Response to 'Bring Back Boring Banks' [update]

The NY Times published an interesting editorial by AMAR BHIDÉ in which he makes the case for why, despite the Dodd-Frank Act and a blizzard of new regulations, major financial reform is still needed.

He sees a global financial system that is on life support needing frequent rescues by the central banks.  He also sees a lack of confidence in the financial system.

To address these problems, he calls for a return to boring banks.  This call has two major elements.  First, the government should guarantee all bank deposits.  Second, banks should face much tighter restrictions on risk taking including being restricted to easily understood businesses.

While I agree with his analysis of the problem, I disagree with his proposed solution.

The primary source of my disagreement is that regulated banks are fully capable of blowing themselves up even when they are restricted to easily understood businesses.  Examples of this include the US Savings & Loans that became virtually extinct because of losses on mortgages and the current Eurozone banking crisis triggered by losses on Eurozone sovereign debt.

CENTRAL bankers barely averted a financial panic before Christmas by replacing hundreds of billions of dollars of deposits fleeing European banks. But confidence in the global banking system remains dangerously low. To prevent the next panic, it’s not enough to rely on emergency actions by the Federal Reserve and the European Central Bank. 

Instead, governments should fully guarantee all bank deposits — and impose much tighter restrictions on risk-taking by banks.

Regular readers know that my blueprint for saving the financial system calls for governments to fully guarantee all bank deposits.  This guarantee of all bank deposits is needed to prevent bank runs while the banks are recapitalizing after recognizing all of their losses.

Where I disagree with Amar is over how to impose much tighter restrictions on risk-taking by banks.  I think much tighter restrictions should be the result of market discipline.  Market discipline has many sources including investors, competitors and regulators.

My mechanism for bringing market discipline to the financial sector is to require all financial institutions to have to provide ultra transparency by disclosing on an on-going basis their current asset, liability and off-balance sheet exposure detail.  Market participants can use this data as the basis for exerting their respective form of market discipline.

Banks should be forced to shed activities like derivatives trading that regulators cannot easily examine.

With ultra transparency, market discipline would create incentives for banks to reduce their derivative trading.  These incentives include the possibility of predatory trading against the banks given their positions are known.

The Dodd-Frank financial reform act of 2010 did nothing to secure large deposits and very little to curtail risk-taking by banks. It was a missed opportunity to fix a regulatory effort [to prevent financial panics] that goes back nearly 150 years.... 

In fact, an overwhelming proportion of the “quick cash” in the global financial system is uninsured and prone to manic-depressive behavior, swinging unpredictably from thoughtless yield-chasing to extreme risk aversion.

Much of this flighty cash finds its way into banks through lightly regulated vehicles like certificates of deposits or repurchase agreements. Money market funds, like banks, are a repository for cash, but are uninsured and largely unexamined.

The reason that this "quick cash" exhibits manic-depressive behavior has to do with the fact that banks are 'black boxes'.  Currently, banks do not provide adequate disclosure so that the individuals who control the quick cash can assess the risk of each bank.  As a result, these individuals tend to extreme risk aversion and shift their investments should there be any hint of trouble.

Relying on the Fed and other central banks to counter panics is dangerous brinkmanship. A lender of last resort ought not to be a first line of defense.

Rather, we need to take away the reason for any depositor to fear losing money through an explicit, comprehensive government guarantee. The government stands behind all paper currency regardless of whose wallet, till or safe it sits in.

The government effectively did this in 2009.

Why not also make all short-term deposits, which function much like currency, the explicit liability of the government?

Guaranteeing all bank accounts would pave the way for reinstating interest-rate caps, ending the competition for fickle yield-chasers that helps set off credit booms and busts. (Banks vie with one another to attract wholesale depositors by paying higher rates, and are then impelled to take greater risks to be able to pay the higher rates.) 

Stringent limits on the activities of banks would be even more crucial. If people thought that losses were likely to be unbearable, guarantees would be useless.

Regardless of the size of the losses, guarantees are useful.  So long as depositors believe that they could withdraw all their funds, they will continue to use a bank even if it has a large, negative book equity value.

I agree that guaranteeing all the deposits requires stringent limits to be place on bank activities.  My preference is to put these limits on by requiring ultra transparency.  That way, if the bank's risk increases, everyone can see it and market discipline exerted.

Without ultra transparency, bank managers are likely to gamble on redemption like the managers of the US Savings & Loans did.

Banks must therefore be restricted to those activities, like making traditional loans and simple hedging operations, that a regulator of average education and intelligence can monitor. If the average examiner can’t understand it, it shouldn’t be allowed. 

Giant banks that are mega-receptacles for hot deposits would have to cease opaque activities that regulators cannot realistically examine and that top executives cannot control.... 

Amar's solution still leaves the financial markets dependent on a single point of failure:  the regulators.

By providing ultra transparency, the regulator can tap the market for understanding and monitoring the risks that banks are taking.

These radical, 1930s-style measures may seem a pipe dream. 

But we now have the worst of all worlds: panics, followed by emergency interventions by central banks, and vague but implicit guarantees to lure back deposits. 

Since the 2008 financial crisis, governments and central bankers have been seriously overstretched. The next time a panic starts, markets may just not believe that the Treasury and Fed have the resources to stop it.

Update

I would like to thank SW for calling my attention to the fact that savings and loans didn't just get wiped out by mortgages.  Given the opportunity by regulators to gamble on redemption, many of these also managed to lose a considerable amount of money in junk bonds.

Ultimately, the problem faced with a 100% deposit guarantee is the asset side of the balance sheet.  The question becomes how to eliminate all the ways that banks can fail.  Ironically, when we eliminate all the ways a bank can fail, we end up with a money market mutual fund that invests in short term government securities.

I like the 100% deposit guarantee only for the period during which banks recognize all the losses currently hidden in the financial system.  After these losses have been recognized, I think that deposit guarantees should be reduced.  The reduction in the deposit guarantee forces the banks to raise funds from the market.

When the market has ultra transparency, the cost of the non-guaranteed funds will reflect the risk the bank is taking.  Hence, market discipline is applied to the banks.