What Side Are You On?

The President of the KC Fed, Thomas Hoenig has joined a rather loud chorus clamoring for “Glass Steagall-type” measures to prevent another financial crisis (h/t R). (It should give Mr. Hoenig some pause that LaRouchies are very outspoken advocates of Glass-Steagall, btw.)

I find this nostalgia for Glass-Steagall to be bizarre and disconnected from the realities of Financial Crises I and II. The theory behind Glass-Steagall (and GS-lite measures like the Volcker Rule and the swaps pushout provision of Dodd-Frank) is that banks with insured deposits are subject to moral hazard, and will take on too much risk.  This problem can be reduced by restricting the activities in which banks with insured deposits can undertake.  That is, the problem is deemed to be giving banks too much discretion on the asset side of the balance sheet, when the liability side is insured.

But this bears no relationship to what happened in the 2008 crisis, or the one currently going on.

For starters, most of the major institutions that cratered in 2008 were not universal banks that funded capital market activities (such as underwriting) with insured deposits.  Indeed, the opposite was true.  They were investment banks/broker dealers (Bear, Lehman, Merrill); GSEs (Fannie, Freddie); insurance companies (AIG); commercial or universal banks heavily dependent on wholesale funding; and SIVs (many of which did have connections to commercial banks, admittedly).

Indeed, one could make the case that those who prescribe Son of Glass-Steagall to cure our financial ilss have the diagnosis exactly backwards.  Many of the institutions that cratered–notably the IBs and SIVs–did so precisely because they did not have sticky funding (like insured retail deposits): they relied on short-term, uninsured funding like repo and commercial paper.   Others, like RBS, had some retail deposits, but notably were very dependent on wholesale (uninsured) funding, and that dependence had grown over time.  All of these institutions suffered classic runs.

In this interpretation, it is the concentration of risk in institutions that do not fund primarily through insured deposits that is the problem.  David Murphy has a new paper that looks at Lehman and RBS, and arrives at a similar conclusion.  This would imply that Glass-Steagall is utterly off-point.

The history of banking in the US supports this view as well.  Banking panics occurred throughout the 19th and first-third of the 20th centuries due to funding fragility.  These panics destroyed banks that engaged in traditional banking activities like commercial and real estate lending.  Yes, there were runs on investment houses too (Jay Cooke & Co., Barings) but the point is that it’s the liability side of the balance sheet that matters more than the asset side.  There was tremendous diversity in the asset side of the balance sheets of firms that suffered runs prior to deposit insurance: there was very little diversity on the liability side.  All were funded with short term liabilities that could run at the drop of a hat.

Similarly, S&Ls raped and pillaged deposit insurance even though they were very “narrow banking” institutions with significant restrictions on the asset side of the balance sheet (though those restrictions were eased by Garn-St. Germain in 1984).

As a last point, Financial Crisis II is concentrated in European banks heavily dependent on wholesale funding, and the underlying source of the problem is assets that regulators deemed to be utterly safe for commercial banks–highly rated sovereign debt.  Relatedly, many of the assets that caused commercial and universal banks in the US problems in 2008 were again deemed by regulators to be super-safe, carrying very low (and in some cases zero) capital charges. The assets that are raising/raised questions about the solvency of financial institutions would have been perfectly copacetic even in a Glass-Steagall world.

Which all suggests that the Glass-Steagall focus on the asset side of the balance sheet is completely misguided.  The fragility in the financial system comes from the liability side, and regulators and legislators are terrible at identifying the assets that are “safe” for insured institutions to hold.  Given this, measures to stabilize funding–like deposit insurance, or the existence of a lender of last resort–are key to establishing stability.

Of course this raises moral hazard concerns, but the Friedman-Kraus analysis in Engineering the Financial Crisis convinces me that this was not an important part of Financial Crisis I.  Gorton also argues that the moral hazard effects of deposit insurance have been overstated.  The S&L Crisis was a large part a moral hazard problem, but it occurred in large part because of grossly negligent regulators who (under pressure from Congress) let insolvent thrifts continue to operate rather than shutting them down when their financial condition weakened in the late-70s and early-80s: regulators (and Congress) let readily containable moral hazard flourish.  That crisis also shows that banks have plenty of room to engage in morally hazardous behavior even when they are very narrow institutions with extensive restrictions on the asset side.

Identifying the fragility of liabilities as the true vulnerability of the system of course raises important questions: why do financial institutions routinely rely on run-prone funding, as they have done for centuries? Diamond-Rajan argue that fragile funding plays an important disciplinary role: the threat of a run limits the ability of banks to act opportunistically and expropriate those who lend to them.  This implies that trying to reduce reliability on fragile funding will have a cost: There will be more opportunism.  The hard thing is to design regulations that balance between micro incentives (to control opportunism) and macrostability (arising from the fact that the fragile funding that controls opportunism is vulnerable to jumps to bad coordination game equilibria).

But though I don’t have an answer to what the right balance is, I am pretty confident that it is appropriate to focus more on the liability-side issues as opposed to the asset-side issues.  Which further implies that pining for a return of Glass-Steagall is misguided, and positively dangerous, because it distracts attention from the real problems.

About Craig Pirrong 230 Articles

Affiliation: University of Houston

Dr Pirrong is Professor of Finance, and Energy Markets Director for the Global Energy Management Institute at the Bauer College of Business of the University of Houston. He was previously Watson Family Professor of Commodity and Financial Risk Management at Oklahoma State University, and a faculty member at the University of Michigan, the University of Chicago, and Washington University.

Professor Pirrong's research focuses on the organization of financial exchanges, derivatives clearing, competition between exchanges, commodity markets, derivatives market manipulation, the relation between market fundamentals and commodity price dynamics, and the implications of this relation for the pricing of commodity derivatives. He has published 30 articles in professional publications, is the author of three books, and has consulted widely, primarily on commodity and market manipulation-related issues.

He holds a Ph.D. in business economics from the University of Chicago.

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