Other people’s money

USA Financial Crisis Inquiry Commission, “primer” issued by the Republican party defectors from the project —

If the bank uses deposits to fund poorly performing projects, depositors can become concerned that eventually their bank is going to fail and they will not get their deposits back. If a bank lends too much of its deposits to finance long-term projects, depositors might begin to worry that they will not be able to withdraw their money according to their needs. Therefore, banks hold enough cash on hand, or “liquidity,” to be able to honor withdrawal requests and offer confidence to depositors that their money will be there when they want it. If depositors lose confidence in their bank, the only rational thing to do is to withdraw their money and move it to a safer place. With each depositor withdrawal, the bank becomes more leveraged, the mismatch between its assets and liabilities becomes more pronounced, and liquidity on hand is further diminished.

With the credentials that one assumes qualified them to be on the commission in the first place, you’d hope to do better than what you’d get from putting “bank run” into The Google.  But do you?

For one thing, there’s no mention of bank capital in this story.  The depositors get nervous not because of loan losses per se, but loan losses that exceed the bank’s ability to dig into its own resources to cover them.  That raises another point … “with each depositor withdrawawl, the bank becomes more leveraged.”  Since the depositors have lent money to the bank, how does loss of deposits make the bank more leveraged?  In a bank run, the bank in fact is undergoing a brutal deleveraging.  It’s certainly becoming less liquid, and if it goes into its capital — that word again — to meet its liquidity needs, then its leverage ratio is increasing.  But their’s a very hard story to tell without discussing capital.

One more thing.  Moral hazard is mentioned precisely once in the report, in the context of a perceived government backstop leading to a too big to fail dynamic.  But more hazard is an intrinsic characteristic of having someone else’s money in a limited liability framework.  Such as being a financial intermediary, bank or non-bank.  The solution to moral hazard is supposed to be that the intermediary’s, yes, capital, exposed to the first losses.  There is no discussion in the report of why this solution failed. 

In short, preventing the next financial crisis has involved thinking about a mix of more capital and more regulation — using the former may lessen the need to use the latter, and vice versa.  But in a report that’s not willing to talk much about capital or regulation, the authors likely have problems with both.

3 thoughts on “Other people’s money

  1. Pingback: My Sense of Humour « New Economic Thought

  2. The authors of that report have won this year “stupidest economist alive” price:

    http://delong.typepad.com/sdj/2010/12/joe-nocera-on-the-winners-of-this-years-stupidest-economist-alive-contest-wallison-hennessy-holtz-eakin-and-thomas.html

    Here are ten interesting questions that this experts just did not venture to answer:

    http://www.ritholtz.com/blog/2010/12/10-questions-for-gop-members-of-financial-crisis-inquiry/

    1. From 2001 to 2003, Alan Greenspan took rates down to levels not seen in almost half a century, then kept them there for an unprecedentedly long period. What was the impact of ultra low interest rates on Housing, credit, the bond markets, and derivatives?

    2. How significant were the Ratings Agencies (S&P, Moodys and Fitch) to the collapse? What did their AAA ratings on junk derivatives affect? What about their being paid directly by underwriters for these ratings?

    3. The Commodities Futures Modernization Act of 2000 removed all Derivatives from all oversight, including reserve requirements, exchange listings, and disclosures. What effect did the CFMA have on firms such as AIG, Bear, Lehman, Citi, Bank of America?

    4. Prior to 2004, Investment Houses were limited to 12-to-1 leverage by the SEC’s net capitalization rule. In 2004, the 5 largest investment banks asked for, and received, a full exemption from leverage restrictions (known as the Bear Stearns exemption) These five firms all jacked up their leverage. What impact did this increased leverage have on the crisis?

    5. For seven decades, Glass Steagall separated FDIC insured depository banks from riskier investment houses. Prior to the repeal of Glass Steagall in 1998, the market had regular crashes that did not spill over into the real economy: 1966, 1970, 1974, and most telling of all, 1987. What impact did the repeal of Glass Steagall have on the banking system during the 2008-09 crash?

    6. NonBank Lenders: Most of the sub-prime mortgages were made by unregulated non-bank lenders. They had a ”Lend to securitize” business model, and they sold enormous amounts of subprime loans to Wall Street for this purpose. Primarily located in California, they were also unregulated by both the Federal Reserve and the California State legislator. What was the impact of these firms?

    7. These firms abdicated traditional lending standards. They pushed option arms, interest only loans, and negative amortization mortgages, all of which defaulted in huge numbers. Was non-bank sub prime lending a major factor in the crisis?

    8. The entire world had a simultaneous global housing boom and bust. US legislation such as the CRA or Fannie & Freddie only covered US housing and lenders. How did this cause a worldwide boom and bust — even bigger than that in the US ?

    9. Prior to the 2004, many States had Anti-Predatory Lending (APL) laws on their books (and lower defaults and foreclosure rates). In 2004, the Office of the Comptroller of the Currency (OCC) Federally Preempted state laws regulating mortgage credit and national banks. What was the impact of this OCC Federal Preemption ?

    10. Corporate Structure: None of the Wall Street partnerships got into trouble, only the publicly traded iBanks. Partnerships have full personal liability for their losses. What was the impact of this lack of personal liability of senior management on Wall Street risk management?

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