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This piece is a partial response to Rolfe Winkler's post which asserts (a-la Volcker) that the repeal of the 1933 Glass-Steagall banking act is largely responsible for the financial carnage we are witnessing today.
In a sense this is trivially true, but not in the sense Volcker or Winkler mean. The abandonment of the "Chinese firewall" clause of Glass-Steagall (no banking and investment intermingling) is only a proximate contributor to the present crisis; not the cause.
The overarching problem with the banking system in my opinion is that there is no realistic requirement for "cash" reserves anymore. It is backed by nothing -- not even cash fiat money. This simply means that diversification = contagion when something goes wrong. Intuitively, this is obvious: intelligent diversification by itself is good. Diversification using leverage is quite bad ... even when "intelligent". No reserves is infinite leverage. Scary, but unfortunately, this is our present reality.
The Fed still doesn't get this. Proof: one of the things they've been doing in response to the current crisis is effectively lowering reserve requirements even further -- in the form of regulation 23A exemptions for Citigroup, BofA, Suntrust, et al., so the impact of their SIV failures is muted.
In my view, the true spectrum of control is: Regulation, de-regulation, and anti-regulation. On the left is centralized, top-down order -- but also suffocation and stagnation; and on the right is outright chaos, blatant incentives for participants to take wild gambles -- with privatized gains and socialized losses.
Removing "Chinese firewalls" from the banking system without true reserve requirements is not really de-regulation, it is anti-regulation. That is what we have.
I think financial institutions need to be widely diversified -- but they need to do it on a sound basis. Allowing non-binding, zero-liability ratings agencies to effectively set capital ratios is clearly an example of having pretend reserve requirements. The banks simply bought the ratings they needed to minimize their capital outlays. Go figure. Now as a result we have the farcical spectacle of banks with no capital -- but they did it all legally! That's anti-regulation; that is preventing nature from taking its course.
Incidentally, I think the other major provision of Glass-Steagall was also bad: that of making US government securities into standardized collateral. This made Treasury securities essentially money, encouraging reckless growth of the public debt, asset bubbles, and a loss of meaningful effect of the Fed's open market operations (I'm a money center bank: see if I care if you replace my $1B of cash with Treasury securities. Doesn't matter one lick. In fact it's even better, since Treasuries have yield and hence are "better" than cash!)
I think Glass-Steagall is just about as wrong-minded as most Depression-era legislation (none of which did anything to end the Depression, either). What we are seeing is simply that the repeal of it has interacted destructively with other forms of financial rot that have set in since.
The reason we appear to need things like Glass-Steagall is because our banking and monetary system is akin to a jalopy; fundamentally unsound, and held together with regulatory duct tape. Since the 80's we have been removing the duct tape and running the jalopy faster in the name of "de-regulation", getting us farther in the short-run for sure; but what do you know, now the jalopy is falling apart.
If you are going to have a fiat currency, you at least need meaningful reserve requirements to hold the system together (the same goes even for a centralized hard-money system; but even moreso for "pretend" money). Otherwise there is absolutely no restraint anywhere. But astoundingly, and in a trend almost entirely unknown to nearly all observers, we (or I should say, Greenspan) gradually did away with all meaningful reserve requirements in the banking system beginning in early 90s (the last time the lion's share of the banking system was faced with insolvency).
Yes, we could add more duct tape to the jalopy as we keep flooring the accelerator. But I suggest considering as a possibility replacing the whole jalopy with a more soundly-engineered vehicle -- in this case a competitive banking/monetary system, which would be free to employ sound money as necessary. We don't need arbitrary firewalls on how money is handled. What we need is to separate the sound from the unsound once again.
In a sense this is trivially true, but not in the sense Volcker or Winkler mean. The abandonment of the "Chinese firewall" clause of Glass-Steagall (no banking and investment intermingling) is only a proximate contributor to the present crisis; not the cause.
The overarching problem with the banking system in my opinion is that there is no realistic requirement for "cash" reserves anymore. It is backed by nothing -- not even cash fiat money. This simply means that diversification = contagion when something goes wrong. Intuitively, this is obvious: intelligent diversification by itself is good. Diversification using leverage is quite bad ... even when "intelligent". No reserves is infinite leverage. Scary, but unfortunately, this is our present reality.
The Fed still doesn't get this. Proof: one of the things they've been doing in response to the current crisis is effectively lowering reserve requirements even further -- in the form of regulation 23A exemptions for Citigroup, BofA, Suntrust, et al., so the impact of their SIV failures is muted.
In my view, the true spectrum of control is: Regulation, de-regulation, and anti-regulation. On the left is centralized, top-down order -- but also suffocation and stagnation; and on the right is outright chaos, blatant incentives for participants to take wild gambles -- with privatized gains and socialized losses.
Removing "Chinese firewalls" from the banking system without true reserve requirements is not really de-regulation, it is anti-regulation. That is what we have.
I think financial institutions need to be widely diversified -- but they need to do it on a sound basis. Allowing non-binding, zero-liability ratings agencies to effectively set capital ratios is clearly an example of having pretend reserve requirements. The banks simply bought the ratings they needed to minimize their capital outlays. Go figure. Now as a result we have the farcical spectacle of banks with no capital -- but they did it all legally! That's anti-regulation; that is preventing nature from taking its course.
Incidentally, I think the other major provision of Glass-Steagall was also bad: that of making US government securities into standardized collateral. This made Treasury securities essentially money, encouraging reckless growth of the public debt, asset bubbles, and a loss of meaningful effect of the Fed's open market operations (I'm a money center bank: see if I care if you replace my $1B of cash with Treasury securities. Doesn't matter one lick. In fact it's even better, since Treasuries have yield and hence are "better" than cash!)
I think Glass-Steagall is just about as wrong-minded as most Depression-era legislation (none of which did anything to end the Depression, either). What we are seeing is simply that the repeal of it has interacted destructively with other forms of financial rot that have set in since.
The reason we appear to need things like Glass-Steagall is because our banking and monetary system is akin to a jalopy; fundamentally unsound, and held together with regulatory duct tape. Since the 80's we have been removing the duct tape and running the jalopy faster in the name of "de-regulation", getting us farther in the short-run for sure; but what do you know, now the jalopy is falling apart.
If you are going to have a fiat currency, you at least need meaningful reserve requirements to hold the system together (the same goes even for a centralized hard-money system; but even moreso for "pretend" money). Otherwise there is absolutely no restraint anywhere. But astoundingly, and in a trend almost entirely unknown to nearly all observers, we (or I should say, Greenspan) gradually did away with all meaningful reserve requirements in the banking system beginning in early 90s (the last time the lion's share of the banking system was faced with insolvency).
Yes, we could add more duct tape to the jalopy as we keep flooring the accelerator. But I suggest considering as a possibility replacing the whole jalopy with a more soundly-engineered vehicle -- in this case a competitive banking/monetary system, which would be free to employ sound money as necessary. We don't need arbitrary firewalls on how money is handled. What we need is to separate the sound from the unsound once again.
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