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Saving monster banks that ought to fail
June 15, 2009, Monday
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EDITOR'S Note:
This is the second of three articles about the causes of the global financial crisis. Stuart P.M. Mackintosh is executive director of the Group of Thirty. Allan H. Meltzer is a professor of political economy at Carnegie Mellon University. The article is adapted from a digital video conference on Global Financial Systems hosted by the US Consulate General on May 14.
Q: Is faith in the self-regulating nature of markets misplaced?
Mackintosh: I wouldn't go so far as to say that the foundation of our economic system is drawn into question, but I do think you can say it is a crisis of the system, not in the system.
Self-regulation is an oxymoron. I don' think we can rely on that. I don't think we're going to see self-regulation again used in the same way that we have seen it in the run-up to this especially severe crisis. It simply didn't work.
These banks took extremely large risks, put the entire financial system - and indeed the real economy - at risk. And we can't allow that to happen again.
Q: Dr Meltzer, you said the US system - what you call democratic capitalism - is sufficiently flexible to make the needed adjustments to economic policy. Do any of the recommendations out there right now go beyond the limits of democratic capitalism?
Meltzer: First, I would like to say that the banking system is a heavily regulated system, and it always will be a heavily regulated system, because we and everyone else, either de facto or by law, have deposit insurance.
If you have deposit insurance, you've taken a lot of the risk away from the depositors, but you can't allow them to adjust the banks, to adjust the asset side of their balance sheet.
We didn't deregulate the banking system. We changed a few laws, but most of them didn't have much effect any more because the bankers had learned to circumvent them.
The first law of regulation, as far as I'm concerned is, that bureaucrats and lawyers make regulations, but bankers and markets learn how to circumvent them. And they circumvent them all the time.
They circumvented Glass-Steagall. They didn't remove very many regulations, and the banking system is not self-regulated. It is examined over and over again by all sorts of agencies of the government, of the states.
It just isn't true that they are deregulated.
What we do have is a government policy which is heading in the wrong direction. What they want to do or what they say they want to do, is to find a super-regulator.
There are two reasons why I think the super-regulator is a bad idea.
First because I don't think they can do it. The record of the Federal Reserve is, it never was ahead of a crisis. The SEC - this is the age of Madoff.
The SEC was given 20 or more pages, explaining what Madoff was doing. It couldn't possibly be what he actually was doing. They couldn't figure it out. They didn't regulate him. To give them more power to regulate is a non-starter. It won't work.
Second, it is a mistake to give them that power.
What you want to do is increase the responsibility of the bankers. And the way to do that is not to move the responsibility to some Washington office; move it back to the bankers.
Tell them, look, we do not allow "too big to fail." If you take risks that cause you to fail, you fail. And then they become much more prudent.Now, our Chinese friends should understand very well that if you allow bankers or encourage bankers to take risky securities, you have big losses.
Mackintosh: I agree with the professor that the banking sector was regulated and that there were failings by the supervisors, not least the Fed, and others.
However, part of the transmission mechanism that created this sort of burst from being a small subprime crisis that people thought was worth at most a few hundred billion dollars of defaults, into a global crisis of colossal magnitude was the transmission mechanism of these risks through complex securities in markets which were largely unregulated or lightly regulated.
I'm talking about the credit default swaps, I'm talking about the CDOs (collateralized debt obligation), the CDOs squared, and so on. Those markets were not regulated.
And furthermore, a lot of the companies that were very active in these places, in these spaces were not regulated. AIG, big failing of the US system, was not properly regulated.
And that is why the response of the Obama administration and indeed others around the world is to say, okay, henceforth, what they call the "shadow banking industry" will be under some form of modest regulation and if institutions become too big to manage or too big and systemically important, we will take actions to mitigate those risks and try and cut down on the risk-taking by those institutions.
Meltzer: It doesn't work. I mean, simply the history is it doesn't work.
I mean, the SEC is supposed to regulate the financial markets. What do they do? They told the investment banks they could increase their leverage from 11 to 33 times. That's terrible. And that creates big losses.
What you want to do is you want to put the burden of managing the losses on the people who make the decisions. And then they will be more prudent.
This is the second of three articles about the causes of the global financial crisis. Stuart P.M. Mackintosh is executive director of the Group of Thirty. Allan H. Meltzer is a professor of political economy at Carnegie Mellon University. The article is adapted from a digital video conference on Global Financial Systems hosted by the US Consulate General on May 14.
Q: Is faith in the self-regulating nature of markets misplaced?
Mackintosh: I wouldn't go so far as to say that the foundation of our economic system is drawn into question, but I do think you can say it is a crisis of the system, not in the system.
Self-regulation is an oxymoron. I don' think we can rely on that. I don't think we're going to see self-regulation again used in the same way that we have seen it in the run-up to this especially severe crisis. It simply didn't work.
These banks took extremely large risks, put the entire financial system - and indeed the real economy - at risk. And we can't allow that to happen again.
Q: Dr Meltzer, you said the US system - what you call democratic capitalism - is sufficiently flexible to make the needed adjustments to economic policy. Do any of the recommendations out there right now go beyond the limits of democratic capitalism?
Meltzer: First, I would like to say that the banking system is a heavily regulated system, and it always will be a heavily regulated system, because we and everyone else, either de facto or by law, have deposit insurance.
If you have deposit insurance, you've taken a lot of the risk away from the depositors, but you can't allow them to adjust the banks, to adjust the asset side of their balance sheet.
We didn't deregulate the banking system. We changed a few laws, but most of them didn't have much effect any more because the bankers had learned to circumvent them.
The first law of regulation, as far as I'm concerned is, that bureaucrats and lawyers make regulations, but bankers and markets learn how to circumvent them. And they circumvent them all the time.
They circumvented Glass-Steagall. They didn't remove very many regulations, and the banking system is not self-regulated. It is examined over and over again by all sorts of agencies of the government, of the states.
It just isn't true that they are deregulated.
What we do have is a government policy which is heading in the wrong direction. What they want to do or what they say they want to do, is to find a super-regulator.
There are two reasons why I think the super-regulator is a bad idea.
First because I don't think they can do it. The record of the Federal Reserve is, it never was ahead of a crisis. The SEC - this is the age of Madoff.
The SEC was given 20 or more pages, explaining what Madoff was doing. It couldn't possibly be what he actually was doing. They couldn't figure it out. They didn't regulate him. To give them more power to regulate is a non-starter. It won't work.
Second, it is a mistake to give them that power.
What you want to do is increase the responsibility of the bankers. And the way to do that is not to move the responsibility to some Washington office; move it back to the bankers.
Tell them, look, we do not allow "too big to fail." If you take risks that cause you to fail, you fail. And then they become much more prudent.Now, our Chinese friends should understand very well that if you allow bankers or encourage bankers to take risky securities, you have big losses.
Mackintosh: I agree with the professor that the banking sector was regulated and that there were failings by the supervisors, not least the Fed, and others.
However, part of the transmission mechanism that created this sort of burst from being a small subprime crisis that people thought was worth at most a few hundred billion dollars of defaults, into a global crisis of colossal magnitude was the transmission mechanism of these risks through complex securities in markets which were largely unregulated or lightly regulated.
I'm talking about the credit default swaps, I'm talking about the CDOs (collateralized debt obligation), the CDOs squared, and so on. Those markets were not regulated.
And furthermore, a lot of the companies that were very active in these places, in these spaces were not regulated. AIG, big failing of the US system, was not properly regulated.
And that is why the response of the Obama administration and indeed others around the world is to say, okay, henceforth, what they call the "shadow banking industry" will be under some form of modest regulation and if institutions become too big to manage or too big and systemically important, we will take actions to mitigate those risks and try and cut down on the risk-taking by those institutions.
Meltzer: It doesn't work. I mean, simply the history is it doesn't work.
I mean, the SEC is supposed to regulate the financial markets. What do they do? They told the investment banks they could increase their leverage from 11 to 33 times. That's terrible. And that creates big losses.
What you want to do is you want to put the burden of managing the losses on the people who make the decisions. And then they will be more prudent.
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