Dudley explains why TBTF firms need to shrink

William Dudley claims that there are two sources of instability inherent to financial intermediation.  The first is universally recognized: maturity transformation.  The second is not:

The second inherent source of instability stems from the fact that firms are typically worth much more as going concerns than in liquidation. This loss of value in liquidation helps to explain why liquidity crises can happen so suddenly. Initially, no one is worried about liquidation. The firm is well understood to be solvent as shown in Figure 1. But once counterparties start to worry about liquidation, the probability distribution can shift very quickly toward the insolvency line, as shown in Figure 2, because the liquidation value is lower than the firm’s value as a going concern.

In his analysis Dudley fails to ask one very important question:  When is there a big difference between the liquidation and the “going concern” value of financial firms?

I would posit that for old-fashioned banks that hold loans on the balance sheet and take deposits the difference between the liquidation and the “going concern” value of the bank is not necessarily large.  Simple loans are relatively easy to value.  Branches can be sold off.  Key employees who know the borrowers and have relationships with large depositors can be kept on by the firm that purchases a branch.

Almost certainly too big to fail firms have much higher liquidation costs than old-fashioned banks.  Complex asset portfolios are harder to liquidate than simple loan portfolios and are likely to be particularly hard-hit when markets are unstable.  Furthermore too big to fail firms are frequently too large to be managed well even when they are going concerns and thus must be split in many, many pieces in liquidation.  The process of selling off divisions will inevitably lead to some loss of information as employees with broad experience must go in one direction or another.

I read Dudley’s second source of instability as a reason to protect the financial system from oversized financial supermarkets.

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Does Caballero support a convertible bank debt policy?

Ricardo Caballero is once again proposing that the government insure private financial institutions against risk.  His theory is that there are no solvency crises, only liquidity crises, and therefore public insurance is needed to support asset prices.  (“Once the crisis sets in, insurance acquires great value and leads to more risk-taking and speculative capital injections into the financial system, but by then this is mostly desirable since the main economy-wide problem during a financial panic is too little, not too much, risk-taking.”)

Caballero is opposed to the resolution of failed financial firms, because decisions made during the resolution would be based on panic prices and therefore error-prone.  Thus resolution, he believes, would only fuel the panic.

I would like to know what Caballero thinks of the idea that whole debt structure (excluding deposits) of financial firms should be convertible in tiers.  By insuring that banks have ample access to capital when they need it, a convertible debt structure guarantees that resolution will occur only when bank assets fall so low that they can’t even support the bank’s deposits.  As long as Caballero’s theory that all crises are liquidity crises is correct, conversion into equity will be in the interests of bank creditors because they will earn spectacular gains as the economy recovers from the crisis that triggered the conversion.  And if Caballero is wrong and there are solvency crises, then the policy insures that it is the creditors of the firm — instead of the government — that bear the cost of the crisis.

On the role of CDS in the Bear Stearns collapse

In William Dudley‘s very informative speech on the what and why of the investment bank failures, there is a very interesting footnote:

One final factor that was important in exacerbating the funding crises was the novation of over-the-counter (OTC) derivative exposures away from a troubled dealer. In a novation, a customer asks a different dealer to stand in between the customer and the distressed dealer. This process results in the outflow of cash collateral from the distressed dealer. The novation of OTC derivatives was an important factor behind the liquidity crises at both Bear Stearns and Lehman Brothers.

Dudley cites three sources of the failure:
(i)  withdrawal of repo credit backed by illiquid assets
(ii) loss of primary dealer accounts, and
(iii) drain on cash collateral via novation of OTC derivatives

Given the aggressive action in the credit default swap (CDS) market that was demanded by the NYFed after the Bear Stearns failure, I think that it is safe to conclude that the novation of CDS was an important source of cash outflow for Bear Stearns.  This is worth noting because one periodically runs into claims by financial market participants that CDS markets operated effectively throughout the crisis and that CDS are being unfairly targeted by people who don’t understand them.

I suspect that when the full history of the Bear Stearns collapse is written, CDS will play a non-trivial role in the story.

On TARP and tragedy

I had the rather traumatizing experience of running into a professor this weekend.  A man whose early work was brilliant, but who did not pursue it and ended up devoting his life to justifying why economic theory does not need to change.  Basically, someone who inhabits an alternate reality constructed to protect his self-image.  True to form, he is still justifying the failure to act by viewing the world as just fine as it is:  he genuinely believes that the financial system has been saved.  I challenged this view and pointed out that only a complete failure of analysis could lead one to conclude that the financial system was sound, but I didn’t really expect him to process what I had to say.  With some people communication is simply impossible.

The world we live in is one where a lot of people desperately want to believe that everything is okay.  Facing the possibility that the foundations of our economy are deeply unstable, that the authorities have a mammoth task before them and that it is possible that our political system does not have the strength to pass the necessary legislation is frightening.

People want to believe that the disaster that was the TARP program did good things for the economy.  For this reason, voices like Steve Waldman’s and Haldane and Alessandri‘s are extremely important.  Steve Waldman makes the key point about TARP:  Everybody knew after the Bear Stearns debacle that a resolution authority was necessary — and Treasury chose instead to write up a bill that was designed to give taxpayer money away to the banks.  Given that after the Bear Stearns collapse it was clear that none of the investment banks had a viable business plan in a crisis (unless you consider running to the Federal Reserve for a handout a plan) and thus that the whole industry was on the short-list for resolution, Henry Paulson’s close ties to Goldman Sachs almost certainly affected his judgment on this matter.  (Remember that, if resolution was an option in September 2008 the Fed might not have extended additional support to the investment banks via the repo market and the conversion to bank holding companies.  These actions were taken because there were no alternatives.)

Now, we all need to admit that Paulson’s failure was an extremely human failure — that none of us can actually know whether we, having spent the whole of our working lives at a firm and then finding ourselves handed the job of drafting the law that would in all probability dissolve that firm, would not also have balked at the task and failed.  But the fact that a playwright could turn Henry Paulson’s career into a classical tragedy, doesn’t change the fact that TARP was a failure.

As Waldman observes, it is important to state clearly that the policy decisions taken in 2008 were a failure, and that they were a failure because they were shaped by people with close ties to the financial industry.  The old saw is still true:  “The first step in recovery is admitting you have a problem.”

An alternative to a resolution regime

This post of Steve Waldman’s prompted a discussion that I still think provides the best alternative to a resolution regime.  Regulators are currently encouraging the issue of contingent convertible bonds (or CoCos).  Because these haven’t been issued before some are concerned that the conversion itself could cause a crisis.  And there is much discussion regarding the value of this form of convertible debt.

Broader application of this contingent convertibility would do a lot to fix the problem of “too big to fail” financial institutions.  All financial institution debt should be convertible, with a few carefully chosen exceptions — such as deposits and perhaps some select categories of secured loans.  The convertibility of debt should be tiered, so that some investors are buying CoCos comparable to those that Lloyds is issuing and other investors — whose purchases convert only after 20 other issues convert — are very unlikely to convert and therefore are more like traditional forms of debt.

Requiring banks to have a convertible liability structure would solve for regulators the problem of not being able to put such banks through bankruptcy court.  It would obviously also raise the cost of funds for financial institutions — but only because lenders would have to be compensated for the costs that taxpayers are currently bearing.  Allowing the market to price the risks that banks are carrying is surely better than asking regulators to devise some model that will allow them to guesstimate an insurance premium for “too big to fail” firms.

A theory of publicly listed firms

John Kay’s column today prompted this line of thought:

Here’s a theory that in my view merits consideration.  Although I am sure that it is far from 100% correct and may be as little as 10% correct, I believe that it has as much truth as the view that large corporations are competitive firms in competitive markets.

The rise of stock markets and the ability to finance huge firms that deliberately exploit the benefits of size to undermine competition destroyed the relationship between a free market and a competitive market.  Thus, the presumption should be that industries with publicly listed companies are oligopolies and profits earned by these companies should be viewed with suspicion as they are likely to be rent-seeking profits.

When publicly listed companies are viewed as rent-seeking entities rather than competitive firms in a competitive market, there is a clear role for government in protecting smaller unlisted firms from predatory behavior.  Since it is far too difficult for government to determine what market based prices would be in a environment where publicly listed companies are predominant, remedies for their existence should be at the macro level:  (i) high taxes on publicly listed companies whose profitability is significantly higher than the average in competitive markets (i.e. where non-publicly listed companies predominate) and (ii) high taxes on wages paid to employees of publicly listed companies (that for example are more than double the wages of employees with comparable years of education outside the publicly listed sector) to prevent employees from extracting the rent-seekers surplus.  In addition, all publicly listed companies should be prohibited from spending any money on lobbying, campaign contributions or providing freebies for politicians.

Any other policy can be viewed as a government subsidy to rent-seeking behavior.

On the crisis of 1763

Via alea I found this paper by Schnabel and Shin on the Crisis of 1763.  While the paper does a good job of showing that the balance sheet channel of crisis transmission proposed by Shin and Adrian was alive and well in the 18th century, I’m not sure that it captures some of the most interesting features of the crisis of 1763.

First of all, the crisis of 1763 was one of the first instances of a lender of last resort acting to save the financial system.  The finance of the Seven Years War (aka the French and Indian War) had led to large scale interbank liabilities across the continent.  [Aside: one of the most important works on the evolution of money that has yet to be written is probably a careful study of the financial innovations and interrelations that made the finance of this war possible.]  For this reason the British banks were heavily exposed to the Dutch banking system — and were able to convince the Bank of England to provide liquidity support to the largest Dutch banks through the crisis.  This action was so remarkable that it is mentioned in the Wealth of Nations (II.2.85).

Notably, this stabilization of the financial system appears to have had moral hazard effects.  As Schnabel and Shin detail, leveraged speculators triggered the crisis in 1763.  While there were some failures in 1763, leveraged speculation would trigger another crisis in 1773.  In this instance, the British banks were less exposed and the Bank of England had just embarked on tighter policies designed to restrain the growth of speculative asset bubbles.  For these reasons, no cross-border liquidity support was forthcoming and two of the largest banking houses in Holland collapsed.

This collapse which was closely tied to both moral hazard and leveraged speculation was a first step in the complete collapse of Holland as an economic power.  With the failure of its largest banks, Holland lost its comparative advantage in trade — low cost short-term financing.  It is not likely to be a coincidence that Holland’s economic growth rates never recovered after this episode.  Without robust economic growth the public debt and ongoing military expenses became an overwhelming burden.  By 1795 — less than a quarter of a century after the 1773 collapse — the Dutch Republic was no longer an independent country.

Personally, I think that the lessons of the Crisis of 1763 are much harsher than those drawn by Schnabel and Shin.  An economic powerhouse still in its heydey faces a financial crisis and is bailed out.  Just ten years later the next crisis comes, and there is no bailout this time.  The resulting financial collapse ends the country’s status as an international financial power and over time as an economic power.

Financial systems are not stable entities.  They come and they go.  A policy that manages to put the financial system on sound footing for another half-century — such as Roosevelt’s reforms or the Bretton Woods agreement — are all one can hope for.  Policymakers should be focused on reforms that will buy our financial system another half-century of stability.