Has Wall Street Been Tamed?
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Bail-in is a fundamental change to insolvency law. It is a power given to the regulator to declare a bank non viable, whether it is because of capital or liquidity concerns, and to imposes losses on its bond holders over the course of a week end. This would auto-recapitalise the bank which should be open for business the following Monday with a healthy capital position. You can think of it as a flash, extra-judiciary chapter 11, specific to banks.
The intention is to imposes losses on wholesale investors of the bank, essentially investors in bonds and capital instruments, and to spare depositors, even if technically depositors have the same ranking than bond holders (and therefore would share the losses equally in a bankruptcy). However should the magnitude of the losses require an extraordinary large bail-in, uninsured depositors may be targeted too (essentially corporate clients and high net worth individuals).
Banks are required to accumulate a large amount of wholesale funding to ensure that there is enough debt to bail in the day the shit hits the fan.
This should largely mitigate the too big to fail, as it would avoid the messy aspects of a large bank bankruptcy (Lehman scenario) while not using any tax payer money and making investors bear the losses related to their investments.
Does it solve all problems? God knows what will be the magnitude of the next crisis. If the US, the UK or France default, that may not be sufficient to save the banking system. But it should certainly mitigate a lot the too big to fail risk. And it is extremely unlikely that a bail-out would be considered before a bail-in would have happened.
Disclaimer: I work in a bank.
The problem with the bail-in is that at the end of the day, if there isn't enough wholesale capital available, depositors are still on the hook. Indeed, we saw the only instance of the bail-in in practice (that I'm aware of at present) so far in Cyprus resulted in depositors having a portion of their savings converted to equity (in a nearly-insolvent entity).
At the end of the day, the risk still lies with the public if things get bad enough at a big bank. Through their deposits, through the FDIC, or through a bail-out, if the political winds blow that way.
The truly safest solution is to separate investment banking from depository banking again and to further limit both the size and the allowable exposure levels of investment banks.
I don't think the bail-in can yet be framed as a good thing. It's theoretically helpful in limited situations where enough wholesale capital is available (or can be made available) to solve a crisis of liquidity. Outside those boundaries, it induces greater risk on depositors. And in that situation, it may actually be good (in a perverse way) that the public doesn't know more about it, because if they did it'd likely increase the incentive/pressure on deposit bank runs.
Again, the solution here is to separate depository banking from investment banking. Or, put another way, to very tightly regulate the sorts of investments that depository banks can make. On top of that investment bank investments should be regulated more than they are today. And on top of all that, continuing with a rapid-insolvency process + bail-in would make sense for both depository and investment banks, should the need ever arise in either case (which likelihood would be greatly reduced through these further regulations). But the bail-in without these other measures carries risk and will be of only limited assistance.
Bail-in will only be useful when the banks have built up enough bail-inable capital, and depending on what is the definition of bail-inable capital, most banks are not there yet (regulators take different views on what constitutes good bail-inable debt).
However all the draft regulations that are being prepared now point to relatively high requirements, in the region of 25-30% of the Risk Weighted Assets, which should be ample to absorb a very large loss.
So if the crisis happens this week, it won't help, if it happens in 5 years or after it will certainly help a lot, and be a first line of defence before contemplating a bail out.
On the separation of commercial and investment banks, I am not convinced it actually helps. Reproducing another of my comments on this article:
If we take the example of the UK, all of the bank failures were because of non investment banking activities. RBS failed because of its excess of leverage as a result of its disastrous acquisition of ABN AMRO and because of its loan book, HBOS because of its loan book (essentially commercial real estate exposures), and Northern Rock because of their over-reliance on wholesale funding.
There are examples of banks failing or making large losses because of the investment banking activities (Lehman, Merrill, Bear Stearn, UBS) but my point is rather that the principle "Retail banking = safe, Investment banking = risky" is simply not true.
In a way, universal banks tend to be more robust than a specialized bank, as it benefits from funding and revenues diversification (and cheer size to absorb losses).
I'm glad to hear you say this. There is definitely a wide gap between the reality of available bail-in capital today and the promise of the theory if it were available.
> However all the draft regulations that are being prepared now point to relatively high requirements, in the region of 25-30% of the Risk Weighted Assets, which should be ample to absorb a very large loss.
Theoretically. But the problem is the "Risk Weighted Assets". How do you do the weighting? A great deal of work has gone into this (as you know), but RWA calcs existed pre-crisis, as did specific RWA tiers for securitized instruments. We failed to properly weight the risks before and nothing says we won't do so again. The Fed is still wrestling with "advanced approaches" to RWA and the last time I checked finalizing the requisite approach was on "indefinite delay".
Point being... we don't have any assurance here. And we don't want to repeat the mistakes of overconfidence in our prowess of risk-assessment that we made last time around.
> So if the crisis happens this week, it won't help, if it happens in 5 years or after it will certainly help a lot, and be a first line of defence before contemplating a bail out.
I agree with you fully here. We also need to address what happens in the more extreme cases (and we need to go further in preventing the likelihood of more extreme cases).
> On the separation of commercial and investment banks, I am not convinced it actually helps. Reproducing another of my comments on this article:
You were replying to me in that other comment as well. :)
As I mentioned there, I also think depository banks should be more regulated in a) the total risk they can take on, and b) what sorts of investments they can make. (So the total quantity of risk and the type of risk.)
The depository banks in the UK were not regulated enough, clearly. I don't see how combining poorly regulated depository banking risk with poorly regulated investment banking risk would possibly help. Imagine Lehman directly combined with RBS... it's an even bigger disaster.
Besides, my contention is not that retail banking = safe while investment banking = risky. Both are risky. It's that contagion is bad. Increased correlation is bad. Combining retail banks and investment banks is a bad idea both theoretically and as proven in practice.
We should contain risk. Let's allow some institutions (investment banks) to create complex derivatives, advanced securitizations, make markets, participate in diverse investments, trade fairly liberally and generally do what investment banks do. Let's put that type of risk in one bucket, and still regulate the total risk they can take on, the means by which they are unwound in crises, etc.
Let's have a separate bucket of risk for depository/retail banks, which is as separated as possible (in an interconnected and fast-moving economy and financial system) from that bucket of risk.
The only possible reason not to separate these two buckets of risk is if you think they diversify each other. But that's not right even theoretically and it definitely has not been the case in practice.
Correct me if I'm wrong, but isn't the key ingredient for contagion (in an available capital freeze scenario) uncertainty? And doesn't money from depository banks eventually end up in investment banks anyway?
My (possible stupid) question: why are they attempting to regulate the actors when the internet has shown us the benefits of regulating interfaces (i.e. robustness, innovation, scalability).
Allow depository banks to put capital to good use via investment / other financial institutions, but severely restrict the instruments they have available to do so. Limited differentiation, simple terms, able to be modelled. With the goal of building a de facto contagion firewall through standardization and control of the boundary rather than the market actions on either side.
Sorry! Will teach me to not read avatars!
On your point on RWA, whether RWA appropriately reflect the risks of a financial institution is I think a separate debate, but the definition of "appropriately capitalised" from a regulator point of view is based on RWAs, and therefore sizing how much debt needs to be bailed in to recapitalize the bank on RWAs is not absurd.
But there is a separate push to reduce the size of banks through regulatory constraints:
- Introduction of new capital ratios (leverage ratio)
- Higher capital requirements
- More penal capital treatments of exposure (you have more Risk Weighted Assets against the same business)
All of which result in banks deleveraging across the board. And most large international banks have now several time more capital as a % of their exposure than they had in 2006, as a result of both raising more capital and reducing their exposure.
So the primary bank that failed might still be standing but you'll have many other institution getting hit pretty hard because what they considered safe capital just vanished.
1. Banks are not allowed to have a too large exposure to a single counterparty, so the bail-in of a single bank should never result in another bank failing.
2. The investment in regulatory capital or in bail-inable bank capital is likely to be treated in a very penal way from a capital point of view.
Banks do have this exposure naturally as they tend to be market makers for other banks paper, so typically always hold some inventory of these bonds, but these are relatively small amounts. Banks should normally not hold large positions in other banks capital and debt as these instruments are not eligible for their liquidity pools.
There are some courts that would ignore the contractual agreements. Italy is known for its weird ruling. But I do not believe the gross positions are meaningful.
The expedited and more regulated insolvency proceedings are a big improvement and the bail-in provisions help within some lower boundary cases. But if "shit hits the fan", bail-in alone is not going to be enough.
The point is that Wall St won't really be "tamed" until we further minimize the possibility of shit and fan colliding. To do that, we need to further limit the risks investment banks can take on and greatly limit the risks that depository banks can take on.
If we don't do that, we're talking about how to cure the disease as opposed to how to prevent it. The fact is, we need more preventative measures and more cures. The bail-in is a good cure for some situations, but if the patient is too fargone it'd be too little, too late.
Are people going to be okay with getting no interest and instead paying large-ish fees every month to cover the cost of bank branches, ATMs, debit cards, websites, money transfers, checks, and so on?
If depository banks are going to be very risk adverse they won't be earning much on the use of those demand deposits. Those services have to be paid for somehow.
Anyway, if the answer is yes, I don't see what's stopping people from putting their money with neo-goldsmith banks right now.
Looks at bank statements: .... Zero interest, check. High fees, check. I'm pretty sure... that's how it already is? What bank do you recommend? Hook a brother up.
> If depository banks are going to be very risk adverse they won't be earning much on the use of those demand deposits
You realize that this is how it used to be, right? Up until 1999. I don't know about you, but I got more interest and paid fewer fees back then...
I think this is oversimplifying things overall. Higher risk doesn't necessarily mean higher return in general, and definitely not when dealing with tremendously large pools of capital as depository banks do. There is a limit to how much total capital you can invest in a given level of risk, and what return you can actually achieve in practice for that level of risk. It's fallacious to think that regulating the types of risk depository banks can participate in and how much total risk they can take on would necessarily lessen their returns over the long-term in practice.
Moreover, on an operational basis banks are more profitable today than possibly ever. So, those fees and low interest rates are paying for more than all their services, by a wide margin. (At least as of the last time I looked into this.)
> You realize that this is how it used to be, right? Up until 1999. I don't know about you, but I got more interest and paid fewer fees back then...
No it isn't. Yes, the retroactive magic bullet Glass-Steagall act was in place but no they were certainly not very risk adverse. Do you remember Savings & Loan? 'cause I do.
Again, what's stopping you from opening a neo-goldsmith bank today (we have mattresses so you don't have to!)?
Savings and Loan associations (while they perform some similar functions) are different institutions than banks, governed by different laws and regulations, and the high-risk behavior that played a major role in the S&L crisis was directly enabled by the deregulation of that industry (it's a much more clear example than the ties between the banking deregulation and the recent housing finance crisis.)
You can't point to the S&L crisis as evidence that banks weren't risk-averse at the time, since high-risk behavior at issue there was at S&Ls, not banks, and was directly tied to the laxer regulatory oversight of S&Ls at the time, compared to banks.
Ordinary equity will be wiped out.
Other forms of equity (Preference shares) will be fully converted to ordinary equity.
More senior debt (Tier 2 and Senior Unsecured) will be fully or partially converted to ordinary equity depending on the size of the bail in.
The reason why bailout money couldn't be used to restructure underlying mortgage debt directly, we were told, is that individual consumers would see it as license to take on risky housing debt, believing that the government would bail them out again in the future.
Unfortunately, that's exactly what happened, with one small difference. Because it was the banks that were recapitalized, the largest banks are actually incentivized to make risky bets, seeking higher returns.
The bailout now constitutes an implicit government guarantee.
The bailout continues, but through monetary policy. The prolonged low rate environment is the biggest robbery of the century. Savers are being robbed from their savings to subsidize over-borrowed house owners. And I think it is fair to talk about a moral hazard. I know bankers (disclaimer: I am a banker too) who deliberately over borrow personally because they think the central banks will always be there to save their ass through low rates, pumping liquidity to push prices up, etc.
It is the individual's responsibility for their own financial security, and the larger economic scheme of the United States should continue to support and encourage profiting off of moral hazards.
That said, there does seem to be some US consumer backlash, where individuals are basically attempting to stay out of this system altogether. Millennial house buying rates say it all: these rules are unfair, and the next generation don't want to play.
Is this enough to make them cease to be TBTF? I don't think anyone knows. But the largest banks have generally been less risky, not more risky over the past half-decade.
* No individual bank is "too big to fail". Today we have several banks which are all too big to actually let fail, which means we're likely to need to do structured bailouts for them again.
* Commercial banking and investment banking are split again. As it stands with commercial banks and investment banks housed in the same entity and sharing risks, there is the constant risk of contagion from bad IB bets jeapordizing commercial banking assets and operations. This not only creates further interdependence and correlation between IB activity and commercial banking, but also adds more pressure for bailouts of big, cross-breed banks.
* There are legitimate personal fines and even criminal penalties and a demonstrated will of enforcement for individuals who participate in fraudulent or negligent investments. We pursued (to a lighter degree than we probably should have) the banks themselves for these activities and received judgments and settlements, yet we didn't pursue many personal penalties nor criminal cases related to any of them. See: http://www.theatlantic.com/magazine/archive/2015/09/how-wall... We need to reconcile this and even strengthen the laws governing bank investing, so as to disincent poor investment behavior at the most personal level, rather than simply being a financial calculus for the company itself, with no expected loss or penalty for the persons involved in the decision making.
If we take the example of the UK, all of the bank failures were because of non investment banking activities. RBS failed because of its excess of leverage as a result of its disastrous acquisition of ABN AMRO and because of its loan book, HBOS because of its loan book (essentially commercial real estate exposures), and Northern Rock because of their over-reliance on wholesale funding.
There are examples of banks failing or making large losses because of the investment banking activities (Lehman, Merrill, Bear Stearn, UBS) but my point is rather that the principle "Retail banking = safe, Investment banking = risky" is simply not true.
In a way, universal banks tend to be more robust than a specialized bank, as it benefits from funding and revenues diversification (and cheer size to absorb losses).
> we didn't pursue many personal penalties nor criminal cases
I am not saying that there hasn't been any fraud in the financial crisis but I am of the opinion that it is not fraud that caused this crisis. It is the over-reliance on leverage, short term funding, and a belief that the US real estate market would never go down (belief that many people have today in the UK).
You can't send people to jail for making bad business decisions. Some banks were run in a moronic way, but being incompetent or missing a fundamental economic driver is not a crime.
Another note here is that much of what brought down these UK banks was contagion, due to the bubble in commercial and residential real estate pricing and then to the spreading financial crisis and it's effects on chilling available financing and liquidity.
> In a way, universal banks tend to be more robust than a specialized bank, as it benefits from funding and revenues diversification (and cheer size to absorb losses)
This is not only an unproven claim, but a disproved claim. In the US, cross-breed banks resulted in greater contagion across the financial sector and put depositories at risk, increasing the need for bailout.
You could in theory get the best of both worlds by having a highly, highly regulated and constrained investment banking arm of a depository bank. But then how well would it compete with standalone investment banks? And would we really be able to ensure complete separation of risk between activities? Doubtful, in practice. This is a suboptimal set up.
Depositors in a bank do not deposit their money with the idea that it is going to be put at any significant risk. It's supposed to be effectively warehoused and insured. Taking complex and risky bets with deposits, or capital derived from or backed by a depository base of capital, makes no sense on first principles and the theory of combining operations for some benefit in diversification has been falsified in practice... the opposite happened, with higher degrees of correlation and contagion happening in reality.
> You can't send people to jail for making bad business decision
No, but we didn't pursue even a tiny fraction of the cases of negligence, let alone fraud. Also, reducing the discussion purely to jail time is a straw man. Civil penalties for individuals are perfectly justifiable, especially when you're well-compensated and when your decisions result in gross harm to the public.
I am not sure I agree. The example of Lehman has shown that a pure investment banks (and technically not even a bank, it was a broker-dealer) can cause a financial collapse. So I do not think we can work on the assumption that we only need to worry about deposit taking institutions and let investment bank collapse. Investment banks can be too big to fail too.
> So I do not think we can work on the assumption that we only need to worry about deposit taking institutions and let investment bank collapse.
I did not say that. Or anything like.
I'm consistently saying:
We should regulate both retail banks and investment banks more.
And part of that increased regulation ought to be splitting investment banking risk from retail banking risk again. Both are risky enough as is. Combining their (sometimes correlated!) risk is a really bad idea.
I agree with you that retail banks can cause huge problems (eg your UK examples). I agree with you that pure investment banks (or merely broker-dealers) can cause huge problems. Hence the need to regulate both and do what we can to prevent crises (not just treat them more effectively), while constraining economic activity as little as we can, of course.
the implication of calling retail and investment banking risks "sometimes correlated" is that they are also sometimes uncorrelated.
The two common examples of diversified survivors of the last GFC are Citi and JPMC.
> The two common examples of diversified survivors of the last GFC are Citi and JPMC.
Are you actually holding Citi and JPMC up as examples of some kind in regard to benefits of combining retail and investment banking? If so, would you similarly argue that because not all S&L associations had gone bankrupt or been shuttered by the late 90s, that's somehow an indication that S&L associations needed no regulatory reform? If there are 10 people on an island and all of them eat a particular indigenous fruit and then 8 of them die from it-- but two survive unharmed!!-- would you say it is wise to continue eating the fruit?
> would you say it is wise to continue eating the fruit
i would say it is wise to do what the 2 survivors did... which is to have a diversified portfolio of retail and investment banking revenue streams.
https://petitions.whitehouse.gov//petition/hold-accountable-...
Two signatures? Really? Why are we also not setting examples of these people who knowingly destroyed lives?
EDIT: I see that people are using the downvote button as a disagree button. Please, enlighten me as to why CEO's who knowingly committed fraud shouldn't be charged with wire fraud? I'm legitimately curious.
Do you remember Occupy Wall Street? "The people" organized, disseminated information, marched, protested, petitioned, wrote and called legislators, held sit-ins and partook in civil disobedience by the millions.
> Take this petition for example
That link isn't illustrative of anything. There were many petitions, with many tens of thousands of votes. You won't find them any more because they were created many years ago, and expired petitions are eventually deleted from the site.
> Why are we also not setting examples of these people who knowingly destroyed lives?
People went to prison. Not everyone you'd like to have charged (a) actually committed a crime, and (b) there's a prosecutor who can both prove this and prevail over a larger and better-funded legal team on the defense.
> shouldn't be charged
Putting words in the mouth of others probably isn't going to get you whatever response you're hoping for.
Overall, I'm done with this site. You cannot accomplish anything constructive here. This place has become a contrarian dumpster fire. People will literally disagree with you for reasons that add zero value to any discussion. It's to the point where if I exclaim that the sky is blue, some troll will inevitably show up and argue that I'm wrong and the sky is azure instead.
Those that left it in, continued buying (maybe because of discipline or because what else do you do when you're incredibly rich), became even wealthier.
Real taming would mean brokerages who aren't allowed to trade for their own account. Real taming would mean no more "hedge funds"; all funds must be organized as SEC-registered mutual funds. Real taming would mean a Tobin tax (0.01% on every financial transaction) to discourage high-frequency or excessive trading. Real taming would mean not treating interest as a deductible business expense, which would kill the leveraged buyout/private equity industry and end equity to debt conversions.
Since at one time all of those restrictions were in effect, or something else with the same effect was, this is the conservative approach. We know this works.
(Restoring Glass-Stegall is in the GOP platform, amazingly enough.)
It functionally eliminates bank runs and the need for most regulation.
People will be able to bank like normal, but contagion and bank failures go away.
Not all banks need to be forced to go this route. But if you offered banks the option to opt-out of Dodd-Frank if they were 95% financed by equity and retained earnings, I'm pretty sure most would.
Longer essay here:
http://johnhcochrane.blogspot.com/2016/05/equity-financed-ba...
https://news.ycombinator.com/item?id=12220961
I honestly do not believe a politician will accept to face the political heat of a bail out before having attempted a bail in first.
Of course, that does not absolve Wall Street of blame for managing risk poorly, for fraudulent behavior, for negligence, and for short-term risk taking over long-term growth.
Pretty much everyone is to blame, but the people with more power deserve much more blame.
Government still decides what law and whats not.
-Oil surging like cray.... not
-Tech companies (cough twitter) valued in several hundred
millions with no clear business plan... not
-insert here next big thing to invest in
Update:
-medical services...
-risky operations where blame can be deferred for a long
time, e.g. Dupont and teflon or frackling
-crimes against environment (gas leak on california)- The mortgage lending industry is largely influenced by Fannie May and Freddie Mac, which exist under the implication of a bailout, which means they have an undisciplined appetite for risk. They also have not been required in the past to disclose financials like regular firms are required to. Subsidized loans are the fountainhead of "credit as a right" policies intended to help the poor take on debt that would not otherwise be affordable.
- There has been a tremendous increase in education lending, which has helped to fuel the education bubble. But unlike credit card debt, student loans are not discharged if the borrower is forced to declare bankruptcy. Our politicians have rallied to have more and more of this lending occur, which has resulted in no price pressure on universities (which is why the US has the highest priced secondary education in the world). Banks love it because they get to live in a world where bankruptcy laws intended to protect consumers don't exist.
- These are all part of the "too big to fail" policy of US regulators.
When governments have a stake in particular prices (such as the price of a loaf of bread, a home, or a college education) the market starts to distort, and supply and demand no longer help guide investment. When a bank has purchased massive amounts of Mortgage backed securities under the impression that they are low risk, and the price changes, the bank cares a lot about certain prices. The corruption is what happens when the government starts to care and starts to build policies to shelter banks from market price movement.
Wall Street has not been tamed. For a while the game was to collude to structure risk so that every ounce of leverage benefitted the banks and the systemic risk was unhedged. Now the game is to engage in "credit as a right" policies that couple the bank's outcome to a government policy goal, with profits coming from barriers to entry and lack of competition moreso than from successful portfolio management or efficiency.
Without the strict discipline of total failure to guide bank behavior, it is without question that myriad perverse incentives exist and are being exploited. Greed is not the issue, it's much simpler than that. It's corruption. Regulators are equally at fault.
http://www.bloomberg.com/view/articles/2016-08-03/tamed-bank...
http://www.mckinsey.com/global-themes/employment-and-growth/...