Matt Levine helps you understand the bank regulation problem in 1800 words

If you want to understand what bank regulators were doing in 2008, and what people like APRA and the Reserve Bank worry about here, try reading Matt Levine’s latest column.

Leviine’s piece is nominally about a weird court case involving AIG, the insurance behemoth which almost blew up the world financial system in 2008. But in the process of explaining the court case, Levine sets out with admirable clarity why our current banking system doesn’t allow easy, perfect regulatory solutions to banking problems like we faced six years ago. (A different banking system might do that, but so far no-one has come up with anything even faintly convincing enough to make us re-architect the entire financial world.)

Extract:

Simplifying a lot, a bank is a thing that allows some people (“savers”) to put money somewhere, get paid interest on it and be confident that they’ll get it back, and that allows that money to be invested in the real economy. That is: Banks have risky claims on the real economy and hand out risk-free claims to their savers.

This is a bit of magic that works most of the time, but not all of the time. Sometimes people realize that their risk-free claims are backed by risky assets, and might be riskier than they thought, and then they panic and pull their money out of the banks and that’s a big problem for the rest of the economy. This has been an extremely well-known problem for centuries, and the solution has been extremely well-known for about 140 years. It’s for the central bank to lend the banks money until the crisis passes.

This has nothing to do with subprime, or derivatives, or too-big-to-fail banks. It’s just a feature of banks, which are where the money is, but only in a probabilistic sense. Sometimes they are not where the money is, and that’s a crisis. But if the central bank (or, sort of equivalently, the government) lends them money, then the crisis will pass, and they’ll be able to pay it back with interest.

Many people dislike this, and it is sort of unseemly, but it really is a well-known set of facts. You can reduce the risk of banking crises happening, but not to zero, because of that core mismatch between banking’s risky assets and savers’ expectations of safety. And if crises do happen, central-bank support seems to be the only effective way to solve them.

Among other things Levine points out, in his copious and typically excellent footnotes*, that what we call “bail-outs” are less about helping bankers and more about helping the people (“bank creditors”) who have lent a lot of money to banks. In Australia these days, of course, people who have lent a little bit to banks are generally covered by a government guarantee.

Read the whole thing.

* I have no idea why so few journalistic articles in online-only publications have footnotes. They seem like a terrific idea for dealing with thoughts that aren’t core to your main narrative. Levine’s footnotes are a series of tasty hors d’ouevres sprinkled through the main meal.

About David Walker

David Walker runs editorial consultancy Shorewalker DMS (shorewalker.net), editing and advising business and government on reports and other editorial content. David has previously edited Acuity magazine and the award-winning INTHEBLACK business magazine, been chief operating officer of online publisher WorkDay Media, held policy and communications roles at the Committee for Economic Development of Australia and the Business Council of Australia and run the website for online finance start-up eChoice. He has qualifications in law and corporate finance. He has written on economics, business and public policy from Melbourne, Adelaide and the Canberra Press Gallery.
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Nicholas Gruen
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Nicholas Gruen(@nicholas-gruen)
7 years ago

David some people have met your bar of producing “faintly convincing” plans to “re-architect the entire financial world”. I would describe the Chicago Plan as even more than “faintly convincing”. Like Martin Wolf says, it’s worth a try.

Why is that unlikely? It has costs as well as benefits like any re-architecting of course. But it isn’t being tried in any of the national monetary systems that might give it a go not because it’s failed to convince people, but because it doesn’t play to incumbent interests.

paul frijters
paul frijters
7 years ago

Seems to me that Matt Levine is doing a Professor Pangloss: creating an orderly image of the financial world that has little to do with the problems in the financial world, but in which the government is making sensible decisions and there are no agency problems with bankers. Despite Levine’s mention of ‘moral hazard’, it is the child-like moral hazard of whole organisations that he talks about, not the moral hazard of each individual bank manager and fund manager, which is far more important. If only a bank was like a single individual! The problem is rather that banks are rents in themselves to the people working in them, creating opportunities within them for managers and decision makers to make money off the whole set of creditors. When one bails them out, the bail-out is actually managed by someone: it allows some people to help themselves and not others.

Banker bonuses in Europe thus remained sky-high because the bailouts there did in fact directly benefit bank profitability, in the rather strange “professed hope” that this would lead banks to then lend money to other people. Also, the ‘bank-run’ reasons for temporary bailouts that Levine cites are singularly unapplicable to the GFC since we were talking about a lot of bad loans that were not going to be paid back and for which the people who decided on the loans will not be held accountable.

I find the Levine article thus quite naive. He clearly has not really got his head round the issue of agency problems in the financial world.

And the agency problem is not that hard to see: if you are making decisions about other people’s money then there is the constant incentive to siphon off some of that money and use it for personal gain and political patronage.

Ingolf Eide
Ingolf Eide(@ingolf)
7 years ago

David,

Most enjoyable, and amen on the footnotes.

Paul,

Wholly agree the agency problem is huge and still very alive. Still, although you may be right that he’s a bit naive (haven’t read much Levine), it’s not really the impression I came away with from this article.

I thought it was a concise and rather amusing tiptoe through the issues. Far from viewing the financial world as orderly, seems to me Levine sees it as fundamentally flawed and given to chaotic outbreaks (which of course it is).

Nicholas,

Implementing anything like the Chicago Plan would make the incumbents very unhappy but I don’t think that’s the only reason it’s not being tried.

Francis Coppola summed up some of the main problems with Wolf’s proposal back in April.

http://www.pieria.co.uk/articles/martin_wolf_proposes_the_death_of_banking

She also pointed out that the field of alternative approaches to FRB banking is in itself highly contested. It’s not like there’s a “Plan” (Chicago or otherwise) that everyone eager for a change agrees on.

paul frijters
paul frijters
7 years ago
Reply to  Ingolf Eide

I disagree: at the end of the day, the only theories he really gives the reader and hence the lens he offers to view the sector through, is the rational-bailout theory plus a bit of moral hazard for the organisation as a whole. If you buy that, you have no real idea as to what could have been done before the GFC, why repealing Glass-Steagall was a mistake, how regulatory capture could even happen (because that requires a view in which the regulator is not a good sheppard and hence not just the principle in a moral-hazard game, which is the implicit view), etc. It is amusing, yes, but intellectually lazy in a way that contributes to the problem.

Ingolf Eide
Ingolf Eide(@ingolf)
7 years ago
Reply to  paul frijters

Well, it seems we may have to agree to disagree.

On my reading, Levine is sceptical (at times bordering on cynical) about the financial system, its denizens, regulation and pretty much everything else. This is more evident in the footnotes than the article itself (e.g. his general agreement with much of Matt Stoller’s article).

The only point IMO where he’s obviously either naive or disingenuous is in footnote 8. I’m with Stoller; I think AIG’s derivative obligations with GS et al could (and should) have been subject to drastic haircuts.

On the deeper issues about the structuring of banking and financial systems, for all I know we may have similarly radical views. However, this article never pretended to address them (Levine takes the broad systemic status quo as a given).

Fyodor
7 years ago
Reply to  Ingolf Eide

I’m going to disagree with your agreement to disagree, because you’re both right.

Levine does provide a “concise and rather amusing tiptoe through the issues” AND at the same time he doesn’t provide any deep theories on the crisis. As Ingolf notes on that latter point, that wasn’t Levine’s intention – he was focused much more on the tiptoeing and less on the grand theorising. It’s thus unfair to criticise a financial journalist for being “intellectually lazy” simply because he didn’t address the grand issues that interested Paul but would have been distracting from what was already a fairly technical and complicated issue in an article.

On the tiptoeing, I think Levine highlights a very important point in this coverage, namely the bias and moral hazard pervading the AIG bailout. Given the extent to which AIG’s counterparties were made whole at the expense of AIG’s shareholders, and the preferential treatment meted out to Wall Street broker-dealers in their own bailouts, US regulators clearly showed bias – if not regulatory capture – in their intervention. As Levine implies, moral hazard is an inevitable problem whenever the state intervenes in a “lender of last resort” capacity, as Bagehot knew well, but it’s hard to look back at the whole experience and conclude that US regulators approached the financial system participants objectively, logically or consistently. It was a regulatory clusterfuck and as a result there’s been lasting damage to the financial system and the perception of its regulators’ integrity ever since.

As an aside, it’s rather disappointing that mention of fractional reserve banking has not summoned Teh Old Ones from the abyssal depths of insanity. Apart from me, natch.

Paul Frijters
Paul Frijters
7 years ago
Reply to  Ingolf Eide

He does do grand theorising, but it is the wrong grand theorising. The quoted bit in the main post is the usual bank-run stuff and he augments it with moral hazard 1.0. If a regulator started with that mindset, the same mistakes involved in the the GFC would probably be made again. The piece is thus not, contrary to the title of the post, informative about the current regulatory problems and in a way shows that Levine has learned nothing of the GFC (or at least that he has not read and absorbed real lessons from the GFC). It is, as you say, amusing commentary, but it points you in the wrong directions when it comes to understanding. Particularly the quoted bit is extremely unhelpful.

Nicholas Gruen
Admin
Nicholas Gruen(@nicholas-gruen)
7 years ago
Reply to  Ingolf Eide

Thanks Ingolf

I will try to read Frances Coppola’s stuff, which I find on a second review of the links provided in her piece you linked to are more substantial than I thought. I first linked through to this post by her which was very unlike her in my view. It was a kind of smearing piece in which she seemed to suggest that full reserve banking was motivated by a kind of strange envy or ideological opposition to private money creation. If the full reservers are right – and I’m not decided on that – then they’re right on the basis of long run efficiency not ideology.

In fact Francis Coppola’s piece makes a good bookend to another really outrageous piece in which Ann Pettifor wrote a whole newspaper column attacking full reserve banking and Martin Wolf and then completely refused to engage in debate about it. It made her look like a complete impostor, afraid of debating the issues lest she give herself away – it’s hard to think clearly about this stuff without falling into various fallacies – that’s what I find anyway.

Anyway, looking at some of Frances other links they’re clearly more careful and straightforward, so I hope I get the chance to read them soon. Alas not now.

Ingolf Eide
Ingolf Eide(@ingolf)
7 years ago
Reply to  Nicholas Gruen

Nicholas, I don’t read Coppola all that often; in truth, I’ve been taking a break from all this banking type stuff! From what I have read she’s usually pretty good. She’s certainly serious.

Wholly agree about Ann Pettifor’s piece. Her opening paragraphs (in particular, her quotes) had me looking forward to reading the rest. Uh uh . . . I gave up after a page or two; vacuous, confused, boring.

Fyodor
7 years ago

I agree with you, Paul, that this post is misnamed but, again, I don’t think that’s Levine’s fault as I don’t see the grand theorising you mention. As I implied earlier, I think Nicholas over-egged the pudding in talking up Levine’s piece.

It’s not clear, at least to me, that Levine intended to provide any Grand Theory in describing and explaining an interesting legal hangover, i.e. the AIG litigation. Could you provide some examples of this grand theorising you see?

paul frijters
paul frijters
7 years ago
Reply to  Fyodor

sure: the main quote in this post depicts banks as individual rational actors who lend from many and then loan to many, ie whose job it is to assess risks and opportunities in the productive part of the economy. There is trust involved in that job in that those who have lent should not en masse come collecting their deposits because the lending out part means that the money takes time to come back. So a bank-run based on an inappropriate breakdown in that trust (ie., the bank is liquid in the long run) would provide a role for lender of last resort and we shouldnt be squeemish about bailouts since most bailouts are said to be of this type. From that theoretical perspective, regulation is inherently about when to offer bailouts because of the moral hazard whereby bailouts that come too quick give incentives for lending out too riskily. There is a tricky balance.

This is a theory: a story for what the essentials are. The thinking involved is very powerful to the uninitiated who dont have other theoretical stories to play it off against. It flows so nicely, sounds so logical, and depicts the main actors as essentially good-natured and with a real positive role in our economy: it is seductive. It sets up the regulator as a well-meaning informed person operating in a very difficult environment. Within that logic, one accepts bailouts more or less as they have occurred, with polite discussions had over champagne and caviar as to whether the timing could have been slightly better and whether a few crooks could have been unmasked earlier. Within that set-up there is no systemic problem nor any systemic solution. Just a few hick-ups we can all laugh at and we ourselves would surely avoid as we are sipping that champagne….

It is a very seductive theory and people prone to see good in the rich and powerful anyway (which is most of us as we are nearly all wannabees) are easily swayed by it. The problem is that it has almost nothing to do with reality. It makes the reader not the ask the question where banks actually make their money (productive investments in the economy or fleecing the uninformed and the unattentive). It makes the reader not ask who the regulator is and hence whether the same people who are regulating are also the regulators. It makes the reader not examine how the bailout is organised and whether other ways are available to ‘protect the creditors’ or whether the bailouts have actually lead to a resumption of all that good lending. It fails to ask the question how politicians actually come to power, who they are and where financial interests are involved in their ascendency.

In effect, the theory told rapes you with its eloquence and lulls you to sleep on the big issues. You get seduced by the thought that you now know something profound that few others have realised. Isnt Levine clever for explaining it so clearly, in such simple language? What more can you expect from a mere journalist? Those noble regulators and their difficult problems! Sure, there are a few bad apples amongst the banks and the bankers, but men of good intentions will surely find the ways the plug a few regulatory holes and return to normal…..the champagne is getting warm….

ARGGGGG!
Levine bought the convenient story, hook, line, and sinker. Lazy and part of the problem. David seems to have been fooled.

Ingolf Eide
Ingolf Eide(@ingolf)
7 years ago
Reply to  paul frijters

Paul, I wonder if you aren’t at least in part missing Levine’s schtick. Unusually for an American he often downplays things and employs dry humour. Kind of a “nudge nudge, wink wink” approach. He is after all writing for insiders.

As I said, I haven’t read much of his stuff so I may be wrong. However, consider some of the people he refers to in footnotes 3 & 5. They’re not your standard white bread commentariat. He’s interested, he’s digging. Doesn’t mean he gets it right all the time, but IMO he deserves some credit.

Nor can I see that he has a particularly benevolent view of regulators, much less of bankers. For example:

“This doesn’t always work, because regulators can be wrong or lazy or deceived or captured or whatever.”

There are certainly critical systemic matters he doesn’t touch on: the endogenous nature of money creation, for example; or, the possibility that “free banking” could square the circle. However, while they (and other issues) are vitally important, as Fyodor suggests he probably deserves a pass for not bringing them into this article. Remember his headline: that’s what the piece was centred around.

paul frijters
paul frijters
7 years ago
Reply to  Ingolf Eide

you are making excuses for him, Ingolf, you really are. He offers no understanding for how ” regulators can be wrong or lazy or deceived or captured or whatever.”. 6 years after the GFC, his understanding, the theory he offers his readers, is the one that lulls you into sleep again. You seem to miss the central importance of causal story lines in ‘understanding’. Mentioning in footnotes, or even in the main text, that mistakes can be made and that things may be different to how you just sketched them to be (including a judgment on what a ‘normal bailout’ is!), is ultimately irrelevant to the understanding you have offered the reader: it is the causal storyline you feed them that is the thing they can take away, the thing that they can use to be political actors themselves. When the caveats and humorous snipes are forgotten for the irrelevancy that they are, what is retained is the theory bought into. And 6 years of thinking on the topic has bought him this? I despair when I read such things. Is this the best we get in American financial journalism land? Does this count as informed commentary, fearless and independent of vested interests? Can’t you see how tragic this actually is?

Nicholas Gruen
Admin
Nicholas Gruen(@nicholas-gruen)
7 years ago
Reply to  Fyodor

Fyodor,

Far be it from me to agree with you but I didn’t egg anything. I agree with you and Paul. I didn’t post the post.

Fyodor
7 years ago
Reply to  Nicholas Gruen

Whoops! My bad – sorry, Nicholas and David.

Back to Paul: thanks for the exposition, but I’m still not convinced. I really think you’re asking too much of a financial news column that was never intended to delve into the Grand Theory in the way that you think is necessary. Responding below:

sure: the main quote in this post depicts banks as individual rational actors who lend from many and then loan to many, ie whose job it is to assess risks and opportunities in the productive part of the economy. There is trust involved in that job in that those who have lent should not en masse come collecting their deposits because the lending out part means that the money takes time to come back. So a bank-run based on an inappropriate breakdown in that trust (ie., the bank is liquid in the long run) would provide a role for lender of last resort and we shouldnt be squeemish about bailouts since most bailouts are said to be of this type. From that theoretical perspective, regulation is inherently about when to offer bailouts because of the moral hazard whereby bailouts that come too quick give incentives for lending out too riskily. There is a tricky balance.
This is a theory: a story for what the essentials are. The thinking involved is very powerful to the uninitiated who dont have other theoretical stories to play it off against. It flows so nicely, sounds so logical, and depicts the main actors as essentially good-natured and with a real positive role in our economy: it is seductive. It sets up the regulator as a well-meaning informed person operating in a very difficult environment. Within that logic, one accepts bailouts more or less as they have occurred, with polite discussions had over champagne and caviar as to whether the timing could have been slightly better and whether a few crooks could have been unmasked earlier. Within that set-up there is no systemic problem nor any systemic solution. Just a few hick-ups we can all laugh at and we ourselves would surely avoid as we are sipping that champagne…

You see, now you are over-egging. There are plenty of inferences you make there that are not stated or arguably even implied by Levine: “banks as rational”, “those who have lent should not en masse collect their money”, “most bailouts are said to be of this type”, “the main actors are essentially good-natured”, “the regulator as a well-meaning informed person”, “no systemic problem nor any systemic solution”.

I think you’re ascribing far too much theory and ideology to what is intended, I think, to be a description of prevailing practice in the application of LLR. I also think he’s highlighting that there ARE systemic problems. It’s the fact that he doesn’t critique the status quo that seems most to bother you but, again, I don’t think that theoretical critique (or even suggesting alternative systems) was his intention. His focus was much more simple: the conduct of participants and regulators in a specific bailout.

It is a very seductive theory and people prone to see good in the rich and powerful anyway (which is most of us as we are nearly all wannabees) are easily swayed by it. The problem is that it has almost nothing to do with reality. It makes the reader not the ask the question where banks actually make their money (productive investments in the economy or fleecing the uninformed and the unattentive). It makes the reader not ask who the regulator is and hence whether the same people who are regulating are also the regulators. It makes the reader not examine how the bailout is organised and whether other ways are available to ‘protect the creditors’ or whether the bailouts have actually lead to a resumption of all that good lending. It fails to ask the question how politicians actually come to power, who they are and where financial interests are involved in their ascendency.

Here I think you’re simply wrong. It’s very clear that Levine is questioning the conduct of the bailouts, the market participants and the regulators and, again, you seem disappointed that Levine doesn’t provide a political economy critique of the entire financial regulatory system but then, again, that wasn’t his intention.

In effect, the theory told rapes you with its eloquence and lulls you to sleep on the big issues. You get seduced by the thought that you now know something profound that few others have realised. Isnt Levine clever for explaining it so clearly, in such simple language? What more can you expect from a mere journalist? Those noble regulators and their difficult problems! Sure, there are a few bad apples amongst the banks and the bankers, but men of good intentions will surely find the ways the plug a few regulatory holes and return to normal…..the champagne is getting warm….
ARGGGGG!
Levine bought the convenient story, hook, line, and sinker. Lazy and part of the problem. David seems to have been fooled.

Hyperbole. However, given your evidently passionate interest, I’d be very interested in your theorising on the subject.

Ingolf Eide
Ingolf Eide(@ingolf)
7 years ago
Reply to  Fyodor

Agreed, Fyodor, I’d be interested in Paul’s systemic take as well if he wants to share it.

I read back through your earlier comments and was struck by this:

It was a regulatory clusterfuck and as a result there’s been lasting damage to the financial system and the perception of its regulators’ integrity ever since.

Absolutely right. Back in 2010, Mervyn King and Adair Turner openly examined banking’s deep-rooted problems in a speech and a chapter in a book respectively. King went so far as to say “Of all the many ways of organising banking, the worst is the one we have today.”

Both concluded (ref Nicholas’ suggestion above) that the single most useful reform would be to drastically increase bank capital requirements. In addition, however, they were both adamant that bank creditors should take the hit before taxpayers. That’s long been a bugbear of mine; in a piece I wrote at the time (“Some further thoughts on financial reform“) keying off King and Turner, I expressed similar thoughts to yours above:

As well as playing hell with the public finances, this decision [giving creditors a free pass] ensured that public faith in the fundamental fairness of the official response to the crisis was profoundly undermined, and understandably so. Whether it was done out of fear and panic, or because of the uncomfortably close relationships between government and the major players in the financial system, I don’t know, but the “fat tail” costs of this decision are likely to be very high indeed.

We haven’t even really begun to see those “fat tail” costs; in the next leg of the crisis they will, I fear, rise up and bedevil us for years to come.

David Walker
David Walker
7 years ago

Note to self: Never, ever suggest to Troppodillians that writer X will help you understand problem Y.

Ingolf Eide
Ingolf Eide(@ingolf)
7 years ago
Reply to  David Walker

Yes, no good deed will go unpunished . . .

paul frijters
paul frijters
7 years ago
Reply to  David Walker

yes, I am sorry David. You caught me on a bad day. Not that I said anything I didn’t think and it’s good to have this sort of discussion now and then, but I should have put my critiques more politely.

Nicholas Gruen
Admin
Nicholas Gruen(@nicholas-gruen)
7 years ago

By the way, I think you could reduce the chance of banking crises happening pretty much to zero with some good, juicy skin in the game. I think the Wall St Journal endorsed 15% (that’s of course a throwaway line that would be immediately repudiated the moment such a thing were implemented once the WSJ received a few plutocratically placed phone calls). Wolf I think talks of 20% with 10% as a minimum. This wouldn’t remove the odd banking problem, but it would mean that central banking wasn’t an invitation to moral hazard and the resulting micro-regulation. The central bank would pretty much always make a profit when it had to go to the rescue. As it should.

Meanwhile we’re at 3%!

Ingolf Eide
Ingolf Eide(@ingolf)
7 years ago
Reply to  Nicholas Gruen

Agreed Nicholas, it’s the most straightforward solution (see my reply to Fyodor just above).

Ingolf Eide
Ingolf Eide(@ingolf)
7 years ago

Paul,

Again, let’s just agree to disagree. In any case, Fyodor covered a lot of the ground very nicely.

Let me leave you with one small illustration that suggests Levine may actually be a pretty curious, burrowing sort of fellow. His first link from footnote 4 is to another of his pieces which examines some of the curious aspects to and consequences of the Lending Club model, and compares it to banking.

Nicholas Gruen
Admin
Nicholas Gruen(@nicholas-gruen)
7 years ago

One other thing on Frances Coppola Ingolf (formatting insets for replies have run out).

She seems to know what she’s talking about in a lot of this, and then says this:

But my bigger concern is this. Wolf’s idea amounts to replacing a demand-driven money supply creation mechanism with central planning of the money supply by a committee. Central banks’ record on producing accurate forecasts of the economy is dismal, and their response to economic indicators is at times highly questionable.

Here we have the idea that we have ‘demand driven’ money creation versus central planning. Well it’s central planners that set the short term interest rate, which I presume Coppola supports if she’s generally supportive of existing arrangements – which is that monetary policy – the condition of how much money is washing round the system – is a policy and run collectively not by decentralised supply meeting demand. Indeed, even those calling for a gold standard are doing the same – seeking monetary policy to be run by the state (via its public anchoring of money to gold) not as a ‘demand driven’ system.

Now maybe I’m missing something, but wouldn’t you think Coppola would address this in her claim? So I’m at a bit of a loss.

Ingolf Eide
Ingolf Eide(@ingolf)
7 years ago
Reply to  Nicholas Gruen

I’m mostly on Coppola’s side on that point, Nicholas. In broad terms, I think we do have “demand driven” money creation. Up until the crisis, bank lending (and bank asset purchases) created almost all money.

Post crisis, it’s been a different picture. Since end Sept 2008 US M2 went up by roughly $3.6 trillion while the monetary base climbed about $3.2 trillion. In the 10 years to end Sept 2008, on the other hand, the figures were $7.2 trillion and $0.45 trillion respectively.

During expansive times, central banks’ influence tends to be greatly exaggerated. They usually follow more than they lead, adding to reserves and/or cutting reserve requirements as needed to enable the banking system to keep pumping out credit (and hence money). They can squash the process if they want to get aggressive enough but that’s a pretty rare event.

In the bigger picture, their mere existence (together with other forms of direct and indirect official support) is absolutely instrumental in facilitating the underlying secular credit creation trend.

Where they do have a dominant immediate influence is during contractionary times, as per the post-crisis figures quoted above.