The panel--and already, some of my commenters--are talking about the role of regulators in keeping banks from levering up too aggressively. As I've said elsewhere, repeatedly, this is one of the few proposed reforms that seems like a slam dunk. And pretty much everyone, across the board, agrees.
On the other hand, keeping leverage levels down may not protect the economy from a crisis; it may simply keep the tab down for the taxpayer. To see why, consider the arguement about reserve requirements advanced by my old macro professor, John Huizenga. In theory, a reserve requirement makes the bank safer, right? After all, it means the bank has to have, say, 20% of its outstanding loans in hard cash at any given time. That's money that protects against bank runs.
Actually, no, it doesn't--because the bank has to have 20% of its outstanding loans in hard cash at any given time. It can't give that money to the depositors, because doing so reduces the reserves faster than it reduces the bank's liability.
Say depositors who collectively account for 10% of your demand deposits all come and ask for their money. You give them half your reserves. But you only reduced your reserve requirement by 10%. That means you need to make up that lost 40% somewhere. Fast.
Imagine there were a law requiring you to have $100 on you at all times. For most people, this initially seems like ample means to cover their daily spending. Then you realize that because you always have to have that $100, you actually need much more than that to take care of your needs.
In theory, the bank regulator can lower the reserve requirements in times of crisis. But as Professor Huizenga pointed out, one thing that regulators do not like to do in times of crisis is announce "Hey, your banks have less cash than they used to!"
The reserve requirements protect the regulator--it limits the loss in the case of a collapse. And that's a worthy goal. But Huizenga argued that it didn't really make the banks all that much sounder. I am still mulling what this implies for regulatory action on investment banking leverage.
Repeal Legal Tender laws, give depositors a true Choice as to the type of Currency they choose to hold, and all the AGW caused by the endless gas-bagging you're witnessing at that 'Conference' would be seen as just that..Also, you may care to understand that if not for the 'Central Bank', all this 'leverage' could have never been created, in the first place..
I'd suggest you suggest that, but I'd hate to see you Tasered/Thrown-out/disinvited/crossed off the 'in-crowd' list...
All bank CEO's sign a contract on taking office, agreeing that if the bank becomes bankrupt, they hang for it. Problem solved.
Interesting point. Is there any workable middle ground in which there's a strong incentive for banks to hold higher reserves, but they're able to draw down those reserves when it's necessary? The idea being that you automate the regulator's decision to permit lower reserves.
I'm going to back up Mark on this one. The reserve requirements set by the Fed are effectively an endorsement of institutionalized fraud. If you deposit $100 with a bank with the understanding that $100 will be made to you on demand, then as soon as the bank lends out any fraction of that $100 without compensating reserves elsewhere, it has stolen your money and it is, at that moment, insolvent. Government decrees cannot negate that reality.
Actually, the reserve requirement these days is little more than a historical curiosity. Banks sweep funds nightly from demand deposit accounts to other accounts where there are NO reserve requirements. This is why those who jump up and down about M1 money supply not growing are clueless. The money (except for currency) isn't in M1 anymore.
Bernanke has spoken about this:
the Federal Reserve is not permitted to pay interest on the balances held at Reserve Banks to meet reserve requirements, depositories have an incentive to reduce their required reserve balances to a minimum. Institutions use various techniques to minimize required reserves, such as sweep programs that move funds between deposit accounts subject to reserve requirements and money market accounts not subject to those requirements.
http://www.federalreserve.gov/newsevents/speech/bernanke20061016a.htm
Isn't this what Certificates of Deposit are for: to transfer significant amounts of cash-on-hand into non-demand deposits?
@Matt B
CD's are longer term time-demands (3 months, 6 months etc.)where customers direct funds, generally not sweeps.
What Bernanke is referring to is money you put into a checking account that may be swept overnight into a savings/money market account without your knowledge (or you receiving any interest payment). When a check hits your account, money is swept back into your checking account. All this occurs without your knowledge.
When you get your statement showing your checking balance, it should really read something like "amount of funds swept into special savings account that is available to be swept back into checking account when a check or other withdrawal occurs."
I would think the argument in the present case is greater than the benefit to the regulator.
In the case of derivatives trading, the issue is not only that leverage increases risk if markets go south, but that leverage creates viable businesses in arbitrage which would otherwise not exist. Without the ability to massively lever their investments, Long-Term Capital wouldn't have been able to be a fund with trillions in total liabilities. There wouldn't be a market today in Credit Default Swaps nearly equal to the GDP of the entire human race.
Arbitrage is an important tool to promote market efficiency. But frankly, markets don't need arbitrage to resolve every price difference that can be measured by a single basis point. And taxpayers simply cannot bear the expense of bailing out trillions levered at 30 to 1.
But Huizenga argued that it didn't really make the banks all that much sounder. I am still mulling what this implies for regulatory action on investment banking leverage.
I disagree with Huizenga.
With greater reserves and therefore lower leverage, losses (and gains) are magnified less. A 3% loss with 10 to 1 is 30%, while with 5 to 1 is 15%. Elementary, but 3% losses are common, so are 5 and 7% losses. A 35% loss vs. a 70% loss is the difference between a solvent institution and a bank run.
Yes, in a bank run, greater reserve requirements are not going to help. However, getting to a point where a bank run makes sense to the depositors is much more difficult with higher reserve requirements.
I like dearime's call for an enormous increase in Bank CEO's pay. It's a novel suggestion.
Megan,
You're confused on this topic, which is understandable, because it is a little confusing, since there are two limits on a banks practices.
1) Leverage limitations. Leverage = (Debt/Equity) which roughly = (Deposits+Loans from other banks)/(Capital). So the key question for the SOLVENCY and bankruptcy of a bank is the capital ratio. This is also a key concern for the moral hazard -- increased capital requirements would mean that a larger portion of a bank's loans would be the bank's own money.
2) Reserve ratios tell us nothing about leverage, solvency, or bankruptcy issues. They tell us something about LIQUIDITY and the bank money multiplier. Our current situation is not really a liquidity crisis, but rather a solvency crisis -- do these banks still have a positive net worth?
"Say depositors who collectively account for 10% of your demand deposits all come and ask for their money. You give them half your reserves. But you only reduced your reserve requirement by 10%. That means you need to make up that lost 40% somewhere. Fast."
Which you can do by reducing your loans outstanding by 10%.
Anyway the current problems are from bad loans not from depositors withdrawing their money. Margin requirements keep banks solvent by forcing them to delever when their loans start going bad. Just like margin requirements keep stock investors solvent by forcing them to reduce their positions (or put up more money) when the market moves against them.