No "Free Lunch" in Banking Regulation

The Bankers' New Clothes:
What's Wrong with Banking and What to Do about It

by Anat Admati & Martin Hellwig.

Publisher: Princeton University Press

MY REVIEW

The ability of financial intermediaries, normally banks, to create money via the device called fractional reserve banking ("FRB") is capable of being both a boon and a bane.

When it works well, savings are mobilised, economic activity is facilitated, incomes increase, wealth accumulates and occasional set-backs are accommodated. It is a magical device without which the modern world could not exist.

In this, it resembles fire. Fire is essential to civilisation but is also extremely destructive when control of it is lost, Similarly,when money creation goes "bad", the consequences can be cataclysmic.

Some say that this is basically unavoidable, and that humanity is condemned to endure such disasters from time to time, just as we must expect another Ice Age sometime, no matter how well we restrain our pollutive natures. That may or may not be so, but I agree with the authors of this book that lessons can be learned and things can be done.

Admati & Hellwig are enthusiasts for the idea that Society can be spared future pain by a more conservative approach to one of the key fractions in FRB, the leverage ratio (often also called the capital ratio). "Whatever else we do, imposing significant restrictions on banks’ borrowing is a simple and highly cost-effective way to reduce risks to the economy without imposing any significant cost on society" is the message of this book, which also gives much space to rebuttal of many contrary arguments. It is a good book, and overall, I think that it makes its case well.

I really wasn't aware, before the book came to my notice, that the issue was so controversial, and I am still a little bemused at the pretty unanimous enthusiasm with which the book has been greeted by some. You can read The Grumpy Economist (No, John Cochrane - and he claims that he is "not really grumpy") and Patrick Honohan - who does admit to some "chafing", mind you - to get the full enthusiastic flavour, or just look at the reviews (including one by Ken Rogoff) summarised by the publishers here. Based on what I have seen myself, the selection appears, unusually for a publisher, to be quite representative. The Amazon ones are here.

My reason for buying the book, though, was because I was astonished by the authors' vehemence (visible in interviews and the Internet) on a point that I (still) think to be incorrect.

I agree that lower bank leverage will bring probably all the benefits that the authors say that it will. Furthermore, I note that they have wisely avoided pinning their colours to the mast of a specific figure, though it's clear that they have roughly 30% in mind (the current average figure is 3%, they say; others put it at nearer 11%). I also tend to side with them in the rebuttals of objections.

My problem is with their insistence that their plan is cost-free for the economy as a whole. I find it odd that there has been so little discussion or challenge of the view that higher bank capital requirements will not actually reduce the flow of loan finance out of the banks. Their approach to this in the book, in interviews and their website is not only wrong, in my view, but perverse.

It is perverse because it requires us to accept that banks' funding structure will have NO effect on banks' activities, whereas Admati & Hellwig spend quite a lot of space describing how the need to attract equity will improve lending standards. Better lending ceteris paribus pretty inevitably means less lending. Admati and Hellwig at different points appear to accept and also to deny this.

While one of the points well made in the book is that (non-bank) users of capital have become too fond of credit and too equity-averse, the authors appear to believe that this preference will frictionlessly pivot on both sides of the balance sheet i.e. depositors will voluntarily become more inclined to take an equity position in the institution where they keep their liquid savings, and borrowers will become more willing to pay in the form of a profit-share to lenders. If anyone doubted that before the Cyprus "bail-in", their fears will not have been assuaged by that fiasco.

I share Arnold Kling's view,

The non-financial sector wants to issue risky, long-term liabilities and to hold riskless, short-term assets. The financial sector accommodates this by doing the reverse.

.

Finally, though, I am dismayed by this book, and nearly all of its reviewers, because I see no appreciation of the multiplier effects of capital, and other ratios, on the dynamism of FRB. (Indeed, the words "multiplier", "fractional" and the phrases "fractional reserve banking" and "money-creation" are entirely absent from the text.) Central Banks wishing to dramatically slow down over-heating economies or sectoral markets always could (but very rarely did) increase the minimum ratios.

Raising the capital ratio, which is another way of saying "reducing the leverage ratio" even from 11% to 25% will drastically cut the money supply, even if the appetite for bank equity increases a lot. Raising equity capital may not be as difficult as it once was, but it is still and will always be slower than borrowing from money markets. For Klingian reasons, I doubt that bank balance sheets will, following such a change, end up as big as they were. This will have effects in the real economy.

But, even if this is, improbably, insufficiently optimistic, consider what the position will be going forward with a ratio of 25 instead of 11. Where before the multiplier was 9, now it is 4. For every extra million in deposits, 4 million can be injected as new credit, instead of 9 million. That is a formidably less dynamic monetary environment.

Of course, there will be positive aspects to this: less inflationary pressure and less reckless lending, to name but two benefits well worth having. And as we have painfully re-discovered, excessive dynamism is undesirable. However, as the authors say in another context, "it is impossible to discuss coherently the need for anything without considering its cost". The flow of credit will be reduced, and money creation will be suppressed considerably if we do, as we probably should, adopt Admati & Hellwig's proposal either in whole or in part. Those are significant costs. We should not pretend that they do not arise, even if we think that they are exceeded by the benefits.

Update on Friday, July 12, 2013 at 11:15AM by Fergus O'Rourke

Whoops ! Nearly forgot to mention this by Arnold Kling on the book, in which he adopts, unsurprisingly, a Klingian perspective. My own review was drafted before I discovered this article.

Update on Friday, July 12, 2013 at 11:19AM by Fergus O'Rourke

It's not explicit above, so let me make it so: the authors' repeated claim that they will show, and then that they have shown, that there is no cost to be paid for what they propose is, I say, not sustained in the book, or in the subsequent responses to its critics.

Book review: "Engineering The Financial Crisis" by Friedman & Kraus

"Engineering The Financial Crisis" by Jeffrey Friedman & Wladimir Kraus, University of Pennsylvania Press. Available from Marston Book Services, 160 Milton Park, Abingdon, Oxon, OX14 4SD, England / direct.orders@marston.co.uk. Price £29.50

This is a superb book, which deserves to be read by anyone who is serious about trying to understand how the Banking Crisis happened.

It has insights to offer on more general topics as well. These relate inter alia to the (alleged) delusions of the economics profession, the futility of some common expectations of democratic policy-making, and even to the limitations of human capacity to manage the complex systems that now dominate our lives. We think we understand these systems because it is we (or people like us) who constructed them, but even the most sophisticated of us are sometimes caught out.

A long time ago, the American wit H.L.Mencken observed

for every complex problem there is an answer that is clear, simple, and wrong.

The response of commentators, wherever located, to the Banking Crisis illustrate this quite well. The standard narrative (hereinafter "TSN"), not just in Ireland, is that what happened in 2008 followed years of reckless behaviour accompanied - indeed encouraged - by inflated salaries and ridiculous "bonus" payments to bankers. When the inevitable "feco-ventilatory intersection event" occurred, these same bankers then turned around and expected to be rescued from the consequences of their folly.

As Friedman & Kraus point out

... [these views have] immediate and important consequences. The informed public's impressions of the crisis are based in part on journalists' and scholars' hasty pronouncements. These impressions have now hardened into convictions. Political movements of the right and the left are already acting upon dogmas about the crisis that have little or no basis in fact, and policy changes have been made on the basis of these dogmas.

They go on to pick apart systematically the most popular U.S. explanations for the Crisis - which overlap with the most popular in Ireland, too - test them against the facts, and, one by one, discard them as unsatisfactory. (The authors might put it more strongly than that).

For example, they show that, as indeed in Ireland, the banks that failed most disastrously were also the ones led by men whose personal shareholdings were highest. This is counter-intuitive, as well as inconsistent with TSN.

They also show, in what they appear to regard as their most controversial finding, that the banks consistently chose security over high returns. This, too, is inconsistent with TSN, which takes it as axiomatic that "moral hazard" wreaked havoc by encouraging executives to take excessive risks, since it was (supposedly) a "tails I win, heads you lose" situation.

"The Right Kind of Regulation" ?

The book authors go on to propound their own explanation, which could be briefly summarised as

it was the Basel rules wot done it.

That is their précis, not mine. (The wording is not theirs, though).

And, more fundamentally,

the crisis was caused by ignorance on all sides.

That ignorance was not necessarily attributable to incompetence or similar faults. Nor was it otherwise culpable: it was a consequence, possibly not completely avoidable, of the complexity of the systems which had to be understood, and managed. Friedman & Kraus describe it as "radical ignorance".

In doing so, they "take a pop" - one of several, mainly at him, but at the economics community generally - at Joe Stiglitz, the Nobel laureate:

Essentially, his solution to this problem is consistently to downplay the possibility of human error - that is, to deny that human beings (or at least uncorrupt human beings such as himself) are fallible. ...

Simply turning over all power to a Nobel laureate economist such as Stiglitz is no answer. There are many Nobel laureate economists, and they quite frequently disagree with one another. Which one of them should be the economist-king who will ensure that regulators do not make even worse mistakes next time ?

...If economists are our most important advisers, but their world-views have no place for genuine human error, we are in deep trouble

While the book is about only the U.S. dimension of the crisis - the authors say that all the data available there is not available for Europe or elsewhere - I believe that the basic analysis is accurate for Ireland as well.

What we have (or had) in common was an unquestioning belief that property values could never fall significantly. While I was previously aware of this fateful delusion, this book has brought home to me more than before the extent to which the Basel rules not only sanctified it, but incentivised banks to become more property-focussed.

In view of where we are now, the fact that the same conventions, in effect, also encouraged banks to over-lend to badly-run sovereign states is noteworthy as well.

Remembering that our own Nyberg report laid so much emphasis on the role of "group-think", the book’s observations on what it describes as "homogenisation" as a necessary effect of regulation are thought-provoking.

Another insight which merits attention, and helps to explain why "the bail-out keeps clocking up the billions", is the inappropriateness of the term "cushion" to describe minimum capital standards for banks. As the authors say, "hard-floor" would be a more accurate short-hand: as soon as a bank hits that level, those in control are in imminent peril of losing that control. They are naturally, and this is the intention, impelled to either raise fresh capital or to shrink loan-books.

That looks fine in theory, and may be considered to work well for a crisis confined to a single bank. As we have found, it does not work well in circumstances when there is a system-wide, and international, problem. In that situation, it is illusory to suggest that borrowers can repay quickly (or perhaps at all), and this will be so well-known that the normal suppliers of capital will not re-capitalise lenders.

In another finding which TSN ignores, Friedman & Kraus point out that

even the commercial banks that actually became insolvent had significantly higher regulatory capital levels than required by law

It is difficult to quarrel with their observation on that, viz.

This suggests that the chief cause of their insolvency was not (as a rule) deliberate risk taking but ... risk taking in which the bankers were ignorant of the true level of risk

I do not agree with every judgement of the authors. For example, contrary to their view, not every economist - and none of those who taught and still teach me - believes that any economist has precisely modelled reality. Also, while generally correct as to it having a major direct role in causation, their implicit view that remuneration models were of no relevance at all is one that I am not yet prepared to accept. As Steve Randy Waldman remarked recently on Twitter:

to the frustration of social scientists everywhere, a thing can be an important factor yet neither a necessary or sufficient cause...

Nevertheless I am grateful to them for their scholarship, and for their clear presentation of it, to which I cannot do adequate justice in a short review.

I heartily commend this book.