Recapitalize the non-Govt Sector, not the Financial Sector

When you have a credit bubble -- ie. banks make loans that do not get paid back -- then the subsequent credit bust de-capitalizes banks (as they must write down assets and equity) constraining their ability to lend anew.

As the non-government sector needs additional financial assets to grow, if banks cannot lend (capital constrained) then the economy as a whole starts to trouble.

This, in a nutshell, is where the "Too Big to Fail", "We Must Bail Out the Banks" argument comes from, and it is true, as far as it goes.

Nevertheless, there is more to the story. First, if banks were making loans that did not get paid back, then they were not doing their primary job which is to make good credit decisions. Bad credit decisions should be punished, and the owners and operators of such companies should be fired and/or wiped out. This is how markets work. Rewarding such behavior only encourages more bad practices in the future, and people (rightly) start to wonder why we have a financial system at all.

Second, if banks fail, that contraction in private financial asset growth can be balanced by "capitalizing" the rest of the non-Governmental sector directly (through some combination of tax cuts and spending increases -- whatever increases the deficit). Since economists at Harvard and Princeton do not understand that the Government is the sole creator of net financial assets (equity) for the private sector, they do not know that this policy lever is on the table. So we are where we are.

From Macroeconomic Resilience

My policy proposal has three legs all of which need to be implemented simultaneously:

* Allow Failure: Allow insolvent banks and financialised corporations to fail.
* The Helicopter Drop: Institute a system of direct transfers to individuals (a helicopter drop) to mitigate the deflationary fallout from bank failure.
* Entry of New Banks: Allow fast-track approvals of new banks to restore banking capacity in the economy.

The argument against allowing bank and corporate failure is that it will trigger off a catastrophic deflationary collapse in the economy while at the same time crippling the lending capacity available to businesses and households. The helicopter drop of direct transfers helps prevent a deflationary collapse and the entry of new banks helps maintain lending capacity thus negating both concerns.

Mortgages (2004-2007) are not like normal loans

Megan argues that defaulting on your mortgage is not OK just because your house is underwater. Having the property secure the debt does not give you a free put option.

Ordinarily I would agree, but not for loans made during the housing bubble. During that time, lenders were not concerned about the borrowers ability to repay (see NINJA), but were, in collaboration with the borrower, making a bet on rising housing prices.

Since ability to repay was not part of the loan decision, there is no obligation to pay on the part of the borrower.

Financial "reform" bill a dud

Yves is merciless about the Obama administration's financial "reform" bill:

I want the word “reform” back. Between health care “reform” and financial services “reform,” Obama, his operatives, and media cheerleaders are trying to depict both initiatives as being far more salutary and far-reaching than they are.

So what does the bill accomplish? It inconveniences banks around the margin while failing to reduce the odds of a recurrence of a major financial crisis.

The only two measures I see as genuine accomplishments, the Audit the Fed provisions, and the creation of a consumer financial product bureau, do not address systemic risks. And the consumer protection authority was substantially watered down. Recall a crucial provision, that banks be required to offer plain vanilla variants of products, was axed early on. In addition, the agency, initially envisioned as independent, will now be housed in the Fed, which has never taken any interest in consumers (witness its failure to enforce the Home Owners Equity Protection Act, a rule which would have limited subprime lending) and has a long standing hands-off posture towards its charges.

Most of the rest is mere window dressing.

I have a lower opinion of the bill than Yves, since I don't like the consumer protection agency. I see that as to households what the bond rating agencies are to corporations -- third parties with no skin in the game whose job it is to keep you "safe" by making credit decisions for you. Not only did the ratings agencies fail, they actually made things worse by enabling bad credit to pass as triple-A. A loan is not a product, it is a combination of a financial instrument and a borrower, and treating it as if it were a product, "good" or "bad" by itself, misses the fundamental nature of a credit transaction, which is a promise between a lender and borrower.

I also don't like the "audit the Fed" provision. What are they going to do? Send Bernanke to jail? Which leaves nothing in the "good" column.

Two threads -- what I learned

I strongly recommend the thread on Unqualified Reservations (not the post). Some key things I learned:

1. Even people in banking do not seem to understand how banking works. The Academy, and therefore the Fed, are most clueless though.
2. Post-Keynesians tend to focus on how loans create reserves, that then get cycled into deposits via the overnight interbank lending market. In practice, banks run a day-to-day Treasury function that tries to fund assets with liabilities other than borrowed bank reserves overnight. The degree to which banks utilize the overnight interbank market varies by bank and bank business model, but generally, they try to get deposits and other liabilities instead.

This makes sense since bank profit is generated by the spread, and the lower your cost of capital, the higher your profit margins (as lending is capital constrained).

What is a bank run

The standard model of bank runs, as detailed in the Diamond-Dybvig Model is a situation where long term assets are back by short term liabilities. If the short term liabilities are withdrawn, then the bank cannot liquidate assets on the long side fast enough, and some short term liabilities holders will not be paid back. This means that a bank run can start at any moment, for any reason.

The Diamond-Dybvig model, however, is constructed on a gold-standard model of banking where institutions were reserve constrained, and thus does not apply to banking today. I have no issues with the model, just as I have no issues with carburetor design. It just isn't applicable when talking about fuel injected vehicles.

So, in the days of FDIC, reserve accounts, and fiat currency, what is a bank run?

1) When depositors take out their money, the bank debits its liability account, and also debits its reserve account. Let's say that the deposits are being transferred straight to another bank so we don't have to worry about inventory issues with physical cash. That other bank credits its deposit and liability accounts.

2) The first bank now has a lower reserve position, and it may be so low that the bank cannot make its reserve requirements. No worries, it can borrow the excess reserve it needs on the overnight interbank market -- but only if other banks are willing to make the loan. This then, is a "modern" bank run. A bank is below its reserve requirement, and other banks are not willing to lend them their excess reserves overnight.

3) The bank short on reserves can always go to the discount window and borrow directly from the Fed. The Fed, howerever, has asset requirements it demands for collateral, and the bank may or may not have those assets.

4) If the bank cannot borrow at the overnight market, nor at the discount window, then functionally it is reserve constrained. It can no longer operate as a bank.

Three interesting observations:

1) The Fed's mechanism for setting the FFR, a number which it could simply declare by fiat the way McDonalds prices its hamburgers, is susceptible to credit risk. If this looks like a broken design to you, it should, because it's terrible.

2) Over the past 12 months, the Fed has taken on ever crummier assets as collateral to lend against at the discount window. If you're asking yourself "why is the Fed asking for collateral at all, as Treasury money is the ultimate backstop anyway?" you are asking yourself an excellent question. This collateralized lending is terrible as well.

3) Note how a bank operationally is only constrained by the Fed's rules for collateral at the discount window, and capital requirements. If the Fed chose to lend uncollateralized, and simply ignored capital requirements, then a bank could operate UNIMPAIRED even if it had massive negative reserves ("liquidity constrained") and massive negative equity ("insolvent"). When someone assets that the Govt could not let Goldman et. al go under, simply say that the Fed could lend unsecured (as it ended up doing anyway) and ignore capital requirements (as it ended up doing anyway) and bank operations would be unimpaired, but the capital structure would be maintained. You can keep a bank running, but let the equity investors "go under" without any problems.