macroblog

May 13, 2010

Regulatory reform via resolution: Maybe not sufficient, certainly necessary

This macroblog post is the first of several that will feature the Atlanta Fed's 2010 Financial Markets Conference. Please return for additional information.

On Tuesday and Wednesday the Federal Reserve Bank of Atlanta hosted its annual Financial Markets Conference, titled this year Up From the Ashes: The Financial System After the Crisis. Much of the first day was devoted to conversations about rating agencies and their role in the economy, for better and worse. The second day was absorbed by the issues of too-big-to-fail, macroprudential regulation, and regulatory reform.

One theme that ran throughout the second day's conversations related to the two aspects of regulatory reform highlighted by Chairman Bernanke in his recent congressional testimony on lessons from the failure of Lehman Brothers:

"The Lehman failure provides at least two important lessons. First, we must eliminate the gaps in our financial regulatory framework that allow large, complex, interconnected firms like Lehman to operate without robust consolidated supervision… Second, to avoid having to choose in the future between bailing out a failing, systemically critical firm or allowing its disorderly bankruptcy, we need a new resolution regime, analogous to that already established for failing banks."

Though those two aspects of reform are in no way mutually exclusive, there is, I think, a tendency to lean to one or the other as the first most important contributor to avoiding a repeat of our recent travails. To put it in slightly different terms, there are those that would place greatest emphasis on reducing the probability of systemically important failures and those that would put greatest emphasis on containing the damage when a systemically important failure occurs.

I offered my views last month at the Third Transatlantic Economic Dialogue, hosted by Johns Hopkins University's Center for Transatlantic Relations.

"…the best chance for durable reform is to start with the assumption that failure will happen and construct a strategy for dealing with it when it does…

"In a world with the capacity for rapid innovation, rule-writers have a tendency to perpetually fight the last war…

"I am not arguing that … the 'Volcker rule,' derivative exchanges, trading restrictions, or any of the specific regulatory reform proposals in play are necessarily bad ideas. I am arguing that we should assume that, no matter what proposed safeguards are put in place, failure of some systemically important institution will ultimately occur—somewhere, somehow. And that means priority has to be given to the development of resolution procedures for institutions that are otherwise too big to fail."

At our conference this week, University of Florida professor Mark Flannery expressed concerns that, placed in an international context, a truly robust resolution process for failed institutions may be tough to construct:

"In principle, a non-bankruptcy reorganization channel for SIFIs [systemically important financial institutions] makes a lot of sense. But the complexity of SIFIs' organizational structures introduces some serious problems. Not only do SIFIs operate with a bewildering array of subsidiaries… but they generally operate in many countries. Without very close coordination of resolution decisions across jurisdictions, a U.S. government reorganization would likely set off a scramble for assets of the sort that bankruptcy is meant to avoid. Rapid asset sales could generate downward price spirals… with systemically detrimental effects. Second, supervisors would have to assure that SIFIs maintain the proper sort and quantity of haircut-able liabilities outstanding. Once a firm has been identified as systemically important, this may be a relatively straightforward requirement to impose, but there remains the danger that 'shadow' institutions will become systemically important, before they are properly regulated. (This is not a danger unique to the question of resolution.)

"I conclude that the international coordination required to make prompt resolution feasible for SIFIs is a long way off, if it can be achieved at all."

Not an encouraging note, and the point is very well taken. Flannery concludes that we would be better served by focusing on changes that lie on the "avoiding failure" end of the reform spectrum: standardized derivative contracts, tying supervisory oversight to objective market-based metrics on the health of SIFIs, limitations on risky activities, and higher capital standards.

As I noted above, I am certainly not hostile to these ideas, and the answer to the question "should reform strategies be rules-based or resolution-based?" is surely "all of the above." But even if it will take a long time to develop better resolution procedures to address the types of problems that emerged in the past several years, I strongly argue that development of such procedures are necessary for the long-term, and work on these procedures should begin. And here, I have a relatively modest proposal, returning to my remarks:

"…there is a pretty obvious way to vet proposals that are offered. We have a couple of real-world case studies—Bear Stearns, Lehman, AIG. One test for any proposed resolution process would be to illustrate how that plan would have been implemented in each of those cases. This set of experiments can't be started too soon, and I think should move it to the top of our reform priorities."

Whether it be the specific provisions of reform bills winding their way through Congress or the "living will" idea championed this week by the Federal Deposit Insurance Corporation, I think we would do well to let the stress testing of those proposals begin.

By Dave Altig, senior vice president and research director at the Atlanta Fed

May 13, 2010 in Banking, Financial System, Regulation | Permalink

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My thoughts on this are posted at my blog, www.pointsandfugures.com. To summarize them, we need a drastic change in the structure of the cash equity marketplace. We need to look at the role of each marketplace in the economy, and eliminate some traditional practices.

As far as OTC, we certainly should clear many of them. But there is not any way to safely clear all of them. Let the market decide.

Posted by: Jeff | May 15, 2010 at 06:33 PM

Does anyone at the Fed or within the banking system have a thought on the system as a whole?

We've been "at" capitalism now for a few hundred years. Seems odd that now, in 2010, we need some regulation that some previous authoritative body overlooked.

I'm hinting that the problem is not legal, it's physical. Our current manifestation of economy may in-itself be dying.

3 major crashes in one decade, and we almost went down again last week. What is "law" really going to do?

Posted by: FormerSSResident | May 15, 2010 at 07:04 PM

I genuinely do not understand why this is such a problem. The share price of any institution that fails ought to be zero, in which case, the institution can be taken into the temporary ownership of the government for, say, one cent per share. The government are then free, as the new owners, to dispose of the business as they see fit, either through an orderly liquidation or recapitalisation and sale. In that way, any systemic shock can be avoided. Except for petty political prejudice against nationalisation, which it ought to be possible to set aside in an emergency, what is the problem with that solution?

Posted by: RebelEconomist | May 16, 2010 at 02:57 PM

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April 06, 2010

Breaking up big banks: As usual, benefits come with a side of costs

Probably the least controversial proposition among an otherwise very controversial set of propositions on which financial reform proposals are based is that institutions deemed "too big to fail" (TBTF) are a real problem. As Fed Chairman Bernanke declared not too long ago:

As the crisis has shown, one of the greatest threats to the diversity and efficiency of our financial system is the pernicious problem of financial institutions that are deemed "too big to fail."

The next question, of course, is how to deal with that threat. At this point the debate gets contentious. One popular suggestion for dealing with the TBTF problem is to just make sure that no bank is "too big." Two scholars leading that charge are Simon Johnson and
James Kwak (who are among other things the proprietors at The Baseline Scenario blog). They make their case in the New York Times' Economix feature:

Since last fall, many leading central bankers including Mervyn King, Paul Volcker, Richard Fisher and Thomas Hoenig have come out in favor of either breaking up large banks or constraining their activities in ways that reduce taxpayers' exposure to potential failures. Senators Bernard Sanders and Ted Kaufman have also called for cutting large banks down to a size where they no longer pose a systemic threat to the financial system and the economy.

…We think that increased capital requirements are an important and valuable step toward ensuring a safer financial system. We just don't think they are enough. Nor are they the central issue…

We think the better solution is the "dumber" one: avoid having banks that are too big (or too complex) to fail in the first place.

Paul Krugman has noted one big potential problem with this line of attack:

As I argued in my last column, while the problem of "too big to fail" has gotten most of the attention—and while big banks deserve all the opprobrium they're getting—the core problem with our financial system isn't the size of the largest financial institutions. It is, instead, the fact that the current system doesn't limit risky behavior by "shadow banks," institutions—like Lehman Brothers—that carry out banking functions, that are perfectly capable of creating a banking crisis, but, because they issue debt rather than taking deposits, face minimal oversight.

In addition to that observation—which is the basis of calls for a systemic regulator that spans the financial system, and not just specific classes of financial institutions—there is another, very basic, economic question: Why are banks big?

To that question, there seems to be an answer: We have big banks because there are efficiencies associated with getting bigger—economies of scale. David Wheelock and Paul Wilson, of the Federal Reserve Bank of St. Louis and Clemson University, respectively, sum up what they and other economists know about economies of scale in banking:

…our findings are consistent with other recent studies that find evidence of significant scale economies for large bank holding companies, as well as with the view that industry consolidation has been driven, at least in part, by scale economies. Further, our results have implications for policies intended to limit the size of banks to ensure competitive markets, to reduce the number of banks deemed "too-big-to-fail," or for other purposes. Although there may be benefits to imposing limits on the size of banks, our research points out potential costs of such intervention.

Writing at the National Review Online, the Cato Institute's Arnold Kling acknowledges the efficiency angle, and then dismisses it:

There's a long debate to be had about the maximum size to which a bank should be allowed to grow, and about how to go about breaking up banks that become too large. But I want to focus instead on the general objections to large banks.

The question can be examined from three perspectives. First, how much economic efficiency would be sacrificed by limiting the size of financial institutions? Second, how would such a policy affect systemic risk? Third, what would be the political economy of limiting banks' size?

It is the political economy that most concerns me…

If we had a free market in banking, very large banks would constitute evidence that there are commensurate economies of scale in the industry. But the reality is that our present large financial institutions probably owe their scale more to government policy than to economic advantages associated with their vast size.

I added the emphasis to the "probably" qualifier.

The Wheelock-Wilson evidence does not disprove the Kling assertion, as the estimates of scale economies are obtained using banks' cost structures, which certainly are impacted by the nature of government policy. But if economies of scale are in some way intrinsic to at least some aspects of banking—and not just political economy artifacts—the costs of placing restrictions on bank size could introduce risks that go beyond reducing the efficiency of the targeted financial institutions. If some banks are large for good economic reasons, the forces that move them to become big would likely emerge with force in the shadow banking system, exacerbating the very problem noted by Krugman.

I think it bears noting that the argument for something like constraining the size of particular banks implicitly assumes that it is not possible, for reasons that are either technical or political, to actually let failing large institutions fail. Maybe it is so, as Robert Reich asserts in a Huffington Post item today. And maybe it is in fact the case that big is not beautiful when it comes to financial institutions. But in evaluating the benefits of busting up the big guys, we shouldn't lose sight of the possibility that this is also a strategy that could carry very real costs.

By Dave Altig, senior vice president and research director at the Atlanta Fed

April 6, 2010 in Banking, Financial System, Regulation | Permalink

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I understand Krugman's argument, but doesn't it emphasise the importance of dealing with the TBTF problem for all types of financial institutions - whether deposit-taking or not? I agree that dealing with the TBTF problem only for depositary institutions is pointless - after all, the big failures of the current crisis were all non-banks (Bear Stearns, Lehman Brothers, AIG...) - but why should that be the end of the story? If PIMCO or Blackrock create systemic risk, that should be regulated - including structural remedies if necessary - just as it should if the culprit is Citi or Bank of America.

Posted by: Carlomagno | April 06, 2010 at 04:00 PM

Higher capital requirements might be one way to establish a driving force for reducing the size of a bank. Another one could be higher fees to pay for being a big bank, like an insurance premiums: because the damage of a bank failure would increase over proportionally with the size of the bank, the insurance payments should increase also with size and much more than linearly. If a bank wants to get bigger, to do some things better, it pays the price and is allowed to grow.

Posted by: Peter T | April 06, 2010 at 07:11 PM

The most obvious "economy of scale" associated with large banks is ability to influence the regulator. This is bad, not good, for the system even if it is good for bank profits.

The other key reason why banks might grow large is diversification -- but increased securitization should have reduced, not increased, the correlation between size and diversification. Computing power is even less plausible. Cross-selling never was plausible except to the extent that it involved the potential for profiting from breaches of client confidentiality.

Posted by: D Greenwood | April 08, 2010 at 09:07 AM

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March 05, 2010

In the beginning, there was a lender of last resort

Steven Pearlstein, business columnist for the Washington Post, asks and answers the question "should the Fed stay out of the bank supervision business?"

"As the Senate begins to focus on how to fix financial regulation, one of the remaining unresolved issues is what role the Federal Reserve should have in supervising banks.

"The correct answer? None at all."

One of the centerpieces of the Pearlstein argument is this:

"The reality is that the Fed's primary focus is and will always be on monetary policy. Bank supervision will continue, as it has been, as a secondary activity that not only receives less attention from the top but will be sacrificed at those rare but crucial moments when the two missions might conflict. Indeed, by arguing that the Fed needs the insights gleaned from bank supervision to be more effective in making monetary policy, the Fed essentially acknowledges this hierarchy in its priorities. Bank supervision is important enough that it ought to be somebody else's top priority."

If you might allow me a moment of personal indulgence, there was a time when I had some sympathy with the sentiment that the "Fed's primary focus is and always will be on monetary policy." I, of course, knew the story of the creation of the Fed, motivated by the need to provide an elastic currency to avoid disruptive fluctuations in prices and a lender of last resort to stop liquidity stress from becoming a full-blown financial crisis. But that was a story from the past. The modern world began in 1935 with the statutory creation of the Federal Open Market Committee, which would eventually evolve, with its central bank brethren in the rest of the world, into the institution described by Pearlstein as being primarily focused on monetary policy.

I felt that way until Sept. 11, 2001. On an average day in the week ending Sept. 5 of that year, the Federal Reserve extended $21 million in discount loans to banks, a reasonably representative volume. On Sept. 12, discount loans amounted to over $45 billion. As a result, the U.S. financial system did not collapse.

The horrible circumstances of 9/11 have been thankfully unique, but there is a case to be made for the proposition that the most important role of the central bank in the recent financial crisis was not in the realm of traditional monetary policy but in the exercise of variations on the lender-of-last-resort function. In fact, in times of acute financial stress, this role must always be so. Witness this remark by Alan Greenspan on Oct. 20, 1987:

"… in a crisis environment, I suspect we shouldn't really focus on longer-term policy questions until we get beyond this immediate period of chaos."

Which brings us to the question of the Fed's role in bank supervision. More precisely, it brings us to comments from Atlanta Fed President Dennis Lockhart, who delivered remarks on Wednesday to the New York Association for Business Economics:

"… the Fed must play a central role in a defense structure designed to prevent or manage future crises. My key argument is the indivisibility of monetary authority, the lender-of-last-resort role, and a substantial direct role in bank supervision. Only the Fed can act as lender of last resort because only the monetary authority can print money in an emergency. To make sound decisions, the lender of last resort needs intimate hard and qualitative knowledge of individual financial institutions, their connectedness to counterparties, and the capacity of management.

"There is sentiment in Washington that would separate these tightly linked functions that are so critical in responding to a financial crisis. Removing the central bank from a supervision role designed to provide totally current, firsthand knowledge and information will weaken defenses against recurrence of financial instability. Flawed defenses could be calamitous in a future we cannot see."

If this advice goes unheeded, I fear we might discover its wisdom in the worst possible circumstances.

By Dave Altig, senior vice president and research director at the Atlanta Fed

March 5, 2010 in Federal Reserve and Monetary Policy, Financial System, Monetary Policy, Regulation | Permalink

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Dave, is the Federal Reserve taking action to strengthen its level of expertise in banking and financial intermediation and risk management ? The argument has been made that its academic staff were very good at doing 1001 variations on the Taylor rule but lacked the human capital necessary to understand financial developments. I don't know if that was true, but it would explain the Fed's dereliction of duty in the latter years of Greenspan tenure.

Posted by: PE | March 05, 2010 at 06:08 PM

The best banking system in the world (Canada) separates the two functions.

Posted by: JKH | March 06, 2010 at 11:11 AM

Indeed, if this crisis demonstrates nothing else, it is that monetary policy is indivisible from regulation. Loose regulation is a form of loose monetary policy.

Since virtually all innovation has eventually come around to the Fed to backstop, one would wish the Fed would get out in front to decide what it can and cannot defend. We suspect it is too late.

Posted by: Alan Harvey | March 06, 2010 at 06:13 PM

What of the argument that it was the Fed's failed supervision and regulation that in part caused the crisis? If the Fed hadn't failed in S&R, then maybe we wouldn't have needed all the new liquidity facilities in the first place. Perhaps a somehow more effective regulatory body could have avoided the current crisis? The question seems to come down to "who can do it better?" Perhaps the answer is noone.

Also, for 9/11, I wonder what the counterfactual would have been if the Fed didn't have bank regulatory powers. That is, would the Fed still have opened the liquidity spigot without the "hard and qualitative knowledge of individual financial institutions..."?

Posted by: MH | March 09, 2010 at 10:45 AM

The best banking system in the world (Australia) separates the two functions.

Nevertheless, this rule is necessary but not sufficient.

Posted by: Thomas Esmond Knox | March 15, 2010 at 03:26 AM

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February 19, 2010

Should the Fed stay in regulation?

One of the central issues in the postcrisis effort to reform our regulatory infrastructure is who should do the regulating. The answer to some in Congress is none of the above:

"… under consideration is a consolidated bank regulator, one aide [to Alabama Senator Richard Shelby] said. The idea is supported by [Connecticut Senator Christopher] Dodd, who proposed eliminating the Office of Thrift Supervision and Office of the Comptroller of the Currency, and moving their powers, along with the bank-supervision powers of the Federal Reserve and the Federal Deposit Insurance Corp., to the new agency.

"Negotiators are still deciding how to monitor firms for systemic risk, including how to define and measure it, what authorities to give a regulator and which agency is best suited to get the power, a Shelby aide said."

As reported in The New York Times:

"The Senate and the Obama administration are nearing agreement on forming a council of regulators, led by the Treasury secretary, to identify systemic risk to the nation's financial system, officials said Wednesday…"

Though the idea of a council to provide regulatory and supervisory oversight is still contentious (the Times article offers multiple opinions from Federal Reserve officials) the formation of a council is not necessarily the same thing as removing the central bank from boots-on-the-ground, or operational, supervisory responsibility. In other words, there is still the question of how to monitor systemic risk and which agency is best suited to get the power.

Earlier this week I made note of a new International Monetary Fund (IMF) paper by Olivier Blanchard, Giovanni Dell'Aricca, and Paulo Mauro, taking some issue with the proposal that central banks consider raising their long-run inflation objectives. Though that part of the paper seemed to attract almost all of the attention in the media and blogosphere, the discussion in the IMF article expanded well beyond that inflation target issue. Included among the many proposals of Blanchard et al. was this, on systemic risk regulation and the role of the central bank:

"If one accepts the notion that, together, monetary policy and regulation provide a large set of cyclical tools, this raises the issue of how coordination is achieved between the monetary and the regulatory authorities, or whether the central bank should be in charge of both.

"The increasing trend toward separation of the two may well have to be reversed. Central banks are an obvious candidate as macroprudential regulators. They are ideally positioned to monitor macroeconomic developments, and in several countries they already regulate the banks. 'Communication' debacles during the crisis (for example on the occasion of the bailout of Northern Rock) point to the problems involved in coordinating the actions of two separate agencies. And the potential implications of monetary policy decisions for leverage and risk taking also favor the centralization of macroprudential responsibilities within the central bank."

Consistent with the even-handedness of the Blanchard et al. paper, the authors did not come to this conclusion without noting the legitimate issues of those who would separate regulatory authority from the central bank:

"Against this solution, two arguments were given in the past against giving such power to the central bank. The first was that the central bank would take a 'softer' stance against inflation, since interest rate hikes may have a detrimental effect on bank balance sheets. The second was that the central bank would have a more complex mandate, and thus be less easily accountable. Both arguments have merit and, at a minimum, imply a need for further transparency if the central bank is given responsibility for regulation."

But, they conclude:

"The alternative, that is, separate monetary and regulatory authorities, seems worse."

I wonder, then: Would a regulatory council of which the Federal Reserve is a member, combined with operational supervisory responsibilities housed within the central bank, be a tolerably good response to Blanchard's and his colleagues' admonitions?

By Dave Altig, senior vice president and director of research at the Atlanta Fed

February 19, 2010 in Banking, Financial System, Regulation | Permalink

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The Fed is ill suited to a regulatory role. Regardless of the general trend, we have to deal with this Fed in this country, not central banks in general.

Why?

First, the Fed utterly dropped the ball on AIG which it had regulatory authority over. It had a reputation at the time for lax regulation and nothing has happened to change this impression. The Fed simply isn't set up to be a regulator in the same way as other bank regulatory agencies.

Second, few agencies are dispositionally less suited to monitor systemic risk. No federal government player is more focused on the short term here and now concerns of the economy. The Fed is a day to day, month to month participant in and manager of the markets. It does so in a very stylized, through, predictable way. It is all about the trees.

Systemic risk monitoring is fundamentally a long run, see the forest operation. Systemic risk is particularly likely to be hiding precisely where entities like the Fed are not out there collecting data. It is hiding off the books and in novel relationships.

Third, systemic risk regulation is a voice in the wilderness job. The regulator needs to zig when everyone else zags and defy the conventional wisdom of the establishment. The Fed is the establishment. The Fed uses mainstream economic models. The Fed's actions establish conventional wisdom. The Fed is at its most inept when the usual tools stop working in the usual ways (see stagflation). Putting systemic risk regulation in the Fed is to doom that regulator to group think and ideological capture.

Posted by: ohwilleke | February 19, 2010 at 07:14 PM

Do councils in regulatory authorities work? Any examples of where this works today? Seems like an excuse to meet X times a year and yet do nothing.

And, I wish Shelby good luck with defining exactly what all constitutes risk. That could be everything from CDS to police on the street. I think what they mean is "Banking system risk". That's only one part of this apparatus.

Posted by: FormerSSResident | February 21, 2010 at 11:22 AM

I think that regulators need to pay much closer attention to market structure rather than writing rules. For example, in the cash equity markets, they allow dark pools of liquidity, delayed price and volume reporting, payment for order flow, internalization of order flow. These things lead to distortions in the marketplace.

Just wrote a piece on fungibility at pointsandfigures.com.

Posted by: Jeff | February 21, 2010 at 01:13 PM

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December 23, 2009

Change the bathwater, keep the baby

What have we learned from the experience of the last two years? The Wall Street Journal offers up one discouraging conclusion:

"For much of the past century, America has served as the global model for the power of free markets to generate prosperity…

"In the 2000s, though, the U.S. quickly went from being the beacon of capitalism to a showcase for some of its flaws…

"But one thing is certain: America's success or failure over the next decade will go a long way toward defining what the world's next economic model will be."

One of the article's implied alternatives for the world's next economic model seems a bit of a stretch:

"The troubles in the U.S. stand in sharp contrast to the relative success of other countries, notably China. With a system that is at best quasi-capitalist, China's economic output per person grew an inflation-adjusted 141% over the decade, and hardly paused for the global crisis, according to estimates from the International Monetary Fund. That compares with 9% growth in the U.S. over the same period."

Let's put that comparison to rest right away:

122209

The theory of economic growth is rich, interesting, and somewhat unsettled, but it stands to reason that emerging economies, where the fruit hangs low, can for a time grow much faster than advanced, fully developed countries. Furthermore, I find it reasonable to assume that, contrary to representing an alternative economic model, the Chinese experience over the past decade is itself evidence that even incomplete movements in the direction of free markets can pay large dividends. But even if you doubt that interpretation, the gap between the material circumstances of the average American and Chinese citizen is so large as to make comparisons about the success of the respective economic models premature by several decades.

In fact, the picture above nicely illustrates what I believe is a more on-the-mark observation in the WSJ article:

"At least twice in the past century, the U.S. has re-emerged from deep crises to reinvent capitalism. In the 1930s, the Depression compelled Franklin Roosevelt to introduce Social Security, deposit insurance and the Securities and Exchange Commission.

"After the brutal stagflation of the 1970s and early 1980s, then-Federal Reserve Chairman Paul Volcker demonstrated the ability of an independent central bank to get prices under control, ushering in an age in which powerful, largely autonomous central banks became the norm throughout the developed world."

So what, then, is the alternative model waiting in the wings to replace the current one? It's not given a name, but the features are clear in the article:

"Policy makers' focus now, though, is on the financial sector that failed so spectacularly. Progress has been slow, and key pieces are missing, but the contours of a new system are taking shape. Banks will face stricter limits on their use of borrowed money, or 'leverage,' to boost returns. The Fed will keep a closer eye on markets during booms, and possibly step in to curb excessive risk-taking—a U-turn from its previous policy of mopping up after bubbles burst.

"Such changes would amount to a grand bargain: Give up some of the growth and dynamism of the U.S. economy for a safer, more equitable brand of capitalism—one that could avoid the kind of busts that turned the 2000s into such a disaster."

OK, but here is the central question: How can we be sure that the "new system" will be an improvement on the one it replaces? Some of the most significant failures of the last couple of years occurred in highly regulated industries. So the absence of regulation is not really at issue, but rather what kind of regulation we will have, and how it will be implemented. And there is the obvious point that regulatory change is not really reform if it undermines a system's existing strength. Some of the reform proposals on the table, for example, have the potential to seriously compromise "the ability of an independent central bank to get prices under control," the very feature of our current system that the article identifies as an historical source of resilience.

I worry about a regulatory change that commences from the proposition that we must "give up some of the growth and dynamism of the U.S. economy for a safer, more equitable brand of capitalism." In their introduction to a comprehensive set of reform proposals from New York University's Stern School of Business, professors Viral Acharya and Matthew Richardson have this to say:

"There are many cracks in the financial system, some of which we now know, others no doubt we will discover down the road.… A common theme of our proposals notes that fixing all the cracks will shore up the financial house but at great cost. Instead, by fixing a few major ones, the foundation can be stabilized, the financial structure rebuilt, and innovation and markets can once again flourish."

One of those major cracks is the "too-big-to-fail" distortion. Is it important to remember that too-big-to-fail is itself a creation of regulation, not markets? I think so.

By David Altig, senior vice president and research director at the Atlanta Fed

December 23, 2009 in Financial System, Regulation | Permalink

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This was very interesting, but I think you made the question too narrow.

"Too-big-to-fail" is not a creation of either regulation or markets per se. It was created by cornering the market for regulation. The new model involves changing the regulations in this meta-market, via campaign finance and other procedural reforms to our democracy.

Posted by: capax | December 23, 2009 at 05:15 PM

Yes, Yes, Yes, all of us know what the term regulatory capture means. Who's gonna regulate the regulators? Have fun chewing on that one..

The fact is so very few people really understand how the machine works. I won't even pretend I do. The history of the machine is that when it breaks, it's like the human body. Doctors rush in to prescribe this and that, but often it self heals.

So, take two aspirin and call us in the morning would be my advise.

However I do thing something structurally did change. What it is, I do not yet know. But I see it's sign and footprint all over California.

Posted by: FormerSSresident | January 03, 2010 at 10:41 AM

"too-big-to-fail is itself a creation of regulation" HUH? This is preposterous!

Posted by: bailey | January 03, 2010 at 11:17 PM

I see Ben Bernanke said that he thinks regulation is the answer for the current economic problem. It leads me to think this is because they haven't allowed people to fail.

Failure is regulation in and of itself provided an understood framework exists for the particpants.

Now what I suspect is Goldman Inc and such will shift thier burden of responsibility to some gov agent.

Indeed dare I say this could eventually lead to some new form of finance capitalism as people seek to get around the government BS.. Venture backed mortgages I guess..

Posted by: FormerSandySpringsResident | January 04, 2010 at 11:10 AM

I would suggest Wall St. needs to make a decision about whether it wants to be a hedge fund or a bank, but not both. Banking should be boring.

And the government must rid itself of the GSE's.

We can talk about whether anyone is smart enough to control interest rates later:)

Posted by: jim | January 05, 2010 at 07:09 AM

Great post. As far as regulation of the financial sector, I think that the fix supplied by both Congressional committees, and the thoughts of the Treasury Secretary are misguided.

They are not changing anything.

I would rather see regulation based on function in the marketplace. For example, many activities the SEC deems "legal" are very anti-competitive and anti-free market. For example, payment for order flow and the internalization of order flow. These two practices don't make the market more efficient, but certainly line the pockets of the big banks that can practice them.

I'd like to see a ban on dual trading. If you want to be a broker, then get paid to broker your customers' order. Otherwise, take risk and be a trader. There is a huge conflict of interest that has been exploited by specialists, investment banks and others for years. Secondly, I'd ban payment for order flow, and internalization. Also, the reporting of trades is nebulous. A block trade is reported late. They should be reported in real time to give better information to the market.

All the proposed trading taxes working their way through Congress will hurt markets as well.

I certainly can sympathize with the Americans who decry the greed on Wall St. However, the regulations currently in place don't allow for markets to nip a lot of that greed in the bud, and the new proposed regulations will do nothing to curb it either. We are rebuilding the same house of cards.

Posted by: Jeff Carter | January 06, 2010 at 10:35 AM

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November 06, 2009

What is systemic risk, anyway?

On October 30, the Center for Financial Innovation and Stability at the Federal Reserve Bank of Atlanta held a conference on Regulating Systemic Risk. The presentations mostly focused on the recent financial crisis and possible regulatory responses to those developments.

Oddly enough, the term systemic risk hardly came up even though it was a major part of the conference's title. Then again, maybe it wasn't so odd.

Systemic risk is a relatively new term that has its origin in policy discussions, not the professional economics and finance literature. A search of EconLit turned up the following: The first appearance of the term systemic risk in the title of a paper in professional economics and finance literature was in 1994. That appearance was in a review of a book written by a World Bank economist, not a journal article by an economist at a university.

Given its origin in policy discussions, perhaps it is not so surprising that the term "systemic risk" often is used with no apparent precise definition in mind. If it arose from a theoretical analysis as did a term it sometimes is confused with—systematic risk— there would be a very precise definition.1

The G10 Report on Consolidation in the Financial Sector (2001) suggested a working definition:

"Systemic financial risk is the risk that an event will trigger a loss of economic value or confidence in, and attendant increases in uncertainly [sic] about, a substantial portion of the financial system that is serious enough to quite probably have significant adverse effects on the real economy."

While this is a reasonable definition in terms of the concerns in mind, the precise definitions and measurement of terms such as "confidence," "uncertainty," and "quite probably" are likely to be elusive for some time, if not forever. Furthermore, the definitions probably include a lot more than what usually seems to be meant by systemic risk. For example, the risks of an earthquake, a large oil price increase, and a coup fit in this definition. Or maybe "systemic risk" should include such events?

Even George G. Kaufman and Kenneth E. Scott (2003) define "systemic risk" in imprecise terms:

"Systemic risk refers to the risk or probability of breakdowns in an entire system, as opposed to breakdowns in individual parts or components, and is evidenced by comovements (correlation) among most or all the parts."

To me, this definition is better than the G-10 definition because it does not confuse the event being analyzed (the breakdown) with the cause (the loss of confidence). Even so, a precise definition of "breakdown" may be elusive even if the term is evocative.

Darryll Hendricks (2009), who is a practitioner, suggests a more theoretical definition from the sciences in which the term originated:

"A systemic risk is the risk of a phase transition from one equilibrium to another, much less optimal equilibrium, characterized by multiple self-reinforcing feedback mechanisms making it difficult to reverse."

This definition includes many words that aren't used in everyday English and is quite abstract, focusing on the mathematics to characterize the situation. That said, this definition has a better shot at being more precise in terms of economic and financial analysis of actual situations than does the G10's definition. But the economic content of this definition as it stands is zero.

One solution is the following: Kaufman and Scott's definition is a reasonably clear, tentative definition of the term that doesn't use too many other words that require definition. Hendricks's more theoretical definition or something like it probably is a helpful start to ways of thinking about systemic risk in analytical terms.

By Gerald P. Dwyer, director of the Atlanta Fed's Center for Financial Innovation and Stability

References

Group of Ten. 2001. "The G10 Report on Consolidation in the Financial Sector."

Hendricks, Darryll. 2009. "Defining Systemic Risk." The Pew Financial Reform Project.

Kaufman, George G., and Kenneth E. Scott. 2003. "What is Systemic Risk, and Do Bank Regulators Retard or Contribute to It?" Independent Review 7 (Winter), pp. 371-91.

1In the context of the capital asset pricing model, systematic risk is the risk associated with changes in the overall stock market. It can be defined similarly in other theories of asset returns.

November 6, 2009 in Financial System, Regulation | Permalink

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Hendricks definition suffers from a problem that the concept of equilibrium tends to be stationary, but we usually talk about systemic risk as building up. For example, the run up in housing prices or the worsening of global imbalances can be viewed as dynamic triggers of systemic risk events. Perhaps such phenomena could be represented in an equilibrium model that transitions to systemic risk, but maybe not.

Posted by: csissoko | November 06, 2009 at 06:08 PM

It seems that it is necessary to distinguish endogenous systemic risk, i.e., that generated by the system itself that can lead to widespread market failure, such as excess leverage, from exogenous shock, since each requires a different approach.

Posted by: Tom Hickey | November 07, 2009 at 06:40 PM

Conspicuous by its absence in the cites is that 1994 review title by a WB economist.

Posted by: Ken Houghton | November 07, 2009 at 09:11 PM

Risk is a squeaky fan belt, systemic risk is a loud knocking sound in the engine.

Posted by: Jim Gobetz | November 08, 2009 at 10:49 AM

Systemic risk occurs when economic actors are allowed to make promises that they don't have the wherewithal to keep.

Examples:

Banks promise that you can have your money back anytime you want even though they have lent it all out.

Banks promise that you can't lose money in your account even though there's a risk that the loans they have made will not be paid back.

AIG promised to make good on bond losses (CDS) even though they did not have the assets to cover the potential losses.

Annuity sellers promise fixed payments into the future even though they have no control over the rate of return.

Defined Benefit Pension plans promise future payments that they don't have the assets to cover.

The crisis comes when these promises are revealed to be empty promises. If you want a financial system without systemic risk the solution is simple. Don't allow anyone to make promises they can't keep.

Posted by: diemos | November 08, 2009 at 10:50 PM

I don't believe in systemic risk. I think that there is transaction risk-and not priced in or accounted for correctly in models.

What are the chances that your counter party won't perform? I am sure there were folks in the Investment banking industry that said there was no way Lehman would fall. They did.

The question should be how do we mitigate counter party risk? Then when dominoes start to fall, it doesn't take down more dominoes that cause intense losses throughout the whole system.

In 2008, I don't think there was enough cash put up throughout the entire system to hold positions. Of course, because of the amount of leverage in the market, that is an easy statement to make. But even today, I think risk is underpriced in the market.

Posted by: Jeff | November 09, 2009 at 07:51 PM

The way I see you have a core and then bells and whistles. If something affects the core materially, then this is systemic. If something affects the bells it isn't, unless a bell that breaks necessarily also breaks a core.

So, then it's a matter of whats considered to be 'core'. Don't ask me, cause I don't know. Seems like land, and gold, and guns would probably involved.

I like Mr. Hendricks idea, but I wonder if the ladder can be busted down, can we also skip ahead? That is to say maybe we could learn to bust up to higher equilibriums more rapidly.

Posted by: FormerSSResident | November 10, 2009 at 12:12 PM

http://www.americanthinker.com/2009/11/why_wall_street_isnt_main_stre.html

On a tangential note, here are some things that they could do to stem systemic risk, and make the playing field more competitive.

Posted by: jeff | November 14, 2009 at 12:09 AM

Don't forget SYSTEMIC RISK: Fannie Mae, Freddie Mac and the Role of OFHEO www.fhfa.gov/webfiles/1145/sysrisk.pdf

Posted by: Jim A. | November 16, 2009 at 09:54 AM

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July 08, 2009

Markets work, even when they don’t

Remember when it used to be cool to be an advocate of free markets? I do, but after the events of the past year or so maintaining that position feels a bit like being an ice cream vendor in a snowstorm—a peddler of a product that just doesn't suit the environment.

Joseph Stiglitz, skeptic and 2001 recipient of the Nobel Prize in Economic Science, put it this way in his most recent Vanity Fair entry:

… historians will mark the 20 years since 1989 as the short period of American triumphalism. With the collapse of great banks and financial houses, and the ensuing economic turmoil and chaotic attempts at rescue, that period is over. So, too, is the debate over "market fundamentalism," the notion that unfettered markets, all by themselves, can ensure economic prosperity and growth. Today only the deluded would argue that markets are self-correcting or that we can rely on the self-interested behavior of market participants to guarantee that everything works honestly and properly.

I'm not sure how many people identifying themselves as "market fundamentalists" actually subscribed to the notion that markets "guarantee that everything works honestly and properly," but at the very least the ranks of the "no new regulation" camp are growing pretty thin. This shift is undoubtedly appropriate, but that is not quite the same thing as throwing out this following major tenet of "market fundamentalism" thinking: Markets are, everywhere and always, one step (or more) ahead of regulators.

The cautionary examples are legion, but a recent one has been on my mind for a couple of weeks. Writing, about a month ago, on the minimum wage, UC-Irvine professor David Neumark noted the following:

Despite a few exceptions that are tirelessly (and selectively) cited by advocates of a higher minimum wage, the bulk of the evidence -- from scores of studies, using data mainly from the U.S. but also from many other countries -- clearly shows that minimum wages reduce employment of young, low-skilled people. The best estimates from studies since the early 1990s suggest that the 11% minimum wage increase scheduled for this summer will lead to the loss of an additional 300,000 jobs among teens and young adults. This is on top of the continuing job losses the recession is likely to throw our way.

The reduction in jobs for youths might be an acceptable price to pay if a higher minimum wage delivered other important benefits. Many people believe, for instance, that it helps low-income families. Here, too, the evidence is discouraging.… Research I've done with William Wascher of the Federal Reserve Board and Mark Schweitzer of the Cleveland Fed indicates that minimum wages increase poverty.…

How can this be? Because the relationship between being a low-wage worker and living in a poor family is remarkably weak. Many low-wage teenagers and young adults are in higher-income families, and many poor families have no workers.…

In addition, when deciding which low-wage worker to retain following a minimum wage increase, employers may opt for a teenager, who may have high potential, over an adult who, because he still earns a low wage, likely has much lower potential. Thus, the job-destroying effects of minimum wages fall particularly hard on low-skilled adults in poor families.

I added the emphasis on the last part because it is the relevant bit for my present purpose. Labor markets are arguably imperfect—and could hence fail to guarantee that everything works properly—because information is asymmetric. Indeed, it was for the exploration of the economic effects of imperfect information that Professor Stiglitz won his well-deserved Nobel citation.

What is the essential informational imperfection in our labor market example? Workers have attributes—innate skills, adaptability and maturity, preferences between shirking versus expending effort—that are difficult for employers to observe. As a consequence, employers look for signals about these things. Professor Neumark offers one such signal: If you are an adult and still in a minimum wage job, chances are you have those attributes that are associated with low productivity. If you are a teenager, on the other hand, there is still a chance you are a high-productivity type. Faced with a government mandated hike in the wages paid to workers in minimum-wage jobs, the percentages dictate you go with the teenager. Which leaves in the cold the people we probably most want to help.

My point is an obvious one (and the one I associate with advocates of "market fundamentalism"): Markets may not "guarantee that everything works honestly and properly," but neither does regulation. I'll turn again to Professor Stiglitz, who had this to say in an earlier (and oft-cited) Vanity Fair article:

As an economist, I certainly possessed a healthy degree of trust, trust in the power of economic incentives to bend human behavior toward self-interest—toward short-term self-interest, at any rate, rather than Tocqueville's "self interest rightly understood."

That particular article was provocatively titled "Capitalist Fools," an interesting choice as the primary objects of the Stiglitz barbs were not "capitalists" but regulators. And there remains the thorny question of how to keep at bay the unintended consequences of regulatory policy when human behavior gets bent by incentives and market forces—a phenomenon clearly evident in the perverse impact on low-skill adult workers as a result of the minimum wage.

Something to keep in mind as we go about the job of addressing the very real problems in financial markets that past two years have revealed.

By David Altig, senior vice president and research director at the Atlanta Fed

July 8, 2009 in Labor Markets, Regulation | Permalink

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David, It's an interesting thought. I've often observed the 'inefficiencies' of labor and the market for labor. How many folks work for several years before starting their own business or changing companies, only to find how held down they were at their old gig. The dynamics are complex, it's like an eco-system.

What regulation may do is limit the choice available. If so, then the unintended consequence could be less people finding out just what they're capable of economically. 10 years at a firm with 1 year of experience comes to mind.

Did you guys see what the pope had to say about markets? Goes with that de Tocqueville theme.

Posted by: Former Sandy Springs Resident | July 08, 2009 at 06:13 PM

Faced with a government mandated hike in the wages paid to workers in minimum-wage jobs, the percentages dictate you go with the teenager.

Actually no. The reason is the older worker has experience while the younger one usually does not. The older one may have earned more and may be taking a cut to find work. The younger one hasn't and isn't. Why would an employer spend money to train someone when there are already abundant workers with experience? They won't and don't.

Posted by: Lord | July 08, 2009 at 08:17 PM

Ah, yes. Higher minimum wage laws could make teenagers more attractive employees, therefore it must be true.

I think it's about time to legalize prostitution, and ban economics.

Posted by: Markel | July 09, 2009 at 09:13 AM

Enh, nobody's talking about the dynamic effects of moving from a society of workers to a society of serfs. If we continue to allow labor to be sold cheap, we will encourage methods of organization founded on cheap labor.

And none of this takes into account the experiences of illegal immigrants, who are by definition incapable of seeking enforcement of existing laws.

Posted by: Michael | July 09, 2009 at 06:23 PM

As a small business owner, I definitely would keep the teenager, as they would bring the least "bad habits" to the job. Experience means nothing if it's "bad" experience.

Posted by: Tommy | July 09, 2009 at 09:26 PM

Let me just throw one thing out there, to raise some speculation:

While it's true that experience is positively correlated with productivity, this might operate differently in the minimum wage sector. There, I bet 2 years of experience might be as good as 10 - there's not a lifelong learning curve like in more high-skilled industries - so an employee might "plane out", productivity-wise, after 2 years of experience. If that's the case, then older employees aren't categorically better, as they don't have productivity gains in the future that the employer could benefit from. Younger workers still would have these gains in the future. So, if younger and older were about on par productivity-wise, then it would make sense for the employer to keep the younger worker, who has the possibility of future gains from experience, and lose the older worker, who has already planed out.

~fischer

Posted by: fischer | July 10, 2009 at 07:11 AM

Assuming a minimum wage of $8.

You have a worker able to produce $20 in sales now and one that is able to produce $20 in the future, which do you chose? Of course you chose the teenager that may produce $20 in the future thinking that he will produce $30 in the future, but forgetting that he will have long moved on to a new job before he even hits your $20 target.

Posted by: jgoodguy | July 12, 2009 at 12:37 PM

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