Saturday, October 24, 2009

Even Yves doesn't quite get capital requirements

Yves Smith has been doing a great job on Naked Capitalism. I hope her book does well. But even someone with her background exhibits the same cognitive capture as everyone else when it comes to public/private finances and balance sheets.
We have now seen a lot of activity shift from banks to capital markets. And thanks to a host of factors (barriers to entry like high minimum scale, network effects, deregulation which made it easier for firms to span product and geographic markets) we now have capital markets dominated by a very small number of players. And these players are too big to fail by virtue of their ROLE, not simply their size.... Now you could in theory go back to having much more on balance sheet intermediation (finance speak for “dial the clock back 35 years and have banks keep pretty much all their loans”). Conceptually, that is a tidy solution, but it has a massive flaw: it would take a simply enormous amount of equity to provide enough equity to all those banks with their vastly bigger balance sheets. We’re having enough trouble recapitalizing the banking system we have.
The massive flaw in Yves conception is that we already need exactly that same enormous amount of equity already.

Look at Govt/Non-Govt balance sheets, you see this:

1) The Govt deficit precisely equals the sum of all Non-Govt equity.
2) Non-Govt entities build assets and liabilities on top of this equity cushion, banks by extending credit, and non-banks by taking on debt.
3) Non-Govt entities need to service that debt out of income for it to be sustainable. They can manage by taking on ever more credit (credit bubble) but eventually, the debt needs to serviced by income.
4) A credit bubble pops when the Non-Govt sector realizes it has taken on liabilities far in excess for them to be able to service out of income, and start to either pay down, or write off, that debt. At the same time, they try to increase their equity.
5) Unless the Govt runs larger deficits, the Non-Govt sector cannot increase its net equity.

Securitization let banks evade their entire purpose: 1) credit analysis constrained by 2) capital requirements. Volker is exactly correct, the Govt shoulder-focused the industry on its core public purpose. If the banks are undercapitalized to shoulder the credit they've extended, it means that the private sector is undercapitalized to shoulder the credit it has taken on.

The solution to private sector recapitalization is simple, and it does not involve Obama lending the banks money (which does not recapitalize them) and telling them to lend it to non-bank non-Govt sector entities (which does not recapitalize them either).


Blogger Noumenon said...

Hey, you enabled comments! That's new, right? I've been wishing for a long time you had them because you keep saying stuff nobody else agrees with and I want to hear why they disagree. I feel like this whole "the deficit equals the savings rate by definition" thing is something that's too simple for everyone else to miss if it were actually true.

9:54 AM  

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