The Map and the Territory Read online

  The share of U.S. gross domestic product accruing as income to the private finance and insurance sectors rose fairly steadily from 2.4 percent in 1947 to 7.9 percent in 2012 (Exhibit 5.2).6 Many other global financial centers exhibit similar trends.7 Only a small part of the rise of U.S. finance and insurance represented an increase in net foreign demand for U.S. financial and insurance services.8 Income accruing to finance and insurance results from their services being purchased by nonfinancial firms and foreign businesses. These are consolidated figures. Banks cannot generate income by trading with themselves.

  A Misread?

  Given the historic breakdown of 2008, did nonfinancial market participants over the decades misread the efficiency of finance and inappropriately compensate this segment of our economy? The prevalence of so many financial product failures during the crisis certainly suggests so. The share of finance and insurance in GDP, at 8.2 percent in 2006, fell back to 7.3 percent in 2008, the lowest level since 1999. But it bounced back sharply in the following years, moving to 8.0 percent in 2010 and 7.9 percent in 2012. The demand for financial services prior to 2008 was apparently not a misread of the efficiency of finance.

  The proportion of nonfarm employment accounted for by finance and insurance since 1947 has risen far less than the share of gross income originating in that sector. This implies a significant upgrading of the salaries paid by financial institutions. There is little doubt that highly skilled mathematicians, model builders, and number crunchers have flocked to finance.9 By 2007, a quarter of all graduates of the venerable California Institute of Technology were entering finance, according to the Economist.10

  What are we to make of these extraordinarily persistent and stable uptrends? Is it wholly accidental? (After all, there is no evidence of such a trend in the prewar years.) The rising value of assets to be managed accounts for part, but only part, of the increase.11 The answer to this question matters because in the context of financial reform, we must address whether the growing share was evidence that a rise in financial services was required to intermediate an ever more complex American division of labor. Alternatively, the growing share of finance in the economy could reflect problems with the structure of, and incentives surrounding, those people working in the financial industry.

  I raise the issue because many policy recommendations in the Dodd-Frank Act seem likely to result in a diminished share of financial services income in GDP. Would such policies affect the growth of U.S. nonfinancial productivity and, with it, our standards of living? More important, given the recent failures of risk management and regulation, could increased financial regulation at this time thwart or, through increased stability, enhance economic growth? We need a far deeper understanding of the role of financial intermediation in promoting growth to answer that question. The Dodd-Frank Act does not, in my judgment, address those issues. I explained my general concern with the act in March 2011, worrying that “it fails to capture the degree of global interconnectedness of recent decades which has not been substantially altered by the crisis of 2008. The act may create the largest regulatory-induced market distortion since America’s ill-fated imposition of wage and price controls in 1971.”12 More than two years later I have seen nothing to alter that appraisal.

  How finance evolves in the postcrisis years should bring clarity to many of today’s uncertainties. We have to assume that the greater the level of capital that financial institutions are required to hold, the less the degree of financial intermediation. That, in turn, is likely to result in slower growth, but presumably more financial stability and less risk of a breakdown in the financial structure of the magnitude of 2008.

  Risky Financial Intermediation

  As I noted earlier, prior to the crisis, the size of the modeled extreme negative tail of the distribution of risks failed to reflect the reality that emerged with the default of Lehman. So long as there are bank debt obligations, there will always be some risk that bank capital cannot cover, and if that risk materializes, some, perhaps even many, banks will fail.

  But that need not become a systemic problem if equity capital and liquidity requirements are raised sufficiently and/or a significant part of an intermediary’s debt takes the form of mandated contingent convertible (CoCo) bonds—that is, debt that is automatically converted to equity when equity capital falls below a certain threshold. Still, we must consider the possibility that private financial intermediaries will falter, with systemic consequences of a magnitude that requires sovereign credit to keep vital intermediation functioning. Short of the elimination of all debt, risk of default can never fall to zero so long as financial intermediaries require leverage (debt) to obtain an adequate return on equity capital.

  Central bankers are always aware of the potential for a breakdown in private financial markets. Indeed, in the United States as recently as 1991, in contemplation of the unthinkable and at the urging of the Federal Reserve Board, section 13 (3) of the Federal Reserve Act was reconsidered and amended by Congress. The section, as revised, granted virtually unlimited authority to the board to lend in “unusual and exigent circumstances,” the statutory basis of much postcrisis economic intervention.13 More than a decade ago, addressing that issue, I noted:

  There is a . . . difficult problem of risk management that central bankers confront every day, whether we explicitly acknowledge it or not: How much of the underlying risk in a financial system should be shouldered [solely] by banks and other financial institutions? . . . [Central banks] have all chosen implicitly, if not in a more overt fashion, to set our capital and other reserve standards for banks to guard against outcomes that exclude those once or twice in a century crises that threaten the stability of our domestic and international financial systems.

  I do not believe any central bank explicitly makes this calculation. But we have chosen capital standards that by any stretch of the imagination cannot protect against all potential adverse loss outcomes. There is implicit in this exercise the admission that, in certain episodes, problems at commercial banks and other financial institutions, when their risk-management systems prove inadequate, will be handled by central banks [sovereign credit]. At the same time, society on the whole should require that we set this bar very high. Hundred-year floods come only once every hundred years. Financial institutions should expect to look to the central bank only in extremely rare situations.14

  At issue is whether the crisis that arrived a few years later is that hundred-year flood. At best, once-in-a-century observations yield results from which it is difficult to draw robust conclusions. But recent evidence suggests that what happened in the wake of the Lehman collapse, as I noted earlier, is among the most severe global financial crises ever, if not the most. In the Great Depression, of course, the collapse in economic output and the rise in unemployment and destitution far exceeded that in the 2008 crisis. And, of course, the widespread bank failures of the Great Depression era markedly reduced short-term credit availability. But short-term financial markets continued to function.

  Financial crises are characterized by a progressive inability to float first long-term debt, then eventually short-term debt, and finally overnight debt. Long-term uncertainty, and therefore risks, are always greater than near-term risks, and hence risk spreads almost always increase with the maturity of the financial instrument in question.15 While widespread economic havoc can be spread by a collapse in asset prices, I find that the depth of a financial crisis is best characterized by the degree of collapse in the availability of short-term credit.

  One has to dig very deep into peacetime financial history to uncover episodes similar to 2008. The market for call money, the key short-term financing vehicle of a century ago, shut down at the peak of the 1907 panic “when no call money was offered at all for one day and the [bid] rate rose from 1 to 125%.”16 Even at the height of the 1929 stock market crisis, the call money market functioned, although annual interest rates did soar to 20 percent. In lesser financial crises, availability of fund
s in the longer-term markets disappeared, but overnight and other short-term markets continued to function.

  The withdrawal of overnight money represents financial stringency at its maximum. Investors must be willing to lend overnight before they feel sufficiently protected by adequate capital to reach out for more distant, and hence riskier, maturities.

  The evaporation of short-term credits, especially trade credits, in September 2008 was global and all encompassing. But it was, on a much grander scale, the same process that I had previously observed at a more micro level. As the credit of New York City became suspect in the mid-1970s, the first failure of issuance was evident in long-term municipal bonds, followed by failures in progressively shorter maturities, until even overnight markets started to crumble. A similar progression led up to the Mexican financial crisis of 1994‒95.

  REGULATORY REFORM

  Principles of Reform

  Given the recent unprecedented period of turmoil, by what standard should proposals for reform of official supervision and regulation be judged? I know of no form of economic organization, from unfettered laissez-faire to oppressive central planning, that has succeeded in achieving both maximum sustainable economic growth and permanent stability. Central planning certainly failed, and I strongly doubt, given the foibles of human nature, that complete stability is achievable in capitalist economies. The latter are governed by an always-turbulent competition driven by fear, euphoria, and herd behavior. In capitalist economies, however, markets do tend to be drawn toward, but never quite achieve, an equilibrium that is continually shifting.

  Although there are often multiple objectives of regulation, when it can identify and inhibit irrational behavior, under certain conditions, regulation can be stabilizing. But there is an insidious cost of regulation in terms of economic growth and standards of living when it reaches beyond containing unproductive behavior. Parenthetically, I do not consider addressing fraud to be regulation. Rampant fraud can significantly diminish the effectiveness of market competition, but fraud is theft and an issue of law enforcement.

  Growth Versus Stability

  Regulation by definition imposes restraints on competitive markets. The elusive point of balance between growth and stability has often been a point of contention, especially when it comes to financial regulation.

  During the postwar years prior to the crisis, with the exception of a limited number of bank bailouts (Continental Illinois in 1984, for example), private capital proved adequate to cover virtually all provisions for commercial bank lending losses.17 As a consequence, there was never a definitive test of the precrisis conventional wisdom that an equity capital-to-assets ratio of 6 to 10 percent on average (the range that prevailed between 1946 and 2003) was adequate to support the U.S. banking system. Risk managers’ assumption of the size and configuration of the negative tails of the distributions of credit and interest rate risk were, as I noted earlier, of necessity conjectural, and we had not had a test of those conjectures for many decades.

  Most of the shape of the perceived distribution of risk of outcomes was developed from data gathered in the precrisis years, which included only “moderate” financial turbulence and mild euphorias. But since compilation of modern financial data began, we never had experienced a “hundred-year flood” that revealed the severe consequences of a shock in the negative tail of the probability distribution.

  Risk managers, of course, knew in earlier decades that an assumption of “normality” in the distribution of risk was unrealistic,18 but because this approximation greatly facilitated calculation, it prevailed. Even as the mathematics implied by fat tails began to be better understood, our number-crunching capabilities fell far short of making the required calculations to guide practical actions, except at prohibitive cost. That is no longer the case.

  Clearly what we observed in the weeks following the Lehman default is exactly the type of market seizure that conjecture about so-called fat tails was supposed to capture, and in practice did not. Having experienced Lehman, risk managers will be far more cautious in evaluating future risk—at least for a while.19

  Indeed, the Lehman default and its aftermath strongly suggest that the negative tails of the risk distribution were considerably larger than almost anybody had earlier imagined. The failure of risk managers to fully understand the effect of the emergence of shadow banking may have been partly responsible for the underestimation of systemic financial risk. Shadow banking was a form of financial innovation that may well have increased rather than moderated the overall level of risk. The creditors of these shadow banks were not being adequately compensated by higher capital buffers for the added risk posed by these entities.

  The Illusion of Market Liquidity

  When risk premiums are low over a protracted period, as they were, for example, from 1993 to 1998 and from 2003 to 2007, investors’ willingness to actively bid for all types of financial assets, such as the high-risk tranches of collateralized debt obligations, creates an illusion of permanent market liquidity. In the latest episode, this turned out to be especially intoxicating. It led several major investment banks to sail into the financial storm with financing that depended on a level of liquidity that was about to vanish.

  The Needed Reforms

  Thus, the most pressing needed reforms in the aftermath of the crisis, in my judgment, are fixes to the levels of regulatory risk-adjusted capital, liquidity, and collateral standards required by counterparties.20 Private market participants are now requiring economic capital and balance sheet liquidity well in excess of Basel requirements. The shadow banks that survived the crisis now are having to meet significantly tighter market standards set by their counterparties, with respect to capital, liquidity, and collateral, than existed before the crisis. Likewise, global regulators will need to assess required changes to capital and liquidity standards to better protect against systemic breakdowns.

  All risk-adjusted capital adequacy measures need to be raised and due consideration needs to be given to the proportion of liabilities funded with overnight or other short-term debt. Regulatory capital requirements prior to the crisis, although based on decades of experience, were clearly too lax. Home mortgages were perceived as far safer than they, in retrospect, turned out to be. And, unfortunately, a large proportion of investment portfolio decisions was, by law, accorded “safe harbor” status if those decisions adhered to the credit risk judgments (or rather, misjudgments) of the credit-rating agencies.

  To ensure that financial intermediaries have adequate cash to meet ongoing commitments in the event of a shutdown in external funding, international regulation of bank liquidity should match the tightening already evident in private risk management paradigms. Collateral (customer assets) has shown itself particularly subject to rapid recapture. Bear Stearns had nearly $20 billion in pledgeable liquid funds a week before it collapsed. Morgan Stanley lost more than a half trillion dollars of pledgeable collateral during the height of the crisis. In the United States, to lower the risk of a “run on the broker,” the amount of customer assets held by broker-dealers that cannot be commingled with their own assets needs to be increased. That would decrease the amount of funds that can “run.” However, such action must be measured and coordinated with other global regulators to avoid regulatory arbitrage.

  Hedge Funds

  Unaffiliated hedge funds have weathered the crisis—as extreme a real-life stress test as one can construct—without taxpayer assistance or, as I noted earlier, default. Although hedge funds are only lightly regulated, much of their leveraged funding comes from more heavily regulated banks. Moreover, as Sebastian Mallaby wrote, “Most hedge funds make money by driving prices away from extremes and toward their rational level.”21 In so doing, they supply much-needed liquidity to financial markets when other competitors have withdrawn. Regulations that inhibit the ability of hedge funds to supply such services have the potential to be counterproductive.

  Capital, liquidity, and collateral, in my experien
ce, address almost all of the financial regulatory structure shortcomings exposed by the onset and aftermath of the crisis. In retrospect, there has to have been a level of capital that would have prevented the failure of, for example, Bear Stearns and Lehman Brothers. (If not 10 percent capital, think of partnerships with 40 percent capital.) Moreover, generic loan loss reserves have the regulatory advantage of not having to forecast which particular financial products are about to turn toxic.22 Certainly, very few investors foresaw the future of subprime securities or the myriad other broken products. Adequate generic capital eliminates the need for an unachievable specificity in regulatory standards.

  The jerry-built regulatory structure that has evolved over the decades in the United States has become much too complex. During the debates that led to legislation resulting in a badly needed opening up of financial competition (the Gramm-Leach-Bliley Act of 1999), policy makers and lawmakers nonetheless failed to recognize that increased competition—especially through shadow banking—also increased negative tail risk.23 And increased negative tail risk necessitates higher capital requirements.

  Much, though not all, of what advocates of broadened oversight of consumer finance are combating falls under the scope of fraud. Again, this is not the province of regulation but of enhanced law enforcement. Misrepresentation, the major source of consumer complaints, is fraud and should be readily addressed in more widespread enforcement of existing law.

  Upward Revisions of Bank Economic Capital