Wednesday, April 1, 2009

Rortybomb argues my point (though he didn't mean to)

Rortybomb is a blog where I find myself entirely agreeing with the mathematics and totally disagreeing with the conclusion.  I have added it to the blog roll – and intend on taking a few shots at it.  I consider Rortybomb as providing an illustration of all the things you can do to abuse mathematics in economics.  

Mike (the blogger) posts empirical research suggesting the obvious – that big banks selling loans that can’t be securitised tend to have fatter margins.  When they sell loans that can be securitised they tend to have thinner margins.

He then concludes that we should have smaller banks and more access to securitisation.  Felix Salmon agrees with him and wants smaller banks and more securitisation.

No objection to the empirical fact that oligopolistic banks without securitisation competition are profitable.  I see it in many places.  And I see it today.  Securitisation is being removed and bank margins are going up.  Pre-provision, pre-trading loss profit of banks is rising.

My objection to Rortybomb is to the conclusion.  Fat margins for banks are a good thing.  They lead to the absence of financial crises.  Thin margins lead banks to take more risk – and when they fail they have huge collateral damage.  

Having a few fat rich banks is a small price to pay if you don’t trigger great depressions.  

In the olden days banks used to give out toasters to anyone who would open an account.  Why?  Because new customers were frightfully profitable.  Why didn't the banks compete with lower prices?  Because they were not allowed to.  Bank regulators actually regulated the value of the gifts (then known as "premiums") that banks could give their customers.  They wanted to ensure that the toasters did not cost too much.  Essentially they wanted to guarantee bank profitability.  Krugman wants to go back to the toaster days.  I just want to go back to days when banks were consistently very profitable over a cycle.

Big banks with no securitisation will be sufficiently profitable.

Rortybomb makes precisely my argument for big banks.  That they rip us off.  And that is a good thing.


Campbell Dawson said...

John, I hate to think what the logical conclusion to all this is if you assume that monopolies/oligopolies are the appropriate structure for financial systems. If ROEs for banks of 20% over the cycle are good, why arent ROE's of 30% better. Why shouldn't we return to the days (in Australia) when home loans were 6% above bank bills, because of the wonderfully cosy nature of the banking system. I suspect the safest and most regulated banking system in the world is Chinas and they now have most of the big cap banks in the world. However I'm not sure thats an economic/financial/social model that many of us would like to replicate.

Anonymous said...

Agreed completely. Barry Ritzoltz tried to defend securitization.

I have no problem with banks that sell loans, especially if they get to the position where they have to sell loans.

I have a big problem with a bank that BUYS loans, especially a bank that has a guarantee from the government.

Anonymous said...

Isn't securitisation a way of increasing asset turnover, i.e. of increasing revenues relative to assets employed? If so, might not a bank rationally forgo margin in pursuit of higher turnover, much like a grocery store, without sacrificing overall return on capital? Thanks.

-Nadav Manham

Anonymous said...

I'm not convinced that your model would work as you think it would.

Ireland has a (normally) high-ROE banking duopoly and both have imploded in the current crisis. And this is the second time in 25 years that AIB has had to be bailed out.

Also what about the impact of traders like traders like Rusniak, Leeson or Kerviel who can lose billions in a short period whilst representing their activities as low-risk regular banking transactions (forex trading etc). Seems like just one of these people can bring your high-ROE oligopilistic bank down.

John Hempton said...

I have dealt with the cross border problem several times.

The country has to be separately capitalised. Read the earlier posts.

Cross border banking is real dangerous.

crazyhog said...

As a consumer of banking services, is it really impossible to have healthy banks with thin margins (i.e. competitive banking industry)?

Can we achieve it through government policy?

For example, I knew China regulated their banks and economic growth by tweaking reserve requirements (in addition to interest rate). Initially, I didn't realize the significance of this. Now, I realize it is a great idea. During boom times, the government force the banks to maintain higher reserve. When the economy slows down, the government reduce reserve requirements. The banks are in better financial health to make more loans when the economy is slow.

I do agree that big bank isn't the root of the problem. However, having big but uncompetitive banks doesn't sound right either. Especially, when the financial system is global and banks have to face global competitors.

septizoniom2 said...

john: your model prefers big safe banks without much competition. how do you define acceptable levels of competiton? why have private sector banking at all?

John Hempton said...

Actually septo has nailed the right question - which is why have private sector banks at all?

My guess - the banks can still make profits in a regulated price environment by cutting costs.

But Australia ran quite well for a long time with one government owned bank.

I would be quite unhappy with four government owned bank.

But you can do it with lots of banks, stifling regulations and toasters.


Peter Rickwood said...

My first reaction was like Septo's.... you are essentially arguing for increased taxation (i.e. fatter bank margins) because the cost is worth it if it generates some bigger general good (no depression). Doing it by letting bank profit margins get big seems like a bit of a roundabout way of going about it though. Its kind of like trying to have your cake and eat it too.... free markets and competition are good things, but not really... or at least not too much. Surely there is a better solution..?

Anonymous said...

In the world with only a few big profitable banks is there room for unregulated non deposit taking finance companies to provide more creative and more expensive credit. Somewhere in between the banks and the hard money guys. Will these big profitable sleepy banks provided the necessary intermediation to the finance companies through warehouse loans or TRS?

Perhaps at the end of the day I would give up some stability for a better chance to make a buck.

Blank Xavier said...

It may be that part of the problem are the guarantees States seem all to offer to savings.

I just read an Economist article;

Basically, a building society, a purportedly conservative saving entity for mortgages, failed. Problem was exactly as John described, they took on a lot more risk.

They did this because they were being out-competed in the market by the regular banks.

Great quote from the article, from the ex-director of the society;

“What do you do when your core product has become everyone else’s loss-leader?”

They were offering mortgages at 5.0%, banks were offering 4.3%.

Now this is where the savings guarantee comes in. Savers have absolutely no reason whatsoever to care about the safety and security of the entity holding their money. No matter what happens, the State will ensure they lose nothing.

So a conservatively investing entity, very safe, with a low return, is dead. You're offering safety - but it has absolutely no value to the saver. He's safe anyway. The risk has been taken on by the State.

If you want financial entities to exist which offer truly low risk behaviour and stick with it - which means they offer low returns *and* make a decent profit - people must benefit from the risk reducation.

So I think this State interference in the market may be causing fundamental problems. I think it may be profoundly altering the type and behaviour of financial entities.

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