Comparing bankers past and present

Even after verifying that banking was indeed an unlimited liability enterprise in the 19th century, TED appears to struggle with the idea that anybody with wealth would be willing to take on such risks — especially for a measly return of 5% or less on assets.  TED writes:

My intuition about unlimited liability is that capital providers subject to it have a natural limit to the amount of credit they are willing to extend regardless of price. Each lender sets her individual limit based on her estimation of the likelihood of loss beyond initial capital invested. Beyond that there is no price at which she would be willing to lend. This certainly would be my preference: if I faced the loss of my home and possessions, penury, and utter ruination, you can damn well be sure I would not extend just one more loan to capture an extra fifty, hundred, or even thousand basis points of yield. I do not think I am alone among heartless, flinty-eyed rentiers in this regard.

What this sounds like to me is that the employees of our financial institutions are so habituated to making outrageously large risk-free (i.e. government guaranteed) returns, that the idea of risking one’s own assets in order to make a profit seems patently ridiculous — which of course it is — if you happen to be one of the few privileged enough to be able to spend your life sucking at the government’s teat.

(My apologies to TED, Alea, Sonic Charmer and all the other financiers looking for a better system, but this bit of hyperbole seems close enough to the truth to me that I couldn’t bring myself to edit it out of existence.)

Given the growth of unlimited liability banking in the past and the plethora of Americans living lives of quiet desperation in the present, I suspect that the risks of unlimited liability banking could in fact attract many, many small lenders whose initial capital may be little more than significant equity in their own home — if it were not the case that the whole industry is overshadowed by government sponsored mega-lenders.  After all, how many small businessmen and women in this country have already signed up to be personally liable for their business debts?  Putting all of one’s assets at risk to start a business is hardly an unknown or rare phenomenon in this country.

To support the view that unlimited liability banking operates as a constraint on the economy, TED writes:

The historical evidence Andrew Haldane cites from early 19th century Britain is entirely consistent with this: compared to the situation today, banks were massively overequitized and highly liquid, and bank assets and hence lending were a very low proportion of the economy. If my intuition is correct, it may well be that prevailing market rates of interest during that period evidence less that capital was plentiful and demand fully satisfied and more that supply and demand were balanced in a regime of artificially limited supply. Certainly Mr. Haldane contends—based upon what, I do not know—that the system of unlimited liability was not capable of supplying the growing need for capital during the rapid industrialization of the mid 19th century.

Given that Britain spent the 19th c. growing economically into its role as a premier world power (“the sun never sets …” etc.) and by the late 19th c. was exporting capital around the world, it’s hard to understand the foundation for TED’s argument that the supply of capital must have been “artificially limited,” since banks were lending at 5%.  If banks in Britain were “overequitized,” there’s little or no evidence that this had an adverse effect on the economy.  As long as banks could be operated profitably, to the degree that existing lenders were at the limit of their ability/willingness to lend, new entrants into the industry — or new partners — could probably be found to expand the business and take advantage of good lending opportunities.

The data on the United States indicates that banks subject to double liability were not “overequitized.”  In 1919 the ratio of the aggregate total capital account for all Federal Reserve member banks to total assets was 11%. (See column 1 of Chart No. 57 here.  This ratio rose to 15% at the depths of the Depression and then dropped with the advent of deposit insurance.)  At the start of the recent financial crisis the Fred database indicates that this ratio was hovering around 10%.  Thus, it’s far from clear that double liability in the US resulted in “overequitized” banks.

I believe that the claim that “the system of unlimited liability was not capable of supplying the growing need for capital during the rapid industrialization of the mid 19th century,” is just an explanation for the growth of stock markets and limited liability non-financial companies.  It is widely recognized – and I do not dispute this claim – that certain industries with extremely high fixed costs but significant risks in the form of aggressive competition to take advantage of recent technological developments, like railroads or fiber optic cables, can, more or less, only be financed via a limited liability shareholder structure.  Since banking developed as a successful industry before the rise of stock markets, and as Andrew Haldane notes the banking industry was very slow to embrace limited liability, it is far from clear that limited liability is an essential element of a efficient banking system.

Mr. Haldane appears to argue that because systems of extended liability did not protect depositors in the Depression, such systems were rejected.  While this may be a historical explanation for the growth of limited liability banking, it is far from clear that Depression-era problems should be taken as conclusive evidence against extended liability.  It’s doubtful that any banking system could have survived Depression-like events, marked most notably by the world’s reserve currency delinking itself from gold and setting off a reserve currency transition, without significant losses.

In short, while unlimited or extended liability banking would almost certainly mean that the economy was populated with a greater number of smaller banks, it’s far from clear that credit itself would be constrained.  Nor should one assume that interest rates would rise.  After all the risk premium portion of interest rates depends as much on the quality of bank underwriting and social enforcement mechanisms as on the characteristics of the borrower, so incentivizing banks to screen borrowers and lend carefully may actually reduce the interest rates available to most borrowers.

Related posts:
What banks do
The problem of collateral
What is capital?

What is capital?

TED recently discussed “the pool of capital available to the economy” as if this were a concept with a clear meaning.  Capital is sometimes used to refer to the equity in a business, to the working capital used to operate a business or simply to the investable funds that investors have and fund-managers or IPO-issuers want to get.

Equity capital is something that we think we understand – until we think about it a little longer.    It often incorporates the value of many intangible assets that may be alienable only as part and parcel of the whole business and/or fragile in the sense that they may be easily destroyed by bad managerial decisions (e.g. goodwill).  Furthermore it is axiomatic that equity capital is inflated when asset prices are too high and it evaporates when they fall.  (Steve Waldman has expounded on these issues much more thoroughly and penetratingly than I do here.)  In order to have a meaningful “pool of [equity] capital,” it’s necessary to have some kind of stability in asset prices – but this is precisely what we don’t have in our current system.

Thus, it’s a mistake in my view to think of equity capital as part of the “pool of capital available to the economy,” as if there were a simple fixed quantity of “capital” in the world and it’s only the price that varies.  What precisely the aggregate value of the stock market represents is far from clear – and that’s why it is in some sense not particularly surprising when this value drops by 40% over the course of a year.  What comes to my mind when I hear “pool of capital” is the “K” of economist’s models working to constrain our ability to think about what capital is.

In addition, the focus on equity capital obfuscates the important role played by the finance of working capital in the economy.  Many real goods come into existence only because of the availability of working capital.  While only a fraction of the output financed by working capital is converted via retained earnings into equity capital, the ubiquitous finance of working capital may mean that it plays a more important role in the economy and production process than equity capital itself.  I get the impression that most people don’t consider working capital to be an important component of the “pool of capital available to the economy,” but it’s far from clear to me why this is the case and whether it could possibility be justified.

As I have argued elsewhere, the finance of working capital plays an important role in the transformation of human capital from an inalienable asset into tangible, alienable assets.  The realization of human capital is, possibly, the most important role played by financial institutions in the economy — and this requires unsecured lending and well developed underwriting processes that distinguish borrowers who are likely to repay from those who will not.  Capital is created along with “good” debt and destroyed when the enforcement mechanisms for debt weaken.

In short, capital should be understood as a social construct, not in fixed supply or growing due to investment, but a product of institutional infrastructure.

Related posts:
What banks do
The problem with collateral
Comparing bankers past and present

The Problem of Collateral

There are two major problems with collateralized interbank lending.  The first is that there’s no reason to believe that collateral will function to protect the lender in the event that a major bank fails and the second is that the shift from unsecured interbank lending to collateralized interbank lending is likely to have a contractionary effect on the money supply.

At least since Keynes, there has been general recognition that the analysis of aggregate economic activity and the analysis of an individual’s economic behavior require different tools.  The reason for this is simple, individuals can often be viewed as price-takers, who have no effect on the aggregate economy.  Effectively micro-economic analysis abstracts from the problem of liquidity, whereas macro-economic analysis must confront this problem directly (which is not to claim that the dynamic stochastic general equilibrium models that dominate the field of “macroeconomics” today  typically do confront the problem of liquidity, but that’s a different debate).

Alea points out (see comment here) that Basel II discourages banks from lending to each other on an unsecured basis.  The fallacy that regulators appear to be engaging in when they favor collateralized interbank transactions is precisely the fallacy that Keynes criticized forcefully in Chapter XII of the General Theory:

Of the maxims of orthodox finance none, surely, is more anti-social than the fetish of liquidity, the doctrine that it is a positive virtue on the part of investment institutions to concentrate their resources upon the holding of “liquid” securities. It forgets that there is no such thing as liquidity of investment for the community as a whole.

Regulators are failing to distinguish between what is optimal for the individual bank and what is optimal for society.   Liquid assets are supposedly “safe” – but for the problem that liquidity itself is inherently ephemeral.  How precisely do the regulators imagine that collateral posted by a systemically important financial institution (SIFI) is going to protect the lenders?  If the SIFI goes down, there is, in the absence of central bank intervention, a fire sale.  And if they’re counting on central bank intervention to make it possible for collateral to function to protect the borrowers from losses (e.g. via a PDCF or TSLF), why not just rely on traditional central bank lending to banks in a crisis?  What precisely does collateral posting by a SIFI add to the existing system of central bank crisis support for regulated financial institutions?

As discussed in my previous post, the biggest problem with allowing SIFIs to post collateral to one another is that it discourages them from restricting credit to banks that are poorly managed.  By discouraging normal market forces from working to limit the growth and interconnectedness of bad banks with the rest of the financial system, a collateralized interbank lending regime places an enormous burden on regulators to both identify and shrink a bank that has deep connections with the rest of the financial system.  Arguably collateralized interbank lending places an impossible burden on regulators.

The second major problem with shifting from a system of unsecured interbank lending to a collateralized banking system is that in the process of purging the money supply of unsecured debt, the money supply may well have to shrink to the size of the collateral base. Precisely because the shift to collateralized interbank lending creates strong contractionary pressure on the money supply, there is a call for governments to create “safe” assets – that is to increase the size of the collateral base to accommodate the money supply.

Why not call on the banks to create safe assets by underwriting loans carefully?  Such loans after all have historically been all that is necessary to back the money supply.  Perhaps the answer to the question is that “safe” privately issued loans aren’t part of the economic model being used?  I sometimes feel that macroeconomic models that treat government as the social planner’s deus ex machina have so infiltrated some economists’ thought processes that they actually expect a real world government to successfully play the role of a benevolent deity.

If the financial system is so fundamentally unsound that the banks should not be extending unsecured interbank credit each other, the government is not going to be able to do anything to save it.

Related Posts:
What banks do:  monetize human capital
What is capital?
Comparing bankers past and present 

What banks do: monetize human capital

After an outpouring of excessive and unwarranted humility, TED gave a nice critique of some of the  points in my previous post, which I will summarize (probably inaccurately) as (i) Can a system of unlimited liability for banks provide enough capital or does the risk-return tradeoff mean that such a system would hamper growth? (ii) What I meant when I claimed that from a theoretical point of view financial systems don’t require capital was unclear.  (iii) TED seems to posit that there is a tension between accurate pricing of risk (i.e. when losses aren’t socialized) and the provision of enough capital to keep the economy growing.  I don’t agree that the first and the last points are an accurate description of the tradeoffs faced by society, and rather than address TED’s points directly, in a series of posts I’m going to present my own vision of the relationship between the financial world and the economy – in the process, I hope, addressing the second issue.  (And I must admit that it was a sense of immense relief that I realized the piece titled “The Standard Model” was not TED producing a new post on this debate before I’d even managed to reply to the first one, but an entirely different topic.  I’m a snail of a writer and look on with envy at the prolific output of bloggers like TED.)

I have long believed that we need to reconceive our understanding of the financial system:  the basic ideas on which most of the discourse is based – i.e. intermediation between lenders and borrowers with decisions based on the weighing of risk and return, and the concept that systemic risk originates in a partial reserve banking system’s conversion of risky assets into safe assets – fail to capture the essentials of the financial system.

Faulty modeling means that we fail to understand the nature of the tradeoffs we face (e.g. TEDBut lowering the risk of loss we are willing to accept as a society will have ironclad implications on the types of returns we enjoy. Surely there is a happy medium between a low-growth, capital-constrained economy hobbled by unlimited liability to capital providers and the reckless bacchanal we financed with “other” people’s money up to the financial crisis.) and also results in egregiously bad regulatory decisions (e.g. the incentives created by Basel II).

The claim that finance is just a simple risk-return tradeoff ignores the fundamental truth of the industrial revolution.  Society went from millennia of washing clothes down by the river (or in a washtub in the house if someone hauled water in) to not even getting one’s hands wet – much less engage in physical labor – over the course of barely more than a century.  While the causes of the revolution are debatable, there’s a strong case that it’s all finance:  that is, that the risk-return tradeoff exists at different levels and within the context of different financial regimes.

An alternative model:  Banks monetize human capital

I want to propose an alternative model: the most important role of banks in the economy is to monetize human capital.[1]  When banks fund the working capital of entrepreneurs on an unsecured basis, they make it possible for the economy to realize the value of what’s inside people’s heads – independent of the other resources available to those individuals.  If banks could know in advance who would and would not default, the most human capital possible would be realized.  Of course, this maximum is unobtainable in practice, so the amount of capital available to the economy is a function of the quality of bank underwriting mechanisms.

The implications of the model are: (i) Banks “create” capital.  They don’t simply move capital from one place to another, but are essential to the process by which an intangible and inalienable asset is converted into tangible, alienable assets.  (ii) Unsecured debt is a cornerstone of a modern economy.

Creating capital

The traditional models referenced above treat finance as if it’s about stocks of capital and how they are allocated, when in many ways finance is a matter of managing flows of money with the stock of capital only relevant in extreme circumstances.  In the simplest framework a disabled landowner, a laborer, and a disabled seed owner can work together to produce food for their themselves, but don’t trust each other.  In a world without a coordination device, the land, the seed, and the labor are worth nothing and everybody starves to death.  If everybody trusts the bank and the bank is willing to lend (at a spread), then (i) the landowner can borrow from the bank (at x%) hire the laborer and “rent” the seed – returning new seed after the crop cycle, and pay both the laborer and the seed owner with bank IOUs or (ii) the laborer can rent the land and the seed, paying with bank IOUs or (iii) the seed owner can rent the land and hire the laborer paying with bank IOUs.  The point is that the bank isn’t lending money that it has or savings that someone has accrued and deposited with the bank, it’s borrowing and lending simultaneously with the result that output, that would not come into existence in the absence of bank intermediation, is produced.  In short, banking can facilitate the creation of capital simply by being trustworthy and managing flows without actually “allocating capital” at all.

Maybe the bank is more willing to lend to the landowner or the seed owner, because they have an alienable asset that can secure the debt, but I would argue that historically economic development starts to take off precisely when the collateralized debt constraint is broken; that is, when institutional structures develop such that banks are willing to lend on an unsecured basis and the owners of inalienable capital can get a small line of credit fairly easily at a reasonable rate (e.g. 5%) and can, with careful management, earn the right to have a much larger line of credit.

The role of unsecured credit

The idea that the financial system monetizes intangible, inalienable assets doesn’t apply only to entrepreneurs and human capital.  The financial system itself is arguably built on the monetization of such assets.  It’s precisely because people trust their banks and the bankers trust each other that the money supply that we have is sustainable.  In economic models, this is sometimes called “reputation.”  (Existing models however rarely include the liquidity problems that banking is designed to address, and in the absence of such frictions often find that reputation-based equilibria do not create enough value to be stable.)

Implications for regulation

A key goal of financial regulation is to preserve this trust in the banking system.  It appears, however, that faulty modeling has meant that regulators don’t have a good sense of the foundations of this trust.

The key here is that lending is unsecured.  When lending by banks is secured, what is being monetized is not trust, reputation or human capital, but only the assets themselves.  Regulators need to understand that there is a “use it or lose it” aspect to unsecured lending.  Unsecured lending forces banks to put in place mechanisms that make unsecured lending reasonable (at least in a world where banks are allowed to fail).  These mechanisms then undergird trust in the financial system itself.

When banks are told to seek collateral for their loans to each other (see Alea’s comment here), these mechanisms start to fall into disuse.  My concern is that it appears that, as the mechanisms supporting unsecured lending by the banking system disappear, so does trust in the financial system itself.  After all, collateralized lending is the easiest and oldest form of lending – it was apparently regulated by the Code of Hammurabi.

In a well-regulated financial system the banks themselves would start the process of shutting down bad banks by restricting their access to credit.  The bankers themselves  are best positioned to do this:  with the movement of employees from one bank to another they can get a very good sense of how their competitors are being managed or mismanaged, and because they compete in the same markets they know when their competitors are mispricing assets.  This is exactly the information that is needed to determine which banks are not trustworthy and it would almost certainly be used by banks that (a) know their competitors can fail and (b) regularly extend sizable lines of credit to these competitors.

In our current system it appears that regulators are trying to do the job that banks are better equipped to do.  The regulators are searching for some fixed formula (called Basel?) that will be “the” source of financial stability.  The underlying problem is that there’s no reason to believe that such a formula exists.  Trust, also known as credit, is an amorphous concept that can be capitalized, but when reduced to a simple formula is usually undermined by the existence of a formula that can be gamed.  The job of the banker is to stay ahead of the game – possibly by not using simple formulas.

In short, I think regulators should make sure that we have a system where (i) banks can fail and (ii) banks have to lend to each other on an unsecured basis.  Bank failures should be a normal enough occurrence that banks are prepared to write off the debt of other banks – and focus on creating safe assets themselves rather than looking to the government to provide such assets in the form of bank liability insurance.

Would this be enough to stabilize the financial system in the absence of increasing the personal liability of the bankers?  I don’t know.  To return to ideas in my initial post, perhaps in order to address the asymmetric information problems that pervade the financial industry we would also need a policy such that in the event that a bank fails there is a lower standard for creditors to pierce the corporate veil than in non-financial corporations.  Imposing the possibility of liability (that would have to be made uninsurable by statute) on directors, officers, employees, and shareholders – to the extent that any of these parties received income from the bank over the previous 10-15 years – may be necessary to prevent misuse of “other people’s money.”  Employees should be granted the strongest safe harbors (including, for example, the first $100K per year of income, but not including decisions to gather nickels before steamrollers) and shareholders the weakest.

In addition — or perhaps alternatively — it may be necessary to circumscribe competition in the financial industry.  But I’ll leave that to a future post.

[1] Notably Rajiv Sethi just put out a post along these lines, observing that the subprime mortgage industry was able to capitalize the dishonesty of locally-connected mortgage brokers.

Related posts:
The problem of collateral
What is capital?
Comparing bankers past and present 

The mantra of some financiers

“Society always stands as the loss-absorber of last resort”  — TED

“There will always be a tail of financial risk that society must absorb”  — David Murphy

[Note:  TED deserves a more thorough response than I have time for right now, but David Murphy’s riff on TED’s latest post generated this brief reply — using time that really should have been devoted to one of my three deadlines.  More to come, but maybe not for a week or so.]

Needless to say I can’t judge the truth of David Murphy’s statement about the future, but the historical evidence is clear:  society as a whole has not always stood as the loss absorber of last resort for the financial system.  (Asteroids, I hope we can all agree, belong to a different class of events).  Our banking system was founded in an environment where the bankers absorbed the losses.  Crises were costly, because bankers’ assets were wiped out.

(Note: in environments without lenders of last resort, society tended to bear more of the losses, after the bankers were wiped out because there was so much collateral damage — e.g. Venice 1300 – 1600.  In a traditional environment with a lender of last resort, e.g. England 1763 – 1900 or so, the last resort lender has to fail before society bears a significant portion of the losses.  Note that the Depression can be viewed as the failure of a last resort lender, since the Bank of England went off gold.)

Treating society, and not the bankers, as the financial system’s “loss absorber” is a new phenomenon, for which the seeds were laid in the reforms of the 1930s.  The evidence lies in the facts:  the Federal Reserve’s non-recourse loan supporting the purchase of Bear Stearns and the TARP legislation were unprecedented events in the nation’s history.  We are treading new ground here – and the response of the financiers is to try to persuade us that society has “always” passed bills bailing out bankers.  Nonsense.

I think that Mr. Murphy’s approach to “tail risk” illustrates the dangers of “putting financiers less on the hook.”  The business of banking used to be about how one can lend without losing money, it used to be about how to turn ordinary commercial loans (and I mean whole loans) into safe assets.  Banking was based on “the science of credit” (Thorton in 1801) and careful underwriting of short-term loans was the bread and butter of banking.

I am happy to acknowledge the theoretic possibility that putting financiers less on the hook is better for society, I just don’t see many facts that support the theory.  The facts indicate that putting financiers “less on the hook” (starting in the 1930s with ever more support from the 1980s on ) and then forcing them to compete with each other (mostly after the 1980s growth of money market funds, commercial paper markets, repeal of Reg Q, etc.) induces them to issue loans without underwriting them – and to be unwilling to lend even to each other without collateral.  How’s that supposed  to be good for society?

I don’t get why arguing that requiring that financial tail risk be born by those who make the decisions determining how much financial tail risk society will have to bear constitutes a “knee-jerk response which is unlikely to lie on the efficient frontier.”  Especially given the amount of money financiers manage to make while creating that excessive measure of tail risk.  In economic terms, the standard description of such an argument is internalizing an externality – and it is very likely to bring society closer to the efficient frontier.

In short I agree with TED entirely when he writes:

the decisions we make about how we allocate, limit, and distribute financial risk throughout society—including how much to put financial intermediaries on the hook—will reverberate broadly through the system and ultimately affect our very living standards and prospects

It is precisely because the current allocation of financial losses is undermining our living standards — and gives every appearance of continuing to make them worse — that we need to reallocate financial risk to ensure that financial tail risk is correctly priced.  The easiest way to do so is to make those who are in a position to price that risk, bear it.  But I’m open to other suggestions.


Updated 2-7-12:  “the” removed from title and replaced with “some.”  See Sonic Charmer’s comment below.

A little fear is a good thing

TED, whose beautifully written posts are always stimulating, challenges me on my last post:

I worry that those who argue for a wholesale return to unlimited liability for the owners of financial intermediaries simply have not thought out the problem of scale inherent in the current global economy.

and I’m first to admit that a wholesale return to unlimited liability in banking by congressional fiat is — shall we say — unrealistic.  But I also think some of TED’s concerns about insufficiency of capital and excessive interest rates in a system with unlimited liability are overblown.

The system of unlimited liability banking grew up in an environment with usury laws, so interest rates (on short-term debt) did not exceed 5% per annum.  Market rates often fell as low as 2%.  It’s far from clear that low interest rates for borrowers are inconsistent with unlimited liability on the part of lenders who choose to use their ability to borrow to leverage their returns (i.e. to act as partial reserve banks).

Furthermore, from a theoretic point of view, a banking system doesn’t need capital, it needs trust (aka credit).  If the institutional framework is carefully structured (that is, debts are enforceable, outright fraud is disincentivized/rare, etc.) there is no shortage of capital — capital is created out of thin air by a plethora of unsecured, but trustworthy, promises.  Effectively, capital is cheap, because the institutional structure of finance reduces the risk of losses to a minimum.

One of the most worrisome aspects of our current financial evolution is the shift to ever-increasing use of collateral, which to me is testimony to the fact that the institutional structures supporting a financial system with cheap capital are disappearing before our eyes.  Collateral adds expenses that are unnecessary when the unsecured financial system works well.  One of the first policies I would propose is a (phased-in) prohibition on the posting of collateral by our largest financial institutions.

I’d be more optimistic about the future of our financial system if certain aspects of banking were understood.

(i)  Total collapse of the financial system is possible.  I’m talking about the kind of event that will cast a shadow over the Great Depression.  I am reminded of the fact that China had a fiat money system that lasted for about 200 years before it imploded, creating a vast demand for silver that fueled the silk and spice trade of the middle ages, and arguably set off the development of European finance.

(ii)   “Safe assets” like deposits and bills of exchange were created by a merchant class subject to common law (i.e. law for the commoners) at a time when the idea of a government guarantee of a financial asset was somewhat ridiculous.  (Kings have a habit of taking property — with or without your leave — and failing to return it.)  That is, when assets were “safe,” they were safe because of a complex web of social characteristics including law, social norms, property rights, etc.  Such safety cannot be recreated by a myth of governmental infallibility — all that will be demonstrated by seeking refuge in government guarantees is the weakness of the governance structures.  To recreate an environment with relatively “safe” assets will require reworking of the institutional structure of the financial system, so that it can provide these assets on its own with little reliance on government.

(iii)  It would be helpful if the members of our financial elite could take a long enough break from their rent extraction activities to take a look at the path we’re on — and whether they’re sure the world they’re leaving to their children is the one they want to leave behind.  And, maybe, throw their weight behind some wholesale reform themselves.  (Pace, TED, I don’t mean you, because you do worry and you are speaking up.  You give me hope.)

With a little fear of total financial collapse, maybe we can manage to change the the system enough to keep it running for another few decades.

In defense of banking …

… but not the banks we have.

Opacity is absolutely essential to modern finance.” “Societies that lack opaque, faintly fraudulent, financial systems fail to develop and prosper.” Steve Waldman

This is a response to three posts at Interfluidity that argue that banking is essentially a con job.   The quotes here are from those posts except as noted.

While I agree on the issue of “opacity” (bankers lend money and it is difficult or impossible for depositors and creditors to monitor bank assets), I also think that Waldman is confusing two things:  modern finance and the financial systems that facilitated economic development.  They have/had very different characteristics:

  • Modern banking:  limited liability, government-guaranteed deposits, high risk of loss to bank creditors (in the absence of government intervention).
  • Before 1930:  at least double liability, deposit “contracts” that were always implicitly conditional, and comparatively low risk of loss to bank creditors (in the absence of government intervention).

In short, prior to the 1930s the assets of the bank-owners themselves were very much at stake with the result that their leverage ratios were much, much lower than in modern times.  (Econometric analysis indicates that  in the late 1800s neither the leverage ratio nor the size of banks was a predictor of either bank profitability or stability of profits.   Lamoreaux, Insider Lending, pp. 97-98.)

History:  Unlimited liability and the nature of the deposit “contract”: 

“A banking system is a superposition of fraud and genius”  “Banks guarantee all investors a return better than hoarding, and they offer this return unconditionally, with certainty,”  “First and foremost, they offer an ironclad, moneyback guarantee.”

Waldman’s model of banking has these properties, perhaps, because he’s referencing a world with deposit insurance instead of bank failures – that is, a world with explicitly government backed deposits:  this form of banking has been around for just three quarters of a century.  Historically banking is built on a conditional promise to depositors to return the money unless the bank closes its doors.  When the bank closes its doors, “time” is lost, but because nobody would entrust his money to a banker who wasn’t wealthy and subject to liability (either unlimited or capital calls on stock owners to pay debts), once the banker’s horses, etc. are sold, you get your money back.  Depositors understood that “time” could be lost and that only a fool would leave his money with someone who wasn’t wealthy.  The contract was conditional on the risk of temporary illiquidity and, in practice, conditioned on the assets of the banker.

To the degree that Waldman’s concept of banking is based on the Diamond and Dybvig model, even they acknowledge that the 19th century solution to the problem of bank runs, suspension (i.e. closing the bank and liquidating) also solved the problem.  It is only dominated by deposit insurance if the insurer has the ability to target a tax to those who withdrew money during a run (or to achieve the same result via inflation).

History:  Bank losses were put to the owners of the bank:  While crises and bank failures were common, there are many historical examples of major bank crises that didn’t result in losses to depositors’ principal.  (See for example the failure of Overend and Gurney in England, which was the Lehman’s of 1866.)

“Second, they point to all the other people standing in front of you to take the hit if anything goes wrong.”

This is a pure invention of modern “limited liability” banking.  Even through the early years of the 20th century, bank shareowners were subject to capital calls in the event the bank failed.  In Britain bank stock was usually purchased by paying only a fraction of par, leaving stockholders subject to a capital call that could be a multiple of the original payment.  In the US the norm was double liability, so stockholders who bought shares with a par value x, were liable for a “second” capital call of x. (Double liability was part of the National Bank Act of 1864 and also enacted by most state legislatures.  It was the law in Massachussets even earlier.)  It’s not clear that losses of principal (i.e. excluding “time”) to depositors due to bank failures were either common or large.  It’s my understanding that there were no such losses in England from 1850 through 1900 – and probably very few between 1800 and 1850.  In the US there were most likely some losses, but how significant were they after the whole legal process was complete?

 “ ‘Shadow banks’ are nothing new under the sun, just another way of rearranging the entities and guarantees so that almost nobody believes themselves to be on the hook.  This is the business of banking.”  “Since no one (most especially the financiers) believes themselves to have agreed to be the bagholder, we are left in an ocean of conflict over who must bear what costs.”

I disagree.  This is the modern business of banking.  When our financial system developed the ones who were most at risk were the bankers themselves.

Bagehot’s Lombard Street is in many ways about the growth and contraction of a shadow banking system.  The “bill-brokers” — of which Overend was by far the largest — grew up as undercapitalized shadow banks that relied extremely heavily on the lender of last resort facilities of the Bank of England in crisis.  The Bank objected to the quantity of Overend bills it had discounted and told Overend/the bill-brokers that they would have to find their own source of capital in the next crisis.  In 1866 the Bank of England kept its word and Overend failed.  As noted above, the Overends had to sell their personal assets (and there was a capital call on shareowners), but every penny was repaid to creditors.

After this crisis, British finance continued to flourish.   The lesson I draw from this is that the key to central banking and a strong financial system is knowing when to close the liquidity spigot.

In fact, it is possible that the problem created by bank failures in the depression may not have been losses to depositors (although they were certainly the more visible), but the wiping out of the stratum of society that had the reputational and financial assets to be bankers or invest as shareholders in banks (i.e. the capacity to answer and the willingness to risk a capital call).

Opacity, confused creditors and growth

“Societies that lack opaque, faintly fraudulent, financial systems fail to develop and prosper.”
“Industrialization occurs in societies with corrupt and fragile big banks.”

From a historical perspective this is unsupported by the evidence.  Societies that develop and prosper have banks that pay their depositors back from the assets of the owners of the bank, should the bank fail.  This is the reason bankers were trusted with “other people’s money” in Venice, in Amsterdam (each, the center of world trade in its time), in 18th and 19th c. England and in the US through the 1920s.  Only in modern times did anyone imagine it is possible to have financial system populated by entities with complete limited liability.  (Observe that banking systems will full liability also can collapse – usually because the flourishing economic activity that made it worthwhile for bankers to take the risk of losing all their property evaporates for external reasons.)

I think the truth that underlies Waldman’s argument is that it’s impossible to have a truly competitive financial system, without destroying the financial system itself – and this is one of the greatest errors of modern finance. Why?  Historically, bankers must take risks and their assets must be at risk; bankers will only do this if they make a hefty return.  In modern times, they must be highly compensated simply to keep them from taking advantage of their access to other people’s money and their abundant opportunities to profit from activities that tend towards fraud.  They will be wealthy, they will control the payments system, and they will favor policies that are in their own interests, not those of the general public.  They will be the target of populist complaints.  If you try to address these complaints by introducing too much competition, you will compete away the profits that will compensate them for their risk (or their access to pilferable funds).  Theory tells us that given too much competition, bankers will decide they’re better off stealing people’s money.

(cf. “Information asymmetry (the source of opacity) is built into the very fabric of the division of labor in complex societies. …  insiders’ privileged position and knowledge enable them to extract rents.”  )

Banking and capitalism

Bankers have historically been the “capitalists” of their time, but only if one understands “capitalism” in the Marxist sense of the word.  Bankers are the wealthy making profits off their wealth.  In modern times where non-wealthy individuals enter the banking profession, the bankers are profiting from their position in a company that has vast amounts of money at its command.  Because these companies have limited liability — and abundant government support systems — however, society, not the owners of the bank are the true sources of their capital.  When profits are being made off of capital provided by the public, a better word for what the bankers are doing is probably best characterized as socialism.  (cf.  Prof. Varma on safe assets, h/t Ashwin Parameswaran)

“Part of what makes an FDR different from a Mitt Romney is that an FDR understood his power to be derived from more or less arbitrary privilege, while a Mitt Romney imagines himself to have “eaten what he killed” in brutally efficient markets.”  Yes.

“They persuaded themselves, long before they persuaded the rest of us, that any games they played for their own enrichment would necessarily lead to social gain over the long term.”  This is very true too.  One thing I’ve learned from blog discussions is that traders think it’s socially efficient for them to make money off of the sorry, uninformed creature who thinks that asset is worth what he’s paying for it.  (They  obviously missed the Econ 101 class on asymmetric information and efficiency.)

“What the market will bear” is not a sufficient statistic for ones social contribution. Sometimes virtue and pay are inversely correlated. Really! People have always been greedy, but bankers have sometimes understood that they are entrusted with other people’s wealth, and that this fact imposes obligations as well as opportunities.

I’m not sure that the right approach to this problem is to place “obligations” on bankers.  I’d opt for incentives.  Jamie Dimon’s houses and financial assets should go on the block to pay creditors if J.P. Morgan fails.

Would this reduce risk-taking?  Absolutely.  But in a good way.  Bankers need to be incentivized to take reasonable risks, not unreasonable ones.  Keep in mind that industrialization and modern banking was born in an environment with precisely these characteristics.

Does (financially-supported) growth require misinformed bank creditors? No

“I claim we would forego a lot of plain booms, the kind that ultimately enrich investors as well as society at large, if we didn’t have a financial sector skilled at getting people to assume risks they’d not directly consent to take.”

I think that what Waldman is missing here is that historically bank accounts in industrial regions start out as loans.  That is they are discounts not accounts.  So no bank creditor is putting their savings at risk, instead the bank (as noted above most likely the wealthiest person in town) is lending to the local entrepreneurs and tradesman, but avoiding having to maintain much of a stock of gold by clearing the whole town’s transactions on his books.  In a well functioning financial system, the town banker can send those debts to the big city and sell them off if he happens to need cash.  There ends up being a large network so that long-distance transactions can be cleared in the big city.  Basically finance is a debt clearing system that requires, in theory, no capital or actual savings at risk at all — but only a bunch of entrepreneurs/tradesmen who are willing to lend to each other because an entity with reputation (the bank) is underwriting the loans. In practice, people with money to lose have to guarantee that the system is sound.  These bank-guarantors make it possible for the system of unsecured trade credit that makes the economic world go round to operate.

Can finance solve the problem of systemic risk?  No, and neither can government.

“Diversification and maturity transformation can protect us from idiosyncratic shocks, and Murphy is right to point that out. But they cannot protect us from systematic misfortunes.”

Finance is unstable, so if a basic precept upon which most banker’s decisions have been based (e.g. the Bank of England will maintain its peg to gold) a lot of bankers can fail and lose their fortunes, taking the economy down with the bankers. (The worst of the bank failures in the Depression took place around the same time or after the Bank of England went off gold in Sept 1931 — causing a big hit to balance sheets around the world.)  Bagehot recognized that banking is a system of credit, so by definition its always within the realm of possibility that the whole system collapses.  There’s no reason the system can’t be born again – as long as there’s someone with assets to lose who recognizes trading activities he’s willing to finance.  But, of course, the process is excruciating.

But on systematic risk allocation, I think it unquestionable that status quo finance is completely terrible.”  Agreed.  But this is not a problem with banking.  It’s a problem with limited liability banking where the people making the lending decisions can put the ultimate losses to someone else.


If regulation will be very intensive, we need regulators who are themselves good capital allocators, who are capable of designing incentives that discriminate between high-quality investment and cost-shifting gambles.

I’m not convinced there is an alternative to the threat of personal losses to keep managers of “other people’s money” honest.  The banks have too much incentive to infiltrate whatever regulatory system is put in place, so it’s probably close to impossible to keep it from being captured in one way or another.

Have we reached the apotheosis of finance?  That is, did we once have a functional (though always changing) financial system that evolved to the degree that it is now on the path to implosion?  Far from Waldman’s view that finance has always been this way and this is the way it must be for growth to take place, I think that finance once had very different characteristics from that which it has today and that the loss of those characteristics significantly increases the likelihood of the total collapse of which  Bagehot warned.

The questions, for me, are:  Is the financial system dying from the effort to turn it into a competitive industry?  And can we save it?

Note: I edited  a phrase that was too strongly worded, and tweaked the text.

The Central Bank as a Deus ex Machina

When I saw the link to Buttonwood’s latest Economist article, subtitled Why low interest rates could also encourage saving, I was hoping that maybe I could just let this post I’ve been working on sink into the depths of my drafts folder.  Unfortunately Buttonwood’s excellent article covered related, but distinct, points, so I’ve gone ahead and reworked my own thoughts on the matter.

A few weeks ago Andy Harless asked whether umbrellas cause rain (quoting Narayana Kocherlakota in the first sentence) :

“To sum up, over the long run, a low fed funds rate must lead to consistent—but low—levels of deflation.”
OK, that is (almost) pure nonsense. It’s true that a low fed funds rate can exist, in long run equilibrium, only if people expect deflation (or if money is worthless). But the causation goes in the opposite direction. People lend at a low interest rate because they expect deflation. People carry umbrellas because they expect rain. An equilibrium with umbrellas must include a significant possibility of rain, but we don’t say that carrying umbrellas must “lead to” rain. If we take away people’s umbrellas, it will not prevent rain, and if we require people to carry umbrellas, it will not cause rain.

The causality argument that Andy Harless makes is far less clear than he implies.  Remember that the Federal Funds Rate is a policy rate and that the Federal Reserve is effectively controlling the nominal return that savers can get on short-term Treasury bills — with clear effects on the nominal returns of other short-term assets.  Thus the statement “People lend at a low interest rate because they expect deflation” reads to me as having the implication that the Fed is trying to engineer an environment where people expect deflation, which clearly is nonsense.

The Fed is forcing individuals (who are unable to borrow at these extremely low rates) to invest their savings either in highly risky assets or at extremely low nominal returns (see Bruce Krasting).  The question at hand is what is the effect of this policy on economic activity — and through this channel on price expectations.  The hope underlying the arguments proposed by Harless et al. is that these negligible returns will have the effect of discouraging saving and increasing consumption — i.e. that monetary policy can be used to address the Paradox of Thrift.

It is not, however, clear to me — and to many others — that when you engineer an environment where saving sucks, you actually convince people that it’s a good idea to consume more.  It is possible that precisely because standard safe investment vehicles are almost worthless, people become even more uncertain about the future and seek even greater precautionary savings though they may become creative about how they store those savings.  In other words, it is possible that maintaining policy rates at absurdly low levels is not only an ineffective means of addressing the Paradox of Thrift, but furthermore that this policy has the opposite effects — it may reduce economic activity and, thus, generate deflationary expectations.

Harless either disagrees with or has not thought about this possibility.  He writes:

What does it mean to say that “the real economy will improve sufficiently that the real return to safe short-term investments will normalize at its more typical positive level”? It means there will be opportunities for real investment that have more attractive expected returns. Even if the Fed’s actions lead people to increase slightly their expectations of falling prices, people will also notice these real investment opportunities and will start investing in those rather than in safe short-term investments. Or they’ll take money and spend it on consumer purchases in anticipation of continued employment. Either way, there will be more purchases made, which will tend to drive up prices, and the deflation prophecy will not fulfill itself.

Ultimately, as people notice the economy improving, they will come to expect rising rather than falling prices, no matter what the Fed does. Ultimately, the effect of having the Fed keep interest rates too low for too long will be inflation, not deflation. Of course, the Fed will notice this and then raise interest rates to slow down the economy and stop the inflation rate from rising further, so it shouldn’t be a big problem.

He (along with Kocherlakota) assumes that eventually “the real economy will improve sufficiently” for everything to come back to normal.  The question that needs to be asked is whether the Fed’s ZIRP policy will slow down or perhaps even forestall this expectation of recovery.  In my view assuming that economic circumstances have to improve is naive and similar to assuming a can-opener — policy should be designed to deal with the possibility that economic conditions get worse — afterall we didn’t have a depression and we’re nowhere near an economic nadir.

The economic circumstances from which the only way out is up, are horribly worse than what we face now.  Nobody wants to go there.  But one path to the nadir is to assume that things are so bad already that improvement is just around the corner, so there’s no need to face up to our current losses.  Thus, even though I understand that normalizing interest rates (by raising them to say 1% and possibly further once the economy has adjusted to the consequences of the first hike) may cause distress, I also think that there’s a measure of distress that can only be delayed, not avoided — and that the policy of delay will only make things worse.  1% interest rates are halfway to normal, we need to start heading in that direction or we may never get there.

In short the zero lower bound is not a good place to be, in large part because we have very little idea how the economy behaves around the zero bound.  Simply assuming that lower rates are always stimulative seems extremely naive to many of us.  Our economy is facing serious problems, but its far from clear that the central bank has the means to solve them.

Good speculation vs bad speculation

Betsey Jensen, a family farm owner and instructor in farm management, has an opinion piece in the NYT today defending speculation:

My biggest worry is what the legislation will do to speculators in the market. These are the traders who buy and sell wheat or corn without taking physical control of the crops. Farmers love speculators when they are buyers, helping push prices higher, and we despise them when they are sellers, driving prices down. Regardless of their position in the market, I am well aware that the system would not function without them — there wouldn’t be enough liquidity, or money, in the market.

According to the trading commission, about one-third of the long positions in hard red spring wheat futures, which is what I trade on the Minneapolis Grain Exchange, are owned by speculators. If speculators were driven out of the market, it would be as if I’d lost a third of my customers.

Will speculators continue to provide market liquidity if the legislation ends up increasing margin requirements — the amount of cash an investor must deposit before buying futures — or restricting how much or how often they can trade? Changes like these could do a lot of damage to agricultural markets.

Contrast this traditional Chicago (referring as much to the pits as to the University) view of speculation with the current corporate view of the state of modern financial speculation.  The FT reports that a survey of “European companies that depend on raw materials markets” finds:

But the companies surveyed ranked financial hedging as the least effective way of managing volatile raw materials costs, believing instead that inventory management and flexible pricing systems were more valuable tools.

In other words even as small American farmers are defending speculation in financial markets in the New York Times, many of the biggest corporations trading commodities are giving up on the pricing provided by those markets.

I’m repeating myself, but here goes:

Speculation is good when the speculator trades with someone in the real economy and therefore bears real economic risk.  Speculation is bad when the market is dominated by speculators trading with each other and, as they become a tiny fraction of the contracts traded, contracts bearing real economic risk stop determining prices.  Futures markets are successful only if the amount and nature of speculation is careful monitored to ensure that “enterprise [does not become] the bubble on a whirlpool of speculation” and “the capital development of the country [does not become] a by-product of the activities of a casino.”

Does anyone really believe that this is a liquidity crisis?

Xavier Gabaix argues that restrained business investment is a natural — and healthy and problematic — reaction to macroeconomic tail risk.  And Brad DeLong responds:

The macroeconomic tail risk that businesses today fear is not a Great Forgetting of technology and organisation or a Great Vacation on the part of the North Atlantic labour force … [These] are the only two “macroeconomic tail risk” shocks I can think of that would make it socially and collectively rational for businesses as a group to refuse to invest in new capacity right now

DeLong’s references make it clear that he persists in viewing our current problems as a liquidity, rather than an solvency crisis.  [Say explains that the Bank of England’s tight monetary policy in 1825 triggered a sharp recession by curtailing the supply of credit firms and causing them to hoard cash.  Mill explains that it was only after the Bank reversed its policy and loosened the money supply that the economy recovered.  And the Kindleberger reference makes the liquidity interpretation entirely clear because a “lender of last resort” only functions because it lends to solvent firms — a condition that Mill also emphasizes.  For more on the crisis of 1825 see here.]

In short, Prof DeLong appears to imagine that if we continue to treat the crisis of 2007 as a liquidity rather than a solvency crisis — eventually the solvency crisis will disappear.  The theoretic foundations of this view are hard to fathom — especially given that our financial institutions have been relying heavily on “liquidity support” for almost three full years — could there be any stronger evidence that we are facing a solvency crisis, not a “panic”?

[The timeline of the 1825 crisis is as follows:  March 1825 Bank of England starts to tighten, December 1825 full blown bank crisis with money center bank failures, met with aggressive lender of last resort action, by June 1826 lender of last resort activities have wound down and by December 1826 monetary measures and bankruptcies have normalized.  See Chart 11 here and Chart 1 here.]

In my view business investment is restrained not because of macroeconomic tail risk, but based on elementary macroeconomic analysis:  As long as policymakers are determined to prevent the bankruptcy of insolvent firms, necessary economic adjustments will be delayed and valuable assets will be entombed in firms without the balance sheet capacity to borrow the funds necessary to realize the value of those assets.  This policy will have the effect of preventing the economy from growing at its natural rate over the next decade and render investment a very dubious prospect indeed.

In short, what’s holding corporate investment back may be uncertainty over future policy and the nature of the institutional structure of the economy.  That is, firms may fear that bad economic policy in the form of using liquidity tools to support insolvent firms until they become solvent — in the next decade or two if ever — (similar to the Japanese “solution” of avoiding the restructuring of banks and firms) is going to cost the economy so much that it really doesn’t make sense to invest in a future without economic growth.

Update 7-7-10: Gabaix points out that it is possible that the future policy that firms are worried about may be a failure to bailout in the next crisis.  Is this the same point I am making or a different one?  Hmm.

And Krugman argues that there’s no need to interject “future government policies” into the discussion at all — a review of data suggests that investment is higher than one would predict in an environment where we simply don’t need that much new construction, etc.

I am happy to acknowledge that I have no way of determining the true source of concerns about the future economic performance, but I hope everyone can agree that too much government intervention, too little government intervention and misdirected government intervention are all on the list of  possibilities.  For which reason the decision-makers who are actually navigating these shoals have all my sympathy.