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Economix Blog: Simon Johnson and John E. Parsons: The Treasury’s Mistaken View on Too Big to Fail

Simon Johnson, former chief economist of the International Monetary Fund, is the Ronald A. Kurtz Professor of Entrepreneurship at the M.I.T. Sloan School of Management.
John E. Parsons is a senior lecturer in the finance group at the Sloan School and co-author of the blog bettingthebusiness.com.

At this point, no one will stick up for too-big-to-fail financial institutions. Even Tim Pawlenty, the newly appointed head of the Financial Services Roundtable, a group that represents big banks, contends that we must end the phenomenon of too big to fail. No financial institution should be so big — or so systemically important for any reason — that its failure would jeopardize the macroeconomy.

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The question of the day has therefore become whether too big to fail is already dead and buried or whether, like some resilient and unsavory zombie, it still stalks within our financial system.

In a speech on April 18, Mary Miller, Treasury under secretary for domestic finance, made the case that the Dodd-Frank reform legislation has substantially ended the problem of too-big-to-fail financial institutions. This is a well-composed speech that everyone should read — and then compare with the broadly parallel messages coming from parts of the financial sector (e.g., see the presentation of the Clearing House, an association of banks).

The original written version of Ms. Miller’s speech did not contain footnotes or precise references to the sources on which she drew, but the Treasury Department was kind enough to share this information with us and has now posted a version of the speech with links to sources; this is also most helpful. As a result, we are able to evaluate Ms. Miller’s arguments in some detail.

Ms. Miller’s argument rests on eight main points. On each there is a serious problem with her logic or her reading of the data, or both. Taken together, we find her position to be completely unpersuasive. Unfortunately, the problem of too big to fail still lurks.

First, Ms. Miller makes a great deal (at the top of Page 2) out of legal changes under Dodd-Frank that make it harder to bail out financial institutions. She is right on the formal changes but misses the essence of the issue. The question is not whether the government can swear up and down not to provide bailouts or some other form of support, but rather whether such commitments are credible. If banks are so big or so linked to the rest of the economy that their distress will bring unacceptable costs, then any government or central bank will be tempted to provide support, for example by seeking new legislation that authorizes emergency bailouts.

Ms. Miller stresses the lack of potential future “taxpayer support” — and that is an appropriate point for a Treasury official to make. But sophisticated modern central bankers have many ways to provide help to troubled financial institutions (e.g., through various kinds of asset-purchase programs), while complying with the letter of Dodd-Frank. To assert otherwise is to create the wrong impression.

Second, Ms. Miller claims that “some evidence actually suggests the opposite conclusion — that larger banks’ funding costs are higher than those of their smaller peers” (see Page 2). The Treasury’s evidence on this point is embarrassingly naïve; it compares funding costs irrespective of the source (see Page 11). A small bank funded mostly with insured deposits will have a lower funding cost than a bank that relies more on wholesale funding. But this difference does not speak to the issue of too-big-to-fail implicit subsidies.

The right comparison is what large banks are paying compared with what they would pay if they did not have implicit government backing.

Banks used to be good at measuring this kind of implicit government support, when it provided an unfair competitive advantage to Fannie Mae and Freddie Mac. Now that they (the private megabanks) are the recipients of this largess, they have become much hazier on methodology — asserting that everything anyone tries to measure is awfully complicated.

In a speech at the International Monetary Fund last week, Jeremy Stein, a Federal Reserve governor, acknowledged that too big to fail is not over: “We’re not yet at a point where we should be satisfied,” he said in the third paragraph. The Fed chairman, Ben Bernanke, has recently made the same point. It’s interesting that Treasury should want to confront the Fed on this relatively technical point. This is exactly the kind of issue on which the Fed usually has better information and analysis, and in the current iteration the Fed also seems to have a distinct edge.

Third, Ms. Miller insists that “the evidence on both sides of the argument is mixed and complicated” because of the many factors besides too big to fail that could be the cause of the funding advantage. But isn’t this why we elevate Treasury appointees to such a high position in the pantheon of our officials, because they are supposed to be able to sort out complex issues?

Where is the Office of Financial Research, a unit created within Treasury by Dodd-Frank, on this issue? In her reluctance to take sides or state a clear position, Ms. Miller appears to be ducking (Pages 3-4). This is a disappointing performance by an experienced and well-informed official.

In fact, there is a long list of studies that find various ways to take into account all of the complicating factors and isolate the too-big-to-fail subsidy. None of these are cited by Ms. Miller, but taken together, the conclusion is clear — the implicit subsidy is large and still with us.

One example is a study by Profs. Viral Acharya of New York University, Deniz Anginer of Virginia Tech and A. Joseph Warburton of Syracuse (released on Jan. 1) that measures the funding cost advantage provided by implicit government support to large financial institutions, while controlling for other factors. Credit spreads were lower (because of implicit guarantees) by approximately 28 basis points on average over the 1990-2010 period — with a peak of more than 120 basis points in 2009 (when having access to this subsidy really mattered). In 2010, the last year of the study, the implicit subsidy this provided to the largest banks was worth nearly $100 billion. The authors conclude, “Passage of Dodd-Frank did not eliminate expectations of government support.”

If Ms. Miller contests the methodology or results of this (or any other) study or regards the numbers as insufficiently current, she should request that the Office of Financial Research, the Fed or any other competent government body devise better methodology on the latest available data (or even use the real-time data available to supervisors). The United States government has many smart people, the best available data and the undoubted ability to conduct sensible econometric work (with full disclosure). Five years after the onset of the worst financial crisis since the Great Depression, we should expect nothing less from the Treasury Department.

Fourth, Ms. Miller is very taken with the fact that credit rating agencies have reduced the “uplift” they determine is due to government support for megabanks — i.e., they assign a lower probability of default (and losses for creditors) because there is some form of official backstop. And she makes a great deal of Moody’s saying that it may eliminate uplift altogether. We can debate for a long time about the value of credit-rating-agency opinions, but the striking fact about Ms. Miller’s reference to Moody’s is that it exactly contradicts her on the current situation (see Moody’s report). Moody’s still has a significant too-big-to-fail uplift for big banks.

Fifth, Ms. Miller is adamant that if too big to fail were a problem, we would see low credit-default-swap spreads across the board (for megabanks). But the figure to which she refers (see Page 10) is not persuasive. Look at the pattern of credit-default-swap spreads at the height of the crisis, when the doctrine of too big to fail was undeniably in effect; it is very similar to what we see today. Or hide the date and try to find the magic moment when Dodd-Frank supposedly changed the bailout game.

Sixth, Ms. Miller points out that credit-default-swap spreads have declined since the crisis. That is correct. But all that tells you is that we are not currently in a crisis phase. The real question is what happens the next time large financial institutions mismanage their risks and bring us to the brink of disaster.

Seventh, Ms. Miller asserts that capital requirements have increased “significantly” since the crisis (Page 4). But notice the complete absence of numbers in this part of her speech. How high are minimum capital requirements under Basel III? They are low — a bank could fund itself with 97 percent debt and 3 percent equity and still comply with the rules (see Section 4 in this handy Accenture guide to Basel III, Page 32). In this context, global megabank is a fancy name for a high-risk hedge fund, albeit one with access to the government-sponsored safety net.

Eighth, Ms. Miller points out that banks now have more capital on their balance sheets than they did four years ago (meaning they are funded with more equity relative to debt). This is correct, but it is a completely standard reaction among corporate survivors of financial crises. They are more cautious, for a while. But then they start to push up their return on equity, unadjusted for risk; this is the basis for executive and trader compensation, after all. And the best way to do this is to borrow more heavily, increasing leverage and reducing equity funding relative to their balance sheets (an equivalent way of saying that they borrow more and rely less on equity — in banking jargon, they reduce their capital levels).

It is alarming that Ms. Miller demonstrates no awareness of this well-established historical pattern — or the ingrained incentives in the financial system that make overleveraging hard to avoid.

Over all, Ms. Miller’s speech is completely unconvincing on the substance of the points that she is trying to make. Dodd-Frank alone will not end too big to fail.

It makes sense that senior Treasury officials should want to put Dodd-Frank into effect. But it is disconcerting when they are unable to confront the market and political realities of too-big-to-fail banks. Any such level of denial will not serve us well.

Article source: http://economix.blogs.nytimes.com/2013/04/25/the-treasurys-mistaken-view-on-too-big-to-fail/?partner=rss&emc=rss

Today’s Economist: Simon Johnson: The Impact of Higher Capital Requirements for Banks

Simon Johnson, former chief economist of the International Monetary Fund, is the Ronald A. Kurtz Professor of Entrepreneurship at the M.I.T. Sloan School of Management and co-author of “White House Burning: The Founding Fathers, Our National Debt, and Why It Matters to You.”

The Clearing House, an association of banks, is at the forefront of efforts to prevent further potential restrictions on how large financial firms operate. One piece of the Clearing House-led pushback is a report recently commissioned from Oxford Economics, which purports to show that higher capital requirements would depress economic growth. (The report appeared on the Clearing House Web site last week.)

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Oxford Economics is a well-known economic forecasting firm with corporate and government clients and some prominent economists on its board. Presumably the Clearing House commissioned the report in order to add credibility to what would otherwise be seen as self-serving claims. Should we take this Oxford Economics report seriously and use it to guide policy? No.

There are three major conceptual and factual problems with the Oxford Economics report. Taken together, these issues are serious enough that the report should be given precisely zero weight in thinking about policy.

First, Oxford Economics fails to engage with the central analytical question: why exactly would higher capital requirements be bad for the economy? We know that banks like to borrow a great deal relative to their equity funding — excessive leverage, as it is known, means that the people running banks get the upside when things go well and someone else gets the downside when everything goes badly. Why is it good for the rest of us to allow global megabanks, for example, to generate a high level of systemic risk and a high probability of economic meltdown? This is a form of economic pollution that we could do without. There is no serious discussion of these issues in the report.

Higher capital requirements address this by requiring that banks fund themselves more with equity and less with debt. This creates a bigger buffer that can absorb losses, making banks less likely to fail and less likely to become any kind of zombie. In effect, requiring higher equity makes both their equity and their debt safer. The properly measured funding costs of banks should not increase, although bankers will scream and shout as their subsidies are withdrawn. (We allow tax deductibility of interest payments but not payments to equity holders, so debt is subsidized relative to equity through the tax code. When banks receive a government backstop because they are too big to fail, this is an additional form of implicit subsidy; you cannot see it in the government’s budget but it may be huge.)

In contrast, the Oxford Economics report assumes the answer that the Clearing House has long offered — that funding costs for banks would increase and by a significant amount (see the equation Oxford Economics uses on Page 8). This is not just a questionable assumption; this approach has been refuted at length in the new book, “The Bankers’ New Clothes,” by Anat Admati and Martin Hellwig.

The Oxford Economics report ignores Professors Admati and Hellwig completely, and consequently appears ill-informed about the current state of the policy debate. Professors Admati and Hellwig are central to all the serious discussions I have witnessed recently. The failure to even acknowledge the presence of leading critics of banking industry hardly helps convince the reader that Oxford Economics really wants to evaluate the available arguments and relevant evidence.

Second, the Oxford Economics report almost completely ignores the costs of financial crises, such as the deep recession that followed the downturn in fall 2008. Highly leveraged banks are more likely to collapse and to bring down the economy; avoiding this is the central rationale for capital requirements. (There is some mention in passing on Page 17 and again on Page 18, but in the context of downplaying potential permanent effects of crises.)

As Oxford Economics says says of one study (see Page 17):

A further key assumption is that financial crises have permanent effects on GDP. If this assumption is discarded and only temporary effects are allowed, the estimated net benefits from reform are dramatically lower — and low enough that further alterations to other assumptions might remove them altogether.

To the extent that Oxford Economics is willing to acknowledge there was a big crisis, it plays down the idea that such catastrophes have persistent negative effects (see Page 17-18). This is news to the millions of people who have struggled to find new employment — and to their children, many of whom will suffer long-term consequences in their schooling and later lives. The economic and social damage from deep financial crises and the aftermath is profound.

More broadly, the Oxford Economics team seems blissfully unaware that we subsidize debt through the tax code and through implicit government guarantees. Again, these points are not really mentioned (I don’t even find the words “subsidy” or “guarantee” in the text). In effect, we are subsidizing the production of financial-system pollution. If we cut back on that subsidy, there will be less pollution, which is precisely the point of the policy. In effect, the report provides cost-benefit analysis without acknowledging any benefits. Why would a serious research firm want to take such a position?

Third, the central mechanism for the negative effect of higher capital requirements does not make sense on Oxford Economics’ macroeconomic framework. It assumes that the interest rates charged on loans will go up (see Page 8). However, they are also aware that monetary policy can offset this effect (for example, see Page 33). They assume that the offset is only partial, but why? If monetary policy wants to offset fully, that can be achieved by some combination of conventional tools (like cutting policy-controlled interest rates) and quantitative easing.

Of course, permanently low interest rates are not a goal. Even the Clearing House, in other materials on its Web site, asserts that low rates were a contributing factor in the crisis of 2007 (see Page 13 in this presentation).

So what exactly is the problem? Is Oxford Economics seriously suggesting that higher capital requirements would reduce the effectiveness of countercyclical monetary policy, or make it harder to recover given precisely where we are in the cycle? I find no coherent macroeconomic discussion along these lines in the report, presumably because such a position would make no sense.

The Clearing House is apparently pleased with the report (see this news release and what is prominent on its Web site). But the Clearing House can produce the level of analysis itself with this simple approach on any policy that removes subsidies enjoyed by its members: ignore the relevant literature, assume the costs of removing subsidies are big and pretend there are no benefits to making the financial system safer.

This kind of work would undermine the reputation of any serious consulting firm.

Let me note also that in the context of my exchanges with Oxford Economics, I looked further into how it cites an International Monetary Fund working paper by Douglas Elliott and some co-authors. The Oxford Economics paper refers extensively to this work as an “I.M.F. study” (e.g., on Pages 7, 8 and 38), creating the impression that this is official work somehow representing the view of that institution (at the staff, management or board level).

It is no such thing. A working paper is no more than a paper written by someone with some affiliation to the I.M.F. (and Mr. Elliott was only loosely affiliated; he was not an employee). It in no way represents the views of anyone other than Mr. Elliott and his co-authors. I was chief economist at the I.M.F. in 2007-8) and I’ve checked this point carefully. In fact, I could not find anyone at the I.M.F. who wanted to be associated with Mr. Elliott’s methodology or findings (perhaps I did not look hard enough). Oxford Economics should withdraw the term “I.M.F. study” from its published paper; it is entirely misleading.

Oxford Economics feels that my assessment of its report does not accurately reflect its views. It states that its terms of reference for the report were narrowly limited to comparing the sensitivity of results to assumptions in particular studies and did not constitute a full cost-benefit analysis. This precluded Oxford Economics from considering the issues that I raise above. It does not deny that financial crises can have substantial economic and social costs. Its critique of raising capital requirements apparently should not be construed as opposition to raising these capital requirements. And its read of macroeconomic realities would preclude monetary policy from fully offsetting the effects of increasing loan rates, in part because quantitative easing may not be effective in the future.

I expect that the Clearing House will use this report as part of its campaign to oppose higher capital requirements. If Oxford Economics wishes to distance itself from that campaign, I would welcome the move. But I expect no such development.

Article source: http://economix.blogs.nytimes.com/2013/04/18/the-impact-of-higher-capital-requirements-for-banks/?partner=rss&emc=rss

Economix Blog: Simon Johnson and John E. Parsons: The Treasury’s Mistaken View on Too Big to Fail

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Today’s Economist: Simon Johnson: The Impact of Higher Capital Requirements for Banks

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