More from Edward Conard, on proprietary trading

Rather than demanding an end to default-prone subprime lending funded with hair-triggered short-term debt, bank critics have, ironically, demanded an end to proprietary trading, which they view as unnecessarily risky, but which was inconsequential to the cause of the Crisis.  In a world where banks underwrite and trade risk, what constitutes proprietary trading?  When a bank takes credit-default risk by making aloan, is it taking proprietary risk?  It is, without a doubt.  But loaning money is what banks do.  When a bank like Goldman Sachs seeks to unwind that risk by shorting mortgages prior to the downturn, is that proprietary trading?  Yes.  So is borrowing short and lending long.  With banks now primarily underwriting, pricing, and trading risk rather than merely funding loans, restrictions on proprietary trading unnecessarily imperil banks and distort capital markets to restrict banks to only the long side of the trade.  restricting banks to long-only positions substantially increases withdrawals in the event of a panic.

I would stress that the real problems come when the overwhelming majority of banks go heavily long on some fairly simple assets — usually real estate — in an overly optimistic way.  Think Ireland, Iceland and the United States during the last crisis, among many other instances.  Once the short-term debt behind those banks starts to unravel, all hell breaks loose and the central bank can at best limit but not stop the carnage.  That is the main problem financial regulation should be trying to address and it isn’t easy.

I am much less worried about “rogue trades” or “rogue investments” at individual banks (or non-banks), even very large ones.  Such trades surely exist: think LTCM or even Continental Illinois.  Ex post, there is usually a way to plug the gap, if only by having the Fed backstop a deal.  After all, the rest of the banking system is sound in these scenarios.  Prop trading may increase the chance of this second problem, but arguably it decreases the chance of the first and larger problem.

You can buy Conard’s stimulating book, Unintended Consequences, here.  Conard, by the way, does object to how the government implicitly subsidizes the short-term debt of the major U.S. banks and he views that as the root of the problem behind proprietary trading, not the trading itself.


"bank critics have, ironically, demanded an end to proprietary trading"

Such as who?

This appears to be a strawman. I have seen lots of critics directing attention toward excessive leverage, too many assets being traded OTC instead of on exchanges, compensation schemes that reward short-term marked to market profits rather than long-term contributions to enterprise value, the agency problems that arise with publicly traded corporations engaging in proprietary trading and other such issues. I have seen very few informed critics demand an end to proprietary trading.

Watch the news much? It's called the Volcker Rule.

The Volcker Rule applies to deposit-taking institutions but not investment banks. And we already have a way to mitigate "panics" on deposit-taking institutions: it's called deposit insurance.

For non-deposit-taking investment banks, the critics have tended to focus on exactly the areas I highlighted above.

Ricardo, there is rarely (and since 2008, essentially not) a physical divide between a deposit-taking institution and an investment bank: they are one and the same. JP Morgan does private banking as well as investment banking. The department at the centre of the recent news -- the CIO -- was charged with dealing with "excess" deposits. From the outside, it looks like the CIO then used those funds (and their correspondingly low internal cost) to place directional bets (initially to hedge other positions at JPM, but ultimately not) which, operationally, seem broadly equivalent to prop trading, although they would probably have been Volcker-rule compliant.

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Well, such as Paul Volker but I suppose it's wrong to think of him as informed.
'Volcker himself stated that he would have preferred a simpler set of rules: “I’d write a much simpler bill. I’d love to see a four-page bill that bans proprietary trading and makes the board and chief executive responsible for compliance."'

Because you're so much better informed?

Any particular experience with sarcasm, HA!? If not, welcome... HA!

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"Volker Rule: it's OK to play with yourself, but only if you think about Rosie O'Donnell, not OK if you think about Angelina Jolie." Isn't all trading about selling for more than you buy? Seems that regulation that tries to discern the underlying motivation is a tad complicated, and ridiculously difficult to enforce.

Isn’t all trading about selling for more than you buy?

Technically yes, but in a short-sale situation you can sell more than you own. Losses are potentially infinite, though bankruptcy steps in first.

Without direct experience, I'm guessing that there are other derivatives out there that are even more explosive.

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If by "strawman" you mean the "stated standard view in the dem party", you would be right!

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As a layman, what is "hair-triggered short-term debt"?

I don't understand the hair-trigger part.

Imagine that at the end of every day you go to the bank. You have bought and sold a large number of financial instruments of various sorts. You have some assets. What you did during that day was possible due to the financing that you got the evening before. You show the banker what you bought, what you sold, your assets. He then finances your operations for tomorrow.

Something happens in the market, a portion of your assets are now worth 85 cents on the dollar. The next evening the banker declines to finance you, there aren't enough assets to cover the liability.

Today you are operating, the financial system looks functional. Tomorrow you are bankrupt and we see the cascade effects of other firms having to scramble when they can't get their financing at the end of the day.

The Fed steps in, writes a very large check, and it all gets back to normal. A short time elapses, everyone forgets that bad day.

I see. Thanks.

So, that seems like a generic argument against all sorts of short term loans. So long as a loan is re-negotiated often, the creditor is going to re-evaluate his financing decisions often too. And that will be based on the creditors perceived status of debtors financials.

Should this be a general argument against all short-term loan arrangements?

Except that these short term loans are technically collateralized derivatives and therefore, should you unfortunately find yourself unable or unwilling to honor your obligations, your collateral can be appropriated by the lender (counterparty) without going through the bankruptcy court.

This might seem like a small difference, but it probably is enough to explain a large part of the volatility of security issued by stressed financial instruments.

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All checking accounts and small savings accounts make up core deposits. These balances stay fairly stable and, even when rates are rising, banks relying on customer loyalty won't have to reprice their liabilities upward as fast as they reprice their assets.

Low interest rates and a flat yield curve are compressing bank net interest margin right now. When interest rates begin to rise, the spread will rise and so will profits. This is why banks are not eager to lend right now.

During the boom, competition between lenders put a cap on loan rates and, over enough time, savings rates rose to competitive levels. So bank margins were getting thinner. Also, they relied on non-core deposits such as brokered deposits that were very high cost. By the height of the boom, they were picking up pennies in front of the steam roller.

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If it's not merely redundant (hair-trigger could just be echoing short-term), it might be referring to early default provisions (such as failure to provide collateral on a daily basis) in the short-term funding arrangements (i.e., repos). When take out a loan to buy a house which is secured by the value of the house, you aren't required to post additional collateral when the value of the houes declines below the loan amount. You also aren't required to post additional collateral to the lender if you lose your job or otherwise suffer a decline in your creditworthiness. You are in repos, securities lending and deriviatives transactions. The failure to post collateral would trigger a default and early termnation of the loans (and possibly, cross-default to all other loans).

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So called hot money would consist primarily of brokered deposits and FHLB advances. Brokered deposits can flee for higher yield. FHLB advances can have call options. Deposits that are higher than the insured limit are also subject to a quick departure at the first sign of trouble.

These are high cost sources of funding, and have a relatively high runoff rate when rates rise.

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When a bank takes credit-default risk by making aloan, is it taking proprietary risk? It is, without a doubt. But loaning money is what banks do. When a bank like Goldman Sachs seeks to unwind that risk by shorting mortgages prior to the downturn, is that proprietary trading? Yes. So is borrowing short and lending long.

This is exactly as I have been saying, over and over again, for at least a year and a half. I am glad to see the meme finally getting out there to a more mainstream audience. Where has everyone been? Why have I felt so lonely while being barraged with endless diatribes against banks 'taking risk with their own money [sic]' which seem oblivious to the fact that (a) there's no 'their own money' and (b) taking risk is what banks do?

Well, better late than never.


[“bank critics have, ironically, demanded an end to proprietary trading”] Such as who?

Such as Paul Volcker, and every single person who favors the 'Volcker Rule' (to name some econ Internet-commentator examples off the top of my head: Paul Krugman, Barry Ritholtz, Simon Johnson, James Kwak...)

I read most of these people as advocating restrictions on FDIC-insured institutions and too big to fail institutions like the largest investment banks. I do not read them as advocating a blanket ban on propriety trading.

Please see Jonathan's link to 'Volcker Rule' above.

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You'd be a lot better off talking about the various exceptions to proprietary trading built into the Volcker Rule that makes the author's statements overinclusive than seemingly to deny that there is a Volcker Rule and that it applies to banks, which is what the author is talking about. The fact that people also talk about other controls on banks doesn't somehow make their support of the Volcker Rule any less real.

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Well, you are, at least, starting to back away from your comment above.

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Gee, since almost every bank in America is FDIC insured and the IBs are SIFIs, you are pretty much talking about every financial institution.

Who is proposing a proprietary trading ban? Just about everyone who calls themselves a Democrat and most libertarians.

Any trade done for profit they call "proprietary." Any trade that looks proprietary but isn't is called a "loophole."

Doesn't FDIC only insure deposits and those too only upto a certain cap?

Is it right to think of the FDIC model as "insuring every bank in America"? For all American banks, what is the ratio of FDIC-insured and non-insured instruments?

Yes, the FDIC insures deposits (up to a certain amount) at depository institutions, but the Volcker Rule applies to entities, not to the portion of their assets that constitutes deposits. Ricardo was speaking as if the Volcker Rule applies only to a subset of banks, when it pretty much applies to every bank in the US.

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"Doesn’t FDIC only insure deposits and those too only upto a certain cap?"
The deposits can and are maneuvered so that when you go above the cap, it flows into a separate account seamlessly. In reality, every single dollar is insured in deposits and money market funds.

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There is currently no cap on non-interest bearing transaction accounts.

The cap is $250,000 on individual accounts, and $250,000 for each co-owner on joint accounts at the SAME INSTITUTION (discrete account categories). But if you spread your money out at different banks (not branches of the same bank), you can have every dollar insured.

I can't tell you off hand how many banks do not have deposit insurance, but there are some. I can't tell you off hand the total amount of deposits that are uninsured.

No, uninsured dollars do not seamlessly flow into insured accounts. If you have a deposit broker, that might be part of his job, but if you don't have a broker then it's entirely your job. If you have $250,000 in a savings account, you will be over the limit at your next interest payment. Only the balance above the insurance limit is in jeopardy, and the FDIC has a practice of making depositors whole whenever they can.

And no, Money Market Mutual Funds are not at all insured by the FDIC. Money Market Deposit Accounts are insured. These are different things.

The risk of deposits above the insured amount is that if you begin to have trouble, those deposits can disappear quickly.

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Could we think of being subject to the Volker Rule the price a bank pays for the privilege of availing of FDIC insurance?

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Banks already pay for the insurance (well, really depositors pay for it, but since they are the beneficiaries, it seems fair); the FDIC charges a premium, although I have heard that it is not sufficient to cover aggregate losses. Blocking or significantly limiting proprietary trading may, in the mean instance, impose additional risk-- and thus cost-- on depositors by making bank failure more likely, but I will admit that is the $64 billion question.

Too many people act like bank regulation will hurt big, bad bankers, when the biggest cost-bearer is ordinary schmucks like me.

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Meanwhile, re: this

I would stress that the real problems come when the overwhelming majority of banks go heavily long on some fairly simple assets — usually real estate — in an overly optimistic way. [...] That is the main problem financial regulation should be trying to address and it isn’t easy.

Indeed. But it's worth pointing out that a phenomenon such as banks going massively long some simple asset doesn't happen just cuz they all got simultaneously, exogenously 'optimistic'. It is usually an artifact of misguided government regulation and policy. For example risk-weightings encouraged the pile-in to (and synthetic creation of) AAA assets. We see an effect like this now on government debt. Etc. You are correct to cite this as the real problem but don't address the possibility that it is largely being caused by, not mitigated by, regulation.

Oh, for the love... It's "usually" caused by government regulation? How about proving it is instead of relying on the same vague platitudes and acting as if they are somehow brilliant insights?

Those are brilliant insights from someone who understands how banks operate.

When you've got GSEs called Fannie and Freddie who buy all your loans, other GSEs called FHLBs that lend you funds and give grants for affordable housing, government agencies like FHA and VA guaranteeing loans, government mandates for affordable housing in every development, mortgage interest deductions, artificially low interest rates for four years, government insured short run funding, and government coordinated risk weighting of capital ratios that provide incentives to buy MBS, and large dollar foreign exchange reserves from trade deficits, then you have a recipe for a housing crisis. Then throw in lax regulatory standards and there are no controls.

Is that enough evidence for you?

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I mentioned some dynamics that contribute to (what Tyler thinks are) 'the real problems'. Do you disagree with the examples/dynamics I gave?

You're right those, I didn't 'prove' a full-on thesis along those lines, here in this comment space. Nor do I think they are 'brilliant' insights: I think they are obvious ones. But that does make me wonder - since they are so obvious - why they do not get more mention?

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Sure, the world would be a better place with a completely free financial system, without the quasi-private fed having a monopoly to create legal tender; and without massive distortion of the short term (and these days) long term rates markets by essentially quasi-government or government interference in those markets, and having a sufficiently tiny federal government which does not issue much debt (which would also kill off the repo market in the current form for want of collateral, to my mind that's a good thing because what would replace it would be something more organic); where the treasury department does not come in and rescue large politically connected financial (and automotive/financial and appliance/financial) players; and where the government arm twist regulatory organizations to stop applying mark to market to prevent the recognition of insolvency.

There is a reasonable ground to believe that the government will not leave the financial sector to live or die as it might. The power obtained by this interference is considerable. If you assume that the government will not stop interfering in this fashion, volcker rule, awful as it is, might still be the best alternative.

You would be right in saying that there is not much way to distinguish between prop trading and market making in illiquid securities; but if the government will not or cannot credibly signal the end of financial rescues of failed firms, such transparently political ploys might be the only way to go forward.

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Well here we are again. Blind men describing the elephant. The worst problem is banks that are too big and systematically important. No one has addressed this issue. Solve this and no one will care what bets the banks make.

BS. The only large CB/IB that got into big trouble was Citigroup.

Wachovia, IndyMac, Countrywide, and WaMu were the largest CB failures that I recall. The remaining hundreds of failures were all SMALL banks.

BOA, JPM, Wells had TARP shoved onto them to hide the problems at Citi. Otherwise, the largest banks got through this fairly well. Some large regional banks had problems, but those aren't on your radar and wouldn't be called TBTF.

A couple of hundred 25 million dollar banks failing doesn't cause the problem that a failing 50 billion dollar bank does. And until the Fed is audited we don't know that BOA, JPM,etc weren't not also vulnerable. Also they got indirect bailout because AIG was bailed out so it could pay out money to them.

I don't know where or how you come up with that assertion. WaMu was a $300 billion failure and only touched off a silent run on Wachovia. IndyMac was only $37 billion and they had a small run.

What does "auditing the Fed" have to do with BOA and JPM? An audit of the Fed would check its financial statements. The condition of the banks they regulate wouldn't be part of any such audit. The FFIEC is probably well aware of BOA and JPM condition, and you can look up their financial statements going back in time on the FFIEC website.

I’m off by over an order of magnitude of size of the largest banks. The point remains that the smaller banks don’t pose the systematic risks of the biggest banks. During the Savings and Loans crisis, hundreds of S&Ls were closed and the Resolution Trust Company was formed to handle the liquidation but there wasn’t the fear that the financial system would seize up.

Whether or not the 5 largest banks were actually in trouble in this crisis if their failure would cause the financial system to seize up and they don’t provide an associated benefit for the risk they shouldn’t exist.

As for auditing the Fed, the idea is whether they have effectively backstopped some assets that would normally be marked lower. There might be better ways to examine the banks conditions. The Fed did loan BOA 78 Billion dollars at low interest rates excluding TARP although it is claimed that it has been paid back.

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Willetts, I agree that TBTF might not be "the worst problem" but I think most of the big banks were in "big trouble" in the sense that they were dependent on the bail outs of their counter-parties.

I also want to make another point on a topic we discussed on yesterday's Conard post. We had a debate about whether or not someone needs to have worked on Wall Street to make a worthwhile contribution to a discussion about regulating Wall Street.

Tyler made the point in his original Conard post that some of the book's observations were "brilliant" and others were "dead wrong." Why do you think that is?

I would submit that while working on the inside does provide you much information outsiders won't have (I have read Hayek) it also tends to immerse you in the assumptions and habits of the industry blinding you to some things outsiders could see more clearly. This is why corporations need outside directors. This is also why CEO's often like to fill those spots with athletes and celebrities and cronies who won't challenge them.

I assume you have read the Michael Lewis book "The Big Short." He points out that none of the people who first saw the housing bubble the most clearly, and with the most conviction, were specialists in housing. The insiders had been blinded by existing assumptions and practices.

Yesterday you said I was ignorant about much of this and that you did not mean it as an insult. I did not take it as an insult because I knew that it was true and I had seen no mean spiritedness in any of your comments. A lot of what I know about this stuff comes from running my own (non-financial) business for 35 years and investing for myself for that entire time. I also invest money for three other family members. Almost everything I have learned has come from my mistakes not my successes.

I always read Marginal Revolution because I know I will find here the best arguments against many positions I might be inclined to hold. And because Tyler is a fiercely independent thinker who never merely parrots the day's talking points.

Being on the outside is a disadvantage in some ways and an advantage in others. Everyone needs to be in this conversation and there are plenty of dumb ideas coming from both insiders and outsiders.

One final point: Insiders who profit from existing arrangements have an inherent conflict of interest in proposing or opposing specific reforms. That is another good reason to also have outsiders in the conversation.

Glad you didn't take it as an insult cause none was intended.

I didn't agree absolutely with his statement, but rather suggested that knowledge of financial instruments as well as insider knowledge and experience is almost essential to understanding what happened.

I welcomed your comments. As I said, I've never worked on Wall Street either. I don't have the chops for it.

Can insiders be blinded by biases? Of course they can. It didn't take an expert in finance to know there was overbuilding in housing. You just had to have eyes.

I was referring more to policy making. Restrictions on financial transactions are a task best left to experts in the field. Some experts are subject to regulatory capture as are inside experts testifying in their own interests. But speech pathology majors aren't likely to have anything knowledgeable or relevant to say, even if they are elected to the US Senate.

Having your own non-financial company is commendable. The vast majority ofy private banking clients are small business owners. I respect all of you. The horse sense of running a small business can be transferrable knowledge, but financials don't operate like other businesses. Like insurance companies, banks are risk aggregators and diffusers. It's risky business, and even prudent professionals make strategic and tactical errors that regulation won't necessarily catch and they can't see until after the fact.

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BoA needed the money, too, but since the Feds forced them to go through with the purchase of Merrill Lynch, I always thought of that as compensation for taking on ML.

They bought Countrywide too, and paid a hefty price afterward.

I'm not sure TARP was welcomed by BOA. It came with too many strings attached. In hindsight, they didn't need the additional capital after all.

I'm not in the know, but I believe all the large banks were forced to take TARP to provide cover for the banks which needed TARP. Otherwise, it would have sent a dangerous market signal.

If Citi were the only large bank that got TARP, there would have been a monstrous run. I do find credence in your suggestion that there were rewards doled out for cleaning up the mess of Merrill Lynch, Countrywide, Wachovia, and others. Frankly, I give the government great credit for managing the fiasco and great blame for causing it. It never should have happened, but it could have been much worse.

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@Willitts - How quickly we forget.

Lehman Brothers went bankrupt. $600billion.
Bear Stearns would have gone bankrupt but for a fire sale to JPMorgan. $350billion.

I don't know if we will ever know how shaky the others had become.

Then Goldman and Morgan became investment banks so that they could take loans from the Government. The bail out of AIG passed billions to Goldman. And Freddie and Fannie were used to buy lots of toxic assets from the troubled banks.

And Fannie and Freddie went belly up.

I didn't forget anything. I just don't buy "the sky was falling" argument.

I'm not trying to argue that there wasn't a crisis and that things didn't get bad. I'm just saying that the largest banks weathered the storm rather well. Indeed, if they were to collapse it could have taken the banking system with them. I don't think the danger was that high, and TARP helped maintain confidence.

I did not support TARP at the time, but if I were the Treasury Secretary, I think I would have a hard time with a "do nothing and see what happens" strategy. Taking action was the less risky move then trying to pick up the pieces afterward.

T'would have been better not to get into the trap in the first place but wherever you go, there you are.

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Small banks are also systematically important if they fail en masse like during the Great Depression.

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More on banks from :

"The dollar amounts are staggering. Andrew Haldane of the Bank of England has calculated that the five largest global banks alone receive an economic subsidy of nearly $60 billion per year from implicit government support. For the full set of global banks, the figure runs into the hundreds of billions of dollars a year. And these subsidies aren’t limited to “too big to fail” firms. They flow to other parts of the financial sector, including hedge funds, through obscure channels. This state of affairs is economically wasteful—and it isn’t fair. Indeed, to state the obvious, it isn’t capitalism."

"five largest global banks alone receive an economic subsidy of nearly $60 billion per year" - that does not seem too high. The US Farm lobby gets about $25 B to $30B a year in direct subsidy, and though that's bad, nobody is having a fit over it. I believe the bigger problem is "moral hazard" which creates perverse incentives when banks or institutions know they are "too big to fail". The solution: abolish all FDIC insurance. Caveat emptor should be the rule. (And abolish the Fed...long term, but that's another matter. And return to the gold standard. And balance the Fed govt. And get all government spending to less than 10% of GDP, pre-1920s style. Leaving soapbox now...)

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Nobody needs to ban or regulate anything. The solution is simple.

Make clear to every person on every board of directors of every bank and every C-suite officer that the government will not backstop their activities. They can either rein in the risk and act as responsible stewards of the moneys entrusted them or should the whole enterprise go belly-up, every last cent earned for as long as that member has had involvement in said bank will be clawed back, in treble.

Yeah, the world is filled with "simple" solutions that just haven't been implemented because nobody take the advice of the "smart" people commenting on blogs.

First of all, in most banks the board members have a sizeable ownership stake in the firm. Second, if Board members had such large exposure to risk, nobody would serve on bank boards or in management except people too stupid to realize the risk they were taking.

So that's who you want running banks? You'd end up with people running banks who truly have nothing to lose.

Are you so naive as to believe that all bank failures are caused by management errors or reckless risk taking? Do you realize that 75% of small businesses fail in their first three years?

I wouldn't work in any job that could take three years of my salary for every year I worked there if it went belly up. This is why we have bankruptcy laws and LLCs. Risk taking is a fundamental concept of entrepreneurship.

Investment banking isn't entrepreneurship, Einstein.

If you can't put your money where your mouth is, you really don't belong in the big leagues to begin with.

Investment banks FUND entrepreneurs, Einstein.

You don't get it - NOBODY would take that job unless they had nothing to lose. The best CEO's would work for non-financial corporations, and Boards would be filled with incompetent people if they could fill a Board at all.

Bank CEOs more than earn their pay. You have no idea what skills it takes to run a large bank. You have no idea how difficult the task of identifying, monitoring, and managing risk at an enterprise level really is.

You are all mouth, no money, and short of meaningful insights.

"The best CEO’s would work for non-financial corporations,"

To a lot of people, that may not be a bad outcome at all............

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By the way, who do you want running banks - the same people who created this mess and are still gainfully employed?

That sounds like a winning strategy. The lesson learned from the 2008 meltdown if you're an IB C-suite exec or board member other than Dick Fuld: nothing to see here. Keep on keepin' on.

Clearly IB execs' incentives are not properly structured. The formula of paying some stuffed shirt tens of millions per year for whatever result occurs isn't working out the way you might have imagined.

To your last point: true, not *all* bank failures are created by management errors or reckless risk taking. Most are though.

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To say (as Tyler does, above) that banking regulation “isn’t easy” is a ridiculous understatement. Government deposit insurance creates such moral hazard that banking regulation adequate to prevent crises is *impossible*.

Geez, you don't know what you're talking about.

Banks got into trouble when they used NON-CORE deposits, described in the quote above as 'hair trigger'. It wasn't the insured nature that made these deposits risky, but rather how quickly they could leave or reprice in a rising rate environment.

There's little evidence to suggest that deposit insurance created a degree of moral hazard such that it touched off a crisis. In fact, deposit insurance demonstrated the key purpose if having it: to prevent bank runs which cause a liquidity crisis.

This is not to say that government regulatory failures didn't play a role. One such failure was regulatory arbitrage such as getting a thrift charter or using MBS for capital requirements. Regulators allowing loan concentrations to grow so large with non-core funding was another problem.

Associated with insurance is the maintenance of capital ratios. That saved a lot of banks from failure. The FDIC also did a superb job of finding buyers for failing banks. The OTS appears to have been the weakest link in the regulatory scheme.

You need to do some reading about core and non-core funding.

You do realize that since about the mid 80s the 'core funding' of most banks has been the whole sale market via repos? And it was the failure of the repo market in 08 that was the immediate cause of the crisis. The reason guys like Bernanke or Paulson didnt understand this was the same reason most people dont understand how a tiny aspect of the mortgage market could bring down the system via failure. Its not because everyone depended for funding on CDO's full of 'AAA' stuff that was toxic. Rather, it was the fact that once 'AAA' was actually meaningless no bank would trust any other banks' description of collateral, which means that no one could post repo margin, which meant the whole sale side of banking froze up and that was that. That and the 40 to 1 leverage the big broker dealers were allowed to go up to thanks to the marvel of 'financial innovation' [which if we are at our most charitable was about the ability to do more actions with less underlying capital support].

Anyway its not particular surprising that Cowen is lining up behind a guy like Conard who seems to understand very little about the crisis. After all, in 07 he thought criticism of sub prime lending standards was 'elitist' and 'undemocratic.'

I'm sure Bernanke and Paulson understood how bank funding works and why it broke down in 2008. I knew it, everyone in the industry knew it. It's one thing to understand why things broke down... it's another to try to get it working again.

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Geez, your misinformation is blinding. Wholesale funding is noncore by definition.

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Seriously, FDIC insurance creates crises? What caused the crisis in 1929? Not to mention the numerous panics before the Fed was created?

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This is correct. The main issue is the highly leveraged, gigantic "balance sheet" carry trades. These trades are generally done by top management and "Treasury". That's what happened at JPM recently for example. What is conventionally thought of as proprietary trading hasn't really caused too many blow-ups, because the desk traders aren't allowed to take that much risk in the scheme of things. There is no way to disentangle all the different types of risk taking a bank does. Regulating leverage (tricky to define in a world of structured products), and/or perhaps VAR/equity capital (also tricky) is really the only way to prevent blow ups in a risk taking environment. Another way is to create vanilla banks that are highly regulated and can only hold certain assets and take certain kinds of risks. These would be the FDIC entities.

I prefer limiting leverage, because even with today's more complicated world, it is vastly more simple than regulating products, and rather than trying to keep ahead of innovation, it provides simple ground rules.

That said, a good reason to limit hedging is that it reduces the false sense of confidence that comes with it. That's what really went wrong in 2007.

Limiting leverage is good, but it has to reflect the underlying. IE levering treasuries 10:1 is not the same as leveraging some inherently leveraged structured product 10:1, or even Greek debt 10:1. These leverage rules can be implemented, but they will involve estimating the risk of the underlying assets somehow, which comes down to some kind of VAR calculation in the end. Someone has to understand these risks in order to estimate them and/or manage them. Ideally, that would be the bankers themselves, not the regulators. However, bankers incentives are grossly distorted by government backing. Because of this you really need to strictly regulate the FDIC insured or otherwise government supported banks into very plain vanilla institutions. For a deposit/mortgage bank to be truly plain vanilla it would have to be able to securitize its loans and sell them off to the market. The bank would not itself hold these types of assets. So the much vilified securitization function has a critical purpose in this vanilla bank conception.

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Volcker rule prohibits not only trading but also long-term "proprietary" risk-taking, being investment in private equity and hedge funds and (depending on exact final implementation rules and actual structure) also direct equity investments into firms (merchant banking). So the banks will continue to lend leveraged acquisition loan facilities to companies or PE funds, but if it's an equity injection instead of a loan, then...well then it's somehow "bad" and equated to "speculation". Sheer craziness. This is an even much more obvious example of idiocy than Conard's about banks slicing and dicing risks and some of that randomly being caught by Dodd-Frank.

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Tyler, you wrote earlier: "So far I find parts of this book brilliant and other parts dead wrong."
Perhaps you could you dedicate one of your next posts to examples for "dead wrong" - for a more complete picture.

What makes you think this wasn't one of the parts he thought was dead wrong? You can't tell from his commentary.

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The biggest issue was the excessive amount of AAA rated debt.
The regulation needed is to limit the total amount of AAA (i.e. risk free) debt that a rating agency can rate. Once the maximum is reached, new debt can only be AAA if some older debt gets downrated.

There is too little economic work done on the maximum level of debt that is sustainable over a long period of little or no growth. I'd guess about 200% of a country's annual GDP. Also, more obviously, gov't (consumption) AAA debt crowds out private, wealth creating debt.

I believe that Tyler's Great Stagnation is directly related to excess gov't debt.

The biggest issues are (say the NY Times review of Conard's book) is rent seeking is not addressed by Conard (big banks in bed with government 'regulators'), and, say I, moral hazard is not addressed if the government backstops all the big banks, as Conard likes. Another bubble waiting to be popped. Solution: free banking, aka no FDIC insurance. Yep, it really is that simple.

I assume you cheered when money market funds broke the buck - free banking at work!

And I gather you would be saying, if you put money in the first "retail" money market fund, "I'm glad I can't get my money out of the fund because this is how banking should work, I deserve to lose money from my reckless investing in Reserve Primary Fund, and have my funds frozen for a year. And everyone else who have over one trillion in money market funds should have also suffered that fate in late 2008 through 2009."

Of course, all the firms who have their payroll and accounts payable reserves in money market fund are well capitalized in bank deposits so they would have had no problems with their speculative trading in money market funds going south and being frozen on October 2008 as well.

Obviously too many people were alarmist in predicting doom like in the depressions from bank runs and frozen accounts in the good old days of free banking up to the 30s and FDIC.

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