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How to Make Banks Safer
Economist and banking expert Allan Meltzer, at AEI yesterday:
My reading of the history of financial crises is that regulators lock the door against the source of the last crisis. Neither regulators nor others can foretell how the next one will develop. They completely missed the causes of the Great Depression of 1929, the Great Recession of 2008 and much in between.
With that in mind, I testified four times on Dodd-Frank. I urged less discretionary regulation with a rule for the largest banks that they be required to hold a minimum of 15% equity reserves. My proposal became the centerpiece of the bipartisan Brown-Vitter bill. It never was voted on. The large banks prefer regulation and the corrupt arrangements of the current regulatory system. This permits them to negotiate circumvention of the rules that the Fed writes. And it penalizes competitors. Current costly regulations one of the main reasons the number of small- and medium-sized banks has declined greatly.
Briefly, increased equity capital makes bank management much more concerned about risks. And their principal stockholders reinforce their attention to risk. The bank’s incentive is to look for all kinds of risk, not the specific risks that regulators guard against. And by relying on equity capital, we avoid the risk that, as in 2007-2008, the regulators will make the wrong decision. Fortunately, after hesitating and regulating excessively, the Fed increased equity capital requirements.
Indeed, Meltzer in the past has noted that at the start of the Great Depression, the big New York City banks “all maintained more than 15% of their assets in equity” and none went bust. Likewise, “losses suffered by major banks in the recent crisis would not have wiped out their equity if it had been equal to 15% of their assets.” (More on this here.) Specifically, Meltzer is talking about a bank’s leverage ratio, or the share of assets funded by equity capital, as the measure of capital adequacy. JP Morgan’s leverage ratio, by the way, is about 8%.
And let’s not forget the cost of financial crises and the benefits of avoiding them. From the WSJ:
Published in Culture, EconomicsAbout one in six U.S. workers became unemployed during the recession years of 2007, 2008 and 2009. Today, nearly 14 million people are still searching for a job or stuck in part-time jobs because they can’t find full-time work. Even for the millions of Americans back at work, the effects of losing a job will linger, the research suggests. They will earn less for years to come. They will be less likely to own a home. Many will struggle with psychological problems. Their children will perform worse in school and may earn less in their own jobs.
This was good information! This post also reminded me how much I would benefit from some finance and economics classes.
It also seems to me that if I am a bank (those that run it), I should desire to look for ways to keep us from needing bailouts should we face a recession-type situation again.
There were a number of pod casts on Econ Talk on this issue last year, maybe 2014, that made me a believer; economists Admati and Taleb I’m too lazy to look them up. If a piece of every loan were equity capital owners would follow bank managers far more closely. So this capital isn’t buildings or valuable paintings, but liquid assets that get lent and directly exposed to the risks. The idea that regulators can centrally manage this global digitized infinitely flexible system is utter nonsense. They never have and never will. Get the incentives and risks placed right and the important parts are self regulated by competition and risk as all markets must be. Higher equity requirement would also shrink bank size and total credit. Both good things. Of course the giant banks don’t want this. They, like those who dominate all sectors, welcome regulations because they get to write them such that the professional managers get all the up side, smaller upstart competitors are repressed.
How to make banks safer. Keep your money under the mattress?
I was staggered by that quote (and the whole article) in the WSJ. We hear things like “the economy lost 200,000 jobs last month…” but we often don’t realize that that net number reflects 5,000,000 job losses and 4,800,000 job gains EACH month! During a recession, those 5M unemployed are stressed, facing the prospect of a long search and never finding a comparable position.
As you point out, so much regulation is the wrong kind, and I picture it like strands of glue that harden over time. Maybe a better metaphor is scar tissue. We suffer damage from a credit crisis, and the scar tissue that forms over the injury reduces mobility a little bit more. Add that up over centuries, and it’s a wonder that we have much economic vitality at all. In fact, I suspect that we only see economic vitality in the nooks and crannies that emerge from new technologies, like fracking, the internet, and smartphones. Outside of that, we’re really quite ossified.
check out Taleb on anti fragility in one of the econ talk pod casts. If we lift weights, run, train in any way we stress our bodies and get stronger. Private sectors, firms, banks individuals must face small regular stress, challenges so that when the big one comes we don’t break. Free markets and freedom do that. Our regulators make our banks brittle and weak, our welfare state makes people brittle and weak. If they could actually manage them centrally it might be worth some added fragility, but they can’t because it can’t be done. So a really big challenge usually caused by the regulators, harms us in ways that wouldn’t happen were the market free and robust with daily challenges, the regulators double down and that is scar tissue.