Potential Smartism #2: The Spinning Top Theory of Financial Regulation

Regulation sets the underlying playing field for everything we know and understand about finance. Yet regulation seems to generally follow a pattern: something happens, regulation is put in place to stop that thing from happening. Something else happens, something else is put in place to stop that other thing from happening. Little thought seems to be given to whether the regulation from the first thing caused the second thing (“were always fighting the last war” syndrome). I’m not cynical enough to think that regulators really don’t think of the bigger picture or realize that there are unintended consequences to regulations, but there have been curious decisions made. I wanted to take a Modigliani and Miller approach in terms of thinking of everything as frictionless, open and perfect first, then layering real world impacts on top of this theory world.

The Theory

In a nutshell this theory is that there is a spinning top on a flat table. There are a ton of moving parts and forces in play, but as long as it’s on a perfectly flat surface, it’s stable. That’s the market with no frictions and perfect transparency. When frictions are introduced they create either lumps, which move the top towards a certain subsection in the market at the expense of others, or they create holes, which trap the market at a sub-optimal level. Regulators then take actions to either prop up these holes or tamp down these lumps. Often these actions have unintended consequences and overcompensate, creating new lumps / holes elsewhere to ensare our fragile spinning top.

Spinning Top - Flat Table

The perfectly flat table involves no saving of any institutions no matter how large (though no bankruptcy costs either), no restrictions on mergers, no deposit insurance, no leverage limits, no interest rate changes from central banks, no lobbying for laws to be changed to benefit financial institutions, no minimum wage, no government set consumer protection standards on mortgages, no government insurance for mortgages etc. If you want to sell a crappy mortgage that’s fine, but you’re responsible for the loan. If you want to securitize it that’s fine too. But in a world of rational actors who understand the inherent risks, you will need to pay interest commensurate with the risk and only get the transaction spread. Everyone will completely understand risk and their own tolerances and think in 50 year increments and unicorns will explode from the treetops in their majestic glory. It’s my theory I can have what I want in there. Point is, we’re in theory land here and this flat, completely unregulated market is a good place to start.

Then one day, into theory land comes a shady dude named Todd (no one awesome is named Todd). Todd has some insider information, say knowledge of an impending merger, and elects to trade on it. Suddenly our market isn’t perfectly transparent anymore and our table isn’t flat it’s got a lump in it! A lump that is shooting our top towards stupid Todd!

Spinning Top Model - Todd #1

Now in a properly functioning regulatory system, an independent, rational body would take steps to restore transparency to the market. Let’s consider two options:

  1. Force all merger talks to be held in a public setting. No more non public merger information for Todd to trade on! Todd lump removed! But clearly this creates a whole other bunch of lumps (or holes). For instance giving away competitive secrets, minimizing any bidding tension, messing with employee morale, etc etc. There are many good reasons that merger talks are held in the strictest confidence and legislating that they all be public would effectively kill the merger market, which is a huge part of the efficiency of our perfect flat table up there. But then you can’t have a moribund merger market! You need to do something to stimulate it! Maybe we lower interest rates? Maybe we offer a government backstop on bridge loans to spur demand? Etc etc. You get the point.Spinning Top Model - Todd #2 (Hole)
  2. Make insider trading illegal. If the threat and enforcement is believable, the market should have faith that everyone is trading on the same information. This introduces monitoring and enforcement costs, people might get around it and it might reduce liquidity, but overall there seems to be a way to detect it and a way to stop it. The Todd lump is removed, with limited additional lumps / holes created.Spinning Top Model - Todd #2 (Lump)

Obviously choice #1 is the better way to return the market to its flat state right? But we’re assuming regulatory independence and rationality here (remember our 50 year time horizons and perfectly rational actors? ….and unicorns?).

Consider a politician who is up for re-election. Rather than trying to explain to voters how an insider trading law would work and how that would protect them (complicated!), they blamed the Todd lump on “shady corporations making back office deals to get richer! Why do they need secrecy if they have NOTHING TO HIDE?!?!” (simple!) Whether the politician is just pandering for votes or truly believes that rhetoric themselves is up for debate, but ultimately irrelevant if the policy gets enacted. So for an independent, omnipotent, economically rational regulatory body, the decision is simple. But when real world limitations and politics get thrown in, anything can happen (and then un-happen……then happen again…..).

Real World Application

Now think of a full regulatory system like the US. Ever since they turfed the centralized Second Bank of the United States in 1836 they’ve ended up with a fragmented, state level, individualistic banking system. With this comes a ton of conflicting regulatory bodies. They also have very aggressive politics that can tend towards populism. They’ve also regulated and partially deregulated in a dizzying cycle since the formation of the country. I can’t even begin to imagine how far away they are from our perfectly flat table up there, but we gotta start somewhere!

Let’s look through a real world example in terms of “the narrative” and also in terms of our Spinning Top Model here. We’ll use Glass Steagall and its subsequent repeal.

The enactment

Glass Steagall was introduced in 1932 in reaction to the perception that investment banks, when combined with commercial banks, took on too much risk and caused the 1929 melt down (this is the super summary version). It was comprised of two parts:

1. Legislation that broke up the banks and forced investment banks to operate independently of commercial banks.

Narrative: The banks are too powerful and too ingrained in the economy. This would restrict investment banks from using retail deposits to fund risky operations. With a lower capital base, the investment banks would have to reduce their scope of operations and risky activities.

Spinning Top Model: The transparency of the market had been compromised by a network of extremely connected bankers who sat on everyone’s boards. Insider trading was rampant and the resulting lump moved the market towards certain financial institutions and people. Forcing the investment banks to be smaller would help reduce some of their influence by reducing the number of companies they were involved in, but this seems to be an ancillary effect rather than a direct one. Though not explicitly part of Glass Steagall, insider trading laws enacted in 1934 helped tamp down on this lump as outlined above (with loser Todd).

The interesting part is that, assuming a perfectly flat and transparent table with equal upside and downside, there doesn’t seem to be any other lump that needed to be solved by breaking up the investment and commercial banks. If consumers recognize that their deposits are being used for risky activities they can either demand to be compensated more for their deposits, or move them to a traditional commercial bank that doesn’t undertake those activities. These retail deposits can be taken out on demand so there is no reason for them to be loyal to an institution. As the investment banks take on more risk, the supply of capital should reduce commensurately and in a short period of time. (Note: fully recognize this is a simple treatment of an extremely complex and touchy topic).

What removing this source of funding from investment banks DOES do though, is make them artificially small. Artificially small intermediaries have an artificially small amount of capital that can be put into activities necessary to our perfect flat table up there. These are activities like underwriting IPOs, doing bond issuances and re-distributing risk. With this artificially restricted capital, deals that are economically viable may not get done and you create a hole in the table.

2. Glass Steagall created the Federal Deposit Insurance Corporation, which guaranteed commercial bank deposits up to a certain threshold.

Narrative: This would guarantee the solvency of banks and prevent any future runs on the bank. Banks will be secure and you can sleep at night knowing your money is safe.

Spinning Top Model: Panics created by runs on banks were distorting the perceived level of risk upwards causing much greater economic pain than necessary given the conditions. This would create a hole, which the top falls into. The FDIC pushes up this hole so that ideally there is no excess loss, only what is economically rational.

However the FDIC also creates lumps in that consumers no longer face a symmetrical return profile. They get all the upside with no downside so there is no incentive to monitor the institutions they put their money into (moral hazard). There is also no incentive for the institutions to manage their risk, knowing that people will never remove their capital from their bank (moral hazard). This creates lumps that tilt the top towards the banks and depositors and away from the tax payer.

So recognizing this tension, the line of questioning becomes:

Is the hole created by panic bringing down healthy institutions bigger than any potential future lumps / holes brought on by the moral hazard introduced from the FDIC?

If it’s not then is there a better way to counter the excess economic loss problem with either no negative externalities or at least ones that don’t outweigh the benefits?

If not then can we politically do nothing and let the occasional panic take down a healthy bank?

Banking is a confidence industry. If an institution inspires so little confidence that people are lining up in the streets to demand their money back, then maybe that bank should change the way it runs its operations?

We’ve forced banks to be small and local so maybe we should remove the restriction on interstate banking so that banks can have cash flows from all over the country instead of being totally reliant on one area?

That reduces the potential hole from panics, but what new lumps or holes would interstate banking bring on? Potential oligopoly concerns if they grew too big?

Etc etc etc

I obviously wasn’t there, but I doubt that this was the kind of dispassionate conversation that was taking place in 1932 in teh depths of the great depression. Again here the narrative (your money is safe!) is much easier to sell to the public than understanding the underlying lumps and where new ones form if you squeeze out the obvious ones. Plus the FDIC fixes things now (within your term of office), while the pain from moral hazard will take decades to come home to roost.

The Repeal

Fast forward now to 1999 and the official repeal of Glass Steagall. Though Glass Steagall had been getting chipped away for years, the Graham Leach Bliley act officially wiped it out in 1999. Investment banks were free to own commercial banks again, but the FDIC persisted…. (cue the ominous music)

Narrative: Look at how free market we are, we’ve gotten rid of these restrictions!

Spinning Top Model: The separation of commercial banks and investment banks created small investment banks and relatively risk averse, traditional commercial banks. Inefficient and keeping the top in a hole, but relatively safe. The moral hazard lumps created by the FDIC didn’t have a huge impact because there generally wasn’t that much risk that needed to be managed by consumers / the FDIC insured institutions.

Now though, investment banks were able again to purchase these commercial banks AND their federally insured deposits. Prior to Glass Steagall a consumer was responsible for monitoring their deposits and either demanding higher interest rates or withdrawing their money if the activities of the institution got too risky. The FDIC removed this incentive. By doing so they  created a system where investment banks had essentially risk free, taxpayer backed funds to collateralize the riskiest (and most profitable) of activities (derivatives, proprietary trading). The reunification of investment and commercial banks unleashed the moral hazard issues and created a lump that tilted the top towards the banks and away from the tax payer.

Fast forward to the aftermath of the 2008 crisis and the narrative becomes “you never should have repealed Glass Steagall! Look at what it caused!! De-regulation is the worst let’s re-regulate everything!”. This would be partially right, but it’s not that de-regulation itself caused these issues, it’s the stuff that was left over from previous regulation. If you create a lump (moral hazard from FDIC), then create an opposite force that tamps that lump down (separating IB and CB), but then only repeal one of them….. you can kinda see where the spinning top ends up.

This type of thinking can be applied to the housing crisis as well. The government started backstopping mortgages for lower income families for political reasons, then never removed the punchbowl and ended up artificially distorting the risk downwards for an entire mortgage market. A full narrative vs. Spinning Top model treatment for housing would be a worthwhile undertaking. This actually ties in with my Potential Smartism #1 theory on bubbles: they need a lump to get started.

Overall this is a massive simplification of a controversial, complex century of American legislation and politics, but sometimes simplifying and starting from nothing allows you to cut down to some interesting issues!


2 thoughts on “Potential Smartism #2: The Spinning Top Theory of Financial Regulation

Leave a Reply

Fill in your details below or click an icon to log in:

WordPress.com Logo

You are commenting using your WordPress.com account. Log Out /  Change )

Google+ photo

You are commenting using your Google+ account. Log Out /  Change )

Twitter picture

You are commenting using your Twitter account. Log Out /  Change )

Facebook photo

You are commenting using your Facebook account. Log Out /  Change )

Connecting to %s