Ritholtz
1. Break up the “too big to fail” banks
Giant institutions and untested “living wills” is make financial system unstable. When the Fed is artificially keeping lending rates at near zero, that’s a flaw.

Solution: Make ‘em smaller

2. Publicly commit to end bailouts
“Market must punish the boneheads.” We should learn from post-2008 bailouts is we should never allow ourselves to be in that position again. Wall Street cannot have an indefinite option to “put” its losses to the Treasury and to taxpayers.

Solution: Make penalties for asking for and getting bailouts egregious — wipe out shareholders, fire management.

3. Cap leverage at large financial institutions
“Bank capital levels maybe isn’t a mainstream issue, but it should be;” Limit banks’ abilities to take on risk via leverage or derivatives or whatever the latest “idiotic new innovation” Wall Street becomes infatuated with.

Solution: Go back to firm 10 to 1 leverage rules.

4. End speculation in the credit derivatives market
If arsonists can’t buy fire insurance on someone else’s house, why allow speculation using credit derivatives? Credit default swaps with no vested interested are the same thing.

Solution: Require CDS buyers to demonstrate a specific interest. Even better regulate CDS as insurance products.

5. End the revolving door between regulators and banks
Separating regulators from the regulated is crucial. Ending regulatory capture is key.

Solution: Require longer periods of time between industry and regulator service.
Vitus: We agree with the above. We will note that Gary Gorton of Yale, who has written extensively on the crisis, sees the above not as irrelevant, but somewhat beside the point - which is, to prevent runs on a banking system. In A Q&A with Cardiff Garcia at the FT:
Read enough books and economics papers about the recent US financial crisis, and at some point you might notice something odd.

Most of them are about the factors that made the crisis and subsequent recession so profound and enduring — excess leverage, deregulation, lax lending standards, the rise of securitisation, blindness of the rating agencies, fraudulent bankers — but very few of them are about what actually started the crisis.

Gary Gorton’s work is different. His 2009 book, “Slapped by the Invisible Hand”, argued that although these factors were all present, they were also somewhat beside the point. The financial crisis started the way all systemic financial crises start: as a bank run. The only difference was that this bank run took place in the shadow banking system, and the creditors who started the run weren’t depositors of retail banks, but the counterparties of investment banks in repo and commercial paper markets.

...financial crises are misunderstood. Crises are now attributed to government actions rather than to the inherent features of bank money. The government tries to prevent bank runs, but then—when the bank run is not observed—the government is blamed for the crisis. The run on repo was not observed by regulators, academics, journalists, or the public. So instead of the Livingston and Blaisdell logic of saving the banking system and providing mortgage relief, there have been proposals to efficiently liquidate banks during crises. Realistically, this would mean liquidating the banking system...

Explain what you think is the relevance of the concepts of moral hazard and Too Big To Fail.

I think these words have really lost any meaning, and instead are bantered about as political slogans. Even before the Federal Reserve System existed banks bailed out other (big) banks during crises. Basically, these ideas attribute crises to the government, seeing government actions as the cause. The underlying problem of bank runs is not seen as the problem. Hence, Dodd-Frank has “living wills” so that it will be easy to liquidate the banking system. This confusion between the actual problem and the government’s response to the problem has largely become a political issue.

Relatedly, you write: “There is almost no evidence that links capital to bank failures.” But you don’t write that capital requirements are a waste of time, only that they won’t prevent crises.

Capital requirements were never the sole focus of attention for bank regulation until the 1980s. Again, there is a basic misunderstanding of financial crises. A bank run is a demand that all short-term debt in the banking system be turned into cash. That is simply not possible. It would be best to create a system where such a demand does not arise because the government’s oversight has created sufficient confidence. Capital per se cannot do this...

Things are worse now because the bank run of the recent crisis was not observed by outsiders. Most people did not observe it and have no idea what happened. This compounds the problem because it leads to effects being mistaken for causes. The run resulted in about $1.2 trillion being withdrawn from dealer banks, which then had to sell assets causing bond prices to plummet. Plunging bond prices caused losses for many firms, many of which failed. The failures were observed, but not the cause. So, the popular narratives focused on bad greedy bankers and other superficial explanations.

Okay, but you can’t be saying that “bad greedy bankers” played *no* role in the crisis, right? That issues like mortgage fraud, lax underwriting, misrepresentations by mortgage lenders to the GSEs, things like the Magnetar and Abacus cases and other items that we’re still picking through should be minimised?

If greedy bankers cause crises, we would have a crisis every week. The Quiet Period from 1934 (when deposit insurance was adopted in the US) until 2007, during which there were no systemic crises, is not explained as being due to non-greedy bankers. What, then, caused bankers to suddenly become greedy? In every crisis in history, it happens that fraud is uncovered. Partly this is due to the fact that everyone asks for their money, and sometimes it cannot be produced (as with Madoff). Other times it is the heightened scrutiny of the financial system that reveals these problems...

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