Regulation Week: What causes a crisis?

Two comments I want to follow up on from last week’s DIY Stress Test fun. One is from qrst over at seekingalpha:

[Me:] “If BoA needs another $75bn, that will have to come from the government.”

Do you have evidence for this assertion? If BofA needed $75B, and the market was extremely confident that this was the last of it, I bet they could raise it.

This is a good point. However the reason I assumed this statement instead of defending it is because the government already has given away the option to the bank of coming to it for money. I want to quote this Matthew Yglesias point, a point that gets embedded options so clear that it qualifies Yglesias to be an Honorary Financial Engineer:

At the end of the day, the valuable thing that systematically significant institutions got from TARP was not so much the TARP money as investors and creditors’ knowledge that money would be provided in the future if necessary to prevent bank failures. That’s something the banks can’t “give back” nor can the government “take it away.” All we can do is try to set rules that make some sense out of the time-consistency issue that’s now been revealed to exist.

So I’d say that even though we haven’t covered these losses, we have in the sense that we’ve given the banks an option to have us cover these losses. We have several options like this. As some people pointed out during the PPIP debate, we give away non-recourse options to cover losses in the form of FDIC insurance.

And that’s great. I really like that, unlike my great-grandfather, I don’t have to worry about whether or not $3,000 in a checking account is going to disappear. I’m willing to pay a fee in the form of taxes to cover that. However in exchange for that option we need some regulation that covers the volatility and recklessness of the person on the other end. That is where regulation comes in – regular banks have to have certain capital requirements, certain risk models, certain portfolio setups. If larger financial institutions want both (a) to be like regular banks and (b) have the implicit guarantee, they’ll need the same regulation. There’s no “opting out”, because the guarantee is always there, whether or not it is consciously being invoked.

Comment #2, from Economics of Contempt:

Second, you have to distinguish between financial crises and normal recessions. Your argument is that the benefits of diversification that a large bank can offer don’t prove to be all that useful in a financial crisis, because all correlations go to 1. True, but not all recessions are financial crises where all the correlations go to 1. The 2001 recession is case in point. In run-of-the-mill recessions, the diversification that large banks can offer will likely prove very beneficial.

I’m going to, perhaps unfairly, extrapolate this point into two views on the recession and the financial sector. A lot of people are confused as to what the Summers/Geithner crew is up to with not massively overhauling the regulatory framework. Thursday may be some weak tea, and people aren’t sure how to read that. Here’s a James Kwak post that is representative. It’s leading a lot of people to worry about corruption, capture, banksters, ideological blindness, etc.

I think it may be more useful to refocus the debate. Here are two opinions about the financial crisis, and I want you to reflect on where you stand:

1) Large financial crises are exogenous; they show up randomly, like a hurricane or an asteroid a few times over many years, and it is important to have a stable and robust financial sector that is capable of withstanding them and government means to pick up the pieces quickly and efficiently for the parts that can’t.
2) A financial sector that is too large, concentrated and unregulated will bring on large financial crises – they are endogenous to the actual setup of the financial sector – and it is important for the government to make sure that the financial sector is not concentrated enough, and that its incentives are properly aligned, to help prevent these crises.

I am not sure what is a more natural position to think. Perhaps #2, but when presented with:

1) The Titanic was slow, unwieldy and poorly manned, and wasn’t able to dodge the iceberg that randomly appeared in front of it.
2) An iceberg appeared in front of the Titanic because it was slow, unwieldy and poorly manned.

I imagine #1 is more natural. If you follow the terms, the question is how endogenous are crises to the setup of the financial crisis itself. Are they exogenous, like asteroids falling from the sky? Or are they endogenous, like getting lung cancer after a lifetime of smoking? Those who are proponents of Fischer Black-ian “noise”, which is a camp I think (I haven’t read his latest paper) Tyler Cowen falls into, are like the exogenous camp. Sometimes you have smart days, sometimes you have dumb (noisy) days, and probabilistically speaking once in a long while everyone will have a dumb day at the same time, they’ll all screw it up together, and that’s a crisis. That leaves market concentration, pay structure, incentives, capture, etc. more or less off the table as drivers.

I think Summers, and by extension, the Obama crew falls into this camp. Check out this speech earlier this year by Summers to other economists (my underline):

Economic downturns historically are of two types. Most of those in post-World War II-America have been a by-product of the Federal Reserve’s efforts to control rising inflation. But an alternative source of recession comes from the spontaneous correction of financial excesses: the bursting of bubbles, de-leveraging in the financial sector, declining asset values, reduced demand, and reduced employment.

Unfortunately, our current situation reflects this latter, rarer kind of recession…

One of the most important lessons in any introductory economics course is that markets are self-stabilizing…This is much of what Adam Smith had in mind when he talked about the “invisible hand.”

However, it was a central insight of Keynes’ General Theory that two or three times each century, the self-equilibrating properties of markets break down as stabilizing mechanisms are overwhelmed by vicious cycles. And the right economic metaphor becomes an avalanche rather than a thermostat. That is what we are experiencing right now.

Off to blow up the financial crisis from the inside.

Two or three times a century an asteroid falls on our financial sector. We should be prepared, have supplies and rescue teams, etc. But there’s little to be done otherwise. I think that’s an important point – sometimes it is all random, and more accurately sometimes we can’t tell what the problems are beforehand, and it is important to have the ability to rapidly pick up the pieces afterwards even if you acknowledge the problems are endogenous. And my suspicion is that Thursday’s new regulatory regime will fall into this camp.

However, in terms of explaining this crisis, I think it goes against the grain of many observers and commentators. The random asteroid story contrasts particularly well with Simon Johnson’s piece in the Atlantic, as well as other observers who see the financial crisis less as an exogenous shock to a stable system but more the result of bad incentives, concentration of risk, firms acting as banks that weren’t regulated as banks, and the sector scaling to a size that was unsustainable without excessive rent-seeking, transfer, and risk taking. What specifically do I have in mind? Stay tuned for more Regulation Week!