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Making Banks Boring

posted by Adam Levitin

Bloomberg has an editorial arguing that making banks boring won't prevent a crisis; only increasing bank capital will do so.  

To the extent that its big point is that banks will suffer during an economic downturn and the only protection against that is more capital (or insurance, including from the government), it's hard to disagree.  But what this editorial misses is that 2008 wasn't just some periodic economic downturn that occured for reasons beyond our comprehension or control, like El Niño and La Niña weather patterns.  Instead, the 2008 financial crisis was made by the banks themselves. The 2008 financial crisis was the inevitable result of the financial services' industry's behavior in the 2000s.  And that's why we have to make banking boring. Boring banks might be hurt by economic crises, but they don't make them. We cannot prevent every economic downturn, but there's no reason we should suffer the preventable ones.  

So how is boring banking a solution? It matters for two reasons, one widely understood, and the second entirely overlooked.  

First, boring banking does a reasonably good job of aligning risks and rewards for the parties actually making loans, and this helps control against asset price bubble. Boring banking, in its simplest, most stripped down form means that banks make loans and hold them on their balance sheets. (There are problems that can stem from this, namely from the asset-liability duration mismatch, but that's another issue, and the other banking crises cited by Bloomberg didn't pose systemic threats like 2008.) 

The primary reason that the banks ran into trouble in 2008 was not because they were making bad loans that they held on portfolio. Instead, they made bad loans because they knew those loans would be securitized. The problem was that the banks then went and bought into those very same securitizations, which they then used as collateral for their short-term borrowings (such as repo), making them intensely exposed to the performance of their MBS. 

The overprovision of underpriced credit enabled borrowers to bid up asset prices, which then meant that subsequent loans looked better than they were in terms of LTV.  Once lax securitization practices ignited the bubble, it affected not only securitized loans, but also balance sheet loans. And then it was pretty much inevitable that someone would get spooked as evidence of poor loan performance speed in and a run and then a market-freezing panic would result that would hit all uninsured short-term credit as no one could be sure which institutions were impaired and which were money good.  The fact that the banks were heavily leveraged didn't help things, and Bloomberg is right that more capital would have softened the blow. But better to avoid the problems in the first place than to hope that capital will be sufficient.  

The second reason for making banking boring is one that is continually overlooked in the New Glass-Steagal debate, namely the political benefit of separating commercial from investment banking, which helps ensure against deregulation. Commercial and investment banks can both get into trouble when they're not regulated. Indeed, the stories of the S&L crisis and of 2008 are fundamentally stories about deregulation.  Glass-Steagal made commercial banking boring by divorcing it from securities. Glass-Steagal also split the financial services industry politically and enabled the different parts of the industry to be played against each other. Commercial banks, investment banks, and insurance companies fought each other for turf for decades. This mattered in terms of regulation because regulation is a political game.

Because of Glass-Steagal, the financial services industry did not present a monolith in terms of lobbying, and a Congressman could afford to take a stand against one part of the industry because there would be campaign contributions forthcoming from the other parts of the industry. This is how William O. Douglas got the Trust Indenture Act of 1939 passed--he made concessions to the commercial banks in order to get their support for legislation that kept the investment banks out of the indenture trustee business. In the agencies, each part of the industry had its pet group of regulators who would push back against other regulators when they thought that there was an encroachment on their turf, which is the basic nature of deregulation---allowing greater activities than previously allowed. And it even mattered in the courts, as the insurance and investment banking industries financed major litigation challenges to commercial bank deregulation. The result of a politically fragmented financial services industry was to hold deregulation at bay for quite a while. This started to unwind in the 1980s and by the Gramm-Leach-Bliley Act, it was over. It didn't take long before we all reaped the fruits of deregulation.

If you want to see more modern examples of the benefits of divided industries, see the FDA's recent decision on the naming of high fructose corn syrup. It's going to keep going by that name, rather than by "corn sugar" because in part from intense lobbying pushback from another part of the sweetener industry--the cane and beet sugar manufacturers. Sarbanes-Oxley passed in part because of a split between the Business Roundtable and the US Chamber of Commerce. And in the financial institutions space, the Durbin Interchange Amendment passed because it posed banks against another heavy duty group, retailers. 

In short, yes, we need more capital and/or insurance as a cushion for banks during downturns. But we also need to make sure that the banks are not fueling the behavior that leads to economic crashes and downturns. That means in part ensuring that there is adequate regulation of the financial sector, and that requires breaking the political power of the banks. Glass-Steagal accomplishes a political breakup of the banks; neither the Volcker Rule nor capital requirements do. That's why we need to make banking boring. 


This is a nice analysis of the political benefits of separating commercial and investment banking.

Even with boring banking, assets (long-term loans) are so hard to value that capital can't be measured effectively. As a result, regulations on capital will be easily gamed. Of course, this problem is much worse with today's banks. Assessing balance sheet solvency is impossible with the risky assets and insurance-type liabilities they contain. The "adequate" capital levels shown on the Lehman financial statements just prior to the massive capital hole exposed by bankruptcy illustrate the point, even though Lehman never made it to bank holding company status.

In addition to Glass-Steagal type changes, we should limit or eliminate bank loans with long terms and/or opaque risk profiles (pick-a-pay, Alt-A, teaser rates, etc.) Regulations focused on increasing transparency and reducing risk will protect taxpayer-insured deposits far more effectively than capital requirements.

Adam Levitin's 5th race, oops, 5th paragraph.
As Levitin clearly stated in a non-humorous manner, when there are no boring laws to control how the bank bets, the bank acting as an agent (bookie) for the gambler (1), aided gambler (1) by creating an investment vehicle for the gambler (1), less fee payable to bank. The bank’s, also being that of a habitual gambler, and lacking oversight purchased the rights to the gambler’s (1) potential profits. The bank, being overly cautious for self interest, sold the ownership interest in the gambler’s (1) profits to another gambler (2), less fee payable to bank. Gambler (2) further complicates the race by doing the very same thing gambler (1) did. Where the race is calculated at say, bet $5 to win $3 ($8 Total) the overall might be seen as bet $5 to win $50. For gambler (1) and all other subsequent gamblers, lose of a singular event potentially could be coverable by winnings in other races. But when the win value is less than bet value, failure is not imminent, failure has occurred and such loss is amplified by the number of subsequent gamblers.
Please do not confuse this tangible issue with that surrounding the secondary intangible market issues, different race, different day though it may involve some of the same gamblers.
Where money is involved, regulation should be involved.

The organizations that failed in 2008 were by and large not commercial banks. Certainly not the first wave. Bear, Fannie, Freddie, Lehman, AIG - no commercial banking to speak of. But all had one thing in common: huge amounts of exposure to residential real estate, far beyond their equity capital. Historically, US bank failures tend by a very large margin to come from one thing - loans against some form of real estate or related collateral, the very essence of boring banking. Securitization is not the problem. You don't find any problems from securitizations of other loans - auto or credit card or student loan, for instance. Glass Steagall is irrelevant - none of the institutions above had any meaningful benefit from the elimination of GS. It's all due to one thing and that is excessively leveraged real estate backed loans. The solution is simple and is much like what was done in the 30s regarding the collapse of securities prices - require buyer margin on real estate loans to 20% or so. Both as to the underlying loan and any loans made against real-estate-backed loans. None of the convoluted reasoning about securitization or Glass Steagall is needed if teal estate loan portfolios are sound. If any one of those organizations had followed that simple rule they would still be here today and the financial crisis might never have happened.

Things worked very well in the days of the 9-3 banker. Then came Garn-St. Germaine, leading up to G-L-B, the last brick in the wall. Now things don't work worth a damn. I don't think that's merely a post hoc logic problem. None of the combined banks may have gone down (yet), but they certainly fed the fire, and so far have been shielded by the collapse of the other players.

To paraphrase what you are arguing, you are advocating that it is preferable that industries compete with each other politically through rent-seeking and industry capture as opposed to economically competing based upon neutral rules. It doesn't make much sense to me, but to each his own.

I also note that, as usual, your argument is predicated on the assumption that bubbles randomly happen as a result of market activity, as opposed to being the product of politically chosen rules. In other words, you appear to think it is mere coincidence that a financial bubble occurred in real estate (as opposed to say, car loans or credit cards, which were also securitized), as opposed to examining the politically chosen rules that incentivized everyone from investment banks to janitors to invest in real estate.

David Shemano--

Your paraphrase is essentially accurate. In the ideal world, yes, we'd have neutral rules, but where does that world exist? The reality of the world is that regulation is political, not wholly technocratic (and technocracy is itself a political choice). Given this reality, I think the best possible route is to try and blunt regulatory capture and industry's natural anti-regulatory push through political competition.

As far as why bubbles happen, I would say that they are often the result of market activity, but I didn't say that they happen "randomly." I'd describe it as closer to deliberate. In any case, it seems like you're implying a "the government did it" argument, namely CRA, GSE affordable housing goals, home mortgage interest deduction, etc. While the government _could_ foment a bubble, it didn't in this case. All of the right-wing "the government did it" arguments have been pretty thoroughly debunked.

The residential mortgage bubble was from perhaps 2003-2007, which makes it hard to connect it to any government policy other than affordable housing goals (CRA and interest deduction long pre-date the bubble). The GSEs at most were buying the senior tranches of private-label MBS. But you can't make senior tranches without junior, and the GSE AHGs don't explain the demand for the junior tranches, much less the commercial real estate bubble, a market in which there is almost no government involvement. And the home mortgage interest deduction has been around since 1986 (actually all interest was deductible before then), and isn't actually taken by very many people because it requires an itemized deduction. So I can't fathom what "politically chosen rules" you are referring to.

As it happened we had bubbles in the two largest classes of securitized assets: residential and commercial MBS. As far as other types of securitization, let's keep a few things in mind. First, credit card securitization is fundamentally different from mortgage securitization, as it is a skin-in-the-game operation. Formally there's at least 8% sponsor investment in most deals, and functionally it's all recourse. That's why there was no bubble in credit cards.

As for auto loans, well, I've never heard of a car that appreciates. The only thing that happens to car values is that they fall. They're not like houses. That's why we couldn't see a car loan bubble. Beyond that, auto loans are largely financed by financing arms of manufacturers. They have a long-term, repeat-player stake that a mortgage originator just doesn't have. If GM securitizes crappy auto loans it will pay the price in the market in the future. Different story when you're talking about fly-by-night mortgage originators working with investment bankers who would make substantial enough bonuses to retire before things crashed.

Adam --

You didn't argue against regulatory capture, you argued in favor of regulatory capture as a good thing in itself. "In the agencies, each part of the industry had its pet group of regulators who would push back against other regulators when they thought that there was an encroachment on their turf,..."

You then argue that an ideal world based on neutral rules is unrealistic, but then substitute an ideal world of objective technocrats, free of political pressue and regulatory capture, who know the public interest and are motivated to implement the public interest. Again, while I don't think a platonic ideal is the standard, I would bet my real world more closely approximates the ideal world than your real world.

Why do you think a house, as opposed to a car, appreciates? If there was ever a protype depreciating asset, it is a house. The only reason we think of a house as an appreciating asset is because of the extraordinary political effort to make real estate an attractive investment (compared to other investments). The major contributor is probably zoning laws, but think of tax policy (capital gains preference and interest deduction), nonrecourse and anti-deficiency rules, the GSEs (which create an artificial world of 30 year mortgages with no prepayment penalty), etc. All of this political activity incentivizes economically senseless real estate investment, which manifests itself in various weird ways (e.g., separation of loan origination from admnistration), which inevitably creates asset bubbles. The exact spark for each bubble is different, but the tinder is always the same. The S&Ls (an entirely political creation) got splattered 25 years ago, and the investment banks got splattered recently.

You are an advocate of the Rube Goldberg method of governance -- where stupid rules create unintended consequences, create more rules to address the unintended consequences as opposed to addressing the stupid rules, which creates more unintended consequences, which creates more rules, ad infinitum

David--if you really believe than the real world more closely resembles one in which there are neutral, objective rules than one in which interest groups shape the rules, then as my Southern relations would say, bless your heart.

I don't think anyone who knows my work would understand me to be arguing for regulatory capture as a good end in and of itself. Rather, given that we are dealing with capture to a greater or lesser degrees, we should try to design a system that blunts its overall effects. If we start from the premise that the commercial banks will have the OCC captured, and the the i-banks will have sway at the SEC, then the best we can do set up a system that pits the OCC against the SEC to blunt the deregulatory impulses of each.

I take exception to your Rube Goldberg line (and its unnecessary tone). It isn't a case of constantly patching over the consequences of stupid rules, but trying to make the best of a world in which regulation is political. The outcomes might not be elegant, but this is the nature of operating in reality. When was the last time you saw an area of regulation redesigned from the ground up? It just doesn't happen. That's the reality in which we have to operate.

As far as what makes cars different from houses, gosh, I've never seen a mass market car that appreciates, while historically housing generally did appreciate. You give a litany of the ways in which we as a society further housing. I could give a similar litany about cars, starting with our subsidization of highways and ethanol. In any event, housing bubbles aren't a particularly common occurrence in the United States. While we have had plenty of _real estate_ bubbles, this is the first time that we had a national _residential_ real estate bubble of any magnitude. Most historical bubbles were farm land and that was based on speculation about Western settlement patterns. We've had some regional residential bubbles and crashes, but those are due to local economic conditions (e.g. oil boom and bust in Midland, Texas). The Depression wasn't a real estate bubble. The S&Ls weren't a real estate bubble.

Indeed, the S&Ls problems were not because they made bad residential real estate loans. Their problems were originally the result of having long-term fixed rate assets and facing rapid inflation in the 1970s. The S&L crisis became much worse because of incompetent regulatory treatment that let insolvent institutions gamble on resurrection by enabling investment in things like commercial real estate, race horses, and junk bonds. Not surprisingly, the largest S&L failures were because of the Milken daisy chain scheme and losses in their junk bond portfolios or in commercial real estate, not bad home mortgage loans.

Adam --

We are kind of arguing in circles. Since the formation of the Republic, banking has been the most politicized industry we have, which has led to constant comprehensive regulation, which in turn has led to the industry to manipulate the regulation, ad infinitum, which leads to a regulatory frame work at any given time that makes no particular sense in certain of the details (for example the ban on interstate banking for most of our history). That is what happens when you have rent seeking and political competition. And your response is that it is more likely that political competition will produce a better state of affairs than economic compeition. Clearly, we are not going to agree.

I note that you fail to explain why housing appreciates. I gave an explanation. I don't see yours.

Finally, regarding S&Ls, I agree with you that the S&L problem was precipitated by the 1970s inflation problem, which goes to show that a politically created industry is usually unable to adapt very well to change in the economic environment -- the change in regulation cannot keep up with the change in the economy. The triggering problem that caused the S&Ls to collapse, however, which you did not mention, was the increase in deposit insurance contemporaneous with the liberalization of investment rules, which created very perverse incentives for both the S&L operators and their depositors. The Milken daisy chain was the product of that regulatory change -- another example of unintended consequences of the political competition you favor.

The argument that the Finance Industry has grown too large compared to the rest of society and has to be downsized was made back in 2011. See this link


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