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Financial regulations

from Lars Syll

A couple of years ago, former chairman of the Fed, Alan Greenspan, wrote in an article in the Financial Timesre the increased demands for stronger regulation of banks and finance:

Alan Greenspan and Ayn Rand at the White House after Greenspan was sworn in as chairman of Gerald Ford’s Council of Economic Advisers, September 1974Since the devastating Japanese earthquake and, earlier, the global financial tsunami, governments have been pressed to guarantee their populations against virtually all the risks exposed by those extremely low probability events. But should they? Guarantees require the building up of a buffer of idle resources that are not otherwise engaged in the production of goods and services. They are employed only if, and when, the crisis emerges.

The buffer may encompass expensive building materials whose earthquake flexibility is needed for only a minute or two every century, or an extensive stock of vaccines for a feared epidemic that may never occur. Any excess bank equity capital also would constitute a buffer that is not otherwise available to finance productivity-enhancing capital investment.

That is — to say the least — astonishing. Not wanting to take genuine uncertainty or ‘fat tails’ seriously is ominous enough. Is there anything the year 2008 taught us, it is that the ‘tail risks’ are genuinely real and must be included in all financial calculations. But even worse is how someone – who surely ought to have read at least an introductory course in economics – can get the idea that demand for higher capital requirements of banks would be equivalent to building buffers of ‘idle resources.’ The claim is from an economist’s point of view absolute nonsense.

Capital requirements are about how the mix between debt and equity of banks’ balance sheets should look like. It is not a question of something having to be set aside. It is not about liquidity or reserve requirements. Capital requirements are not about pea soup in a jar that we should put on stock to have in a crisis. It’s about how much leverage we should allow banks to have.

Higher capital requirements simply mean that we demand that banks finance a larger portion of their portfolios out of equity and less out of money deposited or loans. There is nothing here about resource use, but about how banks should manage risks. And how they are distributed in an economically efficient manner.

Of course, higher capital requirements mean that banks’ risk-taking decrease. It is precisely because of this the requirements have been instituted. We saw in the recent financial crisis how the ‘systemic risk’ shot up when the banks were found to have taken on too great risks. Financial institutions authorized to operate with high leverage generate negative externalities. Of course, we have to — in the light of the financial crisis — ensure that banks operate under less leverage. Higher capital requirements are one way of achieving this.

Let me illustrate the mechanism.

Suppose a crisis would come and there would be a loss of 1 million USD, and the bank’s own capital is, for example, 5% of the balance sheet, that would force the bank to liquidate assets at a value of 20 million USD to regain the 5% level. Obviously, systems repercussions would be monumental. Higher capital requirements would both reduce the risk of liquidation, and the repercussions would be smaller (20% equity level would, in our example, reduce leverage to 5 million USD).

Suppose the initial balance sheet looks like this:

Loan: 100    Shareholders’ equity: 5
Liabilities: 95

Now if you raise the capital requirement from 5% to 20%, the bank can in principle react in three ways:

A: Assets Liquidation
Loan: 25   Equity: 5
Liabilities: 20

B: Recapitalization
Loan: 100 Shareholders’ equity: 20
Liabilities: 80

C: Assets Expansion
New assets: 12.5
Loans: 100  Shareholders’ equity: 22.5
Liabilities: 90

In both cases B and C it is evident that the higher capital requirements do not mean that the balance sheet must be reduced. Banks can continue to provide the economy with the necessary loans. Some negative effects on the banks’ ability to perform their basic system functions need not occur because one raises the capital requirements.

This is basics. That a former Federal Reserve chairman does not understand this is, to say the least, disheartening.

But maybe that is how it goes when you prefer reading Ayn Rand to Keynes or Minsky …

  1. Vince
    May 4, 2018 at 11:13 am

    This is very good,thank you.

    My other point to Greenspan would be that banks are not even using this so called “resource” wisely. According to the BoE’s own figures in the 10 years before the financial crash UK banks lent over half of all their loan portfolios to property markets and 35 % to loans for equity. A mere 8% was lent to the productive wealth generating part of the economy(non financial businesess). So the idea that banks are helping “productivity enhancing capital investment” is a total misnomer,by and large they are not.

    What our current banking system is doing is producing speculation on non wealth generating assets.(property and stock markets).

    Things have not improved since either,

    http://positivemoney.org/2017/02/bank-lending/

  2. May 4, 2018 at 5:28 pm

    More fundamentally the cognitive error is failing to distinguish endogenous shocks from exogenous shocks and their corresponding risks and instabilities. It’s as though ship designers only obsessed about capsize risk from tidal waves hitting the ship while utterly ignoring the possibility of hull breach due to corrosion from deferred maintenance or running aground due to poor sailing. This is not an exaggeration, and the stubborn failure by economics to consider any possible mechanism of internally derived systemic failure is breathtaking.

    • Craig
      May 5, 2018 at 12:53 am

      “It’s as though ship designers only obsessed about capsize risk from tidal waves hitting the ship while utterly ignoring the possibility of hull breach due to corrosion from deferred maintenance or running aground due to poor sailing. This is not an exaggeration, and the stubborn failure by economics to consider any possible mechanism of internally derived systemic failure is breathtaking.”

      Precisely. And the best way to do that would be to find the precise points within and throughout the entire economy where one could undo the dominating and monopolistic monetary and financial paradigm of Debt Only and at the same time thoroughly integrate costless monetary policies at those same points that benefited all agents and resolved modern demand constrained economies….all in one fell swoop. Don’t ya think?

  3. May 7, 2018 at 1:03 pm

    The main reason Sapiens invented agriculture, government, and economics about 7-10 thousand years-ago was to provide security to otherwise comfortable Sapiens foragers. Most of what enters the thinking of economists, including Greenspan was therefore invented to protect and defend humans from precisely the types of “risks” Greenspan claims are not a proper use of resources. Including famines, plagues, homelessness, threating everyday conditions. In the stream of human collective life such occurrences are rare. But rare is not a fixed cultural invention. Famines may happen only once in a lifetime, while threatening weather events may occur several times per decade. Plagues may occur only once per century, but changes in demographics may occur as frequently as every decade. As Sapiens societies grew in complexity, so did the number and severity of risks for those societies. Today no society can prosper or even survive for long without electricity. Loss of electricity through weather, equipment breakdown, or sabotage is intolerable. Society guards against such losses in many ways. For example, stand-by generation plants are constructed that may only operate 10-12 days per year. Similarly, plagues are much less tolerated today than at prior points in Sapiens history. Which leads to the construction of specialized laboratories, creation of stockpiles of vaccines, regular monitoring and testing protocols, and training of thousands of doctors. Modern economics and economists be damned. They have perverted each of the inventions Sapiens intended to keep their species safe and secure. They have turned them all into statistical equations and betting stops on a roulette wheel. Into investment “opportunities” for smart and uncaring business persons. Bad species survival strategy.

    • Craig
      May 8, 2018 at 12:32 am

      Quite. And that is precisely why we need a paradigm change which will bring good, rational and ethical order to a system of dominatingly smothered financial chaos.

      • May 9, 2018 at 7:06 am

        Craig, but what are the origins of any rationality and ethics? The community. The community might be only a family, but the goal is to construct as large communities as possible; eventually a world-wide community. The community is a history of interactions, of accommodations, and mutual understandings and duties. Communities are constructed over time in an identifiable location or locations. Members of the community share a common history and identity, from which each member develops individuation. Communities solve problems first because it’s necessary for the communities’ survival and second because it’s tradition to do so. This view is “conservative” in the long historical sense of conservative. It creates both stability and creative individualism that only exists within the community. This view is also consistent with Sapiens evolution.

      • Craig
        May 9, 2018 at 6:12 pm

        Ken, the origins of rationality and ethics is awareness…of one’s own awareness itself. If one has a firm reality on their own conscious existence then they must come to the conclusion of the reality….that everyone else is a consciously sensitive individual as well.

        As I’ve said here before I don’t necessarily dispute the validity of sociological, anthropological, political or the input of any other body of knowledge, in fact I affirm them, it’s just that the topic is economics and in my mind the current and new monetary and economic paradigms. Deciphering the new one and getting it implemented will by definition be a dramatically beneficial event and realization for the individual, every economic agent and the system itself which is a community of entities, and integrating the best aspects of personal character and intellect while deleting/letting go of any non-survival traits is the real “job” of every individual, and makes the individual him/herself a community as well.

      • May 10, 2018 at 9:29 am

        Craig, one cannot reflect on one’s self until one is a self. And that only happens in communities. Defining selfhood is one of the basic struggles, reenacted repeatedly through the history of human communities. You’re correct that each person is a community. Anthropologists call all communities actor-networks. Which includes each of us. And communities are how Sapiens evolution occurs. Via multi-level group selection. Sometimes the movies and many capitalists (quoting Herbert Spencer) focus on selection of the fitness individual, this does not fit with the evidence about Sapiens evolution. Sapiens survive or perish through groups, not individual members of groups. There is nothing special about economic actions. They are created the same as other actions and can be studied just as any other aspect of the social world. Before there were specialized sciences there was only moral and natural philosophy. Economics falls into moral philosophy, along with law, war, crime, politics, etc. Economists are not special.

      • Craig
        May 10, 2018 at 5:04 pm

        So we’re in agreement that integrative thinking and integrative agreement between groups of individuals is the path of greater wisdom and survivability for humans.

      • May 11, 2018 at 11:19 am

        Craig, no, that’s not it. In the words of Bruno Latour, “The world is not a solid continent of facts sprinkled by a few lakes of uncertainties, but a vast ocean of uncertainties speckled by a few islands of calibrated and stabilized forms.” Nothing permanently defeats these uncertainties. Evolution and cultural adaptation provide groups of Sapiens the opportunities to survive. Wisdom (whatever you take that to be) may be or may not be part of the mix. In any event, it’s defined after evolution, by the results of evolution. Not prior to evolution.

      • Craig
        May 12, 2018 at 6:15 am

        Who said wisdom was prior to evolution? The world’s major wisdom traditions, if understood properly, that is as the purest, highest and most evolved form of human psychology/conscious insight as opposed to a latching onto their various dogmas which are merely guide posts, but not the experience of consciousness itself,…….came about as the result of humans evolving self awareness.

        I don’t get your disagreement with what I am saying here. Wisdom is an integration of psychology and sociology….and many more disciplines. It’s a superior and more inclusive mental discipline than science alone which is a rational yet fragmenting mental process and unfortunately has taken a trend toward the very religious orthodoxy it reacted against 500 years ago. That’s all I’m saying, and of course that we should apply the insights about the temporal universe that can be gleaned from such a study of Wisdom…and apply those insights to economics.

      • May 12, 2018 at 1:31 pm

        Craig, we believe Sapiens brain structure and chemistry have not changed in about 70,000 years. Those changes about 70,000 years ago are the factors that favored Sapiens over other human species in terms of survival. Often described with the words intelligence, thought, or wisdom, I prefer another word to describe these changes, imagination. Imagination allowed Sapiens to create not only agriculture, government, money, etc. but also consciousness, personality, and a variety of forms of knowledge (e.g., religion, science, perception) and hierarchical arrangements for the life of Sapiens (e.g., animal life, cosmology, deities). Wisdom’s in there with all the others. Its story is important, but no more important than the others. Which of these cultural inventions has the greatest benefit for Sapiens in terms of survival is a pragmatic question. It’s answerable only in its effects. In the words of Charles Sander Peirce, “Consider what effects that might conceivably have practical bearings you conceive the objects of your conception to have. Then, your conception of those effects is the whole of your conception of the object.” This is how Sapiens knows and use wisdom.

      • Craig
        May 12, 2018 at 6:35 pm

        Yeah, we do disagree. Consciousness/self awareness is more basic than any separate -ology. Every body of knowledge is a perfectly valid study, but merely a derivative (including the phenomenon of mind as in abstraction) of the fact that we as homo sapiens sapiens are potentially capable of being more self aware than any other species on the planet. Consciousness is essence, wisdom is as much of the integration of mind as one is currently capable of understanding AND the essence of self awareness/consciousness itself. It’s the ultimate integration of the two and yet the key to experiencing self awareness is emptying one’s mind OF abstraction. It’s the meaning behind the verse, ““Truly I tell you, unless you change and become like little children, you will never enter the kingdom of heaven.”

      • May 13, 2018 at 8:52 am

        Craig, humans have no essence. This is the “uniqueness” of humans. Humans create the soul, consciousness, technology, science, etc. from the performances arising out of interactions with humans and nonhumans. Humans are made by themselves and the world. If this is what you mean by self-aware, then yes humans are self-aware. Evolution seems to indicate that humans did not originate as self-aware, however. But rather developed self-awareness via their history of interactions. I see no evidence of a spiritual factor in any of this. Except, of course the spirits humans create. Human communities are the setting for all of this. Here’s where all the work is done.

      • Craig
        May 14, 2018 at 7:21 pm

        Yes, that’s the orthodox scientistic and sociologically fragmented viewpoint. The fully integrated natural and truly scientific look at it is that the thrust toward consciousness is an integral part of the cosmos itself.

      • May 16, 2018 at 6:13 am

        Craig, if we follow the universe, as best we’re able, I believe Fritjof Capra captures the path to insight. “Quantum theory thus reveals a basic oneness of the universe. It shows that we cannot decompose the world into independently existing smallest units. As we penetrate matter, nature does not show us any isolated “building blocks,” but rather appears as a complicated web of relations between the various parts of the whole. These relations always include the observer in an essential way. The human observer constitutes the final link in the chain of observational processes, and the properties of any atomic object can be understood only in terms of the object’s interaction with the observer.” Humans are, of course entangled in the universe, as is the universe in humans. Of course, humans ponder these entanglements. We call this pondering science. Others call it religion. Still others philosophy. So long as we never expect certainty in any of these, we are following the universe. Many humans do seek and hold on to what they claim is certain, in science, religion, and philosophy. In so doing, humans betray any access to insight. It’s difficult sometimes for humans to accept uncertainty. It’s a lesson each human needs to continue to learn.

      • Craig
        May 16, 2018 at 8:13 am

        All things are in process. I couldn’t have said it better. There is one proviso however, and that is has one had the fully conscious experience of the present moment, the present moment, the present moment…… or do they only “know” this as a data point or as a belief in religious….or scientific dogma? Every one of the world’s major wisdom traditions tells us that, the vast majority of us either haven’t had such an experience or do not know how to fit it into their normal walking around state of consciousness and so either invalidate it or latch onto the dogmas within which they were brought up…and so lose the experience itself.

        So how is this relevant to economics? Such an experience is regularly referred to as being in a state of grace or “the flow state” which of course is conceptually reflected in the goals of classical economics’ for balance, equilibrium and flow for the economy. And when you do a definitional/philosophical exegesis of the word grace among its many, many other aspects, most of which are also directly relevant to economic theory….you find grace as in the gift, i.e. monetary gifting. Then if you know the signatures of all paradigm changes you realize that conceptual opposition to the current paradigm is one of them, and so the current paradigm of Debt/BURDEN Only is conceptually opposed by the new paradigm of monetary FREE gifting.

        Perception of a new paradigm is a new conscious and enlightening experience. It’s the “ah ha” or “oh yeah, why didn’t I see that before especially because I’ve been looking at it for 30 years and didn’t see the connection” kind of experience?

      • May 16, 2018 at 10:27 am

        Craig, you make the error I just described. You search for certainty. Consciousness is one of the many ways of life humans invent via interactions. Just one among many. It is no more certain or imposing than any of the others. Sorry, no “a ha’s.” Just, “might be,” “maybe.”

      • Craig
        May 16, 2018 at 5:32 pm

        So there is no such thing as knowing-ness (not to be confused with self knowledge as in identity), or levels thereof?

      • May 17, 2018 at 6:30 am

        Craig, one of the performances that arise from interaction is explaining or giving meaning to the interactions. Often spoken of as knowledge or knowing. Humans make it up as they go, holding onto what seems useful. Knowledge is conditional on its demonstrated usefulness. Which people must continually reassess.

      • Craig
        May 16, 2018 at 8:14 pm

        And it appears you’ve found certainty yourself. Now all you have to do is mentally balance the opposites of certainty and uncertainty in an integrative and dynamic fashion…and you’ll have the natural experience of the flow state of grace.

      • May 17, 2018 at 6:34 am

        Craig, I’ll not oppose any efforts on your part to achieve this result. I prefer not to undertake the effort, however.

      • Craig
        May 17, 2018 at 8:01 am

        Do yourself a favor and keep your mind open to the idea that modern scientific orthodoxy does not have it “all together” so far as awareness of being aware is concerned. I appreciate the back and forth with an obviously erudite individual.

      • May 17, 2018 at 10:00 am

        Craig, that’s me – open and uncertain. Economists are neither, generally. A large share of the problem with their “science.”

  4. tyillc
    May 12, 2018 at 2:08 am

    The fact Greenspan is wrong in his assessment of bank capital doesn’t make your assessment right. Having helped to write what eventually became the Basel I capital requirements, let me clear up a few misperceptions.

    First, bank capital is an easily manipulated, accounting construct. A classic example of how easily manipulated bank capital is occurred in 2008/2009 when mark-to-market was suspended and replaced with mark-to-model for subprime securities.

    Second, bank capital ratios tell you nothing about how risky a bank is. The only way to know the risk a bank is exposed to is to examine its current exposure details.

    Third, banks make loans when there is an opportunity to make a loan. The decision of whether to retain the loan on their balance sheet or sell it on to a third party (hedge fund, pension fund, another bank,….) is made subsequent to origination. Capital ratios have no bearing on the extension of credit. They only influence the hold versus sell on decision.

    Fourth, regulators have shown they will never make banks use their capital to absorb losses during the acute phase of a financial crisis. Their concern is this will make the crisis worse.

    Fifth, as shown by US Savings and Loan Crisis, the combination of deposit insurance and access to a lender of last resort means insolvent financial institutions can continue to operate indefinitely. This is important. Banks don’t go out of business overnight unless the government shuts them down.

    Sixth, the negative externalities financial institutions generate is not a function of their capital requirements. It is a function of their opacity. Since they are opaque, market participants cannot assess the risks the financial institutions are taking and exert market discipline. As a result, banks can take on too much risk. The solution to this problem is transparency and not an easily manipulated accounting construct.

    • May 13, 2018 at 9:22 am

      Twillc, the quote from Bruno Latour above should be emphasized, “The world is not a solid continent of facts sprinkled by a few lakes of uncertainties, but a vast ocean of uncertainties speckled by a few islands of calibrated and stabilized forms.” It is humans who establish these little islands of calibration and stability in the ocean of uncertainties humans confront. You cite what I guess many in the financial sector have established as certainties – bank capital, accounting construct, risk, loan making, bank losses, deposit insurance, financial institutions, and opacity. To support or oppose their use, or the relevance given them we need to understand how and by whom they are created. Greenspan’s use of these terms seems historically inconsistent with not just most other economists, but clearly and profoundly with their use by the public and public policy makers, at least prior to the last 20 years. Ayn Rand’s use of them seems even more divergent. Today, it seems both the public and public policy makers are accepting of if not fully supportive of Greenspan’s and Rand’s creations. How’d these changes happen? In my view they’re screwed up the USA, from top to bottom, along with much of the rest of the world. Since these “certainties” are human made, they can be human unmade. It’s time to unmake them.

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