Equity-financed banking

I gave a talk at the Minneapolis Fed's "Ending Too Big to Fail" symposium, May 16. Agenda and video of the event here.

My  talk is based on "towards a run-free financial system," and a bit on a new structure for federal debt, and blog readers will notice many recycled ideas. But it incorporates some current thinking both on substance and on marketing -- the proposal is so simple, most of the work is on meeting objections.

Here's my talk. This is also available as a pdf here.

Equity-financed banking and a run-free financial system

Premises

We have to define what “sytstemic” and “crisis” mean before we can try to fix them.

My premise is that, at its core, our financial crisis was a systemic run. The mechanism is familiar from Diamond and Dybvig, and especially Gary Gorton’s description of how “information-insensitive” assets suddenly lose that property and become illiquid.

You see a problem at a bank – a word I will use loosely to include shadow-banks, overnight debt, and other intermediaries. You wonder, what about my bank? You don’t really know. The point of short-term debt is that you don’t generally pay attention to the bank’s assets. But you also have the right to take your money out at any time, and the last one out gets the rotten egg. When uncertain, you might as well forego a few basis points of interest and get out now. Everyone does this, and the bank fails.

Runs at specific institutions, caused by identifiable problems, are not really a danger. My story includes a specific “contagion,” that troubles at one institution spread to another, because they cause people to wonder about the other bank’s assets. That “systemic run” element means that banks cant’ easily sell assets to raise cash, or issue new equity.

This description is important for what it denies, and thus for “problems” we don’t have to “solve.”

It’s not a chain of dominoes: A fails, B loses money, B falls, and so forth, so by saving A the whole system is saved.

Contrariwise, even saving A is not enough to assure investors that B’s assets are ok. In fact, saving A might verify investor’s worries about B’s assets, and set off a run!

It’s not huge losses on particularly unsafe assets. Bank assets are not that risky. Bank liabilities are fragile. Small losses spark large runs.

Our crisis and recession were not the result of specific business operations failing. Failure is failure to pay creditors, not a black hole where there once was a business. Operations keep going in bankruptcy. The ATMs did not go dark.

In my premises, the 2000 stock market bust was not a crisis, because it was not a run. Yes, there were huge losses. But when stocks plunge, all you can do is go home, pour a drink, yell at the dog, and bemoan your dumb decisions. You can’t demand your money back from the issuing company, and you can’t drive the company to bankruptcy if it does not pay. Panic selling, even if “irrational,” even if it causes “herding” by others, even if it drives prices down, is not a crisis, and it’s not a run, because the issuing company doesn’t have to do anything about it.

If we want to stop crises, we have to describe when we will say “good enough” and stop trying to fix things in the name of crisis prevention. My premise: an economy with booms and busts, risks taken, and losses transparently absorbed by falling prices, is good enough for now.

If we try to create a financial system in which nobody ever loses money, we will just create a system in which nobody ever takes any risk, and does not fund any remotely risky investment opportunity. That is the direction we are going. And steps that actually matter to fixing crises are getting lost in the effort rush to “fix” every perceived financial “problem.”

(A small random sample of current causes being commingled with crisis prevention, some worthy but separate, some silly: Fannie and Freddie, the community reinvestment act, “predatory lending,” insufficient down payments, FICO scores, Wall Street "greed," executive compensation, credit card fees, disparate-impact analysis, the last names of auto-loan customers, the terms of student loans, hedge fund fees, active management and its fees, “herding” and “crowding” by equity portfolio managers (OFR), over-the-counter versus exchange-traded derivatives, swap margins, position limits, risk-weights, credit ratings, the Volker rule, insider trading, global imbalances, savings gluts, bubbles in houses and stocks, and the ridiculous tiny type on my credit-card agreement.)

I do not mean that other financial regulation is not necessarily bad, or even that one shouldn’t contemplate policies to reduce stock market volatility. But if we actually want to fix crises, or end TBTF, we have to separate those other measures into everyday regulation.

A better world

Given these premises, the central weakness in financial system is clear: fragile, run-prone liabilities.

The answer then is simple too: we should have no more large-scale funding of risky or potentially illiquid assets by run-prone securities – short term debt in particular, but any promise that is fixed-value, first-come first-served, if unpaid instantly bankrupts the company, and in volumes that could even remotely trigger such bankruptcy.

(The caveats here exempt bills, receivables, trade credit, and so on, which are fixed value but not run-prone. “Funding” is the important qualifier. You can trade in short term debt without funding the bulk of investments with it.)

Banks and shadow banks must get the money they use to hold risky and potentially illiquid loans and securities overwhelmingly from run-proof, floating-value assets – common equity mostly, some long term debt. (I say “hold” specifically to distinguish it from “originate” or “make” loans, which are then securitized and sold. )

Once we have done this, financial crises are over. A 100% equity-financed institution cannot fail, and cannot suffer a run. Fail means fail to pay your debts, and if you have no debts you cannot fail.

(OK, technically you can take on such a huge derivatives position that you can lose more than 100% of equity, but it takes very little attention from regulators and analysts to make sure that doesn’t happen.)

Such an institution needs next to no risk regulation, beyond the regular transparency we demand of any public corporation.

Any remaining fixed-value demandable assets must be backed entirely by short-term government debt, or reserves. These are run-proof because there is no doubt on the value and liquidity of the assets (at least for the US, and away from sovereign debt worries, which I also put off the table for now.)

Objections

The major objection is the flow of credit. If banks can’t issue conventional deposits and unconventional short-term debt, they won’t have money to lend and the economy will dry up, the objection goes. Others object similarly that without bank “transformation” of maturity and risk, economic growth would be slower.

This perception is false. Not one cent more or less money needs to be provided, not one iota more risk needs to be shouldered, not one cent less credit need be extended. And I think the case is strong that growth will be substantially higher than the current run-prone but highly regulated system. Let’s look.

Structure (1) is a simplified version of today’s “bank.” There are a lot of complex or illiquid assets. The bank is too complicated to go through bankruptcy. It is funded by very little equity and a huge amount of debt. The debt is prone to runs. (“People” here includes non financial business and institutions such as pension funds and endowments.)

Structure (2) is the simplest equity-financed bank. Banks issue only equity. Households hold that equity, in a diversified form, potentially through a mutual fund or ETF.

In this structure, households provide the same amount of money, and shoulder the same amount of risk, and the bank makes the same amount of loans. But runs and crises are now eliminated.

You will laugh, but I’d like to take this structure seriously. With today’s technology, people can have floating-value accounts.

This was not technically possible in the 1930s, when our country chose instead the path of deposit insurance and risk regulation. But now, you could easily go to an ATM, ask for $20, and it sells $20 of bank shares at the current market value, within milliseconds. “Liquidity” now is divorced from “fixed-value” and “runnable.” Even better, you could go to the ATM, or swipe your card or smartphone, and instantly sell shares in an ETF that holds mortgage-backed securities. This is a “bank,” providing transactions services based on a pool of mortgages and shows that money still flows from people to mortgages. But with floating value, it is run proof.

Unlevered bank equity would have 1/10 or less the volatility it has today. So, we’re talking about something like 2% volatility on an annual basis. Shouldering 2% price volatility is not hard for the majority of depositors (especially dollar-weighted). To argue otherwise, you need some fundamentally non-economic, psychological theory; you need to assert that the same households who are up to their ears in debt, handle 401(k) stock investments, health care copayments, cable and phone bills, and vacation in Las Vegas, can’t somehow stomach 2% volatility in their bank accounts.

(Wait, you ask, the Modigliani-Miller theorem fails for banks, no? The MM theorem for risk is an identity, not a theorem. Risk is not created, destroyed or transformed, it is simply parceled up differently and people end up holding all of it one way or another (even as taxpayers). The contentious part of the MM theorem is whether the price of risk or cost of capital depends on how you slice it. A pizza sliced 10 ways has the same calories, but might sell for more or less than whole.)

But if you want, we can even keep exactly the household assets we have today. Consider structure 3. Banks still issue 100% equity, but that equity is held in a mutual fund, ETF, or similar holding company, which in turn issues debt and equity.

The bank – complex, full of illiquid assets, Ben Bernanke’s specialized human capital, hard to resolve – still can’t fail. The fund can fail. But this failure can be resolved in a morning, and still make it to a 3-martini lunch and golf. The fund’s assets are publicly traded bank equity and nothing else. The bank’s liabilities are common equity and debt. The equity holders get zero, the debt holders get the bank equity. It can be done by computer.

The funds do have debt. But there is little risk of a systemic run on the funds, because their assets are supremely liquid, and visible on a millisecond basis. The failure of one fund need not inspire a run on the next one.

One might object to structure (2) that the Modigliani Miller theorem fails for banks, so it would imply a higher cost of equity. If so, structure (3), by giving households exactly the same assets as they have not, must give exactly the same cost of capital as now — minus the value of taxpayer guarantees.

Structure (3) emphasizes that the issue is not whether “transformation” must occur, whether people really need to hold a lot of fixed-value debt. The issue is whether “transformation,” if it is needed, must be tied to bankruptcy and liquidation of the institution handling the complex assets. One can cook up stories why this must be the case — corporate finance and banking theorists are a clever lot — but are such stories remotely understood and well-tested enough to justify either our occasional crises, or our massive regulatory response? I think not, but I’ll leave that case to be made by our panelists, if they are so inclined.

Structure (3) is a rhetorical point, not a proposal. I do not think it is necessary or desirable to exactly replicate the securities on both ends of the financial system. The point is just that eliminating financial crises by moving to equity-financed banking does not require any new money, any less credit, any less economic growth or any different risk taking. People will likely choose different assets in my world, and thereby improve on it.

Structure (4) elaborates. Not all bank assets are complex and illiquid. Once we remove short-term financing, I suspect that securitized debt and other liquid securities will move off bank balance sheets. They will migrate to long-only floating-value mutual funds and ETFs, and people will move money out of savings accounts and bank CDs into those very safe investment vehicles. The banks will be smaller, holding only those complex and illiquid risks that can’t easily be securitized.

On the other side, banks now have about $2.3 trillion of reserves, (May 5 H.4.1) and $1.2 trillion of demand deposits. Narrow deposit taking is here! We just need to move the deposits and their backing reserves to bankruptcy-remote vehicles (which banks can still operate for a fee, if that makes sense).

How much risk-free assets do people really need? We can provide them up to $14 trillion and counting with narrow deposits backed directly or indirectly (through the Fed) by Treasury debt.

The Fed’s huge balance sheet is a great innovation. Better yet, the Treasury should issue fixed-value floating rate debt so we can all have “reserves.” The last 8 years have taught a revolutionary lesson in monetary economics: huge quantities of interest-bearing money are not inflationary. We can live the Friedman optimal quantity of money, and displace all the private interest-bearing moneys that fell apart in the crisis. As our ancestors got rid of run-prone banknotes in favor of treasury notes, we can get rid of run-prone debt in favor of treasury and fed interest bearing-electronic money. Let’s do it.

How do we get there

We’ve defined and limited the problem, outlined a better world, but we’re still not ready to write regulations. We should check for failures and unintended consequences of current regulations before we go adding new ones.

Our government subsidizes debt, in numerous ways. Let’s start by not simultaneously subsidizing something and also regulating against its use! We can leave that to energy policy.

The tax deductibility of interest payments is an obvious distortion. It’s not the whole story, as nonfinancial corporations don’t all lever this much, but it’s a part of it. I’d rather just get rid of the whole corporate tax, which eliminates demand for a hundred other tax distortions. But treating dividends and interest equally, or better yet reversing the treatment — deduct dividends, not interest — would help.

Implicit and explicit debt guarantees are a bigger part of the distortion in favor of debt. But, while it’s easy to say “end debt guarantees,” I fear the government will always bail out ex-post, and that inability to precommit is an important justification for limiting debt debt. ( V. V. Chari and Patrick Kehoe have elegantly made this case, in “A Proposal to Eliminate the Distortions Caused by Bailouts” Minneapolis Fed Working Paper.)

A lot of law, regulation and accounting subsidizes debt as a liability by privileging it as an asset. Liquidity regulations encourage institutions to hold very short-term debt, with a run option to save themselves individually in times of trouble. Well, that incentivizes someone else to issue that debt, and encourages the fallacy of “sell if things go bad” risk management. Accounting regulations also treat run-prone short-term debt as safe as cash.

Using floating-value funds for transactions purposes would trigger short-term capital gains taxes and an accounting nightmare. That needs to be fixed if we want free liquidity.

In sum, throughout the regulatory system, we should treat non-government short-term debt as poison in the well, both as an asset and as a liability, and we should remove the impediments to the use of liquid floating-value assets. Will this take some effort? Sure. But just carrying the tens of thousands of pages of regulations over to the Dodd-Frank bonfire will take some effort.

Regulatory relief would be a potent carrot and it is my strongest suggestion. We could say, any institution that is financed by more than (say) 75% equity and long term debt is exempt from asset risk regulation, systemic designation, bank regulation and so forth; it will be treated like a non-financial company. I suspect they would come running. MetLife’s suit and other companies’ efforts to downsize suggests that banks really do not like regulation and will do a lot to rearrange their operations to avoid it.

This suggestion reflects a deeper problem: Where is the safe harbor in Dodd-Frank? Where does it say “this is how we want you to set up a systemically safe financial institution. If you do this, you’re doing a good job, and we’ll leave you alone.” Nowhere. Not even an equity ETF, about the most run-proof structure in creation, is exempt.

Adding a safe harbor is an especially attractive way to move to better policy. If we need to repeal Dodd-Frank, we’re asking a lot. Too many people have too much invested in it. If we just add to Dodd-Frank its missing definition of “systemic,” and thus a definition of “not systemic,” a specification of how an institution can be exempt from detailed regulation, they will run for it, and the rest can die on the vine.

At last a bit of regulation

Finally, if after removing all the subsidies and inducements for debt, and a regulatory safe harbor, banks are still using too much run-prone financing, ok, we get to add a bit of stick.

The usual approach to boosting capital combines complex regulation, taking the form of a limit on a ratio of complex numbers, with extensive discretion and regulatory remediation. The ratios don’t work for all sorts of reasons. The denominator is the big problem. Simple leverage — debt to assets ratios — is silly. We require equity on holding reserves, and a stock vs a call option have much different risk for the same asset value. Risk weights violate the fundamental principle of finance, that a portfolio is less risky than the sum of its parts. Risk weights are deeply distorting investing decisions – loans carry large risk weights, while securities formed of the same loans carry small risk weights. Greek debt is still 0 risk weight.

And what level of capital is “safe?”17.437%? 35.272%? Really, the answer is “so much that it doesn’t matter,” and “more is always better.” Since costs and benefits do not suggest a hard and fast number, why regulate one – and then endlessly argue about it?

We need something simple, transparent, and that avoids these pathologies. The best I can think of is a Pigouvian tax, say 5 cents for each dollar of short-term debt (less than a year) and 2 cents for longer term debt. By taxing the amount of debt, arguments about the denominator vanish. So we don’t have to get in to riskweights, leverage, book values market values, and so forth.

Everywhere in economics, charging a price is better than a quantitative limit.

You will ask, just what is the right tax? I don’t know. I suspect however, that the benefits of short-term financing are much less than banks claim when they are trying to convince regulators to lower a quantitative limit. If they faced even a quite low tax, I suspect we would see a swift rediscovery of the Modigliani-Miller theorem. In any case, we don’t have to decide that ahead of time. Adjust the tax rate as needed until you get the capital you want.

As it is sensible to demand more capital of more “dangerous” firms, so the tax could rise on some simple measures of danger. I distrust any accounting measures, so following Chari and Kehoe’s recent suggestion, the tax could be a rising function of the ratio of short-term debt to the market – not book -- value of equity. The market value of equity is easily measurable. Let the firm figure out whether to issue more equity, retain more earnings, find a buyer, restructure debt, pay the tax for a while, or whatever they want to do.

Most importantly though, we are not trying to carefully craft a way for banks to get by on the minimal amount of capital. The point is that capital is not expensive, socially if not privately. We don’t want to jigger the absolute minimum amount of the tax, we want to induce banks to shift overwhelmingly to floating-value run-proof liabilities.

The current path

This all may seem a bit radical, so I think it’s worth emphasizing just how broken the current system is.

Since the 1930s, we have tried a fundamentally different approach to stopping runs and financial crises, emphasizing minimal equity and lots of debt. When depositors run, really the only way to stop it is for the government to guarantee debts. But, once people expect debt guarantees, banks to take too much risk, and their creditors lend without regard to that risk. So, we tried to substitute regulatory supervision of asset risk for both ends of market information processing and discipline. It’s not enough, we have another crisis, guarantee more debt, and so on. The little old lady swallowed a fly, a spider to catch the fly, as the song goes, and now she is trying to digest the horse.

That we are having a conference on “ending too big to fail” reflects he widespread perception that we have not ended this cycle, the “resolution authority” will not work, and it will institutionalize creditor bailouts rather than precommit against them—which might be impossible and unwise anyway.

Regulation quickly failed its first test after the 2008 subprime crisis. Europe’s bank regulators, with that crisis fresh in the rear view mirror, still allowed Greek debt at zero risk weights, and promptly bailed out the French and German banks who were over exposed. Will the same regulators artfully prick asset bubbles, diagnose imbalances, macro-prudentially raise capital standards, promptly resolve nearing failures, and sternly haircut debt holders… next time?

We are devoting enormous resources and suffering large economic distortions to regulate the risk of bank assets. But bank assets aren’t risky! A diversified, mostly marketable portfolio of loans and mortgage backed securities is far safer than the profit stream of any company.

So why are we, as a society, investing so much in regulating some of the safest corporate assets on the planet? Well, because they’re leveraged to the hilt, and we’re holding the bag. We don’t have to.

And asset risk regulation is now spilling over into efforts to regulate asset prices themselves. For example, the OFR proposed to regulate equity asset managers, even though they just trade equity on customer’s behalf. Why? Because the managers might sell, drive asset prices down; and someone might have borrowed money on those assets that asset risk regulators didn’t notice. The Fed is discussing “macroprudential” policy to allocate credit to target house prices, and raising interest rates to manage stock prices.

The result is an increasingly uncompetitive and sclerotic financial system. We are the financial system of zero interest rates where nobody who actually needs one can get a loan.

Already, financial innovators are springing up around the banking system, in peer to peer lending, finance tech, and so on. These give me hope. Maybe equity-financed banking will spring up like weeds around the ruins of the big banks. But those don’t have to be ruins.

If it really does cost 25 bp more for a mortgage in my world, and if we really want to subsidize home mortgages, we can do so by writing checks to homeowners, on budget, rather than set up a dangerous and sclerotic financial system.

Discussion

I got great comments at the conference from panelists Michael Hasenstab, Michael Keen, Donald Marron, and Thomas Phillips. A few points that come out of the discussion:

100% Equity is not necessary. I focus on this option because it is, in fact, cleanest, and I want to make the case that 100% equity is possible and reasonable. Once you accept that, then 75% equity can work too. It would be just about bulletproof: the institutions would have to be at risk of losing 75% of its value before a run could start.

To emphasize, not all debt or fixed value debt is equally dangerous. Your gas bill is a fixed value claim, but the gas company can’t bankrupt you tomorrow if they call and say “we want our money” and you don’t pay up.

The transition sounds hard. Issuing gobs of equity sounds costly. But again, look at structure (3). No new money is needed. We are simply replacing debt with equity. In fact, we could do it in a day. The Bank’s current liabilities are transferred to the fund, in return for newly issued equity. Nobody has to go to the market! That’s not necessary, but I think it makes clear that we don’t need more money or a lot of discombobulation. In fact, I think banks would slowly redeem debt for equity without much trouble.

Michael, as a manager of a bond fund, emphasized the necessity of large banks with global reach to be reliable counterparties and market makers on all sorts of assets. But equity-financing helps them! If equity financed, banks can be as “big” as anyone wants, without causing risks. We don’t need to break up the banks or fear size.

Michael Keen gave a great introduction to tax issues. The tax code is also a bunch of patches applied to cure the consequences of other taxes. He pointed out that the total tax wedge includes the taxes paid by the bank, and the taxes on interest paid by investors. My head hurts, and I can’t help but never to the fact that Eliminating corporate and rate of return taxes, leaving a simple consumption tax, solves all these problems!

Michael also thought in some detail about how to make equity deductible, and even with debt. This has troubled me: allowing a deduction for dividends like interest sounds nice, but we want to encourage banks to keep dividends, which builds capital. He outlined “ACE” rules that allow banks to deduct a “notional cost of equity,” usually a risk free rate plus a few percent. I asked later, why not deduct the actual return.

Donald Marron gave quite a few examples in which the government simultaneously taxes and subsidizes, including carbon, tobacco, and sugar.

Donald pointed out that it’s not always best to regulate via a price rather than a quantity. This is a good question, but I think run-prone securities are a good case for price regulation. Like pollution, the regulator doesn’t really know what the costs of compliance are, and there are lots of creative ways for the business to rearrange things to reduce the pollution.

Donald pointed out that the word “tax” is pollution in our politics. Also “tax” rates have to be voted by congress. Agencies can impose “fees.” Economists understand “taxes” in terms of incentives, politics understands “taxes” as income transfers and ignores incentives. He’s spot on. Forever more, let us call it a “Pigouvian fee” on debt!

Thomas Phillipon questioned whether mutual funds are truly run-free. He has a point, there is a small incentive to run with big losses given the option to redeem at NAV. Answer: exchange tried funds, or an exchange traded backstop, in which you can or must sell your shares to another investor rather than demand money from the fund solves the problem. ETFs are really run free!

Thomas also gave a long and detailed explanation of why leverage ratios or leverage charges don’t work. That’s exactly why I propose to tax debt itself, not a leverage ratio.

In a later section, David Skeel pointed out that Lehman when it failed, had 25,000 employees — fewer than the current compliance staff at citigroup.

I closed with a warning: my vision of a monetary system based on short-term government debt depends on government solvency. If Greece comes to the US, and banks are deeply involved in government debt, considered risk free, we’re in really deep trouble. Insulating a financial system from sovereign debt problems is a separate, and important, question.

Update: A correspondent sent a thoughtful email advocating floating-value equity-like securities  for many cases on the asset side as well. Then, from twitter, "a few more steps and whole world for sharia compliant financing ie 100% equity both on asset and liability side." I'm not sure if that is praise or criticism.

Bond Swap

The U.S. Treasury debates new-for-old bond swap, reports FT. The Treasury will issue more of the popular 10 year bonds, and then buy them back at some point before they mature.

The idea is to make treasury markets more uniform and liquid. Once bonds get several years old, they tend to sit in proverbial sock drawers, and they're harder to buy and sell (they are "off the run.") To the extent that this illiquidity lowers their value, the Treasury can buy them back cheaper.

“By buying cheap issues and funding the buybacks with issuance of rich on-the-run securities, the Treasury could enhance liquidity in these issues, while decreasing its borrowing costs,”

There is a lot of writing about "safe" and "liquid" asset shortages, so issuing more of a few popular issues and leaving less outstanding otherwise is beneficial to markets.

Comment.  I like the idea, but I think the Treasury should go further. Coincidentally, I just happen to have recently written an article called "A new structure for U.S. Federal Debt" that explains it all in detail.

When you think about it, the treasury ends up in a strange place. Why would you constantly issue 10 year debt, and then buy it all back when it's (say) 8 year debt? What is the question that this structure solves? (Other than the desire of dealer banks to double their earnings on buying and selling treasury securities!)  

My proposal is simpler: Issue perpetuities. These securities pay $1 coupon forever. Buy these back, not on a regular schedule, but when (!) the day of surpluses comes that the government wants to pay down the debt. Then there is one issue, with market depth in the trillions, and the whole on the run vs. off the run phenomenon disappears. I hope the Treasury will someday at least try selling some perpetuities.

Central Bank Governance and Oversight Reform

The Hoover Institution Press just published "Central Bank Governance and Oversight Reform," the collected volume of papers, comments, and discussion from last May's conference here by the same name. You can get the  book or e-book here at the Hoover press or here at amazon.com. The individual chapter pdfs are available here.  Press release here.

(My modest contributions are in the preface and a discussion of Paul Tucker's Chapter 1. I agree it would be nice to have a more rule-based approach to lender of last resort and bailout functions, but wouldn't lots of equity so you don't have to mop up so often be even better?)

This is part of an emerging series of monetary policy conferences at Hoover. Tomorrow we will have a conference on international monetary policy. Stay tuned...

The blurb:

How can we balance the central bank’s authority, including independence, with accountability and constraints? Drawn from a 2015 Hoover Institution conference, this book features distinguished scholars and policy makers’ discussing this and other key questions about the Fed. Going beyond the simple decision of whether to raise interest rates, they focus on a deeper set of questions, including, among others, How should the Fed make decisions? How should the Fed govern its internal decision-making processes? What is the trade-off between greater Fed power and less Fed independence? And how should Congress, from which the Fed ultimately receives its authority, oversee the Fed?

The contributors discuss, for instance, whether central banks can both follow rule-based policy in normal times but then take a discretionary, do-what-it-takes approach to stopping financial crises. They evaluate legislation, recently proposed in the U.S. House and Senate, that would require the Fed to describe its monetary policy rule and, if and when the Fed changed or deviated from its rule, explain the reasons. And they discuss to best ways to structure a committee—like the Federal Open Market Committee, which sets interest rates—to make good decisions, as well as offer historical reflections on the governance of the Fed and much more. They conclude with an important reminder: how important it is to have a “healthy separation between government officials who are in charge of spending and those who are in charge of printing money,” the most essential part of good governance.

The contents:

Preface
By John H. Cochrane and John B. Taylor

Chapter 1: How Can Central Banks Deliver Credible Commitment and Be “Emergency Institutions”?
By Paul Tucker

Chapter 2: Policy Rule Legislation in Practice
By David H. Papell, Alex Nikolsko-Rzhevskyy and Ruxandra Prodan

Chapter 3: Goals versus Rules as Central Bank Performance Measures
By Carl E. Walsh

Chapter 4: Institutional Design: Deliberations, Decisions, and Committee Dynamics
By Kevin M. Warsh

Chapter 5: Some Historical Reflections on the Governance of the Federal Reserve
By Michael D. Bordo

Chapter 6: Panel on Independence, Accountability, and Transparency in Central Bank Governance
By Charles I. Plosser, George P. Shultz, and John C. Williams

Equity-financed banking

My dream of equity-financed banking may be coming true under our noses. In "the Uberization of banking" Andy Kessler at the WSJ reports on SoFi, a "fintech" company. The article is mostly about the human-interest story of its co-founder Mike Cagney. But the interspersed economics are interesting.

SoFi started by making student loans to Stanford MBAs, after figuring out that the default rate on such loans is basically zero. It

has since expanded to student loans more generally and added mortgages, personal loans and wealth management. Mr. Cagney says SoFi has done 150,000 loans totaling $10 billion and is currently at a $1 billion monthly loan-origination rate. 

Where does the money come from?

SoFi doesn’t take deposits, so it’s FDIC-free. ... Instead, SoFi raises money for its loans, most recently $1 billion from SoftBank and the hedge fund Third Point, in exchange for about a quarter of the company. SoFi uses this expanded balance sheet to make loans and then securitize many of them to sell them off to investors so it can make more loans

Just to bash the point home, consider what this means:

• A "bank" (in the economic, not legal sense) can finance loans, raising money essentially all from equity and no conventional debt. And it can offer competitive borrowing rates -- the supposedly too-high "cost of equity" is illusory.
   
• There is no necessary link between the business of taking and servicing deposits and that of making loans. Banks need not (try to) "transform" maturity or risk.
   
• To the extent that the bank wants to boost up the risk and return of its equity, it can do so by securitizing loans rather than by borrowing. (Securitized loans are not leverage -- there is no promise of your money back when you want it. Investors bear any losses immediately and without recourse.)
   
• Equity-financed banking can emerge without new regulations, or a big new Policy Initiative.  It's enough to have relief from old regulations ("FDIC-free").
   
• Since it makes no fixed-value promises, this structure is essentially run free and can't cause or contribute to a financial crisis. 

More. SoFi does not use the standard methods of evaluating credit risk:

Instead of relying on notoriously inaccurate backward-looking FICO scores, SoFi is “forward-looking.” That means asking basic questions—“Do you make more money than you spend?”—and calibrating where applicants went to college, how long they’ve been employed, how stable their income is likely to be over time.

Why can’t banks do this? Because if you use depositor money for loans, as all banks do, you fall under the jurisdiction of the Federal Deposit Insurance Corp. and the Community Reinvestment Act,...

And Basel and the FSOC and the Fed and so forth. FICO score based mechanical lending standards are also demanded by government-backed securitizers Fannie and Freddie.

Yes, bank "safety" regulations demand that banks purposely lend to people that one can pretty clearly see will not pay it back, and demand that they do not lend money to people that one can pretty clearly see will pay it back.

Now, what will the regulatory response be to this sort of innovation? The right answer, of course, should be hosannas: You have introduced run-free banking, that solves all the financial-crisis worries that 90 years of bank regulation could not solve. Let this spread, and the army of bank regulators, lobbyists, lawyers, and associated politicians can all go, well, drive for Uber.

Somehow I doubt that will be the response from foresaid army. And SoFi might well want to invest in its own lawyers, lobbyists and politicians in today's America.

Rather than by the FDIC, SoFi is monitored by the Consumer Financial Protection Bureau. The overbearing regulator that was Elizabeth Warren’s brainchild thus far hasn’t come down on SoFi—the CFPB is perhaps too preoccupied with using “disparate impact” analysis of old-school auto-loan businesses to focus on a relatively exotic, app-based form of banking. But Mr. Cagney should watch his back.

Indeed he should. In today's rather rule-free environment, the CFPB -- or Department of Justice -- might just discover it doesn't like the demographics of Stanford MBAs as target borrowers.

He’d like to get a national lending license, but that would entail federal-oversight entanglements he’d rather avoid.

If he can.

A little puzzle crops up at the end. For now, I gather SoFi does not issue public equity. The plan for expansion is

insurance companies and sovereign-wealth funds might rent him their balance sheets. 

I'm not sure what "rent a balance sheet" means, but it sounds a lot like private equity or long term debt.  It would be even better for stability and low cost to issue public equity, which is liquid -- investors who need money fast can sell. But public equity comes with its own regulatory scrutiny, and perhaps even that is too much for innovation these days.

Chari and Kehoe on Bailouts

V. V. Chari and Pat Kehoe have a very nice article on bank reform, "A Proposal to Eliminate the Distortions Caused by Bailouts," backed up by a serious academic paper.

Their bottom line proposal is a limit on debt to equity ratios, rising with size. This is, I think, a close cousin to my view that a Pigouvian tax on debt could substitute for much of our regulation.

Banks pose a classic moral hazard problem. In a financial crisis, governments are tempted to bail out bank creditors. Knowing they will do so, bankers take too much risk and people lend to too risky banks. The riskier the bank, the stronger the governments' temptation to bail it out ex-post.

Chari and Pat write with a beautifully disciplined economic perspective: Don't argue about transfers, as rhetorically and politically effective as that might be, but identify the distortion and the resulting inefficiency. Who cares about bailouts? Well, taxpayers obviously. But economists shouldn't worry primarily about this as a transfer. The economic problem is the distortion that higher tax rates impose on the economy. Second, there is a subsidy distortion that bailed out firms and creditors expand at the expense of other, more profitable activities. Third there is a debt and size distortion. Since debt is bailed out but not equity, we get more debt, and the banks who can get bailouts become inefficiently large.
For sake of argument, I think, Chari and Pat take a benign view of orderly resolution and living wills. Their point is that even this is not enough. Though functioning resolution would solve the tax distortion and subsidy distortion, the debt-size externality remains.

The extent of regulator intervention depends on the aggregate losses due to threatened bankruptcies. Individual firms do not internalize the effect of their decisions on aggregate outcomes and, therefore, on the extent of such intervention. Just as with bailouts, individual firms have incentives to become too large relative to the sustainably efficient outcome 

Their alternative: A regulatory system that

limits the debt-equity ratio of financial firms and imposes a Pigouvian tax on the size of these firms.

The paper is not specific beyond this suggestion. It's intriguing for many reasons outside the paper.

First, they limit the ratio of debt to equity, not the ratio of debt to assets. Current bank regulation is centered on the ratio of debt to assets, but then we get in to the mess of measuring risk-weighted assets, many of them at book value.  Abandoning this whole mess is a great idea.

Thinking about some of the same issues, I came to the conclusion that a simple Pigouvian tax on debt would work better than current debt-to-asset regulations. If you borrow $1 (especially short) you pay an 5 cent tax per year.

There is an interesting question then whether this tax on debt or a regulatory debt-to-equity ratio limit will work better.

Chari and Pat don't say what the optimal debt/equity ratio should be, and how that should be enforced dynamically. If up against the limit, do they want banks to sell assets ("Fire sales" and "liquidity spirals" banks will complain), to issue equity ("agency costs", banks will complain) or what?  Chari and Pat also don't say whether they want regulators to target the ratio of debt to book value of equity or to market value of equity. I like market value, further avoiding accounting shenanigans. I suspect the regulatory community will choose book value, so inure themselves from responding to market signals.

I like announcing a price rather than a quantity -- a Pigouvian tax on debt rather than a debt-equity ratio -- as it avoids the whole argument, and the just this side vs. just that side of any cliff.   My tax could rise with size, to address their size externality as well.

But they don't analyze the idea of a tax on debt rather than their ratio, so perhaps both would work as well within their model. Their ratio of debt to equity is sufficient for their ends, but perhaps not necessary.

Chari and Pat take a benign view of debt, and the functioning of resolution authority: They

start from the perspective that because debt contracts are widespread, they must be privately valuable and, in all likelihood, also valuable to society in general.

They also posit that "orderly resolution" authority will in fact swiftly impose losses on creditors, and that by using "living wills" the offending banks can be quickly broken up.

I think they make these assumptions to focus on one issue. That's good for an academic paper. But in contemplating a larger regulatory scheme, I think we should question both assumptions.

In a modern economy, liquidity need not require fixed value, and I think we could get by with a lot less debt.  That leads me to much more capital overall. They implicitly head this way,  presuming that debt is vital, but then advocating debt equity ratio regulations that will presumably mean a lot more equity.

I suspect that resolution authorities, hearing screaming on the phone from large financial institution creditors of a troubled bank,  and with "systemic" and "contagion" in mind, will swiftly bail out creditors once again.  I think that a bank too complex to go through bankruptcy, even a reformed bankruptcy code, is hopeless for the poor Treasury secretary to carve up in a weekend. So another reason for more equity is to avoid this system that will not work, as well as to patch up its remaining limitations even if it works perfectly.

Chari and Pat also step outside the model, stating that the resolution authority

is worrisome because by giving extraordinary powers to regulators, it allows them to rewrite private contracts between borrowers and creditors...[this]... can do great harm to the well-being of their citizens. Societies prosper when citizens are confident that contracts they enter will be enforced

Their closing sentence is important

We emphasize that regulation is needed in our framework not because markets on their own lead to inefficient outcomes, but because well-meaning governments that lack commitment introduce distortions and externalities that need to be corrected.

A better living will

"US rejects 'living wills' of 5 banks," from FT. WSJ puts this event in the larger story of Dodd Frank unraveling. Juicy quotes:

WSJ: “living wills,” ... are supposed to show in detail how these banking titans, in the event of failure, could be placed into bankruptcy without wrecking the financial system.

FT:...the shortcomings varied by bank but included flawed computer models; inadequate estimates of liquidity needs; questionable assumptions about the capital required to be wound up; and unacceptable judgments on when to enter banktruptcy.

FT: David Hirschmann of the US Chamber of Commerce, the biggest business lobby, said the living wills process was “broken”. “When you can’t comply no matter how much money you put into legitimately trying to comply, maybe it’s time to ask: did we get the test wrong?” he said.

WSJ: Six years after the law was passed, and eight years since the financial crisis, regulators given broad authority to remake American finance, with thousands of regulatory officials on their payroll, cannot figure out a system to allow financial giants to fail, even in theory. What are we paying these people for?

It seems like a good moment to revisit an idea buried deep in "Toward a run-free financial system."  How could we structure banks to fail transparently?

Recall, here is how banks are structured now (extremely simplified). Banks hold assets like loans, mortgages and securities. Banks get money to fund these assets by selling a tiny amount of equity, i.e. stock, and by a huge amount of borrowing, including deposits, long-term bonds, and short-term debt.

The trouble with this system is, if the value of the assets falls by more than $10 in my example, the equity is wiped out, and the bank can't pay its debts. If short-term debt holders worry about this event, they all clamor to get paid first, so a run can happen. That's not really a problem either; bankruptcy is set up exactly to handle this situation. The creditors who lent money to the bank split up the assets. Yes, they don't get their full money back, but if you lend to a bank that's leveraged like this, that's the risk you take.

The trouble is the widespread feeling that big banks are too big, too complex, too illiquid, to utterly muddy, to carve up this way. If it takes years in court, and if all the value of the assets is drained away by lawyers, you have a real problem. Furthermore, we often want the profitable parts of the bank to remain in operation while the creditors squabble about assets. (Ben Bernanke's classic paper on banking in the great depression makes this point beautifully.) The ATM machines should not go dark, the offices where people know their customers and can keep things going should stay in operation.

Hence, big banks become too big -- or too something -- to fail. In that situation, the government is mighty tempted to bail out the creditors and keep the thing limping along. Given that temptation, a lot of large, politically well connected creditors also scream that there will be ``systemic dangers'' if they don't get their cash now, adding to the bailout pressure. A "living will" is supposed to stop this chain, by allowing  bank assets to very quickly get divvied up among creditors.

But the large banks are, apparently, so large and complex that nobody can figure out a living will. That's debateable, for example Kenneth Scott and John Taylor argue bankruptcy can work.  But let's go with the idea. Is there an alternative to Bernie Sanders' bust up the banks? Here's one.

Starting from the left, suppose the bank holds all the same assets it does today. But, it issues 100% equity to finance its assets. Now, a 100% equity financed bank cannot fail. If you don't have any debt, you can't fail to pay debts. Yes, the bank can lose money and slowly go out of business. But it cannot go bankrupt. As it loses money, the value of its equity declines, until shareholders get mad and liquidate the carcass. Nobody can run to get their money out ahead of the other person. End of bankruptcy, end of bank runs, end of financial crises.

(Technical note. Yes, that's a bit overstated. A bank can potentially invest in derivatives and other securities where it can lose more than all of the investment. The amount of monitoring needed to make sure this doesn't happen is trivial next to the Basel sort of thing required to make sure a bank never loses more than a few percent of its value.)

OK, gulp, you say. But don't people "need" to have bank accounts? Isn't "transformation" of debt into loans the crucial feature of the financial system? Don't equity holders "require" high risk, high-return stock? No, argues the "run-free financial system" essay. But let's not go there. Let's just restructure things so that the bank can hold exactly the same assets it has today, and its investors can hold exactly the same assets they hold today.

So, moving to the right in my little picture, suppose bank stock is held in a mutual fund, exchange traded fund, or a special-purpose "bank." Bank stock is the only asset these companies hold, and that stock is also traded on exchanges. These banks fund themselves by the same mix of debt, equity, deposits, and heck even overnight wholesale debt, commercial paper, and so forth.

Now, if the value of the bank stock falls, these holding companies fail, just as my original bank failed. But there is a huge difference. You can resolve the holding company in a morning and still make it to play golf in the afternoon.  The only asset is common stock, commonly traded! There are no derivatives positions to unwind, no strange positions in offshore investment trusts, or whatever.  The "living will" simply specifies how much common equity each debtholder gets in the event of bankruptcy. There is never any need to break up, liquidate, assess, or transfer bits and pieces of the big bank.

Furthermore, there is no more obscurity over the value of  the holding company assets. We see the value of bank assets, marked to market, on a millisecond basis.

The holding companies can provide all the retail deposit services banks now provide. In fact, they could contract out to the banks to provide those on a fee basis, so the customer might not even need to know.

In addition, any sane holding company would hold the stock of several banks, diversifying the risk, and thus reducing the chances of ever needing to be wound up. Come to think of it, any sane holding company would also diversify out of banking, but now we're back to my larger vision of equity-financed banking and sensible small changes in financial structure to achieve it.

In the meantime, there you have it. 100% equity financed banks can still give bank creditors exactly the same assets they hold today, and allow failures of those debts to be resolved in a morning.

MetLife

What does "systemically important" mean? How can an institution, per se, be "systemically important?"  The WSJ coverage of Judge Rosemary Collyer’s decision rescinding MetLife’s designation as a "systemically important financial institution:" gives an interesting clue to how our regulators' thinking is evolving on this issue:

The [Financial Stability Oversight] council argued — bromide alert — that “contagion can result when relatively modest direct, individual losses cause financial institutions with widely dispersed exposures to actively manage their balance sheets in a way that destabilizes markets.”

It's not a bromide. It is a revealing capsule of how the FSOC headed by Treasury thinks about this issue.


"Actively manage balance sheets" is a fancy word for "sell assets." So there you have it. "Systemically important" now just means that an institution might sell assets, because selling assets might lower asset prices. "Contagion" and "systemically important" are no longer about runs; you see one bank in trouble and go take your money out of a different one. "Contagion" and "systemically important"  is no longer the (false, but plausible) domino theory, that if I default and owe you money, you default.

Policy is no longer just about stopping runs. Policy is not just about stopping any large bank from failing, or ever just losing money. Policy is about  stopping asset prices from falling, and stopping even the small marginal additional fall in prices that might accompany one  large institution's sales.  (Except that leverage and capital ratios now force institutions to sell even if they don't want to, a delicious case of contradictory regulatory commands.)

Owen Lamont's classic characterizatiion of policy-maker's attitude toward selling short, now applies to selling at all.

 Policymakers and the general public seem to have an instinctive reaction that short selling is morally wrong. Short selling has been characterized as inhuman, un-American, and against God

The journal nails the basic problem

For eight years, federal regulators have failed to define precisely the “systemic risks” they claim they can identify across the financial landscape.

But no definition makes it easy to endlessly expand the word's meaning.

Central banks as central planners

Two news items cropped up this week on the general topic of central banks as emergent central planers.: a nice WSJ editorial by James Mackintosh on QE extended to buying corporate debt, and the Fed's proposed rule governing "Macroprudential" countercyclical capital buffers. The ECB also has a new Macroprudential Bulletin with similar ideas that I will not cover because the post is already too long. (Some earlier thoughts on the issue here. As usual, if the quotes aren't showing right, come back to the original of this post here.)

The WSJ editorial:

..as the central banks become more desperate to boost inflation and growth, they are starting to break one of the modern tenets of the profession by funneling that cash directly to what they regard as “good” uses.

The Bank of Japan’s conditions for companies to qualify for central bank funding include

offering an "improving working environment, providing child-care support, or expanding employee-training programs".... increasing capital spending, expanding spending on research and development or boosting what the Bank of Japan calls “human capital.” The latter means pay raises for staff, taking on more people or improving human resources.

The ECB

... plans to pay banks to borrow from it for up to four years so long as they use the money to help the “real” economy, meaning that they don’t simply pump up the housing markets by offering more mortgage finance.

The ECB is also causing a ruckus by stating plans for which private bonds it will buy and which it won't.

What's wrong with this?

“It’s a massive politicization of credit: Here are the legitimate things for lending, and here are the illegitimate things,” said Russell Napier,...“It’s capitalism with Chinese characteristics.”

Indeed. But just "politicization" or "central planning" is not the real danger. Our governments do all sorts of highly politicized credit allocation and subsidization -- energy boondoggles, student loans, export financing, housing housing and more housing, community reinvestment act, and so forth. On that scale, it seems hard to get excited about a little more.

But central banks so far don't, at least in well run countries. Why not? Independence. The deal for central banks has been: The bank gets great independence. In return, it accepts sharply limited powers. It handles money and interest rates, but it does not funnel credit to specific borrowers, nor does it target asset prices.  Branches of government that handle such political decisions are subject to quadrennial electoral wrath.  So, though any expansion of financial meddling is unwelcome, the big danger is the inevitable politicization and loss of independence of the Central bank.

And that will happen sooner than you think. Congressional hearings and bills to contain the Fed are already in Congress.

A bit more under the radar, but needing much more attention, the Fed has unveiled rules for implementing "macro-prudential" policy with "counter-cyclical capital buffers."

The proposed rule makes for fun reading. The

countercyclical capital buffer (CCyB) ...is a macroprudential policy tool that the Board can increase during periods of rising vulnerabilities in the financial system and reduce when vulnerabilities recede.

 [CCyB? OMG, DC alphabet soup is now case-sensitive?]

The CCyB is designed to increase the resilience of large banking organizations when the Board sees an elevated risk of above-normal losses. ... Above-normal losses often follow periods of rapid asset price appreciation or credit growth that are not well supported by underlying economic fundamentals....the Board would most likely use the CCyB ... to address circumstances when potential systemic vulnerabilities are somewhat above normal. By requiring advanced approaches institutions to hold a larger capital buffer during periods of increased systemic risk and removing the buffer requirement when the vulnerabilities have diminished, the CCyB has the potential to moderate fluctuations in the supply of credit over time.

Decoded into English, this is what they're saying: Replay the end of the boom, 2005-2007. This time we really will see the crisis coming. This time we will force banks to issue more stock, hold back on paying dividends and bonuses to conserve capital during the boom when things are going great. This time we will directly tell banks to stop lending even though customers are lining up at the doors for cash-out no-doc refis. Replay the beginning of the bust,  2007-2008. This time we really will demand that banks get even more private capital, and stop paying dividends and bonuses, in the middle of a crisis, even though the same banks may be screaming of its impossibility.

(And... "to hold a larger capital buffer. This entire document uses the incorrect verb "hold" to describe capital, as if capital are reserves. One hopes the ideas are not as confused as the language.)

Hayek's famous criticism of central planning is that planners can't possibly have the information needed to properly supply toilet paper. Which they didn't. So as you read this gobbledy-gook, you should ask just that question -- not whether the Fed is well intentioned or not (it is), but how will Fed officials "assess vulnerabilities,"  "potential systemic vulnerabilities" or tell whether "asset price appreciation or credit growth" are or are not "well supported by underlying economic fundamentals?"

The proposal lays out the answer:

.. by synthesizing information from a comprehensive set of financial-sector and macroeconomic indicators, supervisory information, surveys, and other interactions with market participants. In forming its view about the appropriate size of the U.S. CCyB, the Board will consider a number of financial-system vulnerabilities, including but not limited to, asset valuation pressures and risk appetite, ...

The decision will reflect the implications of the assessment of overall financial-system vulnerabilities as well as any concerns related to one or more classes of vulnerabilities. ...

"valuation pressures" and "risk appetite" are not measurable or even defined quantities. "Classes of vulnerabilities" even less so.

If this sounds pretty wooly, you might be a bit reassured by

The Board intends to monitor a wide range of financial and macroeconomic quantitative indicators including, but not limited to, measures of relative credit and liquidity expansion or contraction, a variety of asset prices, funding spreads, credit condition surveys, indices based on credit default swap spreads, options implied volatility, and measures of systemic risk. In addition, empirical models that translate a manageable set of quantitative indicators of financial and economic performance into potential settings for the CCyB, when used as part of a comprehensive judgmental assessment of all available information, can be a useful input to the Board's deliberations. Such models may include those that rely on small sets of indicators—such as the credit-to-GDP ratio, its growth rate, and combinations of the credit-to-GDP ratio with trends in the prices of residential and commercial real estate... Such models may also include those that consider larger sets of indicators...

Though they might as well say "we will look at every number that comes across the wires." It is painfully obvious though that nobody has any clue how to turn this mass of data into a useful real-time index of "vulnerabilities."

The key is to distinguish a "boom" from a "bubble."  In real time. When all the bankers in your "surveys" and "interactions with market participants" are telling you it's a boom. "We'll look at every vaguely plausible number that comes in" is hardly a reassuring tie to the mast.

But in case even this smorgasbord data-dump seems too limiting; in case some congressional committee member says "you looked at the price of barbecue in setting the first bank of Texas' capital buffer, and that violates the regulation,"

However, no single indictor or fixed set of indicators can adequately capture all the key vulnerabilities in the U.S. economy and financial system. Moreover, adjustments in the CCyB that were tightly linked to a specific model or set of models would be imprecise due to the relatively short period that some indicators are available, the limited number of past crises against which the models can be calibrated, and limited experience with the CCyB as a macroprudential tool. As a result, the types of indicators and models considered in assessments of the appropriate level of the CCyB are likely to change over time based on advances in research and the experience of the Board with this new macroprudential tool.

Translation to English: We will be shooting from the hip, but we will cover up the communique's with a lot of numbers and models and mumbo jumbo to give the illusion of technical competence.

To be clear, I'm all for capital. Lots and lots of capital. Capital issued or retained, not "held," please. I'm for so much capital that the precise amount doesn't really matter.

And that's the point. By pretending that the Fed will set capital ratios down to the second decimal point, and then pretending to be able to adjust that ratio up or down by a few percentage points in response to a Rube-Goldberg model, the Fed pretends there is a very important cost to demanding too much capital, that it knows exactly where the cost-benefit optimum is, not just on average, but with great precision vary it over time. All of this is not just false, it is completely pie-in-the sky.  How can anyone with a straight face claim such an absurd level of competence?

So my objection really is the effort to dress this up with the aura of technocratic competence, or pretend the Fed is putting in rules that it will follow. (The link is, after all, a rule-making proposal.) It would be far more honest to issue one line: "The Federal Reserve will adjust capital requirements as it sees fit." Period.

The result is easy to foresee. "Counter-cyclical capital" and "macro-prudential policy" will become one more completely discretionary and judgmental policy tool for the Fed to command the banks.  It will be subject to intense political forces. The Fed will get it wrong, and feed the flames.  The fallout for the Fed, for good monetary policy, and for the economy will not be good.

While we're on gobbledy-gook language and the revealed confusion by our aspiring technocrats, the  "real economy" language is sad. From WSJ, the ECB

 will cut the interest rate to as low as minus 0.4%—the ECB paying the banks—if the banks lend more to the real economy than a benchmark amount linked to their recent loans.

Here we are in 2016, and our central bankers are peddling the medieval distinction between "real" and "financial" investment. Yes, ordinary Joe can be excused from this fallacy. But people with economics PhDs are supposed to understand that every asset is also a liability. Individually we can "buy paper, not real things." Collectively, we cannot.

“The market would much rather companies take the ECB’s cheap money and use it to buy each other,” said Robert Buckland, an equity strategist at Citigroup Inc.

OK, so even private sector equity strategists can get it wrong. But central bankers are supposed to understand accounting identities. I hope these are journalistic misunderstandings and not an accurate reflection of thinking at the ECB.

Oh, and on negative rates:

German reinsurer Munich Re said it plans to store more than €10 million ($11.3 million) of physical bank notes in vaults to test the feasibility of avoiding negative rates.

The ECB may have to get going on Miles' Kimball's plan to devalue currency relative to bank reserves!

Kashkari on TBTF

Neel Kashkari, the new president of the Minneapolis Fed, is making a splash with a speech about too big to fail, and the need for a deeper and more fundamental reform than Dodd Frank.  I am delighted to hear a Federal Reserve official offering, in public, some of the kinds of thoughts that I and like-minded radicals have been offering for the last few years.

I believe the biggest banks are still too big to fail and continue to pose a significant, ongoing risk to our economy.

Now is the right time for Congress to consider going further than Dodd-Frank with bold, transformational solutions to solve this problem once and for all.

From an economic point of view, now is indeed the right time -- calm before the storm. I'm not so sure now is a great time from a political view! But perhaps anti-Wall Street feelings from both parties can be harnessed to good use.

...When the technology bubble burst in 2000, it was very painful for Silicon Valley and for technology investors, but it did not represent a systemic risk to our economy. Large banks must similarly be able to make mistakes—even very big mistakes—without requiring taxpayer bailouts and without triggering widespread economic damage.

This is a key lesson. As Dodd-Frank spreads to insurance companies, equity mutual funds, and asset managers, we're losing sight of the idea that trying to stop anyone from ever losing money again is not a wise way to prevent a panic. It's the nature of bank liabilities, not their assets, that is the problem.

I learned in the crisis that determining which firms are systemically important—which are TBTF—depends on economic and financial conditions. In a strong, stable economy, the failure of a given bank might not be systemic. The economy and financial firms and markets might be able to withstand a shock from such a failure without much harm to other institutions or to families and businesses. But in a weak economy with skittish markets, policymakers will be very worried about such a bank failure.

In other words, the whole idea of designating an institution that is per se "systemic" is silly.

...there is no simple formula that defines what is systemic. I wish there were. It requires judgment from policymakers to assess conditions at the time.

Here I think Kashkari isn't really learning the lesson. If it's undefinable, even in words, and needs "judgment," then perhaps the idea really is empty.

More deeply, I think we need to apply much the same thinking to regulation that we do to monetary policy. At least in principle, most analysts think some sort of rule is a good idea for monetary policy. Pure discretion leads to volatility, moral hazard, time-inconsistency and so on. We should start talking about good rules for financial crisis management, not just ever greater power and discretion to follow whatever the "judgment" (whim?) of the moment says.

A second lesson for me from the 2008 crisis is that almost by definition, we won’t see the next crisis coming, and it won’t look like what we might be expecting. If we, or markets, recognized an imbalance in the economy, market participants would likely take action to protect themselves. When I first went to Treasury in 2006, Treasury Secretary Henry Paulson directed his staff to work with financial regulators at the Federal Reserve and the Securities and Exchange Commission to look for what might trigger the next crisis... We looked at a number of scenarios, including an individual large bank running into trouble or a hedge fund suffering large losses, among others. We didn’t consider a nationwide housing downturn. It seems so obvious now, but we didn’t see it, and we were looking. We must assume that policymakers will not foresee future crises, either.

This is an unusual and worthy expression of humility. Others advocate loading up the Fed with "macroprudential" regulation and "bubble pricking" tools, on the faith that this time, yes this time, they really will see it coming, and really will do something about it.  Regulators are not wiser, smarter, less behavioral, etc. than traders.

Speaking of the "resolution authority,"

Unfortunately, I am far more skeptical that these tools will be useful to policymakers in the second scenario of a stressed economic environment. Given the massive externalities on Main Street of large bank failures in terms of lost jobs, lost income and lost wealth, no rational policymaker would risk restructuring large firms and forcing losses on creditors and counterparties using the new tools in a risky environment, let alone in a crisis environment like we experienced in 2008. They will be forced to bail out failing institutions—as we were. We were even forced to support large bank mergers, which helped stabilize the immediate crisis, but that we knew would make TBTF worse in the long term.

There are no atheists in foxholes, the saying goes.  Notice "forcing losses on creditors and counterparties." This is exactly right. "Bailouts" are not about saving the institution, they are about saving its creditors. We should always call them "creditor bailouts." And a run is in full swing, and when the hotlines to the Treasury are buzzing "if we lose money on this, then the world will end," anyone in charge will guarantee the debts.

I believe we must begin this work now and give serious consideration to a range of options, including the following:

• Breaking up large banks into smaller, less connected, less important entities.

Here, Kashkari caused a stir in the press. Bernie Sanders voiced approval. Since "breaking up" has no subject -- who is to do this and how? -- and no mechanism, I'll give Kashkari the benefit of the doubt that he had something more sophisticated in mind than brute force.

• Turning large banks into public utilities by forcing them to hold so much capital that they virtually can’t fail (with regulation akin to that of a nuclear power plant).

Aha! My favorite simple solution, more capital!  I'm delighted to hear it. Of course (to whine a bit), banks don't "hold" capital, they "issue" capital -- it's a liability not an asset. And if they have so much capital that they virtually can't fail, what is this business about public utilities? And why in the world do they need regulation akin to that of a nuclear power plant? Given how regulation has spiraled costs, stultified innovation, and stopped expansion of the one scalable carbon-free energy source we have, that's a particularly unfortunate analogy. Or maybe it's an incredibly accurate analogy for just where Dodd-Frank style regulation will lead. The point is the opposite: with "so much capital that they virtually can't fail" they don't need the hopeless project of "systemic" designation, intensive asset risk regulation, and so forth.

• Taxing leverage throughout the financial system to reduce systemic risks wherever they lie.

A Pigouvian tax on short term debt -- after we get rid of all the subsidies for it -- is my other favorite answer.

The financial sector has lobbied hard to preserve its current structure and thrown up endless objections to fundamental change.

Many of the arguments against adoption of a more transformational solution to the problem of TBTF are that the societal benefits of such financial giants somehow justify the exposure to another financial crisis. I find such arguments unpersuasive.

This needs some explanation. Banks produce studies claiming that higher capital requirements or reduced amounts of run-prone short-term funding will cause them to charge more for loans and reduce economic growth. Kashkari is pointing out that these arguments are pretty thin, because the cost of not doing it is immense -- 10 percent or so of GDP lost for nearly a decade and counting is plausible.

Obviously, I don't agree with everything in the speech. Kashkari is a bit too vague about "contagion" "linkages" and so fort for my taste. But the good news is to have this conversation, and not settle in to implementing page 35,427 of Dodd Frank regulations, head in the sand, while we wait for the next crisis.

The rest of the speech outlines his plans to get the Minneapolis Fed working hard on these issues, and to push for them at the larger Fed. This is a project worth watching.

In case I haven't plugged it about 10 times, my agenda for these issues is in Toward a Run-Free Financial System and the many blog posts under the "banking" "financial reform" and "regulation" labels.