Is the Financial System Condemned to a "Doom Loop"?

"Banking on the State" by Andrew Haldane and Piergiorgio Alessandri is making waves in official circles. Haldane, executive director for financial stability at the Bank of England, is widely regarded as both a technical expert and as someone who can communicate his points effectively to policymakers. He is obviously closely in line—although not in complete agreement—with the thinking of Mervyn King, governor of the Bank of England.

Haldane and Alessandri offer a tough, perhaps bleak, assessment. Our boom-bust-bailout cycle is, in their view, a "doom loop." Banks have an incentive to take excessive risk and every time they and their creditors are bailed out, we create the conditions for the next crisis.

Any banker who denies this is the case lacks self-awareness or any sense of history, or perhaps just wants to do it again.

The Haldane-Alessandri "doom loop" is fast becoming the new baseline view, i.e., if you want to explain what happened or—more interestingly—what can happen going forward, you need to position your arguments relative to the structure and data in their paper.

For example, at Mr. Bernanke's reconfirmation hearing, these issues will come up in some fashion. The contrast between the hard-hitting language of the "doom loop" and Ben Bernanke's odd statements on the dollar yesterday could not be more striking. Still, there is no reason to regard the Haldane-Alessandri version of the doom loop as the final word; in fact, this where the debate now heads. (This link gives as useful introduction to relevant aspects of banking theory, as well as Eric Maskin's insightful personal take.)

To help move the discussion forward, here are some issues "Banking on the State" raised in discussions with top experts (who prefer to remain anonymous):

1. The authors say that it is clear, in retrospect, that banks were excessively leveraged. But how did regulators/supervisors miss the implications of this at the time? Banks' balance sheets started expanding from 1970 onward (page 3) and by 2000 "balance sheets were more than five times annual UK GDP." This was not an overnight development—see the last sentence on page 8 that says: "Higher leverage fully accounts for the rise in UK banks' return on equity up until 2007." It may be difficult for a central banker to come clean on who convinced whom that modern banking in this form is safe—but at a minimum the authors should draw lessons from earlier failures of regulators/supervisors when discussing prospective changes in the framework of regulation. Could some of the changes being proposed suffer the same fate as all previous attempts to regulate big banks? It seems the authors' answer is that just moving things to Pillar I (from Pillar II) will help. This sounds like wishful thinking.
2. The authors are right that US banks faced a leverage ratio constraint that European banks did not. But US banks circumvented this by setting up structured investment vehicles (SIVs)—see the damage at Citi for details. Again, what were the regulators/supervisors thinking when they allowed this?
3. The authors assume that the equity owners of banks are almost always protected and therefore "the rational response by market participants is to double their bets." This does not seem to have been true in practice. For example, why was it so difficult for banks to raise capital after the initial flurry of new capital from sovereign wealth funds (SWFs)? Why did some banks' share prices fall so much (Citi, Merrill Lynch, Morgan Stanley, etc.)? This can only be characterized as a rational response by markets if equity holders were implicitly protected. In fact, new capital (either from the state or even in some cases from SWFs) came in the form of (expensive) preferred stock and diluted existing holders. The doom loop is surely more about what happens to insiders (rich and powerful bank executives with strong political connections) and creditors (investment funds run by rich and powerful nonbank executives with strong political connections).
4. Part of the (relatively) reasonable performance of hedge funds was due to them being forced quite early on to reduce leverage and asset holdings because banks were short of capital and tightened lending conditions. This fortuitously allowed hedge funds to reduce exposure before the crisis became most acute. Haldane and Alessandri seem a little too inclined to believe the hedge funds' own rhetoric at this stage. This is worrying—the intellectual origins of our last crisis lie with central bankers believing that the private financial sector has evolved into a safer form.
5. To be clear, and a little contrary to what the authors imply: Most hedge funds do not operate with unlimited liability. Often they have "watermark" provisions, limiting their fees while the fund shows losses. But it is a simple matter to close down a failing fund and, a week or so later, open another. (How many funds has John Meriwether closed?) This will feed the next doom loop.
6. The private sector is unlikely to be able to self-insure (e.g., various proposals discussed on page 18) because of the potential size of losses in a systemic event. We know there was private insurance for a large portion of the assets (CDOs insured through monolines, for example) but these insurers did not have credible resources. Similarly, implicit state guarantees may also not be sufficient (e.g., Iceland). This suggests strict controls on size of the financial system relative to the economy (and the tax base) may be necessary.
7. The paper is also relatively weak on the role of monetary policy in fueling the doom loop. But that is relatively easy to add on.

The overall conclusion of the paper follows uneasily from the main analytical thrust. How can we believe that for the regulators "next time is different" ? Most likely, next time will be exactly the same with different terminology: The financial sector "innovates," regulators buy their story that risks are now properly managed, and the ensuing bailout (again) breaks all records.

It's all politics. Unless and until you break the political power of our largest banks, broadly construed, we are going nowhere (or rather, we are looping around the same doom).

Barney Frank points out that small banks have political clout also, and of course he's correct that this drives some issues. But how many small banks spend their time (and lobbying dollars) on Capitol Hill insisting that large banks must not be broken up?

Our core problem is that we now have banks that are too big to fail; if you don't agree, read and publicly refute Haldane. In theory, these big banks could be effectively regulated, but this is a leap of faith that experienced policymakers (e.g., Mervyn King and Paul Volcker) are increasingly unwilling to make.

The biggest banks must be broken up. This is not sufficient to end the doom loop, but it is necessary.

Also posted on Simon Johnson's blog, Baseline Scenario. The following was previously posted.

Global Bubbles, the Tobin Tax, and the Geithner-Brown Split

November 10, 2009

There are two broad views on our newly resurgent global bubbles—the increase in asset prices in emerging markets, fueled by capital inflows, with all the associated bells and whistles (including dollar depreciation). These run-ups in stock market values and real estate prices are either benign or the beginnings of a major new malignancy.

The benign view, implicit in Secretary Geithner's position at the G-20 meeting last weekend, is most clearly articulated by Frederic (Ric) Mishkin, former member of the Fed's board of governors and author of "The Next Great Globalization: How Disadvantaged Nations Can Harness Their Financial Systems to Get Rich," in the Financial Times this morning:

"The second category of bubble, what I call the 'pure irrational exuberance bubble,' is far less dangerous because it does not involve the cycle of leveraging against higher asset values. Without a credit boom, the bursting of the bubble does not cause the financial system to seize up and so does much less damage"

In other words: keep monetary policy right where it is, and don't worry about financial regulation.

The second view is much more skeptical that "benign" bubbles stay that way. Remember that most damaging bubbles—or debt-based overexuberance, if you prefer—during the past 40 years have involved two elements:

1. Borrowers in emerging markets (Latin America and Eastern Europe in the 1970s; Mexico in the early 1990s; Russia, Ukraine, East Asia, Brazil and many others in the earlymid-1990s; Eastern Europe in the 2000s).
2. Citibank (and its descendants), i.e., a bank that was large and global before any other US institution was so inclined. Rather than bringing us the wonderful benefits of financial globalization, Citi has almost failed at least twice—and been rewarded for its incompetence with gold-plated bailouts at least four times.

Of course, other banks from other countries have become involved at various moments, but the point is that the lending organizations behind every bubble come from more "developed" financial markets—even when the origin of the capital flows is elsewhere (e.g., recycling oil surpluses in the 1970s). And the borrowers are always in places where the rules become lax during a boom—in this sense the United States became just like a classic emerging market after 2001 (and arguably earlier).

After months of painful procrastination, Gordon Brown has finally recognized that Adair Turner—head of the UK Financial Services Authority (FSA) and astute critic of Big Finance—is on to something in this regard.

At St. Andrews on Saturday, Brown actually proposed (and his mandarins briefed in private) on the need for a tax on financial transactions—a version of the "Tobin tax."

Brown knows full well that such a tax is unlikely to get traction in the current environment, partly as it would be hard to implement (i.e., the scope for evasion through offshore financial centers is enormous).

But the point of his announcement was to shock and awe finance ministers—and this worked. Secretary Geithner was provoked into uncharacteristically sharp pushback, which came across as the sort of rebuke that a minister of finance seldom directs at a head of government.

Brown and his team have at last understood that reining in the financial sector needs to be front and center in the international agenda—and the troika structure of the G-20 allows them (as outgoing chairs) to keep this issue hot.

It also provides political cover for the IMF, which is working hard on a tax for "excess risk taking" in finance. Dominique Strauss-Kahn (head of the IMF and leading candidate of the left for the next French presidential election) astutely provided more details in the aftermath of the Brown remarks—thus making it harder for the United States to oppose the IMF technocrats (and the French), who now seem so very moderate compared to Brown.

And how we will measure "excess risk taking"? Volumes of technical papers are being written, much math has already been wasted, and ponderous reports will soon appear. But, at the end of the day (which is the G-20 summit in June 2010) there is one central criterion around which you can get your hands: size.

Bigger banks pose more system risk, megabanks pose the most risk, and all bubbles can quickly go bad in the presence of such gigantic institutions. They must face appropriately higher taxes—in fact, so high that the biggest voluntarily break up in anticipation.

The ideas underlying Bernie Sanders's bill are becoming mainstream.