Writing in the Wall Street Journal on Monday, Peter Wallison of the American Enterprise Institute argued that world growth was excessively subdued because Dodd-Frank and other repressive financial regulations were preventing bankers from taking risks. I agree entirely with Wallison’s detestation of regulation, and admire his previous analyses of Fannie Mae and Freddie Mac’s contribution to the 2008 financial crash. Nevertheless, it is clear to me that bankers taking more risks is the last thing we need; they are already taking too many of the wrong kind. Sadly, regulation, while very good at adding costs and blocking useful new businesses, is no good at all at de-risking banking, because if monetary policy gives sufficient incentive to risk-taking the regulations are always evaded.
The problem is evidenced clearly in China, where the Financial Times reports that the banking regulator is cracking down on financial engineering that has enabled Chinese banks to move dodgy loans off their balance sheets, thereby reducing the loans loss provisions they would have to make. By securitizing “debt receivables” to the tune of $2.2 trillion 16.5% of total bank debt, they have reduced the level of provisions and defaults on their own books. Needless to say, these numbers reflect what we have all believed about the quality of Chinese banks’ loan books ever since Ernst and Young was forced to “withdraw” its estimate of $915 billion of bad debt in the Chinese banking system way back in 2006. With masses of lunatic “stimulus” lending during the 2008-10 downturn, the problem has grown very much greater; indeed, it may even exceed the $3 trillion in Chinese foreign exchange reserves. The People’s Bank of China has pumped money into the system since 2007, and a morass of bad debt is the result.
Admirers of Western regulation systems will of course claim that Chinese regulation is relatively primitive, so Chinese excesses could never happen here. Given what the U.S. banks and investment banks were up to in 2006-07, that claim seems very unlikely to be justified. On the one hand, Wall Street managed to palm off much of the risk on hapless German regional banks, such as HSH Nordbank, which has just been bailed out by regional taxpayers to the tune of 10 billion euros. On the other hand, that ability does not make the problems go away, it simply shifts them to other parts of what is after all a global financial system, uncertainly supporting a global economy.
In any case, if Western regulators are better than their Chinese counterparts, the investment banks are also better at inventing new gimmicks – after also, most of the “financial technology” of the last 40 years, that has so increased financial services’ share in the global economy and the risks in the overall financial system, was invented in either New York or London. Thus tight regulation by and large merely leads the major banks to devote extra effort to evading it. By and large, if the banks are able to invent new and extra-risky instruments such as credit default swaps, the regulators won’t catch up to them until something has gone horribly wrong.
The central problem is that neither banks nor their regulators know what risks the banks are taking. As the financial crisis of 2007-08 showed, Wall Street’s assessments of risks were far too low, largely because they rested on assumptions about Gaussian price movements that were simply wrong, and were more seriously wrong the more skewed the instrument — Credit Default Swap risks were the most undercounted of all. This problem was repeated by J.P. Morgan Chase in their “London Whale” trades of 2012, which incurred billions of dollars in losses through managing risk by a methodology, based on Value-at-Risk, that had been shown hopelessly flawed in the market as a whole only four years before.
Why in heavens name would you want banks taking more risk, when they can’t manage it? Regulators try to make banks less risky, but they utterly fail to do so, as the banks simply jump through hoops to evade the regulations. The result is periodic financial crisis and taxpayer bailouts and a financial system that becomes an ever larger percentage of GDP, while providing infinitesimal actual value for money. When Goldman Sachs charges $300 million for carrying out a $1.5 billion bond issue for a Malaysian state entity, conventional GDP accounting says that GDP has been increased by $300 million, but in reality Goldman Sachs has simply collected a rent of about 95% of that amount. (As an old bond man I estimate that 1% of principal, or $15 million, is the maximum justifiable fee for carrying out that transaction, and with competitive bidding you could undoubtedly get the deal done for less.)
The reason for banks’ pathological risk-taking, and for the value-free growth of the financial sector, is the low, then ultra-low interest rates we have suffered for the last 20 years. They encourage leverage in general, thus providing business opportunities for the financial sector, while encouraging that sector to leverage itself ever more outlandishly. Regulations that limit financial sector leverage are gamed by the banks, which lobby for various “haircuts” to be levied against assets that should be taken at full value, and some assets such as government bonds to be treated as having no risk at all, an obvious nonsense in this era of perpetual budget deficits.
The solution is to institute much higher interest rates, which would make excess bank leverage very expensive. The Basel regulations against bank leverage would then become superfluous, because banks would no longer seek to lever themselves to such an extent. You could add an additional layer of security by imposing relatively high reserve requirements, which would make it very expensive to take on additional spurious assets, for example vast holdings of government bonds in order to play yield-curve games. Those reserve requirements have no effect at zero interest rates — indeed, the U.S. banks hold $2.3 trillion of excess reserves, more than their entire commercial and industrial lending portfolio. However, once interest rates rise, provided the Fed has the sense not to pay interest on excess reserves (which it currently lacks, much to the detriment of the banking system) the cost of holding reserves would rise rapidly, forcing the banks to deleverage and get rid of low-yielding extra assets.
With higher interest rates, the typical bank strategy of levering yourself to the eyeballs in order to gamble on tiny interest rate or credit differentials wouldn’t work any more. Banks would be compelled to look for opportunities among assets that provided a genuinely higher yield, at a risk that would be manageable when leverage was only moderate. The obvious such asset would be loans to businesses, the principal purpose of banks on the asset side of their balance sheets, which currently represent only 17% of total bank credit outstanding. Loans to small business, which require much more skill and effort on the part of bankers than mere fooling around on the trading desk, represent only a fraction of even this modest amount. With savings also suppressed by zero interest rates, it’s not surprising that new business formation is running at levels far below those of 40 years ago.
Wallison has got it wrong. The economy will not improve merely through banks taking more risks; if those risks are merely trading gambles, derivatives rubbish and other forms of off-balance sheet speculation they will merely increase the rents available to bankers without doing any good at all for the economy. Bankers need to take the right risks, mostly in the form of lending to small businesses. At the same time, returns to savers need to be increased to a level commensurate with Americans funding their retirements properly and making seed capital available for entrepreneurship.
That requires a revolution in U.S. monetary, fiscal and regulatory policy, which current electoral trends make it appear increasingly unlikely to occur for several years into the future. From the viewpoint of the U.S. competitive position, it is therefore perhaps to be welcomed that China is making the same mistakes as the U.S. From the point of view of the world’s overall prosperity, it is not to be welcomed at all. It is increasingly likely that the enormous and glorious increase in living standards produced by the Industrial Revolution will be ended, not by the failure of innovation itself, nor even by the mere glut of population produced by the impoverished majority, but simply by the inability of the world’s politicians to pursue economically coherent fiscal and monetary policies.
(The Bear’s Lair is a weekly column that is intended to appear each Monday, an appropriately gloomy day of the week. Its rationale is that the proportion of “sell” recommendations put out by Wall Street houses remains far below that of “buy” recommendations. Accordingly, investors have an excess of positive information and very little negative information. The column thus takes the ursine view of life and the market, in the hope that it may be usefully different from what investors see elsewhere.)