I applaud some of the features of the Administrations newly proposed financial regulations. The Administration has proposed reigning in risk taking by banks by limiting insured banking to the more traditional investments of banks and eliminating some serious conflicts of interest. While risk taking is not bad, this step will be good for the American economy because we live in a world where we the taxpayers are on the hook for bank failures. Since we are insuring them, we ought to monitoring them. And we ought to be limiting their investments to what we can monitor.
Some background. Traditionally, banks took in deposits and lent/invested these funds in local businesses, mortgages, auto loans, and so forth. Because deposits could be withdrawn at any time and loans could not be recalled at any time, this system exposed banks to potential runs, that is, the possibility that depositors, fearing they would not get their money, would withdraw their money which in turn would lead to insolvency (due to the illiquidity of the bank’s assets). This insolvency would leave some depositors without their money, which would justify the run in the first place.
To avoid this problem, banks now rely on the Federal Reserve/FDIC/Office of Thrift Supervision. In response to a run, the government ensures that all depositors are paid off in full, so there is no incentive to run. The government charges banks a fee for this service (I enjoy the idea that I as a taxpayer am charging banks fees). But we the government/taxpayers are now on the hook if the assets of the bank are not worth enough to cover the money that we paid to depositors. That is, by providing insurance, we eliminate the danger of a bank run but expose ourselves to taking on the losses of truly (long-term) insolvent banks. And insurance tends to distort incentive – there are times (when the bank is insolvent anyway) when losing money costs the bank nothing. For example, banks that have fewer assets (value of loans, buildings etc.) than liabilities (primarily deposits) might choose to pay very high salaries, give very generous loan terms, take very risky loans, and so forth since losing money costs the bank nothing (in the S&L crisis of the 1980’s, directors of insolvent banks were found to have given bank loans to their own (other) businesses and to have spent bank resources paying large lobbying fees to delay being shut down; several managers acted so egregiously as to be convicted of racketeering). Bailouts of insolvent (not just illiquid) banks costs the government (us) and raises the fees that are charged to banks for this insurance.
To avoid this second problem, we (through the government again) regulate and monitor banks. This allows us to shut down banks when they are close to insolvent rather than only once there is a huge bill for us to cover. (The exception, already mentioned, was in the S&L crisis of the 1980s in which many banks were allowed to operate on as insolvent institutions costing taxpayers over a hundred billion dollars – probably more than TARP will end up costing!)
Currently many banks (Citibank being the biggest example) i) take in deposits, ii) make investments with these borrowed funds, their own equity, and sometimes their employee’s money, and iii) invest the savings of individuals or at least advise them on investment for a fee. This creates a problem. Banks can make large risky investments with their equity (i.e. they can look like a hedge fund). If the gamble pays off, huge bonuses for employees and high dividends for owners. If the gamble fails, we the taxpayers foot the bill. An example of such a gamble would be to sponsor an off-balance sheet vehicle (SPV) to do leveraged investment in mortgage backed securities. “Sponsoring” means charging fees to investors to invest in the vehicle and then providing (collateralized) lending to the SPV (providing the leverage). If the SPV makes money, the loans are paid off and the bank gets to earn the interest and the fees from the investors. Good times all round (bonuses and dividends). If the securities instead lose lots of value, then the investors are wiped out and the bank has only the collateral, now worth less than the loans. The more the securities lose in value, the more money the bank, uh, I mean the taxpayer, lose. That’s right. Even though there is no reason in the world why the taxpayer should be subsidizing or in any way involved in an SPV done by private investors, because the loans to the SPV are made by an insured bank, the taxpayer is on the hook for bank losses.
So I welcome the new proposal to get the casino out of the bank on these grounds alone. But there is another secondary reason to stop banks investing for their own profits. In the above example, the bank was investing in its own SPV. The incentive of this bank is to get private investors to invest in the SPV even if the bank is charging the SPV rather high interest rates. That is, the bank’s own returns can be raised by selling investment customers investments that are profitable to the bank. To some extent this is the goal of banking: get investors to put money in your bank and charge them fees and pay lower interest rates than you earn on loans. But when investment is also a part of banking, banks advise investors which investment to buy. Among a set of stocks or funds with no connection to the bank, there is no conflict of interest. But there is a large conflict when the bank is also investing its own money in the same sorts of investments. And most major Wall Street banks have “proprietary trading” desks that try to make money against the average investor by buying and selling stocks, sometimes at very high frequencies. When a bank is trading to beat investors at one desk and trading on investors behalf at another, it creates a very large conflict of interest. While this conflict of interest need not be outlawed, outlawing it does fit well with the first objective of monitoring insured banks. An alternative for institutions that are not insured and that we can be certain we would not bail out in bad times would be to require simple warnings (think cigarette labeling) by financial institutions that sell products to investors and also do proprietary trading.
The administration’s proposal would deal with these issues by prohibiting banks from investing in or sponsoring an SPV, or engaging in any similar hedge-fund or private-equity fund type activity. The legislation would also outlaw banks investing their own capital or employees’ capital in the market for its own profits (proprietary trading). Importantly, this rule would apply not just to banks, but any institution owning a bank, meaning bank holding companies, meaning, at the moment, every major investment bank. So it looks to me (comments welcomed) that the Goldman’s of the world are going to be dropping their status as bank holding companies as fast as they can if this proposal becomes law. But some of these financial institutions will not. And when I choose who to trust to invest my money, the bank that is not advising me with one hand and investing to beat me with the other will get my business.
Of course the devil is in the details. How do you distinguish proprietary trading from hedging the banks own positions? Banks always hold inventory as their investors sell and buy. How do we discern who is holding so much as to be effectively trading for profits? Any bank worth its salt will work harder to sell quickly the inventory that it expects is more likely to lose value. And where is the line between proprietary trading vs. properly investing bank equity and depositor’s funds? The simple answer that loans are loans and buying stocks is proprietary trading fails in the example of the SPV above. So, good luck to the regulators, but again, props to the administration (finally!).