| At its core, capitalism is all about risk taking. One form of risk taking is leverage. Indeed, without leverage, capitalism could not prosper. Usually, we think of this imperative in terms of entrepreneurs being able to lever their equity so as to grow. And indeed, this is the case.
But more elementally, economies – both capitalist and socialist – require leverage because savers for very logical reasons do not want to have one hundred percent of their stock of wealth in equity investments. Rather, they logically want a portion of their portfolios in a fixed-commitment instrument that is senior to equity.
And savers want some portion of that fixed-commitment allocation in literal money, defined as a government-guaranteed obligation that always trades at par. If you have any doubt about this, put your hands into your pockets and you will find just such an instrument. It’s called currency, a zero-interest, perpetual liability of the Federal Reserve, itself a levered entity, capitalized by its Congressionally-legislated monopoly over the creation of money.
As a practical matter, of course, you don’t hold all of your always-trades-at-par liquidity in currency. You most likely have a demand deposit, also known as a checking account, as well as shares in a money market mutual fund, which is putatively supposed to always trade “at the buck.” You probably also have some longer-dated bank deposits, such as certificates of deposits, or CDs, which don’t necessarily trade at par in real time, but are guaranteed to do so at maturity.
The Nature of Fractional Reserve Banking
The public’s demand for at-par liquidity inherently creates the raw material for leverage in the economy. Indeed, from time immemorial, fractional reserve banking has been built on the simple proposition that the public’s collective ex ante demand for at-par liquidity is greater than the public’s collective ex post demand for such liquidity.
Accordingly, the genius of banking1, if you want to call it that, has always been simple: A bank can take more risk on the asset side of its balance sheet than the liability side can notionally support, because a goodly portion of the liability side, notably deposits, is de facto of perpetual maturity, although it is de jure of finite maturity, as short as one day in the case of demand deposits.
Thus, the business of banking is inherently about maturity and credit quality transformation: banks can hold assets that are longer and riskier than their liabilities, because their deposit liabilities are sticky. Depositors sleep well knowing that they can always get their money at par, but because they do, they don’t actually ask for their money, affording bankers the opportunity to redeploy that money into longer, riskier, higher-yielding assets that don’t have to trade at par.
Enter the Government
A key reason that depositors sleep well at night is the fact that since 1913 here in the United States, banks have had access to the Federal Reserve’s discount window, where assets can be posted for loans to redeem flighty depositors. A second sleep-well governmental safety net was introduced in 1933: deposit insurance, in which the federal government insures that deposits – up to a limit – will always trade at par, regardless of how foolish bankers may be on the other side of their balance sheets.
Thus, the genius of modern day banking, again if you want to call it that, has always been about exploiting the positive spread between the public’s ex ante and ex post demand for liquidity at par, in the context of levering the two safety nets – the central bank’s discount window and deposit insurance underwritten by taxpayers – which provide comfort to depositors that they can always get their money at par, even if their bankers are foolish lenders and investors.
Yes, I know that sounds harsh. But it really is how the banking world works. In turn, banks can be very profitable enterprises, because the yield on their risky assets is greater than the yield on their less-risky liabilities. And that net interest margin can be particularly sweet when recomputed as a return on equity, given that banks are very levered institutions (recall, banks must hold only 8% of liabilities in the form of Tier 1 capital).
Put differently, equity investors in banks can lose only 8% of a bank’s footings, but they earn the net interest margin on 100% of those footings, so long as they don’t make so many dodgy loans and investments, destroying capital, that the providers of the two government safety nets cut them off.
Thus, it has always been somewhat of an oxymoron, at least to me, to think of banks as strictly private sector enterprises. To be sure, they have private shareholders. And, yes, those shareholders get all the upside of the net interest margin intrinsic to the alchemy of maturity and risk transformation. But the whole enterprise itself depends on the governmental safety nets. That’s why banks are regulated.
Conceptually, as is the case in socialist countries, banks could be – and usually are – simply owned by the government, the ultimate form of regulation. Such an arrangement has the benefit of the taxpayer sharing in the upside, not just the downside. Such an arrangement also has the cost of putting the government in the lending and investing business, with little regard for the pursuit of profit, picking winners and losers on the basis of political clout.
Thus, capitalist economies usually want their banking systems owned by the private sector, where loans and investments are made on commercial terms, in the pursuit of profit. But also in the context of prudential regulation, so as to minimize the downside to taxpayers of the moral hazard inherent in the two safety nets for depositors.
The Mae West Doctrine
But as is the wont of capitalists, they love levering the sovereign’s safety nets with minimal prudential regulation. This does not make them immoral, merely capitalists. And over the last decade or so, the way for bankers to maximally lever the inherent banking model has been to become non-bank bankers, or as I dubbed them a couple years ago, shadow bankers.
The way to do this has been to run levered-up lending and investment institutions – be they investment banks, conduits, structured investment vehicles, hedge funds, et al – by raising funding in the non-deposit markets, notably: unsecured debt, especially interbank borrowings and commercial paper; and secured borrowings, notably reverse repo and asset-backed commercial paper. And usually – but not always! – such shadow banks relied on conventional banks with access to the central bank’s discount window as backstop liquidity providers.
Structured accordingly, without explicit access or use of the government’s safety nets, shadow banks essentially avoided regulation, notably on the amount of leverage they could use, the size of their liquidity buffers and the type of lending and investing they could do.
To be sure, Shadow Banking needed some seal of approval, so that providers of short-dated funding could convince themselves that their claims were de facto “just as good” as deposits at banks with access to the government’s liquidity safety nets. Conveniently, the rating agencies, paid by the shadow bankers, stood at the ready to provide such seals of approval.
And it was all grand while ever-larger application of leverage put upward pressure on asset prices. There is nothing like a bull market to make geniuses out of levered dunces. Call it the Mae West Doctrine, where if a little fun is good and more is better, then way too much is just about right.
Also call it the Forward Minsky Journey,2 where stability begets ever riskier debt arrangements, until they have produced a bubble in asset prices. And then the bubble bursts, in something called a Minsky Moment, followed by a Reverse Minsky Journey, characterized by ever-tighter terms and conditions on the availability of credit, inducing asset price deflation and its fellow traveler, debt price deflation.
This dynamic is inherently self-feeding, begetting the Paradox of Deleveraging,3 where private sector bankers – conventional bankers and shadow bankers alike – all move to the offer side of both asset markets and bank capital markets, trying to reduce their leverage ratios by selling assets and paying off debt, and/or issuing more equity. But by definition, if everybody tries to do it at the same time, as has been the case over the last 18 months or so, it simply can’t be done.
What is needed is for the government to take the other side of the trade, effectively becoming the bid side, (1) buying assets, (2) guaranteeing assets, (3) providing cheap funding for assets, and (4) buying bank equity securities (of both conventional banks and shadow banks that are permitted to become conventional banks after the fact).
Government Goes All In4
And indeed, all four of these techniques have been put into play since the fateful decision to let Lehman Brothers fall into disorderly bankruptcy. Put more bluntly, the hybrid character of banking – always a joint venture between private capital and governmental liquidity safety nets – is morphing more and more towards government-sponsored banking. Yes, I know that is harsh, but sometimes the truth is harsh. Capitalism and banking may not be divorced, but certainly are engaged in some form of trial separation.
The Treasury, the FDIC and the Fed – the big three – are caught in the middle, serving both as mediators as well as deep pockets to the estranged parties. It’s not wholesale nationalization. And it’s not likely to become that. But only because the big three are committed to doing whatever it takes to prevent that outcome. Along the way, the big three would also like – need! – to restart the engines of credit creation, so as to pull the economy out of its gaping hole of insufficient aggregate demand for goods and services, also known as a recession.
Will it work? Judging from the markets’ collective reaction to Treasury Secretary Geithner’s announcement last week of the new administration triage plans, there is room for doubt. I do not, however, take one-week swings in the markets as indicative as to where this game will end. And a key reason is actually the special powers of the Fed and the FDIC, which can lever the taxpayer monies that Congress provides for the Treasury.
As evidenced in recent months, the Fed has two incredibly powerful tools:
- Section 13(3) of the Federal Reserve Act of 1932, which permits the Fed, upon declaration of “unusual and exigent circumstances” to lend to anybody against collateral it deems adequate, and
- Total freedom to expand its balance sheet, essentially creating liabilities against itself that trade at par – also called printing money – so long as the Fed is willing to surrender control over the Fed funds rate, letting it trade at zero, or thereabouts.
The Fed has used both of these tools vigorously in recent months, expanding its lending programs mightily, to both conventional banks and shadow banks (i.e., investment banks who have re-chartered as banks, as well as primary dealers), while also doubling the size of its balance sheet, as it let the Fed funds rate fall to effectively zero.
The FDIC also has an incredibly powerful tool: the so-called Systemic Risk Exception under the FDIC Improvement Act of 1991, which allows the FDIC to forgo using the “lowest cost” solution to dealing with troubled banks if using such a solution “would have serious adverse effects on economic conditions or financial stability” and if bypassing the least cost method would “avoid or mitigate such adverse effects.”
It’s actually not an easy clause for the FDIC to invoke, unlike Section 13(3) for the Fed, which can be invoked simply by a supermajority of the Board of Governors. For the FDIC, the Systemic Risk Exception must be deemed necessary by two-thirds of both the Board of Directors of the FDIC and the Fed’s Board of Governors, as well as by the Secretary of the Treasury, who must first consult and get agreement from the President of the United States.
But where there is a will, there is a way, and the FDIC is now living firmly in the land of the Systemic Risk Exception, legally allowed to guarantee unsecured debt of banks as well as to put itself at risk in guaranteeing banks’ dodgy assets.
Bottom Line
The United States government now has both the tools and the will to save the private banking system, and more importantly, the real economy, from its own debt-deflationary pathologies. Not that it will be easy. But it can be done, notwithstanding the catcalls that greeted Secretary Geithner last week.
And the essential game plan is clear: use the power of the Fed, the FDIC and the Treasury to create government-sponsored shadow banks, such as the Term Asset-Backed Securities Lending Facility (the TALF) and the Public-Private Investment Fund (the P-PIF).
The formula? Take a small dollop of the Treasury’s free-to-spend taxpayer money (there is still $350 billion left) to serve as the equity in a government sponsored shadow bank, and then lever the daylights out of it with loans from the Federal Reserve, funded with the printing press. That’s the formula for the TALF, to provide leverage, with no recourse after a haircut, to restart the securitization markets.
The same formula applies for the P-PIF, with the addition of FDIC stop out loss protection for dodgy bank assets that private sector players might buy. With such goodies, such players, it is hoped, will be able to pay a sufficiently high price for those assets to avoid bankrupting the seller bank.
Unfortunately, Secretary Geithner hasn’t laid out the precise parameters of how to mix these three ingredients, which is driving the markets up the wall. But make no mistake, these are the ingredients, along with continued direct capital infusions into banks where necessary.
Uncle Sam has the ability to substitute itself – not himself or herself! – for the broken conventional bank system, levering up and risking up as the conventional banking system does the exact opposite.
Yes, there will be subsidies involved, sometimes huge ones. And yes, the process will seem arbitrary and capricious at times, reeking of inequities. Such is the nature of government rescue schemes for broken banking systems, while maintaining them as privately owned.
You might not like it. I don’t like it, because regulators should never have let bankers, both conventional bankers and shadow bankers, run amok. But they did.
So it’s now time to hold the nose and do what must be done, however stinky it smells, not because it’s pleasant but because it is necessary.
Only with the full force of the sovereign’s balance sheet can the Paradox of Deleveraging be broken.
Paul McCulley
Managing Director
1 “The Paradox of Deleveraging Will Be Broken,” Global Central Bank Focus, November 2008. 2 “Comments Before the Money Marketeers Club, Minsky and Neutral:Forward and in Reverse,” Global Central Bank Focus, December 2007.
3 “The Paradox of Deleveraging,” Global Central Bank Focus, July 2008.
4 “All In,” Global Central Bank Focus, December 2008/January 2009.
And now to Paul Volker’s speech:
Paul Volcker is the former U.S. Federal Reserve Board chairman, and is now a member of President Barack Obama’s advisory team on the economy. He recently gave a speech in Toronto on the extent of the U.S. economic crisis.
Here is the speech in full:
I really feel a sense of profound disappointment coming up here. We are having a great financial problem around the world. And finance doesn’t work without some sense of trust and confidence and people meaning what they say. You take their oral word and their written word as a sign that their intentions will be carried out.
The letter of invitation I had to this affair indicated that there would be about 40 people here, people with whom I could have an intimate conversation. So I feel a bit betrayed this evening. Forty has swelled to I don’t know how many, and I don’t know how intimate our conversation can be. But I will, at the very least, be informal.
There is a certain interest in what’s going on in the financial world. And I will disappoint you by saying I don’t know all the answers. But I know something about the problem. Let me just sketch it out a little bit and suggest where we may be going. There is a lot of talk about how we get out of this, but I think it’s worth remembering, or analyzing, how this all started.
This is not an ordinary recession. I have never, in my lifetime, seen a financial problem of this sort. It has the makings of something much more serious than an ordinary recession where you go down for a while and then you bounce up and it’s partly a monetary – but a self-correcting – phenomenon. The ordinary recession does not bring into question the stability and the solidity of the whole financial system. Why is it that this is so much more profound a crisis? I’m not saying it’s going to get anywhere as serious as the Great Depression, but that was not an ordinary business cycle either.
This phenomenon can be traced back at least five or six years. We had, at that time, a major underlying imbalance in the world economy. The American proclivity to consume was in full force. Our consumption rate was about 5% higher, relative to our GNP or what our production normally is. Our spending – consumption, investment, government – was running about 5% or more above our production, even though we were more or less at full employment.
You had the opposite in China and Asia, generally, where the Chinese were consuming maybe 40% of their GNP – we consumed 70% of our GNP. They had a lot of surplus dollars because they had a lot of exports. Their exports were feeding our consumption and they were financing it very nicely with very cheap money. That was a very convenient but unsustainable situation. The money was so easy, funds were so easily available that there was, in effect, a kind of incentive to finding ways to spend it.
When we finished with the ordinary ways of spending it – with the help of our new profession of financial engineering – we developed ways of making weaker and weaker mortgages. The biggest investment in the economy was residential housing. And we developed a technique of manufacturing class D mortgages but putting them in packages which the financial engineers said were class A.
So there was an enormous incentive to take advantage of this bit of arbitrage – cheap money, poor mortgages but saleable mortgages. A lot of people made money through this process. I won’t go over all the details, but you had then a normal business cycle on top of it. It was a period of enthusiasm. Everybody was feeling exuberant. They wanted to invest and spend.
You had a bubble first in the stock market and then in the housing market. You had a big increase in housing prices in the United States, held up by these new mortgages. It was true in other countries as well, but particularly in the United States. It was all fine for a while, but of course, eventually, the house prices levelled off and began going down. At some point people began getting nervous and the whole process stopped because they realized these mortgages were no good.
You might ask how it went on as long as it did. The grading agencies didn’t do their job and the banks didn’t do their job and the accountants went haywire. I have my own take on this. There were two things that were particularly contributory and very simple. Compensation practices had gotten totally out of hand and spurred financial people to aim for a lot of short-term money without worrying about the eventual consequences. And then there was this obscure financial engineering that none of them understood, but all their mathematical experts were telling them to trust. These two things carried us over the brink.
One of the saddest days of my life was when my grandson – and he’s a particularly brilliant grandson – went to college. He was good at mathematics. And after he had been at college for a year or two I asked him what he wanted to do when he grew up. He said, “I want to be a financial engineer.” My heart sank. Why was he going to waste his life on this profession?
A year or so ago, my daughter had seen something in the paper, some disparaging remarks I had made about financial engineering. She sent it to my grandson, who normally didn’t communicate with me very much. He sent me an email, “Grandpa, don’t blame it on us! We were just following the orders we were getting from our bosses.” The only thing I could do was send him back an email, “I will not accept the Nuremberg excuse.”
There was so much opaqueness, so many complications and misunderstandings involved in very complex financial engineering by people who, in my opinion, did not know financial markets. They knew mathematics. They thought financial markets obeyed mathematical laws. They have found out differently now. You know, they all said these events only happen once every hundred years. But we have “once every hundred years” events happening every year or two, which tells me something is the matter with the analysis.
So I think we have a problem which is not an ordinary business cycle problem. It is much more difficult to get out of and it has shaken the foundations of our financial institutions. The system is broken. I’m not going to linger over what to do about it. It is very difficult. It is going to take a lot of money and a lot of losses in the banking system. It is not unique to the United States. It is probably worse in the UK and it is just about as bad in Europe and it has infected other economies as well. Canada is relatively less infected, for reasons that are consistent with the direction in which I think the financial markets and financial institutions should go.
So I’ll jump over the short-term process, which is how we get out of the mess, and consider what we should be aiming for when we get out of the mess. That, in turn, might help instruct the kind of action we should be taking in the interim to get out of it.
In the United States, in the UK, as well – and potentially elsewhere – things are partly being held together by totally extraordinary actions by a central bank. In the United States, it’s the Federal Reserve, in London, the Bank of England. They are providing direct credit to markets in massive volume, in a way that contradicts all the traditions and laws that have governed central banking behaviour for a hundred years.
So what are we aiming for? I mention this because I recently chaired a report on this. It was part of the so-called Group of 30, which has got some attention. It’s a long and rather turgid report but let me simplify what the conclusion is, which I will state more boldly than the report itself does.
In the future, we are going to need a financial system which is not going to be so prone to crisis and certainly will not be prone to the severity of a crisis of this sort. Financial systems always fluctuate and go up and down and have crises, but let’s not have a big crisis that undermines the whole economy. And if that’s the kind of financial system we want and should have, it’s going to be different from the financial system that has developed in the last 20 years.
What do I mean by different? I think a primary characteristic of the system ought to be a strong, traditional, commercial banking-type system. Probably we ought to have some very large institutions – or at least that’s the way the market is going – whose primary purpose is a kind of fiduciary responsibility to service consumers, individuals, businesses and governments by providing outlets for their money and by providing credit. They ought to be the core of the credit and financial system.
This kind of system was in place in the United States thirty years ago and is still in place in Canada, and may have provided support for the Canadian system during this particularly difficult time. I’m not arguing that you need an oligopoly to the extent you have one in Canada, but you do know by experience that these big commercial banking institutions will be protected by the government, de facto. No government has been willing to permit these institutions, or the creditors and depositors to these institutions, to be damaged. They recognize that the damage to the economy would be too great.
What has happened recently just underscores that. And I think we’re at the point where we can no longer fool ourselves by saying that is not the case. The government will support these institutions, which in turn implies a closer supervision and regulation of those institutions, a more effective regulation than we’ve had, at least in the United States, in the recent past. And that may involve a lot of different agencies and so forth. I won’t get into that.
But I think it does say that those institutions should not engage in highly risky entrepreneurial activity. That’s not their job because it brings into question the stability of the institution. They may make a lot of money and they may have a lot of fun, in the short run. It may encourage pursuit of a profit in the short run. But it is not consistent with the stability that those institutions should be about. It’s not consistent at all with avoiding conflict of interest.
These institutions that have arisen in the United States and the UK that combine hedge funds, equity funds, large proprietary trading with commercial banks, have enormous conflicts of interest. And I think the conflicts of interest contribute to their instability. So I would say let’s get rid of that. Let’s have big and small commercial banks and protect them – it’s the service part of the financial system.
And then we have the other part, which I’ll call the capital market system, which by and large isn’t directly dealing with customers. They’re dealing with each other. They’re trading. They’re about hedge funds and equity funds. And they have a function in providing fluid markets and innovating and providing some flexibility, and I don’t think they need to be so highly regulated. They’re not at the core of the system, unless they get really big. If they get really big then you have to regulate them, too. But I don’t think we need to have close regulation of every peewee hedge fund in the world.
So you have this bifurcated – in a sense – financial system that implies a lot about regulation and national governments. If you’re going to have an open system, you have got to get much more cooperation and coordination from different countries. I think that’s possible, given what we’re going through. You’ve got to do something about the infrastructure of the system and you have to worry about the credit rating agencies.
These banks were relying on credit rating agencies while putting these big packages of securities together and selling them. They had practically – they would never admit this – given up credit departments in their own institutions that were sophisticated and well-developed. That was a cost centre – why do we need it, they thought. Obviously that hasn’t worked out very well.
We have to look at the accounting system. We have to look at the system for dealing with derivatives and how they’re settled. So there are a lot of systemic issues. The main point I’m making is that we want to emerge from this with a more stable system. It will be less exciting for many people, but it will not warrant – I don’t think the present system does, either – $50 million dollar paydays in that central part of the system. Or even $25 or $100 million dollar paydays. If somebody can go out and gamble and make that money, okay. But don’t gamble with the public’s money. And that’s an important distinction.
It’s interesting that what I’m arguing for looks more like the Canadian system than the American system. When we delivered this report in a press conference, people said, “Oh you mean, banks won’t be able to have hedge funds? What are you talking about?” That same day, Citigroup announced, “We want to get rid of all that stuff. We now realize it was a mistake. We want to go back to our roots and be a real commercial bank.” I don’t know whether they’ll do that or not. But the fact that one of the leading proponents of the other system basically said, “We give up. It’s not the right system,” is interesting.
So let me just leave it at that. We’ve got more than 40 people here but they’re permitted to ask questions, is that the deal? |
