Principles for future financial regulation (updated)

This post by Stephany Griffith-Jones states: “There are two broad principles on which future financial regulation needs to be built.” I agreed with this statement and read with curiosity her principles. I don't think her first basic principle is sufficient. (Her second is pretty similar to my second principle below.) She proposes countercyclical capital requirements. Like the "liquidity charges" proposed here, I think these authors are over-optimistic about the capacity of regulators to make good decisions about things like the price of insurance and the correct dynamic level of capital.

The environment in which regulators operate needs to be remembered: the entities with the most time and energy to communicate with regulators are the regulated firms themselves. This creates an inherent tendency in regulators to under-regulate especially when the economy is stable over a long period of time. The fact that in a crisis the regulators will be blamed for capital requirements that are too low or for under pricing insurance works to absolve financial institutions for their own failures in a way that is totally inappropriate.

In short, the incentives in these schemes are all wrong. When crises occur and financial institutions fail, we need to have a regulatory structure that makes it clear that these failures are completely and entirely the fault of the financial institutions themselves -- for the simple reason that the ones with the greatest ability to prevent the crises are the financial institutions.

I would propose one meta-principle from which two subsequent principles follow:

I. Competition without bankruptcy and failure is not competition.

This principle implies:

(i) All financial institutions that carry government guarantees should be protected from so-called market competition. Banks with deposit insurance need to be considered public utilities: They can earn a rate of return deemed fair by regulators, but will be safe investments with a stable, but never remarkable return. If money market funds are to be brought permanently under the federal safety net, then they will be treated similarly. In this case, we need to recognize that the terms of the “competition” between money market funds and banks will be set by government policy, not by the market.

The logic behind this view is simple: there are certain core functions of the financial system that the government chooses to guarantee. One of these is bank deposits. As long as bank deposits constitute a core function guaranteed by the government, any close substitute for that core function will also end up (possibly ex post) with a guarantee. Example: money market funds.

Thus, it makes no sense for there to be competition in guaranteed core functions of the financial system. The financial sector may be permitted to develop such alternatives, but as soon as they are large enough to compete with the guaranteed core function, the playing field must be evened by charging them guarantee fees and bringing them into the protected financial sector.

(ii) Any financial institutions that are left open to competitive market forces must be allowed to fail on a regular basis. In order to make the commitment to failure credible, the government will probably have to regulate the size of these financial institutions individually, the extent of their liabilities to the protected financial sector, the extent of their (conditional) claims on the protected financial sector and the size of the markets they create in the aggregate. Markets that grow large will have to move to regulated exchanges, so they can be carefully monitored to ensure that they carry no risks for the protected financial sector.

A riff on Knightian uncertainty and asset pricing

jck at aleablog quotes Donald MacKenzie on the Single-Factor Gaussian Copula Model or why simple models survive:

The availability of conceptual equipment can matter even if the theory underpinning the equipment is not understood -software systems allow traders with only a rough grasp of the theory of options or of CDOs to calculate implied volatilities or base correlations- or not believed. Those who do understand the models that are used in such calculations frequently view them as oversimplifications. I have, for example, yet to interview a credit-derivatives trader who regards as adequate the ’single-factor Gaussian copula’ model normally used in credit correlation calculations. Nevertheless, the simple models remain in wide use. More complex models face formidable barriers as communicative tools, because for full communication both parties must be using the same model, and that is seldom the case once one moves beyond simple models. Furthermore, the simple models typically have just one free parameter -’implied volatility’, for example- with the other parameters being either fixed by market convention (CDO pricing, for example, was often done assuming a recovery rate after default of 40 per cent, whatever the corpoaration that has issued the debt in question) or regarded as empirically observed facts. When numbers of free parameters are larger, or parameters do not have intuitive interpretations -as is often the case with more complex models- communication and negotiation become much harder.

This is how I understand this quote: The act of pricing complex instruments in financial markets requires addressing Knightian uncertainty -- or deliberately choosing to ignore its effects on asset performance by using a model that everyone recognizes is oversimplified.

But why would anyone choose to trade an asset that they know is being priced incorrectly? Maybe this is what the broker-dealers are thinking: As long as we can get profits by brokering this stuff, why should we bother worrying about the accuracy of the prices we are putting on our products?

In addition to fees, another advantage of a broker dealer keeping a mispriced market going is that in the instances where the mispricing is so bad that the dealer knows for sure which way the market is mispriced, there's a profit opportunity too. If we assume that arbitrage takes place fast enough then we can assume that when dealers are pricing with oversimplified models, the prices will be kept within the bounds defined by Knightian uncertainty -- if prices get too far out of whack dealers will step in to correct the mispricing. As long as the mispricing lies within the bounds of Knightian uncertainty, dealers will be content to broker the mispriced product to their clients.

Note: jck also links to an excellent Mackenzie article from last year.

Understanding what bankers mean by Knightian uncertainty

In previous posts I have discussed the claim that there has been a sudden increase in Knightian uncertainty since the onset of the crisis. Andrew Haldane of the Bank of England has written a paper that helps explain the origins of this claim:

Each of these market failures has been exposed by events over the past 18 months. When risks materialised outside of calibrated distributions, risk models provided little guidance in identifying, pricing and hence managing them. This failure is not of purely academic interest. The breakdown of risk models is itself likely to have contributed importantly to crisis dynamics. Why?

First, the potential losses arising from under-pricing of risk are large. …

Second, the breakdown of these models had the consequence of turning risk into uncertainty, in the Knightian sense.11 Once the models broke down, how were assets to be priced? Practitioners have a devil of a job pricing assets in the face of such uncertainty. So too do academics, though some attempts have been made.12 The theory of asset pricing under Knightian uncertainty throws up at least two striking results. First, in the face of such uncertainty, asset prices are not precisely determined but instead lie in a range. This indeterminacy in prices is larger the greater is uncertainty and the greater agents’ aversion to it. Second, asset prices exhibit a downward bias relative to fundamentals. Uncertainty gives the appearance of “pessimistic” expectations.

Apparently the reason for this abrupt outbreak of Knightian uncertainty is that bankers have suddenly realized that there is a difference between reality and their models. As long as the world behaves according to model, bankers want to claim that they are earning profits from managing “risk,” and as soon as their models fail, risk becomes uncertainty and necessitates a government bailout.

In short whenever you read that bankers can manage risk, but uncertainty requires government intervention, you should hear: “Privatize the profits and socialize the losses.”

The truth is that bankers always have to price assets in the face of Knightian uncertainty, they have just chosen to spend the last decade pretending that this was not their job.


Note: The difference between Haldane's approach and mine is that Haldane believes that is possible to change the models so that they will be "roughly right," whereas I believe that the fundamental flaw was the belief that any model could be "roughly right." Don't get me wrong. I'm not a Luddite. I don't think we should stop analyzing data using models. I just think that every time you use a model, you need to be aware of the many ways in which it is totally and completely wrong. In short, models are never intrinsically valuable, but careful and constructive human interaction with models can be priceless. Update 2-25-09: Have finally read Haldane with some care. This may not be so much of a difference. Haldane's just talking like a regulator who has to design concrete tests for banks to perform. He might agree that the ideal is to keep updating those tests regularly as regulators' understanding and experience changes (and to keep the banks on their toes).


Update 2-15-09: There is a problem with Haldane's use of the term Knightian uncertainty (and probably with the bankers' use of it). Haldane's paper argues that bankers measured uncertainty incorrectly. He then states "the breakdown of these models had the consequence of turning risk into uncertainty, in the Knightian sense."

This statement confuses Knightian or unmeasurable uncertainty with unmeasured uncertainty. The bankers' models were wrong, they mismeasured risk. The bankers apparently wish to claim that this unmeasured uncertainty was unmeasurable -- that is why they call it Knightian. Haldane by contrast argues that this unmeasured uncertainty is in fact measurable by using a broader range of data and stress testing.

In short, when bankers claim that Knightian uncertainty has increased, they are just trying to make excuses for their own failures. Haldane has recognized the banker's failure to properly model risk, and doesn't appear to be using the term "Knightian uncertainty" in a manner consistent with its original meaning.

Has uncertainty increased?

I was going to put a snarky comment up at Free Exchange in response to the post on economists being absolved by the sheer irrationality of recent market events, but didn't because I thought just maybe there was in fact evidence of an increase in Knightian uncertainty or "unknown unknowns."

The basic argument is this: The market is panicked and irrational. In the face of Knightian uncertainty, consumers and firms are refusing to take on profitable risky opportunities. This has led to a massive market failure.

I guess I'm just too much of a believer in markets to fall for this. It looks to me like we have an overleveraged economy that has experienced the shock that will force it to deleverage. This means that mean economic outlook for both consumers and producers is much worse than it was six months ago. In view of the poor economic outlook, firms are less willing to invest, while consumers are saving more and storing their savings in places where they're pretty sure the principal won't disappear. There's no need for uncertainty to generate either a bad outcome or, in the absence of aggressive policy, a downward spiral.

And then I realized that maybe there really is very little evidence of an increase in Knightian uncertainty. Remember Knightian uncertainty is the one we can't measure (i.e. it's not something as simple as the risk of default of an single firm), so it's pretty much an oxymoron to claim that we have demonstrable evidence of an increase in Knightian uncertainty.

Not only that but today I read Lloyd Blankfein in the FT: Since the spring, and most acutely this autumn, a global contagion of fear and panic has choked off the arteries of finance, compounding a broader deterioration in the global economy. Looks to me like the bankers are going to milk that uncertainty model for every penny they can get out of it.

So I think it's time to talk about some common measures of economic uncertainty that are used: the CDX-IG, or the market's measure of the likelihood that investment grade firms will default, and the VIX, or expected stock market volatility implied by the pricing of options. The basic problem with claiming an increase in these indices as evidence of an increase in Knightian uncertainty is that both of these are simple measures of risk -- they measure known unknowns, not unknown unknowns.

Thus the rise in the CDX-IG is just an indicator that expected corporate default rates have increased. This is a pretty new index, but it is surely perfectly predictable that in every recession the CDX-IG would go up. If it's a good measure of risk, it should probably start to go up before the recession starts and to go down before the recession ends, but cyclicality would simply reflect the normal operation of the economy.

Furthermore a simple review of the VIX formula will show that it's guaranteed to rise markedly when the stock market falls by half. Taking this increase as a sign of Knightian uncertainty is foolish.

Perhaps one would argue that the volatility of the CDX-IG has risen and this is a sign of an increase in Knightian uncertainty. However, the CDX-IG is a very thinly traded contract: According to the DTCC through all of the week ending January 23, there were less than 1700 position increases and 700 position decreases total in the four different vintages of the Markit CDX-IG that traded that week. (Trade in the Dow Jones CDX-IG is much smaller.) In the meanwhile on January 23 there were 16 market makers with on average just over 2,800 contracts selling protection each and on average just under 3,000 contracts buying protection each. In a market with this kind of structure, a large dealer that needs to -- or chooses to -- adjust its position is likely to have a "technical" effect on the market.

That prices would be volatile in thinly traded markets is not surprising. The real question that an increase in volatility raises is: What was going on in the two years preceding the outbreak of the crisis to repress the volatility of the CDX IG? My guess is that that financial innovation was steadily bringing new sellers of credit default protection into the market (such as school districts and Australian towns). As soon as the field of sellers stopped expanding -- and in fact shrank as schools and towns realized how much risk they were taking on -- the CDX-IG rose and its volatility returned to a normal level.

19th v 21st c. banking: What has changed ...

There's one last quote from Lombard Street that I want to record. In reference to the Bank of England's lender of last resort activities, Bagehot writes:

No advances indeed need to made by with the Bank will ultimately lose. The amount of bad business in commercial countries is an infinitesimal small fraction of the whole business. That in a panic the bank, or banks, holding the ultimate reserve should refuse bad bills or bad securities will not make the panic really worse; the 'unsound' people are a feeble minority, and they are afraid even to look frightened for fear their unsoundness may be detected.

Is anybody else wondering whether it's still true that: "the amount of bad business in commercial countries is an infinitesimal small fraction of the whole"?

Why Bagehot wrote Lombard Street

A recent exchange made me think for the first time about the events preceding the publication of Lombard Street. The financial crisis of 1866 had rocked the financial system dramatically without really destabilizing it. But Bagehot saw in that crisis the possibility of total financial collapse. (A detailed description of financial collapse takes up much of Chapter 7, part II of Lombard Street.) For this reason he thought it was important to explain what made it possible for the British economy to survive such brutal storms -- and thus to make it clear to politicians and to the Governors of the Bank of England what their obligations were in a crisis.

After 1844 politicians played an important role in the Bank of England's lender of last resort activities. The Banking Act of 1844 (Peel's Act) restricted the issue of Bank Notes. It was, however, written with an escape clause, allowing the law to be suspended by executive order (i.e. bypassing Parliament). And in every subsequent crisis 1847, 1857, 1866, the law had to be suspended in order for the Bank of England to act as lender of last resort to the banking system. That is, without suspension of the law the Bank would have run out of Bank Notes.

Peel's Act was so controversial that Bagehot states: "Two hosts of eager disputants on this subject ask of every new writer the one question -- Are you with us or against us? and they care for little else." For this reason Bagehot chooses not to take sides in the debate, but instead to explain clearly (without condemning the law itself) why Peel's Act had to be suspended in 1847, 1857 and 1866.

Bagehot's main concern in Lombard Street is to put an end to any controversy over:
(i) the importance of suspending Peel's Act in a financial crisis
(ii) the importance of copious lending by the Bank of England in a crisis.
Chapter 7 is dedicated to explaining that public uncertainty about either of these two actions in a crisis is dangerous. He concludes:

The best palliative to a panic is a confidence in the adequate amount of the Bank reserve, and in the efficient use of that reserve. And until we have on this point a clear understanding with the Bank of England, both our liability to crises and our terror at crises will always be greater than they would otherwise be.

Note the subtle reference to Peel's Act in the first sentence. Bagehot avoids controversy, but makes his point clear. In the second sentence he calls on the Bank to publicly acknowledge its role as lender of last resort to the financial system.

One thing needs to be emphasized: Bagehot is concerned about uncertainty -- but that uncertainty references explicitly whether or not a lender of last resort exists and will step in to provide liquidity in a crisis. Thus Bagehot wants the Bank of England to reduce uncertainty in the financial system, but only by promising to lend copiously against high quality assets.

He is entirely at ease with the fact that the Bank of England allowed Overends Gurney, a systemically important bill broker, to fail despite the fact that the failure rocked the financial system with uncertainty, as illustrated by the following two quotes:

In 1866 undoubtedly a panic occurred, but I do not think that the Bank of England can be blamed for it. They had in their till an exceedingly good reserve according to the estimate of that time—a sufficient reserve, in all probability, to have coped with the crises of 1847 and 1857. The suspension of Overend and Gurney—the most trusted private firm in England—caused an alarm, in suddenness and magnitude, without example.

no cause is more capable of producing a panic, perhaps none is so capable, as the failure of a first-rate joint stock bank in London. Such an event would have something like the effect of the failure of Overend, Gurney and Co.; scarcely any other event would have an equal effect.

Thus, Bagehot does not argue that the lender of last resort should act to eliminate general uncertainty, he argues only that a lender of last resort should eliminate uncertainty about the actions it will take in the midst of a financial panic.

Learning from the Crises of 1857 and 1866 Continued

In my last post I never did get to the parallels between 1857/66 and today. First of all note that in 1857 Gurneys was a huge player in the money market and thus in 1857 when the Bank of England lent £9 million to the bill brokers, you can expect that at least £2 million and possibly as much as £4 million went to Gurneys.

In other words the Bank of England probably saw evidence that in a crisis the line of credit it was giving to an individual firm was becoming unreasonably large. Even if all the bills discounted at the Bank by Gurneys were good quality bills at this particular time, the Bank was opening itself to a future problem where reliance on the careful management of Gurneys allowed low quality bills to be discounted at the Bank and thus exposed the Bank to significant credit losses. As the Bank was a private institution, it had an obvious interest in limiting it's exposure to the credit risk of a single firm or to the credit judgment of a single underwriter of commercial bills.

In fact, it was precisely the ultra-conservative management of the Bank of England that created the trust necessary for the Bank to be relied on as a lender of last resort:

The great respectability of the directors, and the steady attention many of them have always given the business of the Bank, have kept it entirely free from anything dishonorable and discreditable. Steady merchants collected in council are an admirable judge of bills and securities. They always know the questionable standing of dangerous persons; they are quick to note the smallest signs of corrupt transactions; and no sophistry will persuade the best of them out of their good instincts. You could not have made the directors of the Bank of England do the sort of business which 'Overends' at last did, except by a moral miracle—except by changing their nature. And the fatal career of the Bank of the United States would, under their management, have been equally impossible. Of the ultimate solvency of the Bank of England, or of the eventual safety of its vast capital, even at the worst periods of its history, there has not been the least doubt.

Thus, in 1858 the Bank put in place a policy that only allowed bill brokers access to emergency credit by exception. The purpose of the policy was to force bill brokers to keep their own reserve, or in other words to be prepared to act as their own lenders of last resort.

Thus, faced with financial innovation and the growth of an extremely large, highly leveraged firm closely intertwined with the banking system, the Bank of England immediately made it clear that it did not support the growth of this firm. It set a policy: if financial innovation was going to allow huge firms to develop, then those firms should be prepared to support themselves through a crisis.

One obvious consequence of this policy is to push the bill brokers to reduce their leverage ratios and thus reduce the likelihood that they will (i) need the services of a lender of last resort and (ii) cause a financial crisis by failing. In short, even though the Bank of England had no regulatory authority whatsoever over the financial system, the fact that it was the lender of last resort meant that its policy decisions affected the stability of the financial system by affecting the leverage in the financial system.

Contrast the behavior of the Bank of England in 1857-8 with the behavior of authorities in the US after the 1987 investment banking crisis. In 1987 the stock market crash could have led to the complete collapse of the investment banking industry were it not for the actions of the New York Federal Reserve President (who basically told the commercial banks to give the investment banks unsecured loans). Notice that at the moment of the 1857 and the 1987 crises both central banks took aggressive action. The difference is in their behavior after the crisis was over. The Bank of England immediately acted in a manner that would push the firms that were endangering the financial system to reduce their leverage ratios and be less reliant on the Bank of England in the future. By contrast, the Federal Reserve stood by without objection when Congress extended it's authority to permit it to lend directly to the investment banks in the 1991 FDICIA law.

In other words the two Banks took diametrically opposed actions: that of the Bank of England would tend over the long run to decrease the leverage of financial institutions and thus decrease the risk of financial instability, whereas that of the Fed tended to increase leverage and increase instability over the long run. Observe, however, that the short run effects of these different policies were precisely the opposite of their long run effects.

The willingness of the Bank of England to let a bill broker fail was tested within a decade. Overend and Gurneys actually made the decision easier by being the subject of rumors (which turned out to be well founded) for over a year before they finally turned to the Bank of England for aid in 1866. (The Economist wrote at the time "the failure of Overend, Gurney and Co. Ltd. has given rise to a panic more suitable to their historical than to their recent reputation." Victor Morgan, 1943) Despite their size, the Bank of England did indeed refuse to discount their bills -- and the result was a financial crisis that matched the worst in living memory.

On the other hand, no further failures threatened to rock the market until 1890, when Barings' exposure to South American loans could have resulted in failure and a major crisis. The potential losses were so great that the Bank of England refused to intervene directly, but it did broker a joint support from the other large banking houses. Overall, however, England's financial system was remarkably stable from 1866 up through 1914 (the year which marked the beginning of the end of the gold standard).

By contrast the Federal Reserve's policy of bringing the investment banks under their wing forced the Fed in 1998 to extend the safety net even further. When the Fed brokered a bailout, it was not a bailout of a systemically important bank, it was the bailout of a hedge fund. In hindsight it's extremely easy to see that the fact that a hedge fund had grown large enough to be systemically important was a clear sign that the financial system was dangerously overleveraged.

If the Fed had been a private bank like the Bank of England in 1857, at this juncture it would have made it clear to all members of the financial system that its balance sheet could not support the liabilities that were growing. It would have told them that they needed to start paying attention to their own reserves by dramatically reducing their leverage ratios.

Instead, the calming effects of an endless sequence of government bailouts of the banking system (Continental Illinois in 1984, Brady Bonds in 1989, low interest rates to ease the burden of bad debts in the early 90s, the late 90s and early noughts) left the Fed with the illusion that financial instability was no longer a problem that needed to be addressed, while at the same time fostering an accumulation of dead wood in the financial system that ensured that the resulting conflagration would be beyond all imagination.

In short, while the Bank of England in 1858 was willing to precipitate a crisis in order to foster stability, the Fed in the 1980s and 90s fostered the illusion of stability, while at the same time creating an environment where crisis was inevitable. Thus, just as the forest manager is better off allowing small fires to flare up regularly, so a central banker is better off precipitating small crises to avoid a disastrous and uncontrolled burn.

Learning from the Crises of 1857 and 1866

I've been rereading Lombard Street, this time reading it as a history of the money market in mid-nineteenth century England. There are some very, very interesting parallels to the current crisis.

In particular, the period (after the passing of the Bank Charter of 1844) was one of remarkable financial innovation. On the one hand, banks that had initially issued circulating notes adapted to the new environment by converting to deposit banks and eventually offering checking accounts. On the other hand, new bank like financial intermediaries were developing. Bagehot calls these financial intermediaries bill brokers, and elsewhere they are called discount houses. In any case, as Bagehot makes clear bill brokers, that in the past were pure brokers matching savers with credit-worthy borrowers, had become intermediaries who guaranteed the bills that they placed in large quantities with banks. This was a tight margin business where the "brokers" borrowed most of their capital from these same banks and thus they were essentially earning money on spreads and the value of their highly specialized knowledge of the quality of commercial bills. Aggressive competition meant that it was not profitable for these brokers to maintain reserves (i.e. capital) to back up their guarantees. Instead the bill brokers relied on the Bank of England's discount policy: Even in the worst of crises the Bank was expected to discount good bills at Bank rate.

In the crisis of 1857, the Bank of England advanced more than £9 million to the bill brokers and only £8 million to bankers. After the crisis, the Bank stated a new policy which restricted the Bank tranactions of the bill brokers to advances which were only offered on a quarterly basis. Should the brokers need discounts at any other time, they would have to ask for an exception to the Bank's policy. The stated goal of the policy was to make the brokers "keep their own reserve."

Needless to say, the bill brokers were unhappy with the new policy. Gurneys, which controlled more than half of the commercial bill market and was in many ways a competitor of the Bank of England, apparently tried to start a run on the Bank in April of 1860 by withdrawing from its deposit account an outrageous sum of money all at once. (While Bagehot claims the sum was £3 million, other sources cite a figure of £1.65 million.) This action was roundly condemned in the press.

In the meanwhile Gurneys was being poorly run by a second generation of the family. As badly underwritten bills went into default, the company advanced money on mortgages and even ended up running a fleet of steamships -- also unsuccessfully. By matching short term obligations with long term assets, Gurneys violated one of the most fundamental principles of 19th century banking. This explains the strong words Bagehot uses to describe the company:

The case of Overend, Gurney and Co., the model instance of all evil in business, is a most alarming example of [the] evil [of a hereditary business of great magnitude]. No cleverer men of business probably ... could well be found than the founders and first managers of that house. But in a very few years the rule in it passed to a generation whose folly surpassed the usual limit of imaginable incapacity. In a short time they substituted ruin for prosperity and changed opulence into insolvency.

In 1865 before all of Gurney's problems were public knowledge, the partners took the firm public, creating Overend, Gurney and Co. While this action required the Gurney family to guarantee the new firm against losses on the business of the old, presumably it was hoped that new capital would save the firm. Unfortunately the losses were so great that the Gurneys had to liquidate their personal property and news of this event caused a run on the Company. Those who had bought shares in 1865 ended up losing £2.9 million. (Because they had only paid 30% of the face value of their shares, they had the misfortune to face a capital call in order to satisfy obligations to creditors -- who were paid in full.) The lawsuit that followed this failure found the Gurneys' actions to be incompetent rather than fraudulent and they were acquitted. (Ackrill and Hannah, 2001, Barclays: The Business of Banking, 1690-1996, p. 46-7)

Because many London banks were exposed to Gurneys, there was a run on the London banks and many solvent banks, such as the Bank of London, failed. Wikipedia claims that in the crisis that followed there were a total of 200 bank and commercial failures. By any standard the crisis was severe. In particular because London held large foreign deposits that were slow to return after the run, the Bank of England was forced to keep the Bank Rate elevated for a full three months -- which undoubtedly aggravated the domestic consequences of the crisis.

It was, however, a watershed because for the first time the Governor of the Bank of England publicly acknowledged "a duty ... of supporting the banking community", that is, he acknowledged that the bank was the lender of last resort to the banking system. (While the Bank had been playing this role for almost a century, it often did so with reluctance and heretofore had never publicly recognized the role as an obligation.)

For this reason, Bagehot repeatedly treats the Bank of England's actions in 1866 as the model for a lender of last resort. A few points are worth mentioning:

(i) In Bagehot's time, it was exceptional for lender of last resort activities to last more than a few weeks. Frequently the simple fact that they were available (e.g. a lifting of government restrictions) was enough to end the panic.

(ii) A lender of last resort is not expected to prevent the failure of a systemically important bank. On the contrary, Overend, Gurney and Co. was systemically important, but it was also so badly managed that the Bank of England could not be expected to discount its paper.

(iii) A successful lender of last resort action will leave the bulk of the financial system standing (i.e. at least say 75% to 90% of the banks). Bank failures -- even large numbers of bank failures -- are part of a typical lender of last resort activity.

(iv) The government should never support a bad bank; such action could only serve to prevent the development of good banks.

So long as the security of the Money Market is not entirely to be relied on, the Goverment of a country had much better leave it to itself and keep its own money. If the banks are bad, they will certainly continue bad and will probably become worse if the Government sustains and encourages them. The cardinal maxim is, that any aid to a present bad Bank is the surest mode of preventing the establishment of a future good Bank.

Update: This post is continued here.

Solutions to the CDS overhang

Solution 1: My first thought was this: Since too many of the dealer-counterparties can't honor their commitments and a chain of failures is the necessary consequence, there's nothing to do but nationalize all the dealer banks and, by aggregating them, wipe out their commitments to one another. However, since JP Morgan seems to have been relatively conservatively run, this is somewhat unfortunate. I imagined a conversation between Geithner and Dimon as follows: "Look, you prepared for a crisis, just not this crisis. I'm sorry we've got to nationalize JPM, but we do have a consolation prize: How would like to manage the great stinking bankpile as your government portfolio?"
(Look, Ma, bank's a four-letter word. Hoocoodanode?)

Solution 2: But then I went for my weekend jog and came up with what I think is a much better solution. Before buying or guaranteeing toxic assets, the government should require participation fees from the banks on the following basis: For each participating bank the Fed should sum the absolute value of the bank's net notional positions over each category of CDS. Let's call this number the bank's non-dealer position. The participation fee should be the non-dealer position (possibly after subtracting off the lowest non-dealer position, so that one dealer bank is guaranteed to pay nothing). The government may choose to finance this fee as a preferred stock-type loan.

What is the advantage of the non-dealer position fee? Two types of banks are creating chaos in the markets: those that guaranteed debt they could not afford to guarantee and those that ignored the dangerous exposure of their counterparties and bought insurance that they knew (or should have known) could only be honored if the government intervened in the market. Both sides of these trades were toxic. On the other hand, any bank that actually behaved as a dealer and thus carefully maintained offsetting positions in each market will find that its non-dealer position is small. This latter type of bank was relying only on the market continuing to function, not on being able to extract money from a government bailout. After paying the fee, every bank is entitled to government protection on it's CDS portfolio either via sales or insurance.

Thus the non-dealer position fee can force the banks that were engaging in the toxic aspects of the CDS trade to bear the costs of the bailout. Will these banks refuse to participate in the toxic asset purchase/guarantee plan? Possibly, but if so they can be required to mark their books to market and will most likely be nationalized due to insolvency. (If too many banks refuse to play ball, the government can "buy" the CDS from the true dealer banks and then play hardball with the CDS counterparties.)

How is that asset guarantee program s'posed to work?

What makes anyone believe that the troubled banks can afford to pay a reasonable insurance premium on their toxic assets?

For example, the NYT has an article describing one MBS. The MBS is composed of 9,000 second lien mortgages and let's assume that the face value of each averages a little over $50,000 so the total value of the MBS (all tranches) is $500 million. Given the valuation the bank puts on the bond, this may well be the senior tranche, so let's assume the bank has a $250 million senior exposure to losses on these mortgages (i.e. the portfolio needs to lose half its value for the bank to lose a penny). The article states that the bank carries this bond at 97 cents on the dollar or $242.5 million.

However, as anyone who follows the mortgage market knows, second lien loans suffer very badly when housing prices fall dramatically -- because in case of foreclosure there's unlikely to be anything left for the second lien holder. Therefore there is some significant probability that a very large number of these mortgages go into default -- with a recovery of zero.

That's why S&P stated that in their worse case scenario the value of the bank's tranche was worth just 53 cents on the dollar or roughly speaking that only $132.5 million of principal will be recovered (assuming $500 million of loans and a senior tranche of $250 million). Let's say there's a 20% probability that this worse case scenario materializes.

In this case the insurance premium collected by the government insurer of the senior 90% losses of this particular tranche needs to be well over 0.20 ($242.5 - $132.5 - $24.25) = $17.15 million (since a full analysis would not assume that with 80% probability losses are less than $24.25 million and therefore cost the government nothing). In other words for assets of this quality the bank would have to pay significantly more than 7% of the face value of the assets as a premium. Spreading this premium over five years would result in a charge that would have to be well over 1.4% of face value per year.

By contrast in the Bank of America deal that is being used as model for this type of insurance the Fed is charging only 0.2% per year in premiums. Of course, the correct premium depends on what's in the portfolio -- which is not public information -- but it is certainly possible that the Fed is charging only a fraction of a fair market premium for the insurance policy.

If the Fed follows the policy reported in the press of insuring the assets that haven't been written down yet (but like the bond in the NYT article should have been written down), then either the premiums need to be very high relative to the face value of the assets or the government will end up tranferring massive amounts of value to the banks and their shareholders.

In short, if paying banks a fair price for their bad assets is likely to render them insolvent, then charging a fair insurance premium for those assets is also likely to render them insolvent. The only "advantage" of insurance over the purchase of the bad assets is that the government gets to duplicate the outrageously stupid behavior of our bank managers -- they get to make optimistic estimates that indicate that the losses will never show up -- until they do.