Loyal NetNet readers know that I’ve long been a champion of the “crisis of regulatory capitalism” thesis of Jeffrey Friedman and Wladmir Kraus. Now it seems JP Morgan Chase CEO Jamie Dimon may be a champion of the idea as well.
In their book “Engineering the Financial Crisis: Systemic Risk and the Failure of Regulation ,” Friedman and Kraus argue that regulation—especially regulation of bank capital under Basel II and similar rules in the U.S.—led to a homogenization of balance sheet assets across the banking system. Risk weighting loaded the dice in favor of buying the assets regulators viewed as safe—especially mortgage backed securities—and as a result the banking system as a whole was over-exposed to mortgages and lacked diversity.
This last point is especially crucial and not well understood. One of the advantages of a free market system is that different businesses can adopt different business strategies. In fact, competition encourages diversity as executives attempt to gain advantage over rivals in the face of an uncertain future. Disagreement among capitalists strengthens the system because it reduces the cost of errors. Some firms win, others lose, and the damage of bad bets is contained and balanced by the benefits of good bets. Regulations that impose one view on business create systemic risk, Friedman and Kraus argue.
Dimon takes up this position in his April 4th letter to JP Morgan shareholders.
Dimon mentions that many of the regulations and regulatory actions of the past few years tend to encourage a concentration of risk around government securities (we bulleted to make it easier to follow).
- Quantitative easing may be good policy to help the economy recover, but it does artificially increase the value of government and government-guaranteed securities.
- The new Liquidity Coverage Ratio gives government and government-guaranteed securities credit only for being liquid – no other assets, including gold, equities or corporate bonds have any liquidity value. This also creates higher demand and, therefore, a higher artificial value for government securities.
- The Volcker Rule, as it currently is written, also allows unimpeded trading and liquidity for government securities and a lot less liquidity for everything else.
- Pension accounting is forcing pensions to hedge their liabilities by buying fixed-rate securities at precisely the wrong time.
- Banks hold large available for-sale securities portfolios to manage their assets and liability risk management. And if rates ever go up (and they will) and there are losses in these portfolios, the losses will have to be deducted in capital – even though the liabilities that they are hedging are not being marked-to-market.
- All the items we just mentioned could be looked at as one large “crowded trade.” If things ever start to go wrong, everyone could head to the exit door at the same time.
In short, Dimon thinks regulations are once again homogenizing the financial system, exposing too many different actors to the same risk—rate risk in government securities.
But it’s on capital requirements that Dimon really sounds like Friedman and Kraus:
Finally, the ultimate goal, with which we mostly agree, is to have Basel III applied fairly and evenly around the world. But this leads to another potential set of issues. Everyone will start to have an increasingly more common view of the risk of a certain type of asset. This is what happened in the United States when everyone thought mortgages were completely safe. Models eventually will replace judgment – and this is a terrible idea. Models always are backward looking and don’t capture true underlying shifts and changes that affect credit or markets; e.g., increasing or reducing liquidity, structural changes in industries that dramatically change the riskiness of an industry (think of what the Internet did to newspapers) or real quality underwriting vs. lax underwriting. And models have a hard time capturing concentration and correlation of risks (think of oil and real estate in oil regions). Many years ago in the United States, there were approximately eight large banks in Texas. Within five years after the oil crisis, only one survived as an independent bank. The others were either sold under duress or went bankrupt – not because of their oil exposure but because of their real estate exposure. Models cannot replace judgment, and judgment helps to balance and diversify the global financial system.
That’s more or less the Friedman-Kraus thesis.
I can't say for sure whether or not Dimon has read "Engineering the Financial Crisis." I do know, through a source, that he has a copy of the book.