Aspirin or Amphetamines?

Dani Rodrik categorizes the different approaches to regulation of financial markets:

Financial innovation: a case of aspirin or amphetamines?, by Dani Rodrik, Project Syndicate: ...[A] half-century of financial stability lulled advanced economies into complacency. That stability reflected a simple quid pro quo... Governments brought commercial banks under prudential regulation in exchange for public provision of deposit insurance and lender-of-last-resort functions. Equity markets were subjected to disclosure and transparency requirements.

But financial deregulation in the 1980s ushered us into uncharted territory. Deregulation promised to spawn financial innovations that would enhance access to credit, enable greater portfolio diversification, and allocate risk to those most able to bear it. Supervision and regulation would stand in the way, liberalizers argued...

What a difference today's crisis has made. We now realize even the most sophisticated market players were clueless about the new financial instruments..., and no one now doubts that the financial industry needs an overhaul.

But what, exactly, needs to be done? Economists who focus on such issues tend to fall into three groups.

First are the libertarians... If you are selling a piece of paper..., it is my responsibility to know what I am buying... If my purchase harms me, I have nobody to blame but myself. I cannot plead for a government bailout.

Non-libertarians recognize the fatal flaw in this argument : Financial blow-ups entail ... "systemic risk" - everyone pays a price..., the government may need to bail out private institutions to prevent a panic that would lead to worse consequences elsewhere. Thus, many financial institutions, especially the largest, operate with an implicit government guarantee. This justifies government regulation of lending and investment practices.

For this reason, economists in both the second and third groups - call them finance enthusiasts and finance skeptics - are more interventionist. But the extent of intervention they condone differs...

Finance enthusiasts tend to view every crisis as a learning opportunity. While prudential regulation and supervision can never be perfect, extending such oversight to hedge funds and other unregulated institutions can still moderate the downsides. If things get too complicated for regulators, the job can always be turned over to ... rating agencies and financial firms' own risk models. The gains from financial innovation are too large for more heavy-handed intervention.

Finance skeptics disagree. They are less convinced that recent financial innovation has created large gains..., and they doubt that prudential regulation can ever be sufficiently effective. True prudence requires ... a broader set of policy instruments, including quantitative ceilings, transaction taxes, restrictions on securitization, prohibitions, or other direct inhibitions... - all of which are anathema to most financial market participants. ...

In effect, finance enthusiasts are like America's gun advocates who argue that "guns don't kill people; people kill people." The implication is clear: Punish only people who use guns to commit crimes, but do not penalize others by restricting their access to guns. But, because we cannot be certain that the threat of punishment deters all crime, or that all criminals are caught, our ability to induce gun owners to behave responsibly is limited.

As a result, most advanced societies impose direct controls on gun ownership. Likewise, finance skeptics believe that our ability to prevent excessive risk-taking in financial markets is equally limited.

Whether one agrees with the enthusiasts or the skeptics depends on one's views about the net benefits of financial innovation. Returning to the example of drugs, the question is whether one believes that financial innovation is like aspirin, which generates huge benefits at low risk, or methamphetamine, which stimulates euphoria, followed by a dangerous crash.

I think the benefits of deregulation are large, there has been a lot of very useful financial innovation that we now take for granted that would not have occurred under the old regulatory regime. I don't want the same restrictions in place now that were in place in 1980 - I could hardly get cash out of state. But some restrictions should have stayed in place, and others should have evolved with the market but didn't. So I also think we need to bring a broad set of policy instruments to these markets to help them function effectively and to think about how to create more responsive regulatory structures going forward. Avoiding meltdowns will allow us realize the benefits of financial innovation on a consistent basis. And I don't think that's an impossible task, we had a "half-century of financial stability," that's not so bad, nor do I think regulation is necessarily inconsistent with the incentive to innovate - effective regulation can create the kinds of stable, competitive conditions where financial innovation can flourish. So, I guess I don't fit very well into any of the libertarian, finance enthusiast, or finance skeptic categories.

Comments

[ken melvin]

What's the net, the reality of innovative finance?

[Farrar]

" I don't want the same restrictions in place now that were in place in 1980 - I could hardly get cash out of state."

Ah, c'mon, Mark! The improvement we have experienced in this respect was not due to any financial innovation, but rather to improvement of existing systems due to technological progress.

[hari]

Mark -

There is a *preventive* system of empowering the financial institutions to innovate and develop their sector without bureaucratic constraints. Thus, regulatory regime and oversite must be so throughly integrated into hi fi sector that there is no complacency with regard to transparency and solvency of the individual operators.

At the present time, the situation is more than dicey- as we know - Libor (Lon) inter-bank rate seems to have been manipulated by member banks of the Bankers Association - it is being investigated and result will be telling, if not a corrective mechanism will be imposed on authorized banks.

I, for one, like Dani's rhetorics - simple political economy. Money being a fungeable commodity - regulatory oversite is as important - as *preventive medicine* is to medical profession.

[hari]

Buiter - FT

He has come down with a simple answer - he doesn't know. However he thinks an arms-lenth approach to oversite may be more efficient. But his conclusion is based on last 20yrs of deregulation - leveraged credit markets and insolvency to boot.

[Bruce Wilder]

My own inclinations I would characterize as mutualism: a preference for both government policy shaped by principles of mutualism and for government-sponsorship of a significant number of institutions founded on the mutual principle.

In other words, Savings & Loans and Savings Banks, GSE's, mutual insurance should be preserved, albeit modernized, as a bulwark against predatory lending.

I am all for keeping the big boys honest. And, I think government would be doing everyone a big favor, if the government stepped in to make and enforce some sensible rules in the derivatives markets, for example. But, I don't necessarily think that subjecting investment banks to full prudential regulation is such a good idea. Full prudential regulation is burdensome -- I recognize that; I also recognize that full prudential regulation was originally about creating and preserving a mutual sector in finance, as a bulwark protecting the working and middle class against financial predation.

My major concern about "financial innovation" is that it is mostly about redistributing income and wealth upward. Student loans with up to 28% interest! Payday lenders that charge 400%! Credit cards that charge 33% and are immune to bankruptcy.

The answer of the progressives and New Dealers to financial predation and loan sharking was mutualism. Mutualism has been the target of the Republican thieves for 30 years. And, I rarely hear anyone even mention it, or its importance in preserving cheap finance for people of modest means.

[Bruce Wilder]

A company organized on the mutual principle is owned by its members and operated for the mutual benefit of the members. In a mutual bank, residual control and ownership rests with the depositors; in a mutual life insurance company, residual control and ownership rests with the policyholders. More broadly, in finance, it is the idea that large numbers of people can engage in effective self-help, through both large-scale private organization and through creative democratic direction of government policy, creating permanent institutions with public purposes and functions that permit large numbers of people to participate, and benefit each other. The savings of a community, for example, can be pooled to provide lendable funds to members of the community at low rates, for example.

[hari]

It is not unthinkable that another Resolution Act (S&L crisis) might be inevitable if there are further deterioration and insolvency cases -> cascading effect is also predictable in case of default by derivatives market dealers.

Intermediaries, Buiter claims, are the culprits unregulated presently and (maybe) creating the waves in the derivatives market.

[donna]

How do we simply write a regulation that says, "Stop doing anything that the ordinary person would see is simply stupid?"

[Farrar]

I've been wracking my poor old brain trying to think of some concrete benefits that financial deregulation has brought to the US economy, and I have come up with next to nothing. In my earlier comment I assumed Mark was referring to ATM machines and wire transfers (the latter now computerized and much more efficient). But that got me to thinking more broadly.

To my mind, the two most important innovations in banking since 1950 have been computerized check and deposit processing and the successful introduction of bank credit cards. Both were pioneered by the old Bank of America about 1960, during an era when banks were well regulated.

Even then banks were selling their RE loans to private investors, although they didn't like to talk about it, preferring to preserve the direct contact with their clients.

Moving over to pure credit and finance, many say that the old systems couldn't handle today's volume and velocity, but I guess I am a finance skeptic. It seems to me that the banks could then throw together large loan consortiums within a week or two. And if the size of the borrowing was too big the investment banks were there to float a bond issue.

So what's really new besides slicing and dicing? And what has that contributed besides speculative excess?

I will admit that interState banking in principle is a positive step because it allows banks to diversify their portfolios more easily. But even that has its drawbacks now that the AG seems to have given up anti trust activity.

Let's face it: when it comes to credit, a loan is either sound or it's flakey, and no amount of "innovation" will make it any better.

[Cynthia]

Great idea, Bruce (Wilder)!

And perhaps we oughta have a two-tier banking system: one for the wealthy and another for the rest of us. Then that way the wealthy can prey on each other -- leaving the rest of us alone.

[dissent]

Prof Thoma and everyone here, I have a question about the financial crisis.

Now that many are saying the worst may be behind us, it seems the imperative for addressing financial innovation with reform may be moderated.

But, why is the worst behind us? I've read up on credit default swaps (what Yves Smith calls the Sword of Damocles hanging over the financial markets) and for the life of me I can't see why this market won't unravel, bringing down the financial system with it. The CDS market is larger than the stock and bond markets put together.

My understanding is that the bail out of BS was really addressed at counter party risk in the CDS market.

Can anyone help me with this question?

What is supposed to keep this CDS market from unraveling?

[Bruce Wilder]

Cynthia: "perhaps we oughta have a two-tier banking system"

That would be one way to frame it, of course.

The "universal bank" -- really financial conglomeration, in which the same criminal conspiracy corporate entity retails the loan, securitizes it, does the appraisal, provides HELOC, promotes credit cards, etc. is a recipe for disaster. There's no way that arm's length relationship can be maintained in such a unified corporate environment.

I am arguing that government policy on chartering and regulating financial institutions ought to look toward maintaining an ecology, in which professional ethics and honesty survive and serve useful functions. The alternative is "competition" eroding the financial sector into a giant casino, run by the same sort of people, who usually end up running casinos (and I don't mean Indians).

An honest savings bank in a poor neighborhood, offering cheap demand accounts, ATM services, etc. can drive payday lenders out of business. But, if we allow, as we have, Citigroup to close Citibank branches and open CitiFinacial branches in their place (the latter being basically a loan shark operation), then we're lining the pockets of Citi executives and Arab banking princes (who will soon own Citigroup) at the expense of the American poor and erstwhile American middle class.

I don't think we necessarily need to resurrect Glass-Steagall, per se. But, we ought to recognize that having diverse and heterodox entities in finance, including a large number, whose risk-taking is limited (and that includes severe limits on executive compensation) is a key to curtailing the upward redistribution of income and wealth.

An heterodox array of financial institutions allows the possibility of regulating some more lightly, and reaping the benefits of aggressive risk management, without the "benefit" of such aggressive financialization being the rape of the middle class and poor.

[robertdfeinman]

We already have a two tiered banking system. The rich get private banking or wealth management services. Most big financial institutions have special units to deal with this and then there are all the hedge funds and the like where the minimum investment eliminates all but the top few percent.

I'm with the majority of commentators so far, the only "innovation" has been to separate risk from reward. This has been done by creating layers of middlemen who take their slice regardless of what is actually going on: mortgage brokers, appraisers, credit rating agencies, "due diligence" lawyers, accounting firms, and the quasi-banks and the similar divisions of conventional financial firms.

The final separation happened when the role of top management was transformed. No longer is their compensation tied to financial probity or performance. They get a golden handshake on entry and a golden parachute when they bail the failing firm. Even criminal behavior isn't a problem any more. Firms are fined (that is the passive stockholders pay) and the management promises not to do the bad thing again, while not admitting that they did it in the first place.

With all the talk about moral hazard lately why is there no discussion of the lack of punishment for management, even when criminal behavior is involved. How many actual convictions and jail sentences have happened? A crooked CEO probably has a higher risk of being hit by lightening than going to jail.

[Farrar]

"...reaping the benefits of aggressive risk management, without the "benefit" of such aggressive financialization being the rape of the middle class and poor."

1. I still haven't heard what those benefits of agressive financialization might be.

2. Who are the risk managers going to agress if they don't agress the poor? The rich won't let them be agressed

[john c. halasz]

Farrar:

Going back to Marx' account, the basic function of the credit/banking/financial system boils down to two points:
1) without credit, particular capitals competing in market sectors would be excessively concerned with conserving themselves and minimizing the risks to their fixed investment, and hence would not expand their output to the full extent possible to meet maximal market demand, such that the leveraged banking system, by extending credit to particular stocks of fixed capital and thereby sharing the risk with them, renders particular capitals better able to extend their output to the full extent of potential market demand, while managing the liquidity constraints posed by their fixed investment; 2) the financial system, somewhat speculatively, functions to underwrite conversions of capital stocks to new technologies on the horizon that enhance the productivity and extend and diversify the scope of output of productive capital, even as older stocks and technologies are rendered obsolete and liquidated, which prospects are highly uncertain both with respect to the viability of technological innovations and with respect to the variable economic conditions of the business cycle, such that such innovations and conversions tend to end up in financial failures before eventual successes, which is why Marx styled the "heroes" of high finance as half prophets and half swindlers. It's presumably with respect to the second point, that of raising large-scale capital formation for technical and industrial innovation, which is the traditional function of investment banking, that Bruce Wilder hesitates to impose strict regulation on investment banks and advocates maintaining a role for "the benefits of aggressive risk management".

I'm not sure he's quite right, as much of the activity of investment banks nowadays seems more concerned with slicing and dicing extant financial assets into ever more complex and derivative financial structures, which draw off, displace, and disperse risks from the real economy without fundamentally altering the quota of risks, but rather seem to function to extract rents from the distribution of risks (and uncertainties) in the real economy through the conversion of assets into debts into new assets and so on. But my biggest objection to all this financial "innovation" is the information loss that is involved. It's not just that these highly derivitized financial structures have render "risks" so complex and so dispersed that they have become utterly opaque and the value of such "assets" virtually impossible to determine, at least when market/credit conditions undergo a phase shift as is now occurring. Traditionally, a bank loan was carefully underwritten and the interest charged was based on an evaluation of the risks involved, so as to adequately compensate for them. But when such loans are sold and resold and passed through into successive securitizations, at each stage of which fees are extracted from the available payment flow, the compensation for risk involved in the original underwriting and interest is eroded, even as the sources of the risks and the capacity to manage them through the original business relationship is lost track of. In short, the argument that risks have been allieviated through being passed on and dispersed into the broader risk-bearing capacity of capital markets is contradictory. In fact, risk has not been decreased through greater financial "efficiency", but rather increased through greater financial fragility and complexity and through the disintermediation of the financial from the real economy, wherein such risks are ultimately rooted and must be managed. And, as for the other point about the large-scale formation of capital to finance technical and industrial innovation, I'm not at all sure that that should be the exclusive provenance of private markets, as opposed to public investment and regulation. (Yes, I think it's high time that possibilities of public industrial policy were discussed).

Of course, as I've already flogged here before, I also think it's high time to start discussing the development of a legal-administrative framework for nationalizing failed banks/financial institutions as the price for their recapitalization, which partial nationalization of the financial system, at the expense of shareholders and top management, would provide the opportunity to downsize and rediversify banks and financial businesses, eliminating the too-big-to-fail syndrome, and re-regulating the financial system through such measures as eliminating whole loan sales, countercyclical adjustments of capital ratios, restrictions on leverage, and forcing OTC derivatives onto regulated exchanges, (which, of course, would eliminate many of their forms and restrict their ever-expanding nature). The financial economy should serve to intermediate the real productive economy, rather than the other way around, and inflated financial assets "values" need to be readjusted in accordance with the productive and income generating capacities of the real economy. But perhaps the main point is that such a partial nationalization would not only discipline remaining private financial "players", but, given the likely course of a gathering severe recession, would be the most economic long-run use of a limited fiscal capacity already hemmed in by large national and external indebtedness, as opposed to the mug's game of attempting to prop up inflated and largely fictive financial asset "values", which in the end would prove far more costly and only delay recovery and reindustrialization. Financial systems used to fail through inadequately projected innovations in the real economy. But it seems to me that much of what has been passed off of late as financial "innovation" is a) no such thing, but just old wine in new bottles, and b) not an enhancement of the risk-bearing and managing capacities of the real productive economy, but a distortion thereof and detrimental to it. Financial "innovation" has yielded little but delusory "efficiency".

[RW]

I normally don't cross-post, particularly on the same blog! But this rant concerning the combination of broker and bank functions in financial markets came at the end of one of my comments in another thread and does belong here I think so (with some modification):

...The source of credit at your stock brokerage is the same conducting the transaction. This creates enormous information asymmetry and conflict of interest; the house has all the information it needs to manipulate spreads, front-run clients, etc and there is considerable evidence they use it. Time to create a new Glass-Steagall and add the investment banks and brokerages to the list of entities that must be walled off from each other.

It is hard to imagine a market working effectively in the absence of transparency but information asymmetry is becoming a serious problem too. Wide corporate access to customer information in real time combined with modern relational database technologies creates a serious imbalance that only a walling-off can cure. When a corporate agency not only knows my transaction intent but the amount of leverage I can apply it is easy to avoid current securities laws; e.g., the broker with whom I am conducting business, indeed the entire brokerage, doesn't need to have anything to do with or even know about what a backroom is doing since that could be a completely different entity with access to the real time order flow data.

Okay, rant over (back to work).

[reason]

First, I'm a bit of an private insurance skeptic. My training in statistics says the best risk sharing is universal (i.e. the wider the base the lower nearer the insured risk is to the actual statistical risk). Adverse selection and the possibility that a limited liability company will knowingly risk bankrupcy for short term gain (and so not pay their counterparties) are serious problems. Doubly so if they can use leverage to minimise the risk to their own capital. It is leverage and limited liability that concern me - people knowing that the downside of the gambles they are taking are limited. A very rich person has the option of spreading their investments to a number of different hedge funds - all trying to make large gains at the risk of bankrupcy. If the individual took the same risks himself, he would think twice about it, because he would not only multiply the gains, but also the losses. And then in the event that this multiplication of risk causes systemic problems, they can rely on a government bailout. This is the root cause of the problems. The only solution I see is that capital/debt ratios be limited by law for financial companies (or some sort of prudential deposit requirements). I would like to see government sponsored re-insurance (Lloyds could well go bankrupt if there was a year with several bad hurricanes and several big earthquakes.)

[Patricia Shannon]

Bruce Wilder
I am in theory in favor of mutualism. But it doesn't always work.

When I was out of work some years ago, I made my house payments with a home equity line of credit from the Redstone Federal Credit Union in Huntsville, AL. Note that they had been encouraging their members to take out home equity lines of credits with them for several years. When I got a job out of state and had to move and sent them my new mailing address, they cut off the line of credit, so I wasn't able to fix up my house to sell it or rent it. When I did have a job, I paid as much as I could against the loan. (I had previously made enough extra payments on my primary mortgage that I was paid ahead 4 years on the principal.) When I was out of work and couldn't make the payments on the house, my mortgage company didn't want to foreclose. It was the Redstone Federal Credit Union that foreclosed, when I had always before paid off my loans ahead of time, and had paid 7 months ahead on the equity loan.

The membership of a mutual company can be in the same position as stockholders, where the supposed owners actually have little if any influence on the company.