Minggu, 31 Desember 2017

Tyler: Equity financed banking is possible!

Tyler Cowen wrote an extended blog post on bank leverage, regulation and economic growth on Marginal Revolution. Tyler thinks the "liquidity transformation" of banks is essential, and that we will not be able to avoid a highly levered banking system, despite the regulatory bloat this requires, and the occasional financial crisis. As blog readers may know, I disagree.


A few choice quotes from Tyler, though I encourage you to read his entire argument:
I think of the liquidity transformation of banks in terms of...Transforming otherwise somewhat illiquid activities into liquid deposits. That boosts risk-taking capacities, boosts aggregate investment, and makes depositors more liquid in real terms.  
Requiring significantly less bank leverage, at any status quo margin, probably will bring a recession. 
...many economies are stuck with the levels of leverage they have, for better or worse. 
I fear ... that we will have to rely on the LOLR function more and more often. 
I don’t find the idea of 40% capital requirements, combined with an absolute minimum of regulation, absurd on the face of it. But I don’t see how we can get there, even for the future generations.
Depressing words for a libertarian, usually optimistic about markets.

This is a good context to briefly summarize why "narrow", or (my preferred) equity-financed banking is in fact reasonable, and could happen relatively quickly.

Tyler's main concern is that people need a lot of "liquidity" -- think money-like bank accounts -- and that unless banks can issue a lot of deposits, backed by mortgages and similar assets, bad things will happen -- people won't have the "liquidity" they need, and businesses can't get the investment they need.

Here are a few capsule counter arguments.  In particular, they are reasons why the economy of, say 1935 or even 1965 might have required highly levered banks, but we do not.

1) We're awash in government debt.



We've got about $20 trillion of government debt. That could back about $20 trillion of risk free assets. (It would be better still if the Treasury would issue fixed-value floating-rate debt, needing no intermediation at all.) Add agency debt -- backed by mortgage backed securities that are already guaranteed by the Treasury -- and you have another $8 trillion. Checking accounts are about $1.5 trillion and total bank liabilities about $9 trillion.

In the past, we may have needed to create money-like deposits by backing them with bank assets. A happy side to our debt expansion is that government debt -- the present value of the governments' taxing authority -- provides ample assets to back all the money-like deposits you want.

2) Liquidity no longer requires run-prone assets. Floating value assets are now perfectly liquid 

In the past, the only way that a security could be "liquid" is if it promised a fixed payment. You couldn't walk in to a drugstore in 1935, or 1965, and trade an S&P500 index share for a candy bar.  Now you can. (And as soon as it is cleared by blockchain, it will be even faster and cheaper than credit cards.) There is no reason your debit card cannot be linked to an asset whose value floats over time.

This is the key distinction. The problem with short term debt is that it is prone to runs. Financial crises are runs, period.  Short term debt is prone to runs because it promises a fixed amount ($1), any time, first come first serve, and if the institution does not honor the claim it is bankrupt.

Seriously. Imagine that your debit card was linked to an ETF that held long-only, full allocations (not risky tranches) of high grade mortgage backed securities. Its value would float, but not a lot. Bank assets are, curiously immensely safe. So it might go up or down 2% a year. In return you get a higher interest rate than on pure short-term government debt (of which there is $28 trillion under my scheme).  You would hardly notice. Yet the financial system is now immune from runs!

3) Leverage of the banking system need not be leverage in the banking system. 

Suppose even this isn't enough and we still need more risk free assets. OK, let's lever up bank assets. But why should that leverage be in the bank. Let the banks issue 100% equity. Then, let most of that equity be held by a mutual fund, ETF, or bank holding company, and let those issue deposits, long term debt, and a small amount of additional equity. Now I have "transformed" risky assets into riskfree debt via leverage. But the leverage is outside the bank. If the bank loses money, the mutual fund, ETF, or holding company fails... in about 5 minutes. The creditors get traded equity of the bank, which is still at 90% of its initial value. There is no reason bank creditors should dismember a bank, go after complex and illiquid bank assets, stop operation of the bank. If bank assets must be leveraged, put that leverage outside the bank.

And, if you need even more leverage, well, these leveraged ETF can hold other assets too. There is no reason not to leverage up stock, corporate bonds, REITS, mortgage backed securities or other assets if we desperately need to provide a riskfree tranche. We don't see this. Why not? Maybe "riskfree" assets aren't so important after all!

Tyler sort of acknowledges this, but with fear rather than excitement:
But what if a demand deposit is no longer so well-defined? What about money market funds? Repurchase agreements? Derivatives and other synthetic positions? Guaranteeing demand deposits is a weaker and weaker protection for the aggregate, as indeed we learned in 2008. The Ricardo Hausmann position is to extend the governmental guarantees to as many areas as possible, but that makes me deeply nervous. Not only is this fiscally dangerous, I also think it would lead to stifling regulation being applied too broadly. 
A lot of commercial bank leverage can be replaced by leverage from other sources, many less regulated or less “establishment.” Overall, on current and recent margins I prefer to keep leverage in the commercial banking sector, compared to the relevant alternatives....One big problem with attempts to radically restrict bank leverage is that they simply shift leverage into other parts of the economy, possibly in more dangerous forms...
Absolutely. In my view nobody should issue large quantities of run-prone assets -- fixed value, immediate demandability, first come first serve -- unless backed by government debt. However, we should cherish the rise of fintech that allows us to have liquidity without run-prone assets. And don't fear even leverage outside commercial banks without thinking about it. My ETF, whose assets are common stock, and liabilities are say 40% "deposits", 40% long-term debt, and 20% equity, really could be recapitalized in 5 minutes, without any of the adverse consequences of dragging a bank through bankruptcy court.

4) Inadequate funds for investment I'm not quite sure where Tyler gets the view that without lots of unbacked deposits, funds for investment will be scarce -- just how leverage
boosts risk-taking capacities, boosts aggregate investment,...
Requiring significantly less bank leverage, at any status quo margin, probably will bring a recession. 
The equity of 100% equity financed banks would be incredibly safe. 1/10 the volatility of current banks. It would be an attractive asset. The private sector really does not have to hold any more risk or provide any more money to an equity financed banking system. We just slice the pizza differently. If issuing equity is hard, banks can just retain profits for a decade or so.

Or, better, our regulators could leave the banks alone and allow on on-ramp. Start a new "bank" with 50% or more equity? Sure, you're exempt from all regulation.

And, in case you forgot, we live in the era of minuscule interest rates -- negative in parts of the world; and sky high equity valuations. All the macroeconomic prognosticators are still bemoaning a "savings glut." A scarcity of investment capital, needing some sort of fine pizza slicing to make sure just the right person gets the mushroom and the right person gets the pepperoni does not seem the key to growth right now.

Update: Anonymous below asks a good question: "What about payrolls, debiting and crediting exports and foreign transactions, escrows."  And I could add, accounts receivable, trade credit and so forth.

Answer: We need to eliminate large-scale financing by run-prone securities. Not all debt is run prone. It needs to be very short term, demandable, failure to pay instantly leads to bankruptcy, and first come first serve. And it has to be enough of the institution's overall financing that a run can cause failure. An IOU for a bar bill -- pay for my beer, I'll catch up with you next week -- is a fixed-value security, yes. But it is not run prone. You can't demand payment instantly, bankrupt me if I don't pay, I have the right to postpone payment,  it's not first come first serve, and such debts are a tiny fraction of my net worth.

Update: A correspondent writes
[Equity financed banking] Already exists! Albeit not at scale yet. It’s called asset management. See, for example, Alcentra, a UK-based company that lends directly to mid-sized European companies. They are largely “equity financed,” meaning that they sell shares in their funds, mostly to institutional investors. They also offer separate accounts, which you can also think of as “equity financing.” They are not a bank, but an asset manager, taking advantage of reduced lending since the crisis by banks to mid-sized and low credit firms in Europe. They have about 30 billion in AUM. This is a “disintermediation” story no one is talking about, and direct lending by asset managers is on the rise more broadly as well.