Do We Have Too Much Financial Stability?

photo by: TheTruthAbout...

Closed savings bank

The notion that we’ve geared our financial system too much toward the goal of stability may strike many people as a bit far fetched. Haven’t we just lurched from one financial crisis based on mortgages to another based on sovereign debt?

But a blog post by an anonymous writer calling himself “London Banker” has been getting a lot of attention for his argument that financial stability is part of our problem. It was picked up on Economonitor, linked to by Matt Ygelsias at Slate’s Moneybox, and by market monetarist economist Scott Sumner (the guy who advocates NGDP targeting, the hottest thingin econ blogging right now).

Here’s the crux of the argument:

One strength of the US banking system from the 1930s to the 1980s was that failures were dealt with quickly and certainly. Foreclosed properties had to be sold by banks within two years of repossession, leading to a quick and certain reallocation of assets from failed borrowers to new owners.

The FDIC swiftly and mercilessly shut down failed banks. New owners - often buying at distressed prices - were encouraged to invest in making the assets productive and profitable. It was this simple recycling from failed managers to better managers that was largely behind the short recessions and strong recoveries during this period of American economic history. With forbearance now institutionalised at all levels of the US economy, we are seeing Japanification instead of recovery. And it is even worse just about everywhere else where dominant banks are much more influential.

Financial Stability - like national security - can never be objectively confirmed as achieved. It is more often used to disguise the ulterior aims of its proponents, or to misdirect attention in aid of bad public policy that harms rather than promotes the public interest. For example, the Greenspan Put was a brilliant mechanism for ensuring financial stability by preventing any adjustment of the markets in response to the S&L crisis or dot-com bust. The Bernanke Put and Paulson Plan were financial stability solutions to the securitisation fraud crisis that revealed the undercapitalisation of global banks and over-leveraging of real estate. Bank bailouts and special liquidity facilities were financial stability innovations to prevent mark downs of mis-priced and illiquid capital assets… I oppose Financial Stability because it is the most misleading banner for a set of bad, harmful and expensive public policies protecting bad executive management and preventing recognition of realistic market outcomes.

So what would I promote instead? Resiliency and resolution. Resiliency means the ability to withstand stresses and shocks which will unavoidably arise in global, competitive markets. Resolution means the dispersion of assets to creditors - and competitors - when banks fail, in hopes the assets and enterprises will be better managed by other managers than the same ones that led the bank to failure. Together these two principles - if made the basis for public policy - would do more to restore sanity to global banking than anything else I can think of. Resiliency will favour more and better capitalisation, with a focus on marketable assets with transparent price discovery (e.g., traded on transparent markets and recorded on balance sheet). Speedy and certain resolution of failed banks will make management and shareholders conscious of the risks of failure falling first on them, then on unsecured creditors and bondholders, and never on the taxpayer.

This strikes me as about one-quarter correct.

It is true that bailouts prevent market clearing, making it more difficult for the market to recover from a downturn. The way we structured our bailouts resulted in further consolidation in the banking sector—despite the fact that the market has clearly communicated that our banks are too big.

But London Banker is way too conventional here. The main problem is that there really isn’t much difference between “resiliency” and “stability.” After all, the main pre-crisis financial mechanisms were capital requirements that sought to make banks more resilient by requiring them to hold assets regulators regarded as safe.

As Jeffrey Friedman and Wladmir Kraus demonstrate in their terrific book “Engineer The Financial Crisis,” regulators have long worried that deposit insurance and other forms of insurance in the financial sector would incentivize bankers to take on too much risk. In order to diminish this temptation, they imposed capital requirements that incentivized bankers to take on different risks the regulators preferred.

The result of this is that banks become too homogenized. Too many of them have asset mixes that are too similar. This created a very dangerous feedback mechanism, in which the regulatory view of risk was seemingly confirmed by market pricing. Essentially the demand for mortgage risk—driven by regulation—became so strong the risk was underpriced.

When the regulatory view of risk turned out to be wrong, the entire system melted down.

London Banker, it seems, would do this all over again in the name of “resilency” rather than financial stability. But this could be a distinction without a difference. The problem was (in Friedman’s phrase) “loading the dice in favor of the regulatory view of risk.”

That shouldn’t really be in the past tense. We still have this problem.

Questions? Comments? Email us [e-mail]

Follow John on Twitter @ twitter.com/Carney

Follow NetNet on Twitter @ twitter.com/CNBCnetnet

Facebook us @ www.facebook.com/NetNetCNBC