We know what happened in 2008: Wall Street was struck by a modern-style bank run. Yet most of the regulatory response hasn’t been concerned with deterring another panic.
The Dodd- Frank financial-reform law and other measures are mostly about making sure that banks don’t do something stupid, such as operate with too little capital, or trade derivatives without transparency. These are good and worthy goals.
But at some point, if history is any guide, banks will discover some new, supposedly foolproof, asset class and become too exposed to it. It won’t be tulips; it won’t be subprime mortgages; it will be something we can’t anticipate now. And when this new “sure thing” starts to look dicey, banks will be vulnerable again.Actually, it was not simply that banks became too exposed to a supposedly foolproof asset class that was the problem.
The problem was and still is that banks are 'black boxes'.
As a result, market participants, including other banks, had no way of knowing which banks were solvent and which banks were not (this conclusion appears in the Financial Crisis Inquiry Commission report).
When a lender doesn't know if the borrower is solvent or not, they don't make a loan. This has been confirmed for the last 5 years by the simple fact that the interbank lending market remains frozen.
Although Congress mostly avoided the issue after 2008, we do have experience in deterring panics.
Regulations tend to focus on what banks own (assets such as loans and securities). Avoiding panics is concerned with what they owe (liabilities, which include deposits).Actually, there is no reason to believe that the institutions involved with the bank liabilities panicked.
In fact, all the evidence points to them behaving in a very rational manner. Since they could not determine if the borrowing bank was solvent or not and therefore capable of repaying their loans, they chose not to roll-over their loans.
After the bank runs of the early 1930s, the U.S. enacted deposit insurance. And since then, customers haven’t run to the bank, even if the bank is thought to be unsound.
This poses a moral hazard: What if banks, realizing their deposits are insured, recklessly gamble on unsound assets?
This happened in the savings-and-loan crisis in the 1980s, and it was expensive....This is why there is a need for banks to provide ultra transparency and disclose on an ongoing basis their current global asset, liability and off-balance sheet exposure details.
With this information, market participants, including regulators, can exert discipline so that bankers don't 'gamble on redemption' (which was what drove up the cost of the savings-and-loan crisis).
We did have bank runs in 2008, though not the kind seen in the old photographs with men in hats and coats lined up on the sidewalk.
Instead of ordinary depositors, the people who pulled their money out were investors in various unregulated instruments such as repurchase-agreement loans, short-term commercial paper and money-market funds.
Each of these is similar, in an economic sense, to a deposit: They offer people and institutions a place to park savings with seeming security and the option of immediate withdrawal.
During the financial crisis, it was these “depositors” who panicked....Again, I disagree with Mr. Lowenstein that these investors panicked. When you cannot tell if the bank you are lending to has the ability to repay the loan, you don't make the loan.
The difference between old- fashioned deposits and the so-called shadow-market loans described above is that the former can only be issued by banks and in certain well-defined circumstances. And banks must purchase deposit insurance.
Shadow deposits are uninsured and mostly unregulated.
The solution, as in the 1930s, is to regulate short-term IOUs and to require, in many cases, insurance.
In broad terms, if you are a financial institution, you would be able to borrow short-term funds only under certain conditions and, when you did, you would need insurance. This would have a cost, just as deposit insurance has a cost....Insurance is the wrong solution for this problem. The right solution is to require banks to provide ultra transparency.
With ultra transparency, these investors can assess the risk and solvency of each bank. As a result, these investors can adjust both the price and amount of their exposure based on the risk of the bank.
These investors have an incentive to assess the risk and adjust their exposure because they know that as a result of the banks providing ultra transparency the investors are responsible for all gains and losses on their bank exposures.
Unlike insurance which doesn't adjust to the increase risks that the banks take on, the cost of funds from investors who can assess the bank's risk because of ultra transparency does increase as more risk is taken on. Unlike insurance, investors provide a restraint on bank risk taking.
Banks are likely to oppose such measures, which would cut into their profits. Recently, to the satisfaction of bankers, international regulators in Basel, Switzerland have actually loosened liquidity standards aimed at preventing a repeat of 2008.As I have previously stated, one of the benefits of ultra transparency is that the market doesn't care what the banks think. Knowing that they are at risk of loss, market participants independently assess the risk for themselves and act based on this independent assessment.
Morgan Ricks, a former Treasury senior policy adviser and now an assistant professor at Vanderbilt Law School, says the banks’ cheap overnight funding provides undeserved, “subsidy profits."
Their borrowing costs, he says, are inordinately cheap because the market believes that banks won’t be allowed to fail. Insurance would put a price on that subsidy.The subsidy would be ended by providing ultra transparency. Insurance does not end the subsidy as there is no reason to think that deposit insurance is priced at a level that removes 'subsidy profits'.
Ricks says the regulatory response to the crisis “focused on the wrong stuff.” The first priority should be “the instability of the funding model.”I agree and the only way to make the funding model stable is by requiring the banks to provide ultra transparency.