If you have ever wandered around the financial district in New York, then you may not have noticed the Museum of American Finance on the corner of Wall and William St. I tend to find there are lots of things I don't notice in New York, probably due to the fact that I am still doing a passable impression of a tourist and find myself looking ever upwards at the skyscrapers rather than at anything at ground level. Anyway MoAF is worth a look-in and having recently become a member (thanks Cognito Media!) I went along to one of their events last night on regulation.Richard Sylla was the moderator for the evening, with support from Hugh Rockoff, Eugene N. White and Charles Geisst.
Richard Sylla on Fractional Reserve Banking and Regulation
Richard started the evening by explaining some basics of bank balance sheets as a means for explaining why he feels banking needs regulation. He showed a simplified and conservative balance sheet for an example bank:
- Deposits 85% (from the likes of you or I)
- Capital 15% (shareholders including surpluses)
- Earning Assets 80% (loans and investments)
- Reserves 20% (cash and deposits at other banks/central banks)
Richard explained that the main point to note from the balance sheet was that the reserves did not match the depositors and hence there is not enough money to repay all the depositors if they asked for their money back all at once. Richard's example was a form of Fractional Reserve Banking and he explained that there were two main reasons why banking needs regulation. The first was the incentive for banks to reduce their reserves to increase profits (increasing risk re: depositors) and the second was to keep capital levels low in order to increase earnings per share.
He then went on to illustrate how at the time of the last crisis Fannie Mae and Freddie Mac had earning assets of 100%, reserves 0%, deposits of 96% and capital of 4%. Lehman and Bear Stearns both had zero reserves and capital of only 3%. He then went on to list a large number of well known financial institutions and showed how the equity of many was simply wiped out given falls in asset valuations, the lack of reserves and the very small levels of equity maintained.
Hugh Rockoff on Adam Smith and Banking Regulation
Hugh is apparently a big fan of free market economics and of Adam Smith in particular. Much as Smith is for the "Invisible Hand" of the free market and against regulation, Hugh was at pains to point out that even Smith thought of banking being a special case in need of regulation and referred to banking operations as "a sort of waggon-way through the air".
Apparently Smith lived through a banking crisis in 1772 involving the Ayr Bank – I think Hugh had misspelt this as "Air" which I not sure whether it was deliberate but made for some reasonable humour about the value of the notes issued by the bank. Apparently this was an international crisis involving many of the then major powers, was based on stock market and property speculation and indirectly lead to the Boston Tea Party so I guess many Americans should pay their respects to this failed bank that became a catalyst to the formation of their country. A key point to note was that the shareholders of the Ayr Bank were subject to unlimited liability and had to pay all obligations owing…not sure how that would go down today in our more enlightened (?) times but more of that later.
Hugh described how Smith thought there were many things that banks should not be allowed to do including investing in real-estate (!) and prohibitions on the "option" to repay monetary notes. Smith also suggested that the Government should set maximum interest rates. So for a free market thinker, Smith had some surprising ideas when it came to banking. Hugh also pointed out that another great free-marketeer, Milton Freedman, was also in favour of banking regulation and favoured both deposit insurance and 100% reserve banking.
Eugene White on Regulatory History
At a guess I would say that Eugene is a big fan of the quote from Mark Twain that "History does not repeat itself, but it does rhyme". Eugene took us briefly through major financial regulations in American history such as the National Banking Act of 1864, Federal Reserve Act of 1913, The "New Deal" of 1932 and others. He notably had a question mark around whether Dodd-Frank was going to be a major milestone in regulatory history, as in his opinion Dodd-Frank treats the symptons and not the causes of the last financial crisis. Eugene spent some time explaining the cycle of regulation where governments go through stages of:
-> Regulation ->
-> Problems caused by Regulation->
-> De-regulation ->
-> Financial Crisis ->
-> back to Regulation ->
Charles Geisst on Dodd-Frank and the Volker Rule
Charles started by saying that he thought Dodd-Frank, and in particular the Volker Rule, might well still be being debated three years hence. As others have done, he contrasted the 2,300 pages of Dodd-Frank with the simplicity of the 72 pages of the Glass-Steagall Act. He believes that the Volker Rule is Glass-Steagall by another name, and believes that Wall St has only recently realised this is the case and has begun the big push back against it.
He left the audience with the sobering thought that he thinks another financial crisis is needed in order to cut down Dodd-Frank from 2300 pages of instructions for regulators to put regulations in place to around 150 pages of meaningful descriptions of the kinds of things that banks can and cannot do.
Rules vs. Principals – One audience member wondered if the panel thought it better to regulate in terms of feduciary duties of the participants rather than in detailed rules that can be "worked around". Charles respond that he thought feduciary duties were better, and contrasted the strictness with which banking fraud has been treated in the USA with the relative lack of punishment and sentencing in the securities industry. Eugene added that the "New Deal" of 1932 took away limited liabiltiy for shareholders of banks, and with it the incentives for shareholders to monitor the risks being taken by the banks they own.
Basel Regulations – Another audience member wanted panel feedback on Basel. In summary the panel said that the Basel Committee got it wrong in thinking it knew for certain how risky certainy asset classes were for example thinking that a corporate bond from IBM was more risky than say an MBS or government debt.
Do Regulators deal with the Real Issues? – Charles again brought this question back to the desire for simplicity and clarity, something that is not found in Dodd-Frank in his view. Hugh mentioned that the USA has specific problems with simply the number of regulatory bodies, and contrasted this with the single regulator in Canada. He said he thought competition was good for businesses but bad for regulators.
Eugene and Charles put an interesting historical perspective on this question, in that it is more often the case that government and the finance work together in composing legislation and regulation. Eugene gave the example that in the financial crisis of the early 30s, banks that had combined both retail and investment banking operations had faired quite well. So why did Glass-Steagal come about? Apparently Senator Steagal wanted deposit-insurance to help the myriad number of small banks back home, and Senator Glass simply wanted investment banks and retail banks to be separated, so a deal was done. I found this surprising (maybe I shouldn't be) but G-S is put forward as good regulation yet it seems it was not treating the observed symptoms of the crisis being dealt with.
How are the regulators dealing with Money Market Funds? – Here the panel said this was a classic example of the industry fiighting the SEC becuase the proposed regulation would reduce the return on their operations. Eugene explained how MMFs resulted from the savings and loans industry complaining about depositors investing in T-Bills. So the government response was to increase T-Bill denomination from $1,000 to $10,000 to limit who could invest, but then this was circumvented by the idea of setting up funds to invest in these larger denomination assets. Charles added that he thought the next crisis would come from the Shadow Banking system and that a more balanced approach needed to be taken to regulate across both systems. Hugh added that Dodd-Frank thinks it can identify systematically important institutions and it would be his bet that the next crisis starts with an organisation that is below the radar and not on this list. The panel concluded with a brief discussion of pay and remuneration and said that this was a major problem that needed better solutions.