Friday, March 27, 2009

The case for letting bankers rip us off

In the last post I proposed the radical – but disagreeable – proposition that the right way to regulate banks is to allow them to rip us all off.

I didn't expect any support – but surprisingly I got some.  At least one commentator noted – as I would – that the only thing worse than bankers making outrageous profits is bankers not making outrageous profits.    

Several Canadians saw their banking system (bureaucratic, dull, profitable and stable) more or less as I saw the Australian system.  

In general – and one commentator actually raised this – I was suggesting we go back to a 3-6-3 banking world – where a banker took deposits at 3 percent, made loans at 6 percent and hit the golf course by 3 pm.   That was a fair summary except that maybe I lean towards a 3-7-3 system.  

Hong Kong was also raised.  Hong Kong had a formalized 3-7-3 system – where the bankers knocked off early every day except Friday.  On Fridays they went to the office of the governor of the currency board and set interest rates for next week.  A truly cozy oligopoly.

The wealth from the great Hong Kong oligopoly is what allowed HSBC to become “the world's local bank” (and America's stand-over merchant).

Of course semi-socialist banking completely killed all Hong Kong entrepreneurship and turned Hong Kong into the poor colonial trash of Asia.  

Ahem – actually it wasn't all that destructive.  

But the Hong Kong example gives the next clue in how a post-crisis banking system should be regulated.  If the Hong Kong subsidiary of HSBC – the extraordinary money machine – is separately capitalized then it will be bailed out.  But if the Hong Kong monies are all lent to the much larger US Subprime market then – hey – it could still fail.

So what you need to do if you are Hong Kong is insist that the Hong Kong subsidiary is a separately capitalized subsidiary and cannot inject money into any other HSBC subsidiary without a 100% capital charge.  The result would be that it would not matter whether the rest of the HSBC went to pot – the Hong Kong subsidiary – and hence Hong Kong – would be fine.  Even if it were insolvent it would be worth someone's while to recapitalize it.  HSBC Hong Kong was of course a goose laying golden eggs.

Some thought that Australia (and presumably Canada) were OK because of the commodity booms.  Sorry – no dice.  If you haven't noticed the commodity boom is over you are not watching the distress coming out of Western Australia.  

One objection to having really large banks (often expressed by Simon Johnson) is that really large banks are good at regulatory capture and that is a bad thing.  But I advocate much higher profitability for banks.  Regulatory capture is to be encouraged so long as it allows the banks – in the manner of a utility – to apply too much capital for reasonable incremental returns.  Regulatory capture in my view is a good thing.

Actually the only real objection I got was the one I expected which was the notion that Fannie and Freddie were my too-profitable-to-fail government mandated oligopoly and provided a counter-example.  Even that notion is garbage.  The peak profit net income of Fannie Mae was about 7 billion dollars – and it was typically in the 4-6 billion range.  The peak net income of Freddie Mac was about 10 billion but it was typically in the 3-4 billion range.  In almost every year the combined profit was under 10 billion.  And for that they took credit risk on over 5 trillion of mortgages.  They earned – at best – 20bps post tax on all risks they took.  The pre-tax fee for taking credit losses was typically about 20bps.  

The thing about Fannie and Freddie was that they were staggeringly unprofitable.  If Fannie and Freddie had earned even half a percent total credit exposure then they would have been so profitable that they would not have failed now.  

The problem with Fannie and Freddie is that they didn't convince regulators to increase their profit enough.  Very sad – but for all their legendary prowess lobbying they just failed miserably to score.  By the end they had regulators who were ideological warriors against their existence – a measure of their total lobbying failure.  What we needed was regulators who were far more captured by Fannie and Freddie.

The shadow banking system as the real competitor

The real problem with Fannie Mae – and with American and English banking – was that the shadow banking system became huge and a devastatingly effective competitor.  The shadow banking system shook margins to very low levels – so low that even Fannie and Freddie – with the seemingly overwhelming advantage of their quasi-government status – could barely eek out a profit.  

And no amount of lobbying – no matter how competent – could undo the huge competitive threat that Fannie and Freddie were under.  Fannie and Freddie's lobbying effort just wasn't up to it because the task was too hard.  The financial engineers who dreamed up the shadow banking system were just too clever.

The Pandora's box of financial innovation

And herein is the ultimate problem – that some of my commentators picked up on.  That is that the real driver of low margins in banking was the shadow banking system.  The highly paid people were the brokers and traders and hedge fund managers who made all that work.

And at the moment the shadow banking system is in ruins – and as a result pre-tax, pre-provision pre-trading loss  profitability of banks (or for that matter Fannie and Freddie) is rising sharply.  And we are getting to the sort of world I envisage, that of fat lazy banks with “lazy balance sheets” who have completely captured their regulators.

But unfortunately markets don't look like that.  Pandora can't put financial innovation back in its box – and when this crisis is over the shadow banking system will re-emerge to crush margins again.  

Of course we can stop it.  All those high-power, high-paid traders and brokers who are central to the shadow banking system should eventually be fired.  They are not necessary in my hoped for 3-7-3 world.  And they caused all the problems anyway.  Firing them now should be done so long as it does not exacerbate the current crisis.

And when the competition is gone even Fannie and Freddie can double or triple their margins – and even they will wind up costing taxpayers very little.  

Alas consumers will pay for the mistakes of the past – interest spreads (and hence rates paid by consumers) will be higher and that “tax” is what  recapitalizes our system and keep us out of future messes.  In first instance it is not good for consumers.

But it is not clear that consumers really benefited in the end from hyper low mortgage rates.  They just seemed to get capitalized into the value of houses – and that was part of the creation of our current predicament.  

Let me end with some stylised facts

This little rant of mine is contrary to the received wisdom both of my training (economics) and of the world we live in.  

But I digress.  

Economics is meant to be a science based on observation – but more often than not degenerates into an ideological slanging match.  Here are a few observations:

  • Highly regulated – indeed price fixed – banking did not visibly hinder economic growth in Hong Kong.
  • Highly indebted countries with highly oligopolistic banking systems and quite a lot of financial regulation are doing relatively well at the moment – see Australia, Canada, possibly Israel.  
  • Fannie and Freddie may have made huge and seemingly formidable lobbying efforts – but those lobbying efforts failed miserably – with Fannie and Freddie combined profits never going about $10 billion for carrying about half of all mortgages in the United States.  This number seems large but is trivial relative to the size of the exposure or the stated profits of competitors.  
  • The collapse of mortgage margins in the UK simply resulted in banks maintaining returns on equity by increasing leverage.  Bank profits did not fall – but bank risk – and system risk 

Some of these facts are uncomfortable because the facts do not fit my off-the-cuff economist's reaction.  They don't fit my usual presumption that markets and deregulation are mostly good.  And they argue that we are better off with nasty bureaucratic Australian banks than most the alternatives.  

But – to paraphrase Keynes – when the facts are inconsistent with my theory I change my mind.  What do you do sir?



Anonymous said...

The best way for banks to raise money is to have a credit crisis just like the current one. Look at those deposit numbers go higher.

Why pay 6% (at least) when you can pay 1% on a deposit?

Imagine the outrage if you tried to MAKE everyone do this?

Tim said...

One thing I find interesting is that there some pure "utility" banks out there. One example I think is quite interesting is Euroclear which is technically a user owned bank based in Brussels that handles settlement of the Eurobond market and provides some ancilliary depository and FX trading services. By definition it has to operate across borders but almost because of that fact it is regulated even more stringently than you typical Australian or Canadian bank. Euroclear pays almost next to nothing on it deposits and because takes them on as a convience factor to facilitate its core settlement business. I would also argue that Bank of NY Mellon to some degree is a simmilar yet shareholder owned business model

Anonymous said...

India also had a terribly stultifying banking sector and seems to have done quite ok through this crisis. The problems of growth in India had more to do with regulatory issues where even today it takes more than 2 months to start a new business rather than lack of credit.

Unknown said...

Another thought provoking article. Thanks John. I was born and raised in HK so a little fun in reading all the mentions of HK.

But how do you explain the fact that HK has so many of these mid and small size banks? I am always amazed at the number of banks in HK. Not just branches, but the number of banking companies operating in HK is truly mind boggling.

Anonymous said...

Actualy, 100% capital charge on HSBC's liquidity support would not prevent the HK subsidiary from helping out its hopeless US operations. HK's HSBC has actually purchased RMBS and other ABS originated by its US and European affiliates as of end-2008. This is even worse than liquidity support. HSBC is bearing actual credit risks on these paper...

John Hempton said...

Separate capitalisation with a 100% charge for related party transactions is necessary. The HSBC internal transaction suck.

Hong Kong could get the horrid deal of too much expensive finance AND a lack of stability.


Anonymous said...

banks don't fail in communist countries. they merge. what else is new? you don't hear of bank problems in cuba. same in australia.

Anonymous said...

I find this analysis overly simplistic. Lets focus on Europe where each country does banking their own way and there were many different results.

The UK supports your argument except for the building society sector which is generally small (with one exception) and largely intact due to higher regulatory standards and reduced focus on wholesale funding. This tends to support the proposition that smaller primarily deposit funded institutions which are closely connected to the local community are inherently more stable. I acknowledge a few building societies have been rescued but this is not nearly as bad as the UK banks.

Italy has the most fragmented banking system in Europe which implies highly competitive yet the opposite was true since they were largely regional (no doubt collusion at the highest levels). As a result they had high profit margins and are largely intact except for their biggest and most acquisitive banks (ok – I’ll give you Italy).

However, Belgium and the Netherlands had created a few highly profitable national champions that still blew up due to aggressive/bad senior management and arguably a lack of regulation.

France is dominated by a few highly profitable national champions that are largely ok (Eastern Europe??) in spite of lax regulation and poor management (you win again).

Germany is somewhere in between. The national champions with large investment banks made the same mistakes as the large US banks - too competitive and too much risk taking. However, your logic would assume the Landesbanks, (highly protected, not competitive, very profitable and until recently quasi government guaranteed) would be very safe. But as we know many of them have blown up largely because the government guarantees allowed them to take massive risk on buying toxic trash from all over the world. If your theory is correct, they wouldn’t have taken the extra risk since they were highly profitable in their own right. Seems to me this was a result of bad management and poor regulation, not too much competition, low profit margins, etc.

Anonymous said...

Agree with the concept and the implications. Of course, being Canadian, maybe I can't help it. You should read ML's Richard Bernstein if you haven't already - his opinion is basically that there won't be a true financial firm/market recovery until consolidation (and some of the conditions you mention as a result of reduced competition) occur. BTW, good blog, thanks for your efforts.

Anonymous said...

Fresh off reading your follow up piece on bank competition I bounced over to Naked Capitalism to read Yves shredding the recent Greenspan article in FT. Her shredding nor his article have much at all do with this discussion except these two little lines Yves has buried deep in the middle of the page, "The problem with competition in banking is banks are horribly imitative and all rush off the cliff together every 10 or 15 years. I have serious doubt about competition being a great measure of success in banking..."

I wouldn't suspect Yves would jump out in support of an oligopolistic banking system. She has appeared to be much more so in the "nationalize, break-up, re-privatize" camp. But her subconscious, or more likely her instincts, while in full rant mode, are saying something interesting.

Just found the tone interesting after having just read your piece.


Advant Guard said...

I would like to note that the large commercial banks, with the exception of Wachovia, have actually done pretty good this this crisis. It is the investment banks and the mortgage-specialist banks that have been the main casualties. America is unusual to have these activities separated, a legacy of Glass-Stegall. While there has been attempts to bridge the two types of banks (Citigroup being the prime examples) most banks still find themselves on one side or the other of the divide.

I think Glass-Stegall was a bad idea but this crisis indicates that what replaced it was not well thought out. The "shadow banking system" was mostly investment banks indirectly supporting the capital of the commercial banks and the mortgage-specialist banks.

Now that the securitization market has disappeared, commercial banks are raise capital the old fashioned way of large spreads between cost of funds and lending rate.

Mike T said...


You write "Of course we can stop it. All those high-power, high-paid traders and brokers who are central to the shadow banking system should eventually be fired. They are not necessary in my hoped for 3-7-3 world. And they caused all the problems anyway. Firing them now should be done so long as it does not exacerbate the current crisis."

I understand that there is an infrastructure that's in place currently that supports the smooth functioning of the shadow-banking ecosystem.

You may be able to force a destruction of this infrastructure today, but how do you prevent it from being rebuilt? -- especially given that in the system you envision, there will be so much fat to "scalp" that the incentives to get the infrastructure up and running again will be huge.

Is the shadow-banking system like a weed that comes back bigger and stronger when you beat it down the first time? How do you hack out its roots without damaging the economy?

What do you think? Thanks.

Anonymous said...

"This little rant of mine is contrary to the received wisdom both of my training (economics) and of the world we live in."

This is just testimony to the fact that knowledge is as often lost as gained. One of the lessons taken from the Depression in the United States was that banking competition was a disaster (see discussions of paying interest on interbank deposits). For decades a principle purpose of bank regulation in the US was to prevent competition.

... and then the 80s came around.

Anonymous said...

By the way, while I think it's pretty obvious that we should protect banks from competition, I also think that the idea that we should "let bankers rip us off" is daft.

3-6-3 is okay with me -- as long as bankers end up being paid like accountants or primary care doctors working for an HMO. Treat 'em like the utilities they are.

dheigham said...

Before opening a bank account, the first question I ask is whether the bank is profitable. If it isn't, the chance of the bank being sound is pretty low. Second, I ask if I believe the bank's accounts. The answer is never a 100% yes; but I will accept profitability as sufficient evidence if there is not a smell of bad fish. (To give the list of banks that I have steered clear of on odour grounds would get the blog into legal trouble. However not all of them have yet got into bad trouble in the present crisis).

If you are bent on elevating my insistance on a profitable bank into public policy, I suggest you also specify a bank regulator with a good nose.

Anonymous said...

But isn't the problem with large concentrations of capital is that when they misallocate, the consequences are disastrous?

FMN and FRE illustrate your point. As you note, their rate-fixing activities eventually found their way into inflated goods prices (they always seem to; heath care and higher education are two other examples of this) not only negating the value of the subsidy, and also distorting the price signals of the market.

This actually helped GIVE BIRTH to the shadow system, IMO, as strategies for monetizing FNM and FRE's pricing errors bloomed. HELOCs, Alt-A, subprime structured products first, then the CDOs and CDSs referenced off them after demand kept increasing. This system didn't compete with FNM & FRE, it was a byproduct of their misjudgments.

I'm all for the idea of the financial system being manned by colorless technocrats, but I'm not quite sold on the idea that large mega-institutions are a necessary part of the equation.

Anonymous said...

I am appalled by the logic in this post. 1) Big banks have too much power (regulatory capture; political) 2) Lord Acton: "Absolute power corrupts absolutely".

Another view:


Anonymous said...

there is usually a good reason when there is a nagging issue stuck in an idea's logic.

as your intuition tells you, it is a TERRIBLE idea to have limited or no competition in the banking system. certainly, it might be better than what was going the last 10 or so years. but that doesnt mean that we can't work on something better.

first, the problem now seems to be that it is hard to unwind the banks when they go bankrupt. so that should be addressed. make it so that otc derivatives are more heavily margined to encourage the transition to central clearing or exchange based transactions. dont be afraid to hurt the creditors.

second, the regulators were complicit in this whole debacle. it simply boggles the mind to think the sec has in any way served the public in the past 10 years. levitt is merely the largest of the hypocrites.

third, the only reason that the shadow banking system could be so competitive was, again, cheap financing. accounts need to be much more transparent. and leverage needs to be limited. the banks themselves created their own competition via siv's. off balance sheet needs to be eliminated. all holdings must be disclosed. we are in an electronic world; the detail can be available via database digging.

and your argument regarding fnm & fre misses a big point -- they were created to reduce the price of mortgages (whether you agree with that policy decision or not). so if the shadow banking system could compete with them, they should have pared down their balance sheet. but instead, they continued to lever up and create paper. that was the result of their lobbying. there had been much hand-wringing over that for some time. but fnm and fre mgmt were able to overcome that. they werent after profitability, they were after gross non-risk adjusted profits.

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