Financial Regulation in the Twenty-First Century

Yesterday I felt obliged to strongly dissent from Greg Mankiw's claim that Austan Goolsbee, in endorsing his boss Barack Obama's position on the regulation of investment banks, had sold his share of the grand Chicago intellectual tradition for a mess of political pottage. Mankiw wrote, of Austan:

Greg Mankiw's Blog: George Stigler rolls over in his grave: Remember when the University of Chicago used to be the intellectual center of the deregulation movement? No more. A reader alerts me to this news: "Investment banks that obtain Federal Reserve Bank loans during a financial crisis should face much closer regulatory scrutiny, a key economic adviser to Democratic presidential candidate Sen. Barack Obama said. Austan Goolsbee, an economics professor at the University of Chicago and one of Sen. Obama's closest advisers on economic issues, said the senator believed strongly in enhanced regulation of any financial institution that has access to the Fed's discount window..."

This claim of Mankiw's seemed to me to be (i) simply wrong in its understanding of the Chicago tradition on financial regulation, as I argued yesterday, (ii) wrong in its analysis of why the Federal Reserve believes it needs authority to both lend to and regulate non-bank banks, as Mark Thoma argued yesterday, and (iii) wrong in its misidentification of the source of the push for enhanced regulatory authority--which comes not out of Barack Obama and the Democratic Party as a partisan issue but out of the Federal Reserve as a technocratic issue. This last is, I think, especially important: getting financial regulation right to deal with financial crises is not properly a partisan or ideological issue, and nobody should try to make it one.

And lo and behold, in this morning's Financial Times we have New York Fed President Tim Geithner explaining what he believes needs to be done: enhanced regulation of any financial institution that has access to the Fed's discount window--with which institutions have access something determined by the regulators in the interest of system stability:

http://us.ft.com/ftgateway/superpage.ft?news_id=fto060820081845293842: Since last summer, we have lived through a severe and complex financial crisis.... Many assets were financed with significant leverage and liquidity risk and many of the world's largest financial institutions got themselves too exposed to the risk of a global downturn. The amount of long-term illiquid assets financed with short-term liabilities made the system vulnerable to a classic type of run. As concern about risk increased, investors pulled back, triggering a self-reinforcing cycle of forced liquidation of assets, higher margin requirements, increased volatility.

What should be done to strengthen the system in the future? First, when we get through this crisis we have to increase the shock absorbers... more exacting expectations on capital, liquidity and risk management for the largest institutions that play a central role in intermediation and market functioning. They should be set high enough to offset the benefits that come from access to central bank liquidity, but not so high that they succeed only in pushing more capital to the unregulated part of the financial system.

Second, we have to... [take] some of the risk out of secured funding markets, increasing resources held against default in the centralised clearing house, and encouraging more standardisation, automation and central clearing....

Third, the regulatory framework cannot be indifferent to the scale of leverage and risk outside the supervised institutions. I do not believe it would be desirable or feasible to extend capital requirements to leveraged institutiions such as hedge funds. But supervision has to ensure that counterparty credit risk management in the supervised institutions limits the risk of a rise in overall leverage....

Fourth, we need to streamline and simplify the US regulatory framework.... The institutions that play a central role in money and funding markets - including the main globally active banks and investment banks - need to operate under a unified framework that provides a stronger form of consolidated supervision, with appropriate requirements for capital and liquidity. To complement this, we need to put in place a stronger framework of oversight authority over the critical parts of the payments system - not just the established payments, clearing and settlements systems, but the infrastructure that underpins the decentralised over-the-counter markets.... At present the Fed has broad responsibility for financial stability not matched by direct authority and the consequences of the actions we have taken in this crisis make it more important that we close that gap.

Finally, we need a stronger capacity to respond to crises...

Comments

[Matt]

"At present the Fed has broad responsibility for financial stability "

This responsibility comes from its biggest customer, and its biggest responsibility is to get liquidity in line for this customer.

So when the Fed asks for authority to do this job, it is partially asking for authority to get large investment firms in line with its biggest customer. Not IMHO a good idea.

If the legislature wants the fed to have more authority, then the legislature has to give up some if its monopoly rights to monetary banking.

[bob]

A prediction:
Given his history of partisan hackery, any future remark by Mankiw that intersects with the policy positions of Obama or McCain will likely be incoherent but aimed to further the cause of the Republican party.

[howard]

i'm gonna say it again: greg mankiw, whatever his background, has become an intellectual hack who should be shunned by polite society for his services to the bush administration. that you continue to take him seriously as a worthy intellectual adversary (that you take him seriously enough to cite him as a fact witness for hillary clinton's supposed "character problem") is not a mark in your favor, prof. why, it's almost a character problem, confusing a degree in the economics guild with a seriousness....

[Robert Waldmann]

"Third, the regulatory framework cannot be indifferent to the scale of leverage and risk outside the supervised institutions. I do not believe it would be desirable or feasible to extend capital requirements to leveraged institutiions such as hedge funds. But supervision has to ensure that counterparty credit risk management in the supervised institutions limits the risk of a rise in overall leverage...."

I don't think that it is counterparty credit risk. Typically hedge funds interact with investment banks using REPO accounts which require the net value of the account to be positive (Last I heard which was long ago 2% of the gross long position). The investment bank has the authority to liquidate the REPO account if it's net value falls below this level. This means that the hedge fund can't owe the bank money or default.

The problem is that liquidating such accounts can cause the value of assets where the hedge fund is long to fall and the value of the assets where the hedge fund is short to rise. This explains the 2% > 0% minimum net value.

The risk to the investment bank is of liquidating a position (which suddenly belongs to the investment bank not the hedge fund) with markets that are not infinitely thick (and become very thin in a crisis).

I'd consider the closing of a REPO account like a short call and not like foreclosing on a home or putting a firm into chapter 7. I mean it happens real quick with no lawyers involved and the hedge fund can't spray anti-banker grafiti on the walls of its REPO account.

I think the solution is not at for investment banks to be required to investigate the soundness of the finances of hedge funds but rather for them to count the assets in REPO accounts (times a coefficient) as their assets. Now, depending on the coefficient, this might eliminate the hedge fund sector by forcing hedge funds to disolve or to redefine themselves as investment banks.

My sense is that delegated supervision doesn't work so great so the FED should supervise or count as risky and not try to get institutions with access to the discount window to supervise other financial institutions.

[mr m.]

Sadly, I agree with howard.

But, for now, as it has been for many decades, in the field of economics anyway, conservative hacks get a pass for being serious intellectuals. The opposite is not true. BDL, who I do perceive as fair, balanced, moderate, and intellectual, is about as "liberal" as it gets.

Since the profession respects Mankiw, BDL needs to debate him, even though the profession shouldn't respect him.

[Bruce Wilder]

". . . financial regulation right to deal with financial crises is not properly a partisan or ideological issue, and nobody should try to make it one."

Well, it is a partisan issue. The Republican Party pushed deregulation far beyond the bounds of technocratic legitimacy. The current crisis is a product of a deliberate policy to NOT regulate, a policy adopted because it would benefit those who would profit from the corruption and predation that followed.

Mankiw does not want what BDL wants. They cannot debate technocratic means, because one wants technocracy and one wants plutocracy. The objectives are profoundly different.

And, yes, in his public pronouncements, Greg Mankiw is a hack, and has been a hack for a long, long time.

[bob]

re: "Since the profession respects Mankiw, BDL needs to debate him, even though the profession shouldn't respect him."

What is the difference between Mankiw and Yoo in terms of their academic integrity?

It seems the only principle they hold to is providing whatever "intellectual" justification their political masters need.

[a]

i think mankiw needs to think of current i-banks in terms of little kids left around wine coolers (alcoholic), with kids being the banks and wine coolers being leverage. a little imbibing of wine collers might have been okay and even (arguably) good for the kids. But too much was a bad thing. and regarding i-banks, someone maybe should have put the brakes on the too much part before year 2008. today we are left with the proverbial band aid on bullet wounds.

[RN]

Why do you even waste 30 seconds of your life on Mankiw? He hasn't made an intellectually honest argument in years.

[baileyman]

Mankiw Death Spiral Watch...

[jamz]

the question who profited by the bubble has been asked, but the answer has not been spoken

lots of words about the financial market crises spawned by the "reforms" to financial regulating structures over the past two decades but little is said about who profited as others lost so much money and how big were the riches they gathered

what makes this silence so effective?

[Rickster Sherpa]

Professor DeLong, I went to Mankiw's blog to see if he responded to you or Mark Thoma or Fed Governor's Geitner (hope the name is spelled right) speech on Monday responding to his snarkiness about Obama and Goolsbee's thinking that since Investment banks now have access to the discount window, they need to be regulated so that their activities are less likely to produce another financial crisis. I am afraid that for a variety of reasons, Mankiw is deep into group think and the bad empirical results of hte last eight years simply cannot be the fault of extreme laissez-faire and imprudent Government based on his ideology. I note that Mankiw, when he was in the Admnistration, did nothing to identify the fact that housing was had become a bubble and that lenders should not offer, or lenders, accept, loans premised more on the belief that prices will go up at 10% percent year ad infinitum, and not on the income of the borrower. As Michael Mandel of that noted "left-wing" publication Business Week wrote, Mankiw protests to much when he says he is not a Republican "stooge." http://www.businessweek.com/the_thread/economicsunbound/archives/2006/08/greg_mankiw_tak.html