It has been a year since the Federal government absorbed Fannie and Freddie and crossed, however unknowingly, the Rubicon of nationalizing the consequences of private risk-taking. A few weeks later we had Lehman, and then immediately the drunken fire brigade: Reserve Fund, AIG, the conversion of Goldman and Morgan Stanley, and TARP and its variants.
Now that the dust has settled somewhat, let’s pretend we have a plan. In fact, let’s make one.
The good news is that a bunch of smart people have been thinking about this very topic. Simon Johnson and James Kwak at Baseline, Mike Konczal at Rortybomb, Elizabeth Warren, Jeremey Bulow, Willem Buiter. Even the brilliant, charming, and witty Taunter has weighed in. The bad news is that no one in power is paying attention.
Part of the challenge – and it is the same challenge we find in health care – is that a solution does not lend itself to incremental changes. There is an entire Washington Consensus of incrementalism – David Brooks embodies this belief – that believes we are either so perfect or so conservative that we cannot possibly make major changes in the way we do business. This is wrong historically; within a hundred days of taking office, FDR jammed through the Emergency Banking Act, creating a bank holiday and then reopening shuttered banks, took the US off the gold standard we had followed since inception, passed the Agricultural Adjustment Act, launched the Tennessee Valley Authority, and for good measure repealed Prohibition. More to the point, moderation only works to the extent that the solutions allow for an intermediate position. If you are alarmed by the prospect of flying hundreds of miles per hour in an airplane, slowing the airplane to walking pace induces a stall, not greater safety.
The New Deal balkanized American finance; between Glass-Steagall and the McFadden Act, we had something like 150 parallel financial systems: state-limited insurance, commercial banks, and investment banks. The intermediate solution was to creat a 151st: the nationally chartered bank. Eventually Phil Gramm came along and tore down most of these walls. In the meantime, the enormous growth of the pension/retirement scheme/endowment business worldwide (both private and public sector) created a parallel version of the entire regulated financial sector as giant institutions with very long-duration liabilities tried to find some method of matching these obligations; the Jimmy Stewart banking world, after all, presumed that banks borrow short and lend long. Throw in some globalization – Japan, the Gulf States, and then China all looking for places to put foreign earnings that, for a variety of political and economic reasons, had no productive use at home – and we found ourselves in a situation where a sleepy government agency that was supposed to bring stability to Middle America’s mortgage market could pull the global economy off a cliff.
Let’s go back and ask a question we haven’t heard much in the past year: what functions require government protection? I would make the argument that there are only two:
- Any depository or custodial activity;
- Any transaction with the great unwashed.
The New Dealers recognized the importance of deposit insurance. That is what brought us the FDIC. Various states have recognized – to different levels, roughly corresponding to the degree of incompetence of their regulators – that insurance is simply the mirror image; instead of handing over the principal and receiving periodic payments, the customer makes periodic payments and receives the principal. So there is a patchwork of insurance regulation. Larger institutions…well, one of the chief problems that became apparent during the Lehman failure was what happens when a prime broker or custodian goes down and interferes with access to securities held through it?
The other area whose failures have been illuminated by events of the past year is the broad ocean of retail financial transactions. I have generally been on the libertarian side of this debate; I would prefer high, legal interest rates to having individuals frozen out of the market and sent to the black market, and I can see reasons for most alternative mortgage structures. I also believe that when these structures fail, foreclosure should be quick; we should not shy away from the consequences of risk. However, the repeated arguments of Konczal and Warren have had some effect, as has, oddly enough, repeated consideration of the challenges in health care; there really are enormous percentages of the population – almost certainly a majority, if not an overwhelming majority – who do not have the analytical abilities to consider the consequences of every esoteric product Wall Street can dream up, and allowing every instrument to come to market is probably a denial of human experience.
So I would propose, quite simply, to separate the entire financial universe into two groups, the Boring and the Exciting.
Boring Finance
Boring status would be required for any company that:
- accepts retail deposits
- makes loans to retail customers, including mortgages
- provides retail insurance, including annuity products
- provides any custodial service beyond traditional settlement (ie if you hold something after T+3, you’re a custodian)
Since the failure of a Boring institution has negative externalities, the government needs to be involved in the supervision of these institutions. Historically, that has simply meant allowing regulators who demand access to have it. No more of that sort of negative obligation. These are positive actions:
- Boring institutions are licensed for nationwide operation.
- If you are Boring, you may have no non-Boring affiliates under common control. No universal institutions, no prop trading arm. However, a Boring institution may carry a full line of Boring products – deposit, mortgages, and insurance, for example.
- Every product offered for sale by a Boring institution needs to be approved for sale by the Consumer Financial Protection Agency. The CFPA will not regulate fees or rates. It will, however, regulate both the form of any transaction and the marketing claims of that transaction, and its categorization of rates and fees will control. For example, a payday loan with a high fee and moderate rate will have to be advertised at its effective APR.
- Boring institutions are forbidden from making or handling any contingent or delayed obligations except as part of approved insurance policies for which the insured party has an insurable interest. A Boring institution can write a homeowner’s insurance policy or a life insurance policy, but it cannot insure a mortgage portfolio in a manner where the insurance can be separated from ownership of the portfolio or enter into a derivative contract where further performance may be required.
- Boring institutions do not have the right to trade or invest for their own account, except to purchase government securities. Among other things, this forbids buying mortgage-backed securities.
- Maximum national market share in any one line of business (including deposits) is 5%.
- Boring institutions do not have the right to choose their own auditor. Instead, the government will appoint and compensate the auditor, and the institution will pay the government a regulatory fee that covers its market-share percentage of the overall supervisory and audit expense of Boring institutions. The government may use internal auditors (the GAO) or contract with external auditors, and may change auditors at its sole discretion.
- Boring institutions do not set the valuations of their assets or the model that determines this valuation. These valuations are determined by the regulator and auditor based on industry-wide models.
- Boring institutions must maintain a Tier 1 capital ratio of 10%. Any deviation below the 10% barrier will immediately cause a bondholder cramdown into common equity until such time as the Boring institution is either in compliance with the 10% ratio or has run out of risk capital to cram down. If at any point in time the Boring institution is not able to cure its deficiency its license to remain a Boring institution is void and the government may seize all of its assets to discharge its regulated liabilities.
The good news about Boring status is that it is a license to make nice, sleepy money. There is price competition – indeed, that is pretty much the only sort of competition, other than convenience – but given the capital requirements, what is really being marketed is cost of capital, and I would expect some level of harmonization. The bad news is that some of the attributes of an independent company – freedom to advertise your products as you wish, freedom to put forward financial statements without prior restraint – are gone, and replaced with the constant peril of immediate seizure. It isn’t a business model for everyone:
Exciting Finance
For the folks who find Boring institutions a bit too, well, Boring, there is plenty of opportunity at Exciting firms. An Exciting firm can do anything it damn well pleases, except anything that requires a Boring license. So an Exciting firm cannot accept deposits or issue retail loans or insurance. It cannot hold instruments or securities for someone else for longer than three days.
An Exciting firm can be a traditional investment bank, selling its advice, or a modern investment bank underwriting debt and equity transactions. It can be a hedge fund or a private equity fund or a venture capital fund. It can change between these forms at will. It does not need to maintain any specific capital ratio, or any capital at all.
Legend has it that when Cortez reached Veracruz he burned his ships, so that his men would know that retreat was impossible. It’s not exactly true – he scuttled the fleet instead of burning it, was concerned not with retreat but with word getting back to Cuba that he was conquering the mainland, and kept one ship safe to go to Spain for the King’s blessing – but it is instructive.
The key act in separating the Boring from the Exciting is this:
the government, including the Federal Reserve, is legally barred from financially supporting an Exciting firm.
Come Hell or high water, Exciting firms must be allowed to live or die on their own. It is a critical distinction, to be disclosed in every list of risk factors in every annual report or prospectus, to be clearly stated in any contract; the government is prevented from stepping in.
Regulators
We have an alphabet soup of regulatory agencies that deal with finance today, and most of them are a sort of governmental appendix, a vestigal body with no function and the occasional ability to cause life-threatening harm. There are two different facets of a Boring institution that need to be regulated:
- The products it sells;
- The way it operates
Essentially, we are talking Outside and Inside. Outside regulation is the business of the CFPA, or whatever organization already exists and decides it wants to morph into the CFPA. This agency is a clone of the FDA; it exists solely to ensure that products put into the market by Boring institutions are understandable by the laymen to whom they are sold, and perhaps more importantly, do what their issuers think they do. Originally, the agency will be fought tooth and nail by Borings; in time, they will come to love it, as big pharma loves the FDA and airlines miss the Civil Aeronautics Board, for it defines a common set of ground rules. Compliance with CFPA will also serve as an affirmative defense against the occasional class action suit alleging predatory behavior, which should let legal counsels sleep a bit more soundly.
Inside regulation is equivalent to a greatly enlarged FDIC, and since Sheila Blair has all but gone on American Idol in her quest to lobby every live microphone for more FDIC power, she can have it. It will make her as popular as FEMA or the Centers for Disease Control; every quarter companies will complain about marks that were rejected, and should cramdowns begin, you can be sure there will be plenty of please for leniency.
The SEC and other, more peripheral agencies (eg CFTC) can focus on their core, Far Outside roles; virtually all of the products they touch will be traded among Exciting firms, and in that lightly regulated part of the world the rules that create some semblance of trading fairness are generally acceptable.
That leaves the elephant in the room: the Federal Reserve. While I could easily be convinced to give Inside or Outside responsibilities to other agencies, the one agency that cannot get either responsibility is the Fed. Indeed, one of the main goals of reform should be to strip any sort of oversight responsibility from the Fed. That is not to say that the Fed’s files should be deleted or its regulators sent to the gulag; they can easily regroup at Inside and carry on. But the Fed’s sole mission should be currency stability (yes, this means stripping employment targeting as well). Like Paul Volker, I have a difficult time understanding the logic behind a 2% inflation target as opposed to a 0% inflation target, but whatever the target, it needs to be the complete focus of the institution with control over the money supply. It is impossible to focus on this mission if the same agency is also supposed to be focusing on the welfare of financial institutions who may be harmed by policy actions taken in defense of the currency.
Consequences
One of the major goals of this regulatory reform is to firewall the Boring institutions we need to defend from the dynamic world of equity investing. There is nothing wrong with deploying capital to maximum effect, and I support John Meriwether‘s right to come up with yet another harebrained scheme that will look great until it doesn’t.
Where I part company with the Exciting, however, is in its ability to infect the Boring. That is why it is so important that Boring institutions not only behave in a different fashion from the Exciting, but not invest in anything Exciting. The Midwest and Plains are full of sleepy little commercial banks whose managers pay themselves a king’s ransom and turn around and invest their capital in whatever idiotic derivative their Chicago coverage officer pitches. If the derivative issuer fails, not only does he make an Exciting hole in the ground, he also tears through all his Boring funding sources, and that naturally scares the government. So let’s remove that fear.
When we want companies to deploy massive amounts of capital in unproven ventures, we often agree to some sort of cost-plus pricing, where we absorb the risk. It might take $1bn to build a destroyer and it might take $2bn, and so one solution is simply to say spend what it takes, add 25% for yourself, and give me the destroyer. The civilian variant can be found in the power industry: we don’t want the lights to go out, so we tell the utility it can earn a certain return on its capital, so it should go ahead and build to its heart’s content and we will simply adjust rates to balance.
In some sense, the reverse can be accomplished if we do not want innovation. By regulating the form of contracts we make it difficult for Boring institutions to innovate and encourage them to compete on rate of return; essentially, we rent their balance sheets for the clearing price of capital. The innovation is channeled into mechanisms that drive down cost – for example, operating a more efficient (or a virtual) branch network – or improve customer service (First Republic versus the overall Bank of America experience).
Once we can tell people that their deposits and their 401ks are held by well-capitalized institutions, we have the freedom to discipline the Exciting in ways we could not previously. The critical importance of not bailing out financial institutions has been well-noted; unfortunately, we threw up our hands when confronted with the simultaneous meltdown of money market and insurance markets, which had not been predicted in the Official Central Banker Handbook. Now it’s time to profit from the experience that these sorts of panics affect not only Third World countries with opaque, interest-group-driven politics but also First World countries with opaque, interest-group-driven politics. While the Boring institutions will undoubtedly do their best to capture their regulators, at least the regulators will be more constrained in the relief they are able to grant.
The Great Gatsby offers the following observation on human nature:
[w]hile he remained with Cody he was in turn steward, mate, skipper, secretary, and even jailor, for Dan Cody sober knew what lavish things Dan Cody drunk might soon be about…
Now that we know that we are liable to spend forty percent of our GDP in a month of panic, let’s make arrangements in the cold light of day to prevent recurrence of these events. Compared with attempts to change compensation or appeal to our better angels to operate with a conservatism diametrically opposed to the nature of the business, it is eminently more practical. It requires one major breakup and reorganization, but that is hardly unusual on Wall Street; virtually every major financial institution has gone through a transformation at least as large on a voluntary basis (BAC – rollup of Bank of America, NationsBank, Fleet, USTrust, MBNA, Merrill Lynch; JPM – formed from successive mergers of Manufacturers Hanover, Chemical, Chase, JPMorgan, and WaMu; C – merger of Citibank, Travelers, and Salomon; WFC – merger of Wells Fargo and Wachovia; GS – transformed from investment bank to bank holding company).
While we are at it, let’s shut down – or, more accurately, run off – Fannie and Freddie and the FHA. The goal should be to get the industry to internalize the costs of its operations, and we don’t help the process by refusing to take our hands off the scale.
Ultimately, this reform will lead to a better financial sector for all players. Boring institutions will continue to feel the real estate cycle, but as cycles heat up, there will be tremendous pressure from bondholders to tighten requirements lest bonds start getting crammed down. Exciting firms will burn bright and flame out, but when they do, the capital that they take with them will come exclusively from big boys. The market share caps will create some waste in the form of duplicative overhead, but that waste is compensated by making the cost of any failure more digestible by the government.
UPDATE
StatsGuy comments about the overwhelming temptation for the government to intervene in any financial meltdown, regardless the nature of the risk capital, because of the potential for loss of wealth and loss of jobs. I understand that, and as an empirical observation about postwar Western democracies, I agree.
However, it might be instructive to look at the other, literal example of contagion: wildfire. The American West has been subject to wildfire since before man set eyes on it. Settlers up to the past century feared it. Then all of a sudden several things came together: massive population growth, a strong central government, and mechanized firefighting tools. For decades the growing population demanded of its elected officials that they use the wealth of the nation to deploy state of the art firefighting tools.
The decades of fighting every fire, politically satisfying though they were, did not solve the problem of wildfire. Far from it. Without regular pruning by flame, western forests grew denser, and with time came lighting strikes and campfires and arsons that grew into fires so hot that even the tools of modern man were overwhelmed.
Ultimately we needed to make a political decision that we were not going to fight every fire. We would fight some fires, of course, and make every effort to protect human life. But one of the risks of building a subdivision amid isolated dry pines is that it cannot be protected at a reasonable cost, and people need to know going in that they in exchange for more affordable square footage and beautiful views and peaceful nights they have bedded down with a monster.
Memories are selective these days, but if true, this is a staggering quote from the European Central Bank administration of Jean-Claude Trichet:
It never occurred to us that the Americans would let Lehman fail.
Was the ECB unaware that Lehman was a private company? From June 1994 to June 2008, Lehman common stock had gone up ten times. Did Trichet think that it was an 18% government bond?
The reason it is so important to both wall off Exciting firms and abjure the right of intervention is precisely that we have such a history of intervention that only drastic measures have a hope of breaking through.
Terrific post. I’d be happy to see the US financial industry changed in the ways you describe.
(By the way, I know you think you lack readers, but I for one look forward to your posts and almost always find them to be well-written and thoughtful. So thanks!)
Mr Taunter: Since the failure of a Boring institution has negative externalities, the government needs to be involved in the supervision of these institutions. Historically, that has simply meant allowing regulators who demand access to have it. No more of that sort of negative obligation. These are positive actions: [list omitted]
The key act in separating the Boring from the Exciting is this: the government, including the Federal Reserve, is legally barred from financially supporting an Exciting firm. Come Hell or high water, Exciting firms must be allowed to live or die on their own. It is a critical distinction, to be disclosed in every list of risk factors in every annual report or prospectus, to be clearly stated in any contract; the government is prevented from stepping in.
————
Your rules sound OK. But you left out the most imporant part, the punishment for Boring Financial Entities engaging in prohibited conduct, and Financial Regulators bailing out Exciting Financial Entities. The Federal Reserve takes unauthorized actions under the Federal Reserve Act because it does not impose penalties on the regulators for violating it.
If an employee or officer of a Financial Regulator bails out an Exciting Financial Entity knowingly, recklessly, or with gross negligence, I would propose a 10 year prison sentence and joint and several liability for all bailout money. If a Boring Financial Entity engages in prohibited conduct knowingly, recklessly, or with gross negligence, I’d propose a 20 year prison sentence and joint and several liability for the greater of all profits (before executive comp and bonuses) from the prohibited conduct or the bailout money received due to such prohibited conduct.
Additionally, you need the Financial Regulator to offer enough pay and prestige to attract and retain good people to enforce the rules. Or if you have the current bunch, that do half-hearted regulation to get a better job in the private sector, you need to empower plaintiff attorneys to bring civil lawsuits against Financial Entities to enforce the rules for a cut of the profits.
Rules without punishment and enforcement is about as useful as coffee without caffeine. (And don’t forget to respond to my comment re me supporting tarrifs and quotas for the same reasons that Adam Smith did.)
I like boring. Boring is good. When it comes to money, I think many people would like the option of choosing between boring and exiting.
I also like Joe’s idea about punishment too. Some harsh words and a little fine are not enough. I’m thinking treble damages, attorney fees (sexy items for plaintiff attorneys) and jail time depending on the nature of the offense. Sadly, leaving enforcement to our criminal justice system has been pretty weak as late. (Can you say, Scooter Libby?)
Nasty civil remedies have been pretty good at keeping corporations on the straight and narrow.
Jeez, I am going to have to pay serious attention to your thoughts since you are the only person I have seen get 90% of the Cortez strategic story right.
Some added thoughts on that tangent, Cortez’s Indian allies were on the beach so he didn’t need to impress them with his commitment.
However, Cortez does point out that when they get inland to fight the Aztecs, they will have wished they hadn’t of dragged all their boat gear so far, so it doesn’t matter now that the majority of the boats have been scuttled.
The best strategic part was that he offered to let anyone return to Cuba on the small boat that wasn’t scuttled, a bunch of takers on that one, for sure.
It’s as good a plan as many of the alternatives, I would think, and similarly purposed.
However, there is a giant chasm between what is and what should be. As you point out, the incrementalism which is the hallmark of American reform is fundamentally mistaken, but nonetheless pervasive.
We need a plan for implementing reforms as much as we need a plan for reform.
If you have a way to convince government, I’d love to hear it. The Bulow plan was vastly superior to the government’s actual plan, was widely known in the winter/spring, and passed over in favor of simply dumping the Treasury on the problem.
My best idea, weak though it may be, is simply to try to get the right ideas out there now so that the next time something happens people know what to do. Despite seven months from Bear Stearns to Lehman, Paulson was taken completely by surprise by the events of September. Just as the military is expected to have mobilization plans for a variety of contingencies, so should the economic team.
Great post, as always. One assumption is that there are no negative externalities with a systemic collapse of Exciting institutions. You and I have disagreed about this in the past, but if there’s an absolute failure in the Exciting domain, bad things can happen to average people, i.e. negative externality.
I presume that Exciting banks are the ones making corporate loans to regular businesses, developers, manufacturers, et al. If these companies cease to have access to capital, companies go bankrupt and fire employees, who reign in their purchasing of other companies, who then fire their employees. You see where I’m going.
The saying that credit is the lifeblood of capitalism is cliche, but also true. Combined with the inherent leverage that can cause a systemic failure, it’s an industry that needs to be regulated. Boring or Exciting.
PS I do agree that financial institutions that receive inordinate government support should have their capital structures wiped out.
Both Exciting and Boring firms would be able to offer loans to accredited investors. However, as noted in the case of Joe the Plumber, who had difficulty grasping the difference between revenue and taxable income, many small businesses are not accredited investors. The non-AI firms would be limited to CFPA-compliant loans issued by Boring firms.
But back to the shock that blows up the entire Exciting world and cuts off the exotic factoring facilities some retailer is using. Sure, there is a negative effect on the employees, but capital structure failure is an accepted part of any business risk. If the company were able to survive on Boring terms, it could switch over an pull through; if its business model relies on some bespoke financial product, I’m not sure its success can ultimately be separated from that of the financial institution providing its oxygen.
Sadia Foods – until recently Brazil’s largest food company – blew up after its dollar/real bets went massively wrong (it was absorbed by the previous #2, Perdigao). Was it a shame that three generations of work and thousands of employees went down in a few weeks’ insanity? Yes. But that doesn’t free the company from the consequences of its actions. I would say the same thing about a firm that got overextended to an Exciting firm, knowing full well that it was dealing with an Exciting firm and not a Boring firm and grasping for whatever few basis points of advantage the unregulated sector could offer.
Capitalism without bankruptcy is just Communism with better cars.
Mr Taunter,
To limit the political temptation to bail out Exciting Financial Institutions, I would try to restrict their political influence by limiting their size by some metric or other.
I responded to your post re Nashian Equilibrium, by saying you assume a world of abundant resources and rapid technological advancement. And said I assume a world of scarcity and limited technological advancement, as assumed by the 17th century economist Thomas Munn, where a country best advances through hoarding natural resources, intellectual capital, etc, and so, is often well served with protectionist tactics and strategies. China understands this.
[...] a comment » Taunter has a comprehensive proposal about how to regulate financial services, dividing them into Boring and Exciting. Boring services are the [...]
Great post. You do a very good job of presenting complex information without dumbing it down to uselessness.
Great post. Trying to imagine a world without MBSs….
My favorite line is this:
“Now that we know that we are liable to spend forty percent of our GDP in a month of panic, let’s make arrangements in the cold light of day to prevent recurrence of these events.”
Ah yes. Seems a goal that should unite us all.
Want to point out that FDR took the oath of office 4 yrs into the crisis, so perhaps the flames of catastrophe that had burned so long helped him pass transformational legislation so quickly.
Let’s hope we’re not still pondering the course of action we need to take 4 yrs from now.
[Can I just ask - are "bank holding companies" boring or exciting? GS is a bank holding company and yet, according to its leaders, still acting as if nothing happened. (http://blogs.wsj.com/deals/2009/07/14/live-blogging-goldman-sachs-earnings-conference-call/)
And can I ask - how could Paulson, who was CEO of GS at the time when the firm supposedly sold off all its MBSs because they realized how toxic they were - how could such a man be so shocked by and unprepared for the crisis? I loved the VF article on him, but this question is one I wish he'd been asked.]
The GS BHC scam is unbelievable; if Bear Stearns or Lehman had any conception that they could convert to bank holding company status and continue to operate as exactly the same free-wheeling investment banks they were beforehand, they would still be in business today.
As for the Taunter universe, under my rules the corporate form would be irrelevant. If Goldman – or any other firm – wanted Boring status it would need to divest ALL non-Boring activities; that’s the point of barring any and all common control with Exciting firms. And once it had Boring status, it would essentially have the 10% Tier 1 ratio thrust upon it, because the moment it went out of compliance the cramdowns would begin automatically until enough debt had been converted to make the ratio.
To the extent that Goldman – or any other firm – decided to stay Exciting, it would be barred from any Federal intervention: no Federally-backed debt, no good/bad structure, nothing.
[...] Taunter on financial regulation. Take the time to read it – it’s a good blueprint going forward, silo-ing out the core things we need financial industry to do, while allowing innovation at the edges, but in a “you are on your own” fashion. [...]
Wow, unbelievably well argued. And written so the lay person can understand! If only the financial firms didn’t run the government, this could be implemented and would prevent the impending catastrophe.
[...] Baseline Scenario blog draws from another blog which comprehensively proposes how to regulate financial services. I warn you this blog post is very long, technical and American in [...]
The boring/exciting division makes sense. The problem is, once exciting financial institutions get big, the government bails them out. Always and in every country that can. We need smaller financial institutions that the government supervises at various levels, but can allow to fail without bringing the whole system down.
Perhaps I am naive.
However, I would point out that even the crony capitalist Bush/Cheney administration – America’s Suharto – declined to bail out Enron when the Crooked E failed. Enron was a massive company, and in essence it was simply an Exciting firm with a few power assets.
If Boring firms were well-insulated from the Exciting firms – preserving this insulation is why my proposal bars Boring firms from even investing in the securities of Exciting firms – the failure of Exciting firms would only strengthen the Boring firms. Furthermore, the government could justly say that the Exciting firms were only playing with knowledgeable investors’ risk capital and got what they deserved.
I think you are completely right to include certain insurance activities into your scheme.
The problem is you do not really allocate corporate credit to one or the other category: This shows that the difference between boring and exciting is not that clear-cut as you might suggest.
I do believe that at least some kind of regulation should also apply to exciting finance.
By the question, it does seem that I wasn’t clear enough. Here is my answer:
Only Boring institutions can lend to small businesses (non-accredited investors). So all small business loans are CFPA-approved transactions.
Accredited investors that have a corporate form are free to borrow from Boring institutions as well. In this case they receive the same CFPA-approved vanilla deals, and enjoy the soundness of a well-capitalized counterparty and the fact that the government will intervene to maintain the well-capitalized nature of the institution.
Alternative, accredited investors may deal with Exciting firms. The Exciting firms may be able to create more exotic bespoke deals that lower the cost of capital for the corporation. The corporation needs to balance the benefit of receiving a better deal with the cost that if push comes to shove, the government absolutely will not intervene to save the Exciting firm.
Should the corporation decide it wants the extra risk for the better pricing, it has to live with the consequence that things will not work out as planned. Indeed, one of my major objections to the government intervention in the money market fund world last September was that there was always a government-backed option for parking money – the Treasury market. People who invested in money market funds were chasing the higher yield of bank securities; that higher yield was attached to the risk, however remote, that the banks would fail. When the banks failed, that risk should have been borne by the investors.
Good ideas. My primary concern is the desperate temptation to intervene in Exciting Finance when we see the economy tanking, and jobs with it. One of the things we learned from this last round of crisis is that Contagion is hard to stop. If we’re going to commit ourselves via legislation barriers to non-intervention (scuttling the ships), it would be nice to have some assurance that we’re not risking global depression and war.
A secondary concern is the difficulty in sustaining barriers. There’s going to be a differential return between the two types of finance (boring will get a lower return, one might expect), and that’s going to create a strong pressure for arbitrage. And arbitrage means innovation! Someone’s going to create a vehicle that is designed to evade the regulation – consider how triple leveraged ETFs that are bought/sold like stocks open up leveraged shorting to retail investors. Are we going to have an active/energetic regulator to stop this?
Or consider an even more prevalent form of arbitrage. Money markets, which were supposed to be as safe as cash. Would these be outlawed in Boring companies? In terms of the panic, the seizing of short-term paper markets when money market funds invested in short term lehman paper vaporized was partly what triggered the LIBOR spike and credit seizing. This shock then reverberated through the system. But, arguably, short term lending to stable companies to meet payroll (AIG looked stable… so did others) might be a Boring function.
Very good points. I suppose I have the different perspective that I don’t think we allowed enough contagion; I think AIG should have failed and Goldman and Morgan forced to decide if they genuinely wanted to be BHCs – in which case they would essentially have needed a prepack with their bondholders to get the capital bases – or test their luck rolling over their commercial paper.
Either way, I absolutely agree that Exciting firms are going to attempt synthetic versions of many of the services provided by Boring institutions. Assuming that there continues to be more capital in the unregulated than the regulated sector, these synthetics will probably have cost advantages over the CFPA-approved vanilla offerings from the Borings. I would not stop this, except insofar as I would not allow unaccredited investors access. You place your bets and you take your chances. For what it’s worth, I don’t consider a leveraged ETF (a security with downside limited to the quoted value) to be analogous to direct shorting with leverage (a security with downside limited only by capital adequacy of the investor).
As for the money markets, I think it was a horrendous decision to intervene. Every single money market investor had the option to invest in Treasuries and declined in favor of the higher yield available from short-term financial institution bonds. Every dollar of higher yield was paid in respect of the higher risk of those securities – the small but nonzero risk that one or more of the financial institutions would not survive 90 days. When that rare event happened, it was of paramount importance that the investors lose their investment; what else would be the point of holding short-term Treasuries?
The Serious wing of the Democratic party dismisses moral hazard as blithely as the crony capitalist wing of the Republican party dismisses deficits; a nice concern when things are going well, but the first scruple jettisoned in times of trouble. Both are terribly short-sighted.
[...] my post about regulatory reform, which James Kwak kindly referenced, most of the attention was given over to defining what firms [...]
[...] [...]
[...] that is financial reform makes health care/insurance reform look like taking a nap. Taunter’s proposal would be one way to start, but it’s only one of many — one with obvious holes, no less. [...]
[...] touches on several of the themes I tried to articulate here, and he does a better job explaining the motivations of each of the [...]
[...] lack of resolve in driving down health care costs. The compulsive need to bail out not only the financial system but also the risk capital profiting from the [...]