I will have a more comprehensive post tomorrow on my thoughts on bank regulation, but I will offer a few thoughts here. One thing I found interesting at the conference was what did not get much play in terms of what helped to create the crisis.
It was fascinating that no one talked about why the US bailed out holding companies, rather than letting them fail, and merely backing up the operating subsidiaries. This is significant. The moment you put money into a holding company, it goes everywhere. Regulators should only care about operating subsidiaries, and let the holding companies fail; let the costs be borne by the stockholders and bondholders of the failed company, but protect the regulated entities.
Also, few fingered the Fed’s monetary policy, where Greenspan and Bernanke created a culture of lenders who knew that the Fed would ride to their rescue when thing got modestly tough. Unlike William McChesney Martin, who joked that the Fed’s job is “to take away the punch bowl just as the party gets going,” Greenspan and Bernanke were slow to remove the punch bowl, and quick to bring it back, creating lenders who would rely on the Fed to allow them to take too much risk.
Another miss was not blaming the failure of neoclassical economics to explain, much less predict the problems that we experienced. Why invite any neoclassical economists at all to the conference? The few economists that were ahead of the asset bubbles were ignoring neoclassical economics. Neoclassical economics is a failed discipline that needs to be replaced by something that realizes that applying math to economics does not yield significant increases in understanding. The Austrians, those who follow Minsky, and the non-linear dynamic school understand what is going on better, because they treat economics the same way we understand ecology. And, no, applying math to ecology doesn’t help that much.
Preventing Too Big to Fail
There are three main ideas as I see it, in preventing “Too Big to Fail.” The first is changing risk-based capital [RBC] policy to raise capital requirements on larger institutions. Use RBC to discourage banks from getting too large.
The second idea, which also wasn’t talked about much at the conference, was to limit regulated entities from owning or lending to other financial institutions. Do you want to limit contagion? Well, if you do, you must limit the amount that regulated banks own of/lend to other financials. That even applies to subsidiaries with the same ownership group. Keep it clean. If you are going to have financial holding companies let them own all subsidiaries directly to avoid capital stacking. Ban cross-guarantees among subsidiaries.
The third idea, which I have touched on is that regulators should ignore holding companies and never, never, NEVER bail them out. Bailouts should only come to regulated entities, and only after the resources of the holding companies have been drained to zero.
On Detecting Fraud
I appreciate what was said on detecting fraud by one presenter: check for adverse selection, honest businessmen won’t do business that way. Also, it never make sense for a secured lender to accept inflated appraisals. In short, the originate to securitize model allows originators to make substandard loans that they will not hold onto.
This is why I say look for gain-on-sale accounting. There is something perverse about making money simply because a sale is made. Under the GAAP principle of release from risk, which I believe is misapplied, financial entities should recognize profits more slowly than is the current practice.
When I was a buy-side analyst, I would analyze a company’s management culture for short-termism. Any management team that seemed too aggressive would get negative marks in my book and I would avoid them, or short them.
Remember you can never get pricing, volume and quality at the same time in lending. Companies that go for volume, or sacrifice quality are begging for trouble. Financial companies are in a mature industry, so beware companies that grow fast. Also beware of long dated accruals. Accrual quality declines with length of time until payment and likelihood of payment.
Those that want to have regulators war-game future problems and predict black swans have their work cut out for them, even considering what I have said already. But most of their attention should be fixed on the areas of the market where the greatest increase in lending is occurring. Where debt is increasing the most is usually the area where there will be the most financing problems in the future.
One more note for regulators: look at the high short interest. The shorts are doing you a favor. They spend a lot of time analyzing who they think is cheating the system, and then they put their money on the line. I would tell regulators to use the shorts as a guide. Don’t automatically trust that there is something wrong, but use it as a guide to now begin your own due diligence into the solvency of the financial institution in question.
More Tomorrow — until then.