What to do

Megan McArdle ponders.  I’ll again mention one suggestion: make sure that financial institutions cannot use off-balance sheet activity to escape standard capital requirements.  Many people asked about this in the comments but my view is simple:

1. As long as the Fed and Treasury are providing a safety net, insisting on capital requirements is entirely reasonable and it lowers moral hazard.  If you’re going to bail out your friend in a poker game, you can ask him not to bet too much beyond his chips.

2. When the "shadow banking system" does not have capital requirements, normal financial activities, as regulated by the Fed, are inefficiently taxed and too much of an economy’s leverage ends up in the unregulated shadow banking sector. 

3. If you are anti-regulation on this issue, make the capital requirement relatively low but still impose it symmetrically across financial sectors.

4. Ideally capital requirements should be adjusted for risk.  That probably implies higher capital requirements for shadow banking activity, not lower requirements.

5. Regulatory issues aside, market participants are less sure of themselves in the shadow banking sector.  Derivatives are non-transparent, for a start.  That’s another reason not to push too much financial activity into the shadow banking sector.

6. A final solution to excess risk-taking and leverage has to come from shareholders; regulation can only do so much and of course capital requirements are only a small part of regulation.  But in the meantime I think the case for more symmetric capital requirements is a strong one, recognizing all the usual comments about horses and barn doors, etc.


make sure that financial institutions cannot use off-balance sheet activity to escape standard capital requirements.

One question I have is why this sentence doesn't end with the word "activity." We seem often to find the phrase, "off-balance sheet" somewhere in the rubble of financial disasters. Maybe that merits attention.

I agree with Bernard. Hiding liabilities by taking them off the balance sheet seems to fundamentally invalidate the reasons for having public financial statements, audits, analysis, and everything else that valuations are based on. It's always struck me as a bit of a shell game.

In a libertarian world, shareholders would demand to know what management is hiding from them, but that seems to be the real underlying problem: a lack of shareholder advocacy on boards and committees. Too many boards are held captive by secretive and imperialist CEOs.

"In a libertarian world, shareholders would demand to know what management is hiding from them..."

In a libertarian world there would be more diversity in how firms are incorporated and run, but there is no silver bullet. The costs and difficulties of shareholder management do not go away. So although innovation would likely improve things in many ways, it won't eliminate all Enrons, Bear Stearns, Countrywide, etc.

"If you're going to bail out your friend in a poker game, you can ask him not to bet too much beyond his chips."

First, I'd tell my friends that they should be investing, not gambling.

Second, these people aren't my friends. I agree with John Kunze. It was the job of the risk assessors to assess risk and they couldn't even do it. How is the Fed or, god forbid, Congress going to set these prior restraint limits a priori.

We take our shots and suffer the losses when we lose. Not these guys. As I said, these people aren't my friends, anyway. They are my enemy, in the financial sense. Most of these financial products are superfluous at best. They can't add value, so they come up with new risky scams and call it financial innovation. Every few years, they blow up, the Fed bails them out, debases my hard-earned, value-added money.

The only financial product I need is improved corporate records that help get to the truth of what companies are doing and help me interpret it so I can better allocate my capital to individual companies. This would also help with governance.

Their financial innovations crowd out the real work of finance. Rational capital allocation. Friends, hmmph.

People fall back on the notion that if the system were allowed to collapse, everybody would be hurting. I think the pain would be short, like taking out a splinter.

Doug Colkitt notes "the "shadow banking system" ie financial institutions outside the Fed purview basically include hedge funds, sovereign wealth funds, individual investors and private equity have all fared much better than the highly regulated banks."

Maybe. Maybe not. Risky investments will tend to look better than safer investments -- unless they crash.

How well have the sovereign wealth funds' investment in financial institutions in the last year done so far?

It seems likely to me that in a "libertarian world" the banking system would be unrecognizable to us. The ills of credit expansion (and collapse) would be internalized by the banks and individuals who chose to use a certain currency. The entire system would likely be far more complex, and I doubt anyone would be able to understand it in full any more than anyone can comprehend the IT industry now. But we aren't going to live in a libertarian financial world any time in the foreseeable future.

Some new legislation is going to come out of this fiasco. Given that our banking system seems to largely be centrally-planned, what I'm wondering is if the new legislation will be better than the old?

"Banks are regulated because rent-seeking through credit expansion results in an unstable financial system."

With stability like this, who needs rollercoasters? Instability, inflation, recession, regulation AND bailouts all at the same time. Is there anything else bad we could throw in just for kicks?

I think banks are regulated because they are under the protection racket of the Fed, just like Tyler says. And they want to be able to multiply the money supply. And they can make acceptable profits on lower interest rates than someone can lending only what's in reserve, crowding out responsible financing.

Some of the issues regarding capital requirements for off-balance-sheet deals are influenced by the company's optional response. Some businesses that set up the Structured Investment Vehicles did not have a legal obligation to support the instruments, but felt either a moral obligation or a long-run interest in doing so. Should that imply a capital requirement?

Consider a non-financial case that is essentially the same. A car company sells a car with a three year warranty. Their balance sheet reflects a liability for warranty costs. The car company builds a car that has a major failing on many cars at 3.5 years of age. The company has no legal obligation, but may feel a moral or business obligation to go beyond its warranty. Should their books have reflected this additional liability? Should the books of all companies reflect liabilities for service that the company never anticipated, but may at some point, under some unforseen circumstances, feel obligated to pay?

More importantly, can I deduct on my taxes the cost of funding an unspecified reserve for future non-legal liabilities I might want to pay? (My CPA says "no" but I don't think he's aggressive enough.)

Doesn't off-balance-sheet activity render things less transparent and lead to less efficient markets?

Why would that be good?

I'm not sure the off balance sheet issue and the knowledge issue are unrelated.
If management can't know the risks of these financial instruments (and if there are computational limits to the ability to assess risk) then maybe the safest choice is regulating the leverage-to-capital ratio. Correct me if I'm wrong, but it seems that some of the loss of trust associated with the liquidity crisis would be fixed if investors could count on something like a reserve requirement for credit.

Very few (if any) triple-A rated mortgage-backed securities have actually defaulted. The problem is that the rating agencies downgraded so many of these securities from triple-A to junk so quickly that the market lost confidence in the ratings and the market for these products was so thin, and the understanding of their respective cash-flows so low, that it sparked a liquidity crisis. The mark-to-market accounting "problem" is really just a symptom. U.S. GAAP mark-to-market accounting allows companies in illiquid situations to use the underlying cash flow of the securities to derive a valuation ("mark-to-model"). However, the supposedly sophisticated investors buying these products were relying entirely on secondary market valuations and did not have the systems in place to model the underlying cash-flows of these complex securities. Consequently, when the market disappeared, they were left high-and-dry and are now complaining that mark-to-market accounting is requiring them to account for these securities "far below economic value" -- which, of course, begs the question of how they know the economic value of the security and why they don't justify whatever model they are using to "know" this information as U.S. GAAP allows. As Warren Buffett once said, never invest in a business you cannot understand.

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