Friday, October 29, 2010

Bet the Farm Or Nurture It?

Bottom line: stability of our financial and commercial markets has costs, "free enterprise" promotes avoiding such costs and thus inherently does not provide stability.

We all know that the return on an investment will reflect the degree of risk: high risk, higher potential returns.

We often forget that (i) reducing risk costs money (which reduces the return on investment), and (ii) our system needs oases of low risk.

Today's financial institutions ("aka "banks" aka "Wall Street") can chose whether to make relatively low risk and low return corporate loans or to make high risk high return speculative investments (such as in the secondary mortgage markets and derivatives markets.)

When bonuses are based on high returns, and stock prices reflecting "return on assets," is it any wonder that bankers now prefer to bet the farm rather then nurture the farm?

Especially when the government will pick up the tab? 

The current financial system in the US is designed to have repeated failures and either (i) government bailouts or (ii) economic depressions.

Something has to change.

After the Great Depression's banking crisis, we divided banking into two basic categories: commercial banks - which take deposits make loans to people and corporations; and investment banks - which accept investment money and re-invest it in various vehicles.

Commercial banks were required to be low risk because the government guaranteed their deposits; investment banks were allowed to take whatever risks they wanted because there were no guarantees to those who used them to channel their investment funds.

(Commercial banks also have had the "unspoken" guarantee" of likely support in cases of financial crisis from the Fed as "lender of last resort."  Bankers and economists have long known that failure of any bank of significant size carries systemic risk, and one of the roles of central banks is provide stability to the banking system by reducing the chances of bank failures thus reducing risk in the system.)

To ensure the low risk nature of commercial banks, the regulatory system imposed certain compliance and economic costs on commercial banks: reserve requirements and, starting in the late 80s capital adequacy requirements (which assess the riskiness in a banks portfolio and set minimum capital requirements based on the overall risk profile of a bank's portfolio.)  These are known as "safety and soundness" requirements
In the 80s and 90s, commercial banks were losing loan market share to non-regulated entities to the extent that commercial banks were becoming non-viable as economic entities.

Stability of the banking system is not a free lunch - of course there are costs of regulations, but those costs provide benefits.

Given the anti-government anti-regulatory political environment of the times when commercial bank profits were slumping (because of "financial disintermediation"), there was simply no way that "safety and soundness" requirements could be placed on the non-bank lending competitors.

Thus, to restore commercial viability for commercial banks, in the 90s the separation between commercial banks and investment banks, the Glass-Stegall Act was essentially gutted, but without imposing "safety and soundness" requirements needed (i) as the quid pro quo for federal guarantees and (ii) to promote systemic stability.

It as the evisceration of the regulatory structure which allowed banks to make high risk decisions and loss big time.

We need to find a way to restore profitability to commercial lending, and not simply make it easier and more lucrative to swing a bank's portfolio to high risk ventures.

Bottom line: stability of our financial and commercial markets has costs, "free enterprise" promotes avoiding such costs and thus inherently does not provide stability.

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