mathbabe

Regulation arbitrage

We had a interesting, lively #OWS Alternative Banking group meeting yesterday, where we split into three groups: the Volcker Rule commenting group, the shadow banking system, and Too Big to Fail (TBTF). I was impressed by the number of people who could come even on Thanksgiving weekend.

These topics have lots of overlap, a fact which came through at the end when we got back together and disseminated our thoughts. Specifically, the question of “regulation arbitrage” came up repeatedly. This is the idea that, no matter what laws you pass on how the banks can behave, they will get around the spirit of the law with some clever sleight of hand. In other words, it’s really hard to avoid a bad outcome if you have to list all of the things that someone isn’t allowed to do- they can avoid a rule governing having repos of no longer than 7 days by inventing a new instrument, which they may call a “nepo,” which has an 8 day lifespan.

It’s frustrating, since real regulation is clearly needed right now, and it makes you want to depend more on standards than specific rules. However, the problem with standards is that they can be avoided as well, by the sheer fact that they are always open to interpretation. Moreover, both of these approaches run the risk of being essentially too complicated for regulators to understand, but the standards one is particularly open to that.

If anyone has a third option that I haven’t thought of, please tell. Oh wait, someone suggested one to me: jailtime. This is actually a good point, and also possibly the best idea I’ve heard of to give some balls back to the SEC and other regulators: give them handcuffs and the authority to use them.

It occurs to me that the software testing community may have an answer, or at least an approach. It may make sense to set up a series of exhaustive tests which evaluates the resulting portfolio of the bank for certain characteristics which would indicate whether the bank has been following the standards appropriately.

To some extent this is being done, using various risk measures, for example looking at the volatility of the PnL to determine if someone is really market making or not. But I’m not sure the super nerds have thought about this onetoo much. I’d be interested to talk to anyone who knows.

Volcker Rule

There are two articles I wanted to bring up today. First, we have this Huffington Post article about the Volcker Rule commenting group Occupy the SEC, which has been meeting with us on Sundays and whom I’ve blogged about here and here. Some key quotes:

A handful of protesters at Occupy Wall Street are doing what the authors of a complex piece of financial legislation may have hoped no one would do. They are reading it.

…

The Occupy Wall Street movement, now in its third month, has drawn fire from people who say its members are too vague in their criticism of the financial system. Occupy the SEC, which consists of between four and eight New York protesters, would seem immune to such charges. Its members are compiling a list of highly specific points, and their ultimate goal is to submit a letter to regulators detailing their concerns before the Jan. 13 deadline.

Anyone can send in comments on the draft of the Volcker rule — and regulators will review those submissions before producing a final version of the measure — but, as in most cases where draft rules are made available for public scrutiny, not everyone has the time or inclination to parse hundreds of pages of regulatory jargon. Goldstein noted that most of the comments on financial rules end up coming from the banks themselves, arguing for greater leniency.

…

Paul Volcker himself has expressed displeasure with the current proposal, which is 30 times as long as the version originally included in Dodd-Frank.

Go team!

TBTF

Next, during the meeting yesterday where we were discussing Too Big to Fail (TBTF) and what can be done about it, Bloomberg published this article, which ranks among the best I’ve seen from them (up there with the Koch brothers article from a few weeks ago which I blogged about here).

The article describes the extent and amount of the secret Fed loans given to each bank for “liquidity” purposes during the credit crisis. Here’s a good quote:

While Fed officials say that almost all of the loans were repaid and there have been no losses, details suggest taxpayers paid a price beyond dollars as the secret funding helped preserve a broken status quo and enabled the biggest banks to grow even bigger.

Thank you! Why doesn’t everyone see that it makes no sense to say “we were paid back” when the underlying problem is still there (in fact worse) and we have given up our standards? On a related note:

The Fed didn’t tell anyone which banks were in trouble so deep they required a combined $1.2 trillion on Dec. 5, 2008, their single neediest day. Bankers didn’t mention that they took tens of billions of dollars in emergency loans at the same time they were assuring investors their firms were healthy. And no one calculated until now that banks reaped an estimated $13 billion of income by taking advantage of the Fed’s below-market rates, Bloomberg Markets magazine reports in its January issue.

Even if the $13 billion is arguable (I don’t have an opinion about that), I know it’s an underestimate because the alternative to this secret unlimited liquidity was bankruptcy, not less revenue.

The article brings up lots of interesting issues, beyond the asstons of cash money that were thrown at the banks during that time. Among them:

1. To what extent would Congress have blocked TARP if they had know the size of the Fed program? Remember they actually voted TARP down before coming back and changing their mind after the stock market dropped by 10%. My favorite quote for this question comes from Sherrod Brown, a Democratic Senator from Ohio: “This is an issue that can unite the Tea Party and Occupy Wall Street. There are lawmakers in both parties who would change their votes now.” I agree- this is a non-partisan issue.
2. How much freaking power does the Fed have to do stuff behind closed doors? To what extent was this motivated by their feelings of shame that they’d let the housing bubble inflate for so long? Related quote from the article: “I believe that the Fed should have independence in conducting highly technical monetary policy, but when they are putting taxpayer resources at risk, we need transparency and accountability,” says Alabama Senator Richard Shelby, the top Republican on the Senate Banking Committee.
3. Geithner seems to be against the idea of ending TBTF: “Geithner argued that the issue of limiting bank size was too complex for Congress and that people who know the markets should handle these decisions.” The article then goes on to say that Geithner suggested we just let the international economic community decide the new rules, i.e. Basel III. But as we know, that treaty has zero chance of being adopted by the U.S. at this point, so the end result is that Geithner put off the discussion by arguing that it would be dealt with internationally, but then it hasn’t been, at all. Moreover, the article mentions that the Dodd-Frank bill has a mechanism for closing down too-big-to-fail banks, decided by a committee of which Geithner is chair. I’m not holding my breath.

The most embarrassing part of the article is next, and deals again with the TBTF issue.

Lobbyists argued the virtues of bigger banks. They’re more stable, better able to serve large companies and more competitive internationally, and breaking them up would cost jobs and cause “long-term damage to the U.S. economy,” according to a Nov. 13, 2009, letter to members of Congress from the FSF. The group’s website cites Nobel Prize-winning economist Oliver E. Williamson, a professor emeritus at the University of California, Berkeley, for demonstrating the greater efficiency of large companies.

In an interview, Williamson says that the organization took his research out of context and that efficiency is only one factor in deciding whether to preserve too-big-to-fail banks. “The banks that were too big got even bigger, and the problems that we had to begin with are magnified in the process,” Williamson says. “The big banks have incentives to take risks they wouldn’t take if they didn’t have government support. It’s a serious burden on the rest of the economy.”

Nice! Hey FSF, you may want to find a new quote! Oh wait, that link no longer works, interestingly…

I’m planning a follow-up blog post to discuss what our group decided to do with respect to TBTF. Hint: it has something to do with a Republican presidential candidate.