The Volcker banking plan?

Obama proposes a new banking plan and everyone is commenting for instance here is Simon Johnson.  The plan seems to involve limits on bank size and limits on proprietary trading.  Some time ago I decided not to "chase around" all the different banking plans on tap.  First, it would make me dizzy, and second it is hard to evaluate the plans in their early forms.  But here are some general questions you should ask about any plan:

1. Do its restrictions apply to subsidaries, affiliates, and holding companies in a meaningful way?  Can they apply?

2. How do the restrictions apply to off-balance sheet activities, if at all?  Keep in mind the various lessons about the construction of synthetic asset positions.

3. How will Congressional oversight committees apply and interpret the plan?  This is a big one.

4. Can a financial institution avoid or sidestep the restrictions by changing its status as a commercial bank, legally speaking?

5. If you cap bank size, are the new and smaller banks still "too big to fail" by prevailing standards?

6. How does the proposal treat bank leverage, including implicit forms of leverage through off-balance sheet activities?  Does leverage get redistributed elsewhere?

7. How does it affect the political economy of bank lobbying?

I don't pretend to know the answers to these questions for the new Obama plan nor do I expect such answers to be announced on day one.

Here is my earlier post on "Itty Bitty Banks."

Comments

We do have to reduce leverage for banks and expose their bondholders to risk, rather than saying the institution is too big to fail. And, don't get me wrong, we don't want them to fail.

But, we don't want to implicitly subsidize them either, making them a substitute Fannie Mae by saying they are too big too fail. And, don't forget, these are INTERNATIONAL banks, taking deposits for foreigners and lending to foreigners, so in effect we are subsidizing depositors and creditors in other nations if we do not act to reduce taxpayer exposure.

It would be nice to at least see them enforce the standards in place now. Since BofA is already over the 10%

Jack -

What do you expect a bank to do with all of those earnings if you've capped assets? If they can't reinvest them by acquirnig assets or making more loans (which are assets backed by capital from earnings) then they cannot "grow". They will be forced to do nothing with earnings but retain them in capital or pay them as dividends. You may think that's fine, but I for one don't really want the government telling any company they aren't allowed to make more loans or underwrite more securities because they've reached their cap on assets.

What we really need is a powerful resolution authority that includes wiping out shareholders and unsecured creditors along with a credible threat to use that authority if a bank becomes insolvent. Combine that with good capital requirements that decrease the likelihood of failure and higher FDIC insurance premiums and I think you get a favorable outcome without telling a bank how big it can be.

Tyler,

You can sure that the architects of this plan don't know the answers to your questions either.

@E. Barandarian,

I think you are confusing concentration--share of the market--for size. Finacial services, particularly if you look at international banking as such, is not highly concentrated. Even on the domestic level, banking is not concentrated. And, the players, to achieve the risk diversification claimed in your post to be a source of economy of scale, is doubtful, since banks diversify risk by selling part of it to other banks to include in their portfolios, as a way for them to further diversify their risks. And, as for regulation being the cause of concentration or size, I think there is more evidence of causality going in the other direction, particularly as banks get bigger and pose more systemic risk.

Arnold Kling has pointed out that the "solutions" to a financial crisis often lay the groundwork for the next crisis. For this reason, he compares financial regulation to a game of chess, with moves and counter-moves. There is no possibility of a lasting solution that will "fix the financial system once and for all".

Anyone feeling especially prescient? Answer this one:
     8. How will this plan contribute to creating the next crisis?

In your previous post on Itty Bitty Banks, you made what I consider to be an economic oversimplification in stating that the big banks wouldn't be so big if their products/services were so easily substituted. In reality, banks are largely substitutable. If anything, smaller banks tend to have better rates, better customer service (less bureaucracy to resolve issues), lower wait times, and so on. Where small banks are at a disadvantage, though, they are at a huge disadvantage. First, big banks get bigger by swallowing other banks, so even if someone starts out a customer of a community or regional bank, the become big bank customer through no effort of their own (i.e. Asheville Trust becomes First Union becomes Wachovia becomes Wells Fargo). Second, big banks have a bigger budget to recruit new customers, not only through traditional advertisement, but through aggressive and local promotions. I suspect I am not the only person to sign up for a checking account or credit card in college because of a free t-shirt or gift card. But these two factors both dwarf the other main advantage of big banks, and that is bigger free ATM networks. The "Itty Bitty Bank" I use (only 1 branch so the name really fits) overcomes the ATM hurdle by refunding ATM fees charged to my account, but I don't know how costly or widespread this practice is, but I can't imagine all consumers know about banks that credit back ATM fees. These advantages, as I see it, create a ton of legacy accounts, and frankly most people see it as a hassle to change banks once they are up and running, so the status quo benefits the big banks. How to overcome these advantages, I don't know.

Who knew the evils of deregulation required so much upkeep on the part of government agencies.

How 'bout the audit the Fed plan. Has the economics profession changed its marker on that one at all now that that plan is mature and likely to affect policy if not pass?

I nod agreement with the comments of Yancey Ward and wlu2009. I add my 0.02RMB yuan that Glass Steagall is returning in some form, and that banks will reorganize some risky business and move it offshore.

@wlu2009

As to your other argument: "What are they going to do with all those earnings?" Seriously?

There are two ways for banks to grow earnings: generate higher returns on invested capital, or increase invested capital.

Limiting assets has no impact on the former, only the latter. Most of the "social good" elements we get from banks comes from the "investing smartly in high-return projects" part of earnings growth, rather than the "corporate bloat" component.

A good example of the "corporate bloat" component: Access to the Fed discount window means virtually unlimited "earnings growth" potential, simply from borrowing short-term at 0% and lending to the US government at 3.6% (i.e. higher nominal invested capital at lower ROIC).

As a client of the bank, or a depositor, how does that help me?

Bill, thanks for your comment. As a former professor of Industrial Organization (IO) and a former adviser to defendants in antitrust cases I know that the IO concept of concentration refers to the market share of large enterprises--in other words, size and market share are closely related. In the ongoing discussion on financial intermediation, we can ignore market share and focus only on large intermediaries. The relevant question is why some intermediaries become too big and the standard IO approach is to look at economies of scale and scope. To apply this approach to financial intermediation we need to refer to functions rather than existing types of enterprises since each type combine functions in different ways. Maybe I was not clear enough in my explanation but I did not refer to risk diversification or risk management (of course it is implicit in the function of pooling funds but the risks associated with the other two functions are quite different and depend heavily on how they are performed). My explanation of concentration as a cause of regulation points to specific economies of scale and scope, not to anything related to managing the risks associated with the pooling of funds.
That doesn't deny other reasons for regulating financial intermediation. I'm familiar with most of these other reasons, in particular with the idea of systemic risk. I have never been persuaded that these other reasons justify regulation. I know that in the past 28 years thousands of books and papers have been written about systemic risk but this literature has failed to agree on a concept that could be relevant to a policy discussion. Many commissions tried to deal with systemic risk but they failed to outline a policy that made sense. As bubbles and other concepts that "experts" like to use, systemic risk can only be identified ex post and therefore it has to be addressed ex post by an authority with discretionary power, that is, by firefighters (familiarity with bankruptcy proceedings is important to understand how to deal with the conflicts of interest that inform systemic risk).
There are other approaches to the regulation of financial intermediation. For example, Arnold Kling has rediscovered the political economy approach to regulation, but he has yet to justify a new regulatory system.

Bill, I'd like to know about the experiment you mention in the last paragraph of your comment.
Let me make clear that system risk, as many other concepts, is ex ante you cannot say which particular actions imply a systemic risk. You can say ex post that some actions caused a systemic risk--like people buying houses because they were persuaded that their prices would continue to rise forever--but ex ante none could argue seriously that they could cause a crisis. In the theoretical analysis of crisis it is common to assume sudden changes in behavior but this amounts to assume the result (I always ignore theories that assume that booms and busts driven by animal spirits determine economic performance over time; if I were to believe that these sudden changes in behavior are critical, I'd study human behavior in depth to understand why they may happen and how psychologists could help).

@e.Barandiaran, The natural experiment was the Lehman bankruptcy and its aftermath. The book you would want to read is Sorkin's, Too Big to Fail.

As to ex ante risk , I would not argue that holding CDOs of bad mortgages "none could argue seriously that they could cause a crisis." Well, there wasn't a willing buyer for those holding those assets, some, such as Goldman evidently thought they were risky and hedge, but in the end, there were no banks who would lend to each other--other than, sadly, the lender of last resort. Guess who that is.

Now, I don't care to be a lender of last resort, particularly to institutions who, because they are too big to fail, do not fully bear the risk (nor do their bondholders).

One of the previous posters would argue we can credibly commit to break them up and unwind them . We can also, if we play the game of chicken, credibly commit to go forward into the oncoming vehicle. No one does. The credible committment is incredible.

IMHO, the size issues and credit swaps and securitization are all primarily caused by regulation and the high barrier to entry and innovation in the industry.

The difficulty of starting a bank and then continuing one under the massive regulatory regime they face is incredible. That's why banks mostly get bigger and not smaller. There is no one to come and do something different to take their market share, because the regulators leave very little room for "different". The reason we have systemic risk in the industry is that the system is a designed one that the regulators make into an environment where only one path exists to profits and growth.

It's not a coincidence that all the big players were using securitization and swaps the way they were. It was created as the most competitive solution by the regulators.

In the interests of full disclosure, my "day job" is for one of the world's largest banks, although my opinion doesn't represent theirs, so I'll just go back to watching the regulators design the next method of financial system failure.

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