Tag: Financial Regulation

Must-Read: Anat R. Admati, Peter M. DeMarzo, Martin F. Hellwig, and Paul Pfleiderer (2013): Fallacies, Irrelevant Facts, and Myths in the Discussion of Capital Regulation: Why Bank Equity is Not Socially Expensive

Posted on by Brad DeLong

Must-Read: Very good. Mind you, I am not sure that it is right–while the risk premium ought to be linear in units of fundamental operating risk, and while requiring banks to maintain larger capital reserves ought to be irrelevant (save for the small financial-repression taxes involved) to costs of financing for Modigliani-Miller reasons, it is not clear to me that that is how things actually work in reality:

Anat R. Admati, Peter M. DeMarzo, Martin F. Hellwig, and Paul Pfleiderer (2013): Fallacies, Irrelevant Facts, and Myths in the Discussion of Capital Regulation: Why Bank Equity is Not Socially Expensive: “We examine the pervasive view that ‘equity is expensive’…

…which leads to claims that high capital requirements are costly for society and would affect credit markets adversely. We find that arguments made to support this view are fallacious, irrelevant to the policy debate by confusing private and social costs, or very weak. For example, the return on equity contains a risk premium that must go down if banks have more equity. It is thus incorrect to assume that the required return on equity remains fixed as capital requirements increase. It is also incorrect to translate higher taxes paid by banks to a social cost. Policies that subsidize debt and indirectly penalize equity through taxes and implicit guarantees are distortive. And while debt’s informational insensitivity may provide valuable liquidity, increased capital (and reduced leverage) can enhance this benefit. Finally, suggestions that high leverage serves a necessary disciplining role are based on inadequate theory lacking empirical support.

We conclude that bank equity is not socially expensive, and that high leverage at the levels allowed, for example, by the Basel III agreement is not necessary for banks to perform all their socially valuable functions and likely makes banking inefficient. Better capitalized banks suffer fewer distortions in lending decisions and would perform better. The fact that banks choose high leverage does not imply that this is socially optimal. Except for government subsidies and viewed from an ex ante perspective, high leverage may not even be privately optimal for banks.

Setting equity requirements significantly higher than the levels currently proposed would entail large social benefits and minimal, if any, social costs. Approaches based on equity dominate alternatives, including contingent capital. To achieve better capitalization quickly and efficiently and prevent disruption to lending, regulators must actively control equity payouts and issuance. If remaining challenges are addressed, capital regulation can be a powerful tool for enhancing the role of banks in the economy.

What I Saw and Did Not See About the Macroeconomic Situation Eight Years Ago: Hoisted from the Archives

Posted on by Brad DeLong

Hoisted from the Archives from June 2008J. Bradford DeLong (June 2008): The Macroeconomic Situation, with added commentary:

Looking back, what did I get right or wrong back eight years ago when I was talking about the economy? I said:

  • That the best way to think about things was that we were in a 19th-century financial crisis, and so we should look way back to understand things (RIGHT)
  • That a recession had started (RIGHT), which would probably be only a short and shallow recession (WRONG!!!!)
  • That the Federal Reserve understood (MAYBE) that it has screwed the pooch by failing to prudentially regulate shadow banks, especially in the housing sector (RIGHT), but that it would shortly fix things (MAYBE).
  • That the Federal Reserve was still trying to raise interest rates (RIGHT).
  • That the Federal Reserve should not be trying to raise interest rates (RIGHT), because the tight coupling between headline inflation today and core inflation tomorrow that it feared and expected had not been seen for 25 years (RIGHT).
  • That central bank charters are always drawn up to make financial markets confident that they are tightly bound not to give in to pressure and validate inflation (RIGHT).
  • That, nevertheless, when the rubber hit the road and financial crisis came there was ample historical precedent that central banks were not strictly bound by the terms of their charters–that they were guidelines and not rules (RIGHT).
  • That the Federal Reserve understood these historical precedents (WRONG) and would, with little hesitation, take actions ultra vires to avoid a major financial and economic collapse (WRONG).
  • That there was a long-standing tradition opposed to central banks’ taking action to stem financial crisis and depression–a Marx-Hayek-Mellon-Hoover axis, if yo will (RIGHT).
  • That this axis thought that business cycle downturns were always generated by real-side imbalances that had to be faced via pain and liquidation–could not be papered over by financial prestidigitation (RIGHT).
  • But that this axis was wrong: business cycle downturns, even those to a large degree generated by real-side imbalances, could be papered over by financial prestidigitation (RIGHT).
  • That even though the Fed and the Treasury believed that interest rates should still go up a little bit, they were also engaged in unleashing a huge tsunami of financial liquidity upon the economy (RIGHT).
  • That this liquidity tsunami was appropriate as an attempt to maintain full employment response to the collapse in construction and to the great increase in financial risk (RIGHT).
  • That this liquidity tsunami would do the job, and the recession would be short and shallow (WRONG!!!!!!!!)
  • That the runup in oil prices was not a speculative bubble that would be rapidly unwound (RIGHT).
  • That the runup in oil prices was a headwind for real growth (RIGHT).
  • That the dollar was headed for substantial depreciation (WRONG).
  • That the housing price and housing construction shocks to the economy were still ongoing (RIGHT).
  • That for those with a long time horizon equities were fairly valued, offering higher returns than other asset classes, if risky returns (RIGHT).
  • That asset prices would fluctuate (RIGHT).

But I did not, even in June 2008, understand (a) how bad the derivatives books of the major money-center banks were, and (b) how weak the commitment of central banks to doing whatever was necessary to stabilize the growth path of nominal GDP was.

PowerPoint Presentation PowerPoint Presentation PowerPoint Presentation PowerPoint Presentation PowerPoint Presentation PowerPoint Presentation PowerPoint Presentation PowerPoint Presentation PowerPoint Presentation PowerPoint Presentation PowerPoint Presentation PowerPoint Presentation PowerPoint Presentation PowerPoint Presentation PowerPoint Presentation PowerPoint Presentation PowerPoint Presentation

Must-read: Anat Admati: “The Missed Opportunity and Challenge of Capital Regulation”

Posted on by Brad DeLong

Must-Read: Anat Admati: The Missed Opportunity and Challenge of Capital Regulation: “Capital regulation is critical to address distortions and externalities…

…from intense conflicts of interest in banking and from the failure of markets to counter incentives for recklessness. The approaches to capital regulation in Basel III and related proposals are based on flawed analyses of the relevant tradeoffs. The flaws in the regulations include dangerously low equity levels, complex and problematic system of risk weights that exacerbates systemic risk and adds distortions, and unnecessary reliance on poor equity substitutes. The underlying problem is a breakdown of governance and lack of accountability to the public throughout the system, including policymakers and economists.

Must-Read: Larry Summers: Four Common-Sense Ideas for Economic Growth

Posted on by Brad DeLong

Must-Read: Larry Summers: Four Common-Sense Ideas for Economic Growth: “Since the summer of 2009, the US economy has grown at about 2 percent…

…The 10-year interest rate at the end of trading today [February 18, 2016] was just a bit below 1.8 percent…. We are having trouble achieving… a 2 percent inflation…. This is the judgment of a market that thinks that the Fed is not going to do anything like what it says it’s going to do…. The real interest rate is at least a kind of measure of the certainty equivalent of the productivity of capital. If the market is saying that’s below 1 percent, that has to be of concern as well. [And] the Fed has been substantially too optimistic in its one-year-ahead forecast every year for the last six….

What should be done?… First, there is an overwhelming case in the United States for expanded public infrastructure investment…. Yt the rate of infrastructure investment is lower now than it’s been anytime since 1947. If you take depreciation out, federal infrastructure investment is negative…. Second, we should increase support for private investment in infrastructure…. With respect to private investment, tax reform is critical…. Third, we should grow our effective labor force…. What we do to educate our workforce matters. What we do to incentivize our workforce—through the design of our social safety net, and through disability insurance—matters. What we do to change our immigration policies—particularly our immigration policies on highly skilled workers—matters….

Fourth, our financial system requires continuing attention… the 1987 crash, the 1990 real-estate bubble, the S&L crash, the Mexican financial crisis, the Asian financial crisis, the internet bubble, Enron, and then the Great Recession of 2008. On average, a crisis every three years for the last 30 years. That surely has taken a toll on growth. At the same time, because pendulums swing, at a time of substantial unemployment, a large number of middle-class Americans are not able to get mortgages today with reasonable down payments. It appears, though the matter is in some dispute, that there are significant impediments in the flow of capital to small businesses as well. Financial reform, labor-force support, stimulus to private investment, increases in public investment—this stuff is not rocket science. Most of it operates on both the demand side and the supply side….

If all you care about is that we’ve got an excessive federal debt, the most important determinant of the debt-to-GDP ratio in 2030 is how rapidly the economy grows between now and then. If what you care about is American national security, the most important determinant of how much we are respected and how much influence we have in the world is how well our economy performs. If what you care about is inequality and poverty, the most important determinant of the employment prospects of the poor is how rapidly the economy is growing…

Must-read: Stan Fischer: “Monetary Policy, Financial Stability, and the Zero Lower Bound I”

Posted on by Brad DeLong

Must-Read: Very disappointing to me that both nominal GDP targeting and price path level targeting appear to be completely off of Stan Fischer’s radar:

Stan Fischer: Monetary Policy, Financial Stability, and the Zero Lower Bound I: “Are We Moving Toward a World With a Permanently Lower Long-Run Equilibrium Real Interest Rate?…

…Research that was motivated in part by attempts that began some time ago to specify the constant term in standard versions of the Taylor rule has shown a declining trend in estimates of r*. That finding has become more firmly established since the start of the Great Recession and the global financial crisis…. A lower level of the long-run equilibrium real rate suggests that the frequency and duration of future episodes in which monetary policy is constrained by the ZLB will be higher than in the past. Prior to the crisis, some research suggested that such episodes were likely to be relatively infrequent and generally short lived. The past several years certainly require us to reconsider that basic assumption….Conducting monetary policy effectively at the ZLB is challenging, to say the least….

The answer to the question ‘Will r* remain at today’s low levels permanently?’ is that we do not know….

Raising the Inflation Target…. The welfare costs of high and variable inflation could be substantial. For example, more variable inflation would make long-run planning more difficult for households and businesses….

Negative Interest Rates: Another possible step would be to reduce short-term interest rates below zero if needed to provide additional accommodation. Our colleagues in Europe are busy rewriting economics textbooks on this topic as we speak…. It is unclear how low policy rates can go before cash holdings rise or other problems intensify, but the European experience has certainly shown that zero is not the effective lower bound in those countries….

Raising the Equilibrium Real Rate: An even more ambitious approach to ease the constraints posed by the zero lower bound would be to take steps aimed at raising the equilibrium real rate. For example, expansionary fiscal policy would boost the equilibrium real rate…. The Federal Reserve’s asset purchases… have reduced the level of the term premium….

Eliminating the ZLB Associated with Physical Currency….

None of these options for dealing with the difficulties of the ZLB suggest that it will be easy either to raise the equilibrium real rate or to mitigate the constraints associated with the ZLB…

Must-Read: Megan McArdle: Why Democrats Fixate on Glass-Steagall

Posted on by Brad DeLong

Must-Read: The reason to repeal the repeal of Glass-Steagall is that (1) it has not led to increased competition and lower fees in investment banking, and (2) it creates a point of vulnerability at which financiers can make bets with the government’s money. narrow-banking advocate Milton Friedman was especially shrill on this point: that deposit insurance was necessary, but that banks with government-insured deposits should be restricted to buying Treasuries and only Treasuries:

Megan McArdle: Why Democrats Fixate on Glass-Steagall: “Team Steagles… seem[s] to have become a powerful force in the Democratic Party…

…The provisions limiting the entrance of commercial banks into investment activities (and vice versa) were gradually relaxed, and then abolished with Gramm-Leach-Bliley (the Financial Services Modernization Act of 1999). Calls to ‘bring back Glass-Steagall’ are, in fact, almost always calls to bring back this one provision…. It would be an amusing and depressing exercise to get any of these candidates in a room with some economists and ask them to explain how Glass-Steagall could have prevented the 2008 crisis. For there is a small problem with the Steagles argument: It’s very hard to think of the mechanism by which the repeal of this rule made any significant contribution to the meltdown….

This is why you don’t hear a lot of experts calling for the return of this rule. Those who do want it reinstated don’t claim that it would have prevented the financial crisis. For example, I quote Raj Date and Mike Konczal of the left-wing Roosevelt Institute, from their paper ‘Out of the Shadows: Creating a 21st Century Glass Steagall’: ‘The loosening of Glass-Steagall prohibitions did not directly lead to the financial crisis of the past few years.’ Why, then, do so many people want it back?  Fighting ‘Too Big to Fail.’… Moral hazard/protecting the taxpayer…. Exotic political economy arguments… [that] are hard to prove or disprove….

Glass-Steagall… is the perfect Washington Issue: a proposal of negligible impact but great popular charm. It is a way for politicians to sound as if they are addressing some major problem without having to go to the trouble of actually doing so. Glass-Steagall’s major appeal is not that it would work, but that it can be explained in under a minute to someone who doesn’t know anything about financial markets…