More Nuance Needed in Bank Regulations

More Nuance Needed in Bank Regulations. By Douglas J. Elliott
Brookings, January 22, 2010

January 22, 2010 — On the day President Barack Obama announced his new banking reform proposals, Reuters carried a story that Treasury Secretary Timothy Geithner had privately expressed reservations about the plan. Having had time to digest it, I can see why.

One of the key parts of this plan is a proposal to limit banks' "proprietary investments." Traditionally, banks took in deposits and put the money to work by lending it out and also by holding a substantial amount of fairly safe financial investments that could be readily sold if cash was needed quickly. Over time, banks have substantially increased the level of investments they held primarily for their higher expected returns and managed them as proprietary investments. They also ramped up the extent to which they traded in and out of securities opportunistically. Banks have also created or invested in external hedge funds for similar purposes, as well as to earn fees from managing the hedge funds.

The argument for limiting proprietary investments is essentially that cheap depositor funds, and other federal support, should not support gambling in the markets. The administration also cited the potential for conflicts of interest when a bank is both working with customers and making its own investments.

But the plan to limit proprietary investments is problematic for a number of reasons. It is so vague that we may find that the eventual details are downright harmful to the economy. In addition, the proposal lacks the subtlety and balance that underlay the administration's earlier financial reform proposals. Previously Obama and his team struck a good balance between the need for regulation and the benefits of letting financial markets work to find the most efficient solutions on their own. Thursday's proposals forbid activities outright, rather than providing appropriate incentives, disincentives and protections.

There is a clear appeal to keeping banks from taking undue investment risks. On the surface, it would appear fairly clear-cut that they ought not to have major proprietary investment positions. However, the issue becomes far more complicated and less clear as one examines it in more detail.

First, it is hard to tell the difference between traditional investment activity, which is a necessary part of banking, and proprietary investments, which are purely discretionary. Banks need to hold significant investment positions as part of their liquidity management. It is in everyone's interest for the return on those investments to be maximized, within acceptable risk limits, since more profitable banks are stronger and less likely to need a taxpayer bailout. It is important not to throw the baby out with the bath water.

Second, banks have long conducted trading activities to serve their clients in which it is often necessary to buy positions from sellers before the bank has an end-buyer. This brings trading risk, since the banks own the position for a time. It was a natural next step to allow the expert traders at the banks to take positions on a longer-term basis when they sensed that the market was moving in one direction. It is not always easy to distinguish these types of trades from ones motivated purely by customer demand.

Third, these investment activities should be unusually profitable for banks on average. They already have the traders and equipment in place, so the additional cost is low. Also, a great deal of information flows through the largest banks that can legitimately be shared. The insight gained from this provides a significant market advantage. Again, it is generally good public policy for banks to engage in profitable activities.

The key issue is to determine when the risk of proprietary investing exceeds the gain. The administration appears to have suddenly decided it is always too risky no matter what the circumstances.

I believe the situation is more nuanced; regulators ought to set limitations on proprietary investments and create capital requirements that are tough enough to hold the risk to the public to a very low level. Unfortunately, banking, like life, is not black and white.

Restricting Bank Activities

Restricting Bank Activities. By Douglas J. Elliott
Brookings, January 21, 2010

January 21, 2010 — President Obama has proposed various measures to restrict the size and scope of activity of the nation’s largest banks. These proposals are broadly in line with ideas being pushed by former Federal Reserve Chairman Paul Volcker and were announced in conjunction with a meeting between Volcker and the president. The key proposals all appear to require legislation and therefore are likely to undergo modification as a result of negotiations in Congress.

As this brief paper will hopefully make clear, the issues being addressed are complicated. This is a classic example of the devil being in the details and many of those details are simply unavailable. My own initial reaction is concern that the administration may be over-reacting to the risks it is trying to address, but it may be that further refinement of the proposals will address my concerns.

The biggest news comes from the president’s proposals to restrict proprietary trading and investments at the banks. Traditionally, banks took in deposits and put the money to work by lending it out and also by holding a substantial amount of fairly safe financial investments. These investments were held primarily because they provided more liquidity than loans, since they could be readily sold if needed, unlike loans. Sometimes investments were held because they would provide an unusually high return, but this was less common. Over the last couple of decades banks have substantially increased the level of investments that they held primarily for their higher expected returns and have ramped up the extent to which they traded in and out of securities opportunistically. Most of this activity is now done in units devoted to such “proprietary trading” where the bank’s own funds are invested in search of excess returns. Banks have also created or invested in external hedge funds for similar purposes, sometimes linked to an ability to earn fees from external investors for managing the hedge fund.

Many of the losses incurred by banks in the recent crisis occurred in their proprietary investment and trading books, although banks certainly lost money in more traditional ways as well. (For example, the mid-sized and smaller banks that are currently failing because of imprudent commercial real estate loans generally made their mistakes in very traditional ways. Larger banks are also losing a great deal of money on parts of their traditional lending activities, such as residential mortgage loans.) Chairman Volcker and a number of other observers have called for a limitation on the ability of banks to benefit from federally insured deposits, and the traditional liquidity supports provided by the Fed, if they are also going to do a significant volume of proprietary investment. The argument essentially is that cheap depositor funds should not be used to gamble in the financial markets.

The president proposes to essentially eliminate proprietary investments and ownership of hedge funds by banks. In addition to the risk management concerns, the administration has also cited the potential for conflicts of interest when a bank is both working with customers and making its own investments.

There is a clear appeal to keeping banks that benefit from deposit insurance and other public support, including potential taxpayer rescues, from taking undue investment risks. On the surface, it would appear fairly clearcut that they ought not to have major proprietary trading positions. However, the issue becomes far more complicated and less clear as one examines it.

First, it is harder than one might think to tell the difference between traditional investment activity, which is a necessary part of banking, and proprietary investments which are purely discretionary. Banks need to hold significant investment positions as part of their liquidity management and it has also generally been considered reasonable to invest the capital supplied by the bank’s shareholders into financial instruments. It is in everyone’s interest for the return on those investments to be maximized, within acceptable risk levels, since more profitable banks are stronger and in a better position to serve their customers. Part of that profit maximization comes from allowing banks to trade in and out of their investment positions as their situation changes or as they see market opportunities or threats. Therefore, it is somewhat difficult to draw a bright line between “proprietary investments” and traditional liquidity management activities. It is also hard to distinguish between investment and trading, since a significant amount of transactional activity can make sense even in a book that is essentially held for liquidity management purposes.

Second, banks have long been allowed to conduct certain trading activities to serve their clients. This is a relatively low risk business to the extent that it consists of trying to match buyers and sellers while earning a small spread for acting as the intermediary. It is often necessary for banks to buy positions from sellers before they have an end-buyer on the other side, in order to provide good service. This brings trading risk, since it is possible that they are not able to find that end-buyer at the price that they themselves paid. The need for these trading activities led banks to employ large numbers of in-house traders who developed substantial expertise. It was a natural next step to allow them to take certain positions on a somewhat longer-term basis when they could sense that the market was going to be moving in one direction or the other. It would not always be easy to distinguish these types of trades from ones that have a purer customer-based motive. Nor is it clear that we would want banks to give up the potential profits from the insights they gain through their general market activities.

Third, there is reason to believe that trading and investment activities should be unusually profitable for banks on average. The infrastructure they use for proprietary investments is generally already in place due to the need to hold large investment portfolios and to serve customers, therefore the marginal cost of adding proprietary investment activity can be low. In addition, a great deal of information flows through the largest banks. Some of this must be held confidential and cannot be shared even within the firm, but much of it can legitimately be shared. The insight gained from these information flows adds up to a significant market advantage that should yield excess returns on average. Again, all else equal, it is good public policy for the banks to engage in profitable activities that will make them stronger.

The key issue, therefore, is to determine when the risk created by proprietary investing exceeds the gain from allowing banks to engage in a generally quite profitable activity. Some observers clearly believe that proprietary investment almost always creates too much risk to the public. It appears that the administration is coming out on that side after a long period in which it had not placed major emphasis on this issue. My own view is that the situation is more nuanced and that regulators ought to have the ability to set limitations on proprietary investment and to set capital requirements for these activities that are high enough to hold the risk to the public to a very low level. Capital requirements can be quite effective as a risk management tool. At the extreme, a 100% capital requirement would mean that all the investment funds could be lost and it would not eat into any of the capital being used to back the rest of the bank’s activities.

The president also proposed that bank regulators be given the power to limit the size of any bank if its scale appears to create undue risk to the financial system. In particular, he proposed that the limits on deposit market share that already exist be extended to include all liabilities. This appears to be consistent with powers already incorporated into the financial regulatory reform bill that passed the House last year, although the president’s emphasis may increase the chance of those provisions surviving Congressional negotiations and even perhaps the probability of those powers being exercised by regulators in practice. If these provisions are included in the final legislation, it will be important to see whether the wording of the law tips the scales towards or away from their actual use. For example, limitations could be negotiated that would narrow the conditions under which regulators could take such an action. Alternatively, the law could provide a presumption that any bank over a certain size would be too big. There would also be a myriad of technical details surrounding how size would be measured. Banks might, for example, be able to able to slim down by moving significant amounts of assets into related entities or securitizing them out to unrelated parties while retaining some stake.

I am concerned, as a general matter, about arbitrarily limiting the size of the banks, since our modern, complicated, global economy demands that the U.S. have at least a few banks capable of providing a very wide range of services each on a large enough scale to be efficient. However, there certainly may be circumstances in which regulators ought to push a bank or banks to be smaller in general or smaller in certain activities. The question is how to balance the considerations and avoid arbitrary limits or decisions.

Defining Deficits Down

Defining Deficits Down. By Isabel V. Sawhill
Brookings, January 29, 2010

January 29, 2010 — When the president submits his budget on February 1, there will be a lot of hand-wringing about the possible economic fallout from a virtually unprecedented accumulation of debt. A long string of deficits out into the future will increase our dependence on foreign lenders, threaten the recovery if borrowers begin to demand higher interest rates, burden taxpayers with the costs of servicing the debt, and leave our children with a less prosperous future. Although these economic consequences are bad enough, the effects on public confidence in their government are even worse. Paralysis in the face of such dire warnings tells the public that their government is not working, undermines trust in our political institutions, and leads to more cynicism about the entire process, with ramifications that go far beyond the fiscal problem itself. Moreover the problem is so dire now that instead of doubling down on our efforts to do something we have moved the goal posts and redefined our deficit reduction goals. Although this may simply reflect the depth of the hole we are in and the difficulty of digging our way out, it may also shift public perceptions toward too ready acceptance of current reality and its associated dangers.

In the past there were bipartisan efforts to deal with deficits that were far smaller than those currently projected. Such efforts were grounded in a common belief that spending beyond one’s means was imprudent, even morally wrong. The goal for most of the pre World War II years was simple: an annually balanced budget. This meant that spending was cut and taxes raised even when the economy was depressed as in the 1930s. Following World War II, economists began to argue that the goal should be amended to allow deficit spending during recessions as long as that was offset by surpluses during periods of full employment. By the 1980s, this slightly amended goal was still extant and enshrined, for example, in the Gramm-Rudman-Hollings bill that called for a balanced budget by 1991. And when Ross Perot campaigned in 1992 on the need for a balanced budget, and won 19 percent of the vote, Clinton responded by working hard throughout his two terms to get to balance. The decade ended with a surplus of $236 billion in the federal budget. Fast forward to this year, and the goal has shifted from balancing the budget to keeping deficits below 3 percent of GDP in the president’s budget. That would mean accepting a deficit of over $400 billion (in today’s dollars) as a goal. However, even this much more modest goal now appears impossible to reach.

The current administration will be criticized for moving the goal posts on deficit reduction and for doing far too little to restore fiscal balance. This year’s budget includes a freeze on non-security discretionary spending, support for pay-go rules, and a presidentially appointed deficit-reduction commission. These are good but totally insufficient steps. The spending freeze will affect only a tiny slice of the budget; the pay-go rules will make it more difficult for Congress to dig the hole deeper but won’t affect currently projected red ink; and the commission will likely be a paper tiger. In short, these proposals will still leave us with unsustainable deficits as far as the eye can see. Granted current deficits were largely inherited and have been further ballooned by the need to fight the current downturn, leaving the current administration with a herculean task. But it is depressing to discover that we can no long even aspire to balance the budget once the recession is over.

The late Senator Moynihan used to talk about defining deviancy down by which he meant that new norms get established in response to bad behavior. The nation’s fiscal behavior is now so bad that I fear we will soon accept a degree of fiscal profligacy that would have been unthinkable in earlier times. Shame on all of our elected officials, past and present, who have allowed this to happen.

How to Make a Weak Economy Worse - FDR's war against business showed that a president must choose between retribution and recovery

How to Make a Weak Economy Worse. By AMITY SHLAES
FDR's war against business showed that a president must choose between retribution and recovery.
WSJ, Feb 02, 2010

You get the feeling President Obama is girding for battle with the financial sector. In last week's State of the Union address, he promised to regulate the industry. On Jan. 21, he was blunter, warning that he would not let companies that enjoyed "soaring profits and obscene bonuses" block his financial reforms. "If these folks want a fight," he said, "it's a fight I'm ready to have."

This declaration of war echoes that of Franklin Delano Roosevelt. In 1936, late in his campaign for a second presidential term, FDR spoke of the challenges of "business and financial monopoly, speculation, reckless banking." Wall Streeters and businessmen hated him, he said, adding that "I welcome their hatred."

Then Roosevelt escalated: "I should like to have it said of my first administration that in it the forces of selfishness and the lust for power met their match. I should like to have it said of my second administration that in it these forces met their master."

Mr. Obama might want to stick to a moderate approach. FDR's war against business played to the crowd, but it hurt the economy. While monetary policies impeded recovery in the late 1930s, it was the administration's assault on companies and capital that ensured the Depression's duration.

Roosevelt had initially opted for safety and picked relatively moderate advisers. His first Treasury Secretary, William Woodin, was a railroad executive. Roosevelt also kept over a Hoover-era official, Jesse Jones, at the TARP of the day, the Reconstruction Finance Corp. James Warburg, the son of Wall Street banker Paul Warburg, also joined the team.

In the crucial days before March 5, 1933, when FDR declared a "bank holiday" to halt the bank run, New Dealers worked with Republicans to resolve the financial crisis. When it came to reforming Wall Street, they were likewise measured. Yes, they created the Securities and Exchange Commission. But their regulation seemed designed to serve markets, not stamp them out. At least mostly.

Though there was nothing establishment about the centerpiece of the early New Deal, the National Recovery Administration, it was friendly to big business. Indeed, too much so. Under the NRA, the largest players in each industrial sector were judged too big to fail not because their failure would create systemic financial risk—the argument for banks today—but rather in the faith that firms of such scale could serve as engines of recovery.

And Roosevelt, like Presidents Obama and Bush, dumped billions in cash onto the country. There was, not surprisingly, a Roosevelt market rally, just as there has been an Obama rally.

But complete recovery proved elusive. The public spending programs had less effect than hoped. Smaller firms complained, accurately, that the NRA's minimum wages and limits on hours disadvantaged them. Unemployment was still high. FDR knew he could not keep asking Congress to authorize enormous outlays forever.

Frustrated, the president shifted to retribution. By 1935, FDR decided that firms, especially big firms, were impeding recovery. They must now redeem themselves and save the economy by sacrificing—or else.

The attacks started with taxes. In 1935, well before the "hatred" speech, FDR led Congress in passaging a law that replaced a flat rate on corporate income with a graduated rate—itself a penalty on larger firms. Personal income taxes went up, as did other rates. In 1936 FDR signed into law the undistributed profits tax, which aimed to force reluctant firms to disgorge cash as dividends or by paying higher wages. This levy too was graduated, with a top rate of 27%.

The 1935 Wagner Act was a tiger that makes today's union law look like a pussycat. It favored unions over companies in nearly every way, including institutionalizing the closed shop. And after Roosevelt's landslide victory in 1936, the closed shop and the sit-down strike stole thousands of productive workdays from companies, punishing earnings and limiting ability to hire.

Of particular relevance today was Roosevelt's switch on antitrust policy. The large companies once rewarded by the NRA now became targets.

The final front of the war was utilities, the country's most hopeful industry. FDR's 1935 law, the Public Utilities Holding Company Act, made it so difficult for private-sector firms in this industry to raise capital that it was called a death sentence.

The result of it all was the Depression within the Depression of 1937 and 1938, when industrial production plummeted and unemployment climbed back into the higher teens. Even John Maynard Keynes chided FDR for his attitude about businessmen: "It is a mistake to think they are more immoral than politicians."

Among themselves, the New Dealers acknowledged failure. FDR's second Treasury Secretary, Henry Morgenthau, eventually determined that the problem was lack of what he labeled "business confidence." Late in the decade, Morgenthau dared to call for tax cuts. He even placed a sign on his desk asking, "Does it contribute to recovery?" Roosevelt told him the sign was "very stupid."

Ultimately the war abroad required FDR to give up his war at home. Now the same industries that had been under prosecution were at the War Production Board, signing contracts. Scholars have argued that wartime spending ended the Depression. But the truce with business played an important role.

The 1930s story suggests not that any individual reform is wrong per se. It reminds us rather that frustrated presidents are inconsistent, that antibusiness policies are cumulative, and that hostility yields more damage than benefit. Presidents can choose between retribution and recovery. They cannot have both.

Miss Shlaes, a senior fellow in economic history at the Council on Foreign Relations, is author of "The Forgotten Man: A New History of the Great Depression" (HarperCollins, 2007).