1st off let me say that I do not hate the big banks. I worked for one (and that is the essence of my point of view here) and I am a shareholder of several. However, enhanced regulation of banking products is essential if the country is avoid a repeat somewhere down the road of 2008.
For those who do not know me personally, I worked in J.P. Morgan's Corporate Risk Management Group when it was founded. I wrote the first credit policy on Credit Default Swaps. It was that policy that led directly to JPM's not having the concentrated exposure to AIG that Goldman Sachs and others had, which in turn necessitated the government rescuing AIG. Concentration of financial risk leads to systemic risk because the financial system cannot be allowed to fail. A failure of the financial system will create a depression because if companies do not have access to bank liquidity, they cut employees. Consumers reduce purchases and a negative cycle begins. I am not sure that any modern country could deal with a depression level of hunger and homelessness. The 1929 depression occurred when the U.S. was still a significant agricultural society and property taxes were not a major source of public sector revenue. Many people could at least feed and house themselves. I cannot imagine what would happen today if we had a depression. Few in our cities could find food or maintain their homes with property taxes due.
There is no way to construct a modern financial system without having too big to fail institutions. Consumers want their bank to offer them free ATM's nationwide. Parents and students love the convenience of their bank having offices at home and school. Corporations like to deal with just a few financial institutions who can serve their needs globally. Bond investors like to deal with no more then 10 institutions for the bulk of their trading because they know that will create the most efficient markets for them. Bond issuers want to know that their underwriters can distribute their offer globally and achieve the lowest yield for them. This desire for broader coverage by single financial institutions means that they will achieve efficiencies for customers and shareholders by becoming bigger. It serves no social purpose to keep them small and inefficient.
However, the nature of banking and markets means that these large financial institutions will have large relationships with each other and create the potential for a systemic meltdown if they all lose access to funding at the same time. Access to funding and the risk of no access is the systemic risk. That is why the Federal Reserve (and all other central banks) have being the lender of last resort as a core function. Central Banks exist to keep the banking system functioning. The US and other governments did exactly what they should have in 2008/09.
What will prevent systemic risk from materializing? Sound regulation of anything that could cause a systemic event. There are not that many things that can cause a systemic lose of confidence in banks. My list includes only too little capital, too much focus on statistical measures of risk and too many losses from credit events. The regulators were already focused on two of these issues, and they are now focused on balancing nominal exposures and statistical risk measures. What they missed and what the Financial Reform bill properly focuses on is consumer finance. No one thought that a diversified pool of consumer finance could create systemic risk. But all you need is for 10% to 20% of consumers to all pile into something poorly structured and you have a systemic problem.
Housing is both a consumer product and a societal Ponzi Scheme in that it is based upon the availability of mortgage financing. If there is no available financing for people looking to buy a home, few can sell their home. You can own your home free and clear and be as conservative as you want to be but if there is no financing market, you will not get what you expect when you go to sell. Add to that some significant percent of people getting aggressive on buying homes they cannot afford and too many homes being built; when it collapses, as it will, every homeowner loses. If you want to sell your house when you need the money, tough luck. Nothing is more systemic then housing and the financing of home purchases. It must be regulated.
When I was with JPM, I became convinced that modern risk management tools would prevent concentrations of risk from developing because I thought the old measure of managing risk would remain while being augmented by this new technology. Instead, except at JPM and Northern Trust, these tools allowed more risk to be taken by placing an over reliance on the benefits of diversification and low correlation between risks. When everyone relies upon the same tools, everyone can make the same mistake increasing the correlation and reducing the diversification. Good regulation is necessary to prevent those animal spirits from harming society as a whole and that is what he Financial Reform Bill was passed to accomplish.
"I wrote the first credit policy on Credit Default Swaps. It was that policy that led directly to JPM's not having the concentrated exposure to AIG that Goldman Sachs and others had, which in turn necessitated the government rescuing AIG. "
ReplyDeleteSo had you stayed at JPM until the the collapse, would you have been rewarded? Goldman honchos should all be in the Big House. Why do so many end up at Treasury?