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What Next For Banks?

The case for keeping banks in something close to their current structure begins to take shape.  It’s not about traditional claims that big banks are more efficient, or Lloyd Blankfein’s argument that this is the only way to encourage risk-taking, or even the House Financial Services Committee view that immediate resumption of credit flows is essential for preserving jobs.

Rather, the argument is: those opposed to banks and bankers are angry populists who, if unchecked, would do great damage.  Bankers should therefore agree to some mild reforms and more socially acceptable behavior in the short-run; in return, the centrists who control economic policymaking will protect them against the building backlash.  This is a version of Jamie Dimon’s line: “if you let them vilify us too much, the economic recovery will be greatly delayed.”

There are three problems with this argument: it is wrong, it won’t work, and it doesn’t move the reform process at all in the right direction.

The “center vs. the pitchforks” idea fundamentally misconstrues the current debate.  This is not about angry left or right against the center.  It’s about centrist technocrat (close to current big finance) vs. centrist technocrat (suspicious of big finance; economists, lawyers, nonfinancial business, and – most interestingly – current/former finance, other than the biggest of the big, particularly people with experience in emerging markets.)

Just as an example, a broad range of entirely centrist people (including in and around the IMF; former Treasury; you’d be amazed) are expressing support for the ideas in our Atlantic article.  People on the left are, not surprisingly, also in line with this view; but we’re also hearing convergent thoughts from some on the right – many who emphasize improving the environment for entrepreneurship don’t see big finance as their friend.  So far, the only person who called to complain works for an “oligarch.”

You might think the “anti-pitchfork” strategy might work, particularly as it has in the past (e.g., in the early Clinton years).  The problem for this strategy now is not just the fragile state of banks – by itself this can be ignored for a long while through forbearance, behind a smokescreen of complicated schemes with confusing acronyms – but the ways in which the markets they created now operate.

Just as global financial liberalization created the potential for capital to move violently across countries and greatly facilitated speculative attacks on currencies, so financial deregulation within the United States has made it possible for capital markets to attack – or, in less colorful terms, go short or place massive negative bets on – the credit of big banks and, in the latest developments, the ability of the government to bailout/rescue banks.

The latest credit default spreads data for the largest banks show a speculative run underway.  As the system stabilizes, it becomes more plausible that a single big bank will fail or be rescued in a way that involves large losses for creditors.  This would like trigger further speculative attacks on other banks, much as the shorting of countries’ obligations spread from Thailand to Indonesia/Malaysia and then to Korea in fall 1997.

The government’s own policies are facilitating these attacks, because as the Fed and Treasury make progress towards easing credit conditions, this makes it easier and cheaper for large hedge funds and others to take large short positions.  And keep in mind the underlying loss of confidence is self-fulfilling: as you lose confidence, you want to go short, and selling the credit causes further loss of confidence – and banks are forced out of business.

The government’s entirely reasonable and long overdue request for a resolution authority will set up runs on that authority.  If the authority is not granted, the runs will be on the government’s low and failing ability to save banks – given that the trust of Congress has been lost and no more cash for bailouts is likely forthcoming (presumably until there are large further shock waves or until Goldman Sachs itself is on the line.)

The continuing pressure on banks has nothing to do with populism and everything to do with the internal contradictions of the house of cards they built.  Now they will scramble to limit short selling or find other emergency measures that will protect their credit.  Such partial fixes would do nothing to stop the underlying deterioration of their credit; think about how countries facing currency attacks throw up futile defenses, try to change the rules, and squander their reserves on the way down.

You can see where this is going, but do not cheer.  The likely result will be misery for many and further financial chaos around the world.

The big issue is of course the financial sector reform process.   Some of my colleagues expressed great satisfaction with the progress made by the G20.  But progressing down a blind alley is not something to be pleased about.  I have yet to hear a single responsible official in any industrial country state what is obvious to most technocrats who are not currently officials: anything too big to fail is too big to exist.

If the bankers were just stupid, as suggested by David Brooks, then regulatory fixes might make some sense.  But we know that bankers are smart, so it is their organizations that became stupid.  What is the economic and political power structure that made it possible for such stupid organizations to become so large relative to the economy?  Answer this and you address what we need to do going forward.

At a high profile conference in the run-up to this crisis, someone destined to become a leading official in the Obama Administration responded to a sensible technocratic critique of the financial system’s incentive structure (from the IMF, no less) by calling it “Luddite”.  By all accounts, this is the prevailing attitude in today’s White House.

But the right metaphor is not breaking productive machines, or peasants with pitchforks, or even the poor vs. the rich.  It’s as if the organizations running the nuclear power industry had shown themselves to be stupid and profoundly dangerous.  You might wish to abolish nuclear power, but that is not a realistic option; storming power plants makes no sense; and the industry has captured all regulators ever sent after them.

The technocratic options are simple, (1) assume a better regulator, of a kind that has never existed on this face of this earth, (2) make banks smaller, less powerful, and much more boring.


Originally published at the Baseline Scenario and reproduced here with the author’s permission.

6 Responses to “What Next For Banks?”

GuestApril 9th, 2009 at 9:36 pm

“Those opposed to banks and bankers are angry populists who, if unchecked, would do great damage.”It’s possible that those who opposed Senator McCarthy, had they been left unchecked, would have done great damage. That’s why the opposition remained muted.In fact, it was only when McCarthy himself was checked that great(er) damage was averted.”Such partial fixes would do nothing to stop the underlying deterioration of their credit; think about how countries facing currency attacks throw up futile defenses, try to change the rules, and squander their reserves on the way down.You can see where this is going, but do not cheer. The likely result will be misery for many and further financial chaos around the world.”That’s why it’s in everyone’s best interest – including that of the problem bankers’ – that they make a graceful and orderly exit.

GuestApril 9th, 2009 at 10:20 pm

“The likely result will be misery for many and further financial chaos around the world.”If the FDIC reimburses depositors, that cash should find it’s way to banks with better management. They should become solvent at that point. Once “business as usual” transfers its patronage from the failed bank(s) to the solvent ones that remain, the credit crisis will end.In the words of FDR, “The only thing we have to fear is fear itself.”

GuestApril 10th, 2009 at 3:17 am

“…the industry has captured all regulators ever sent after them.The technocratic options are simple, (1) assume a better regulator, of a kind that has never existed on this face of this earth, (2) make banks smaller, less powerful, and much more boring.”Laws limiting the size of banks are an excellent idea. Beyond that, the best way to “regulate the regulators” is they same way “government is itself governed:” through checks and balances.

AnonymousApril 10th, 2009 at 6:56 am

Sorry, I have to say it again. Mr Johnson simply has not a clue what he is talking about. Truly.”Such partial fixes would do nothing to stop the underlying deterioration of their credit; think about how countries facing currency attacks throw up futile defenses, try to change the rules, and squander their reserves on the way down.”Mr. Johnson would do well to have a look at the actual mechanics of banking. As a hint: there is a race against time for banks pre-provision profits from back and newly-created loan book to offset credit losses from back-book. This is assisted by the concerted effort to reflate the economy and arrest the pace of activity decline. Once this is achieved it is a matter of time for banks to recapitalise themselves through internal capital generation. Particularly so in this case where front-loading of credit-losses has been substantial, TARP money has been put to work to generate further profits => capital, and some fresh equity capital raising is also taking place (eg. HSBC, Barclays etc). More rigor in your arguments, please, and enough witch-hunting.”(1) assume a better regulator, of a kind that has never existed on this face of this earth, (2) make banks smaller, less powerful, and much more boring.”Clearly failing to understand, let alone address the core problem of the current monetary arrangements in our fiat currency system. Mr. Johnson at last try to get it: money supply creation exceeded the point where the ensuing wealth generation through deployment of money would offset the asset value dilution from more money in circulation. This is in its core a macroeconomic-systemic problem, and ONLY ONLY ONLY on the margin a banking sector problem per se. During the bull years most loan underwriting with the exception of subprime, was “positive carry” money creation on the basis of base-case economic performance expectations. Bankers did not consciously write bad loans to loss-making companies.Please at LAST, try to understand this fundamental dimension of the issues we are facing.Oh, and fewer words would really help readers avoid nausea half way down your articles.

GuestApril 10th, 2009 at 8:54 am

After losing much of their net worth to the NIKKEI crash of 1990, Japanese banks went on “to double their bets” in the Japanese property market “to win their money back.” (Some even blamed the capital adequacy requirements of the Bank of International Settlements as the cause of their investment losses.) When this second bubble burst, fiscal spending and the bond bubble took their place to prop up the Japanese economy. With risk-free interest rates near 0%, their was little opportunity left for Japanese banks to “double their bets” yet again.Instead, they refused to write off their losses and propped up excess supply (often via purchase of corporate bonds). Any cash that was still coming in was otherwise hoarded. The combination of excess supply and the effective sterilization of the circulating money supply led to another round of deflation, fiscal spending, and construction of roads to nowhere.In 2001, fiscal tightening reduced the flows of circulating scrip into the banks coffers even further. Combined with a strong drive by Koizumi to get the banks to write off their bad loans, this hoarded cash was liberated for more efficient use. The zombie firms that were propped up were simultaneously forced to liberate human capital for more efficient use as well.Unfortunately, this liberated capital was reinvested into expanding exports to the US during its property bubble. When it gets liberated again, hopefully it will be invested in a more sustainable growth sector – e.g. exports to China.

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