Who Would You Rather Trust: Bankers Or Regulators?

from the do-we-have-to-pick-one? dept

Cross-posted from

A simple model of banking regulation and, like, counter-regulation goes something like this:

  • Regulators are conservative and dumb, and want to safeguard banks from bad risks even at the cost of preventing good risks,
  • Bankers are aggressive and smart, and want to take lots of good risks even at the cost of taking some bad risks, and
  • Sometimes bankers can find people to put up with their shit and sometimes they can’t.

“Put up with their shit” is meant in the broadest sense – Can banks defeat Dodd-Frank? Brown-Vitter? Is Lloyd Blankfein a hero or a villain? Jamie Dimon? Etc. – but one particularly interesting question is, if you’re trying to do trades that evade or bend or optimize or whatever regulation, will someone do those trades with you? You could write a history of recent finance with the answer to that question: in 2007 you could chuck all of your mortgage risk off-balance sheet via securitizations, in 2008 you … could not, and in 2013 if you’re looking for someone to provide regulatory capital relief all you have to do is call a Regulatory Capital Relief Fund. Six years peak-to-peak, same as the S&P.

You could probably use words like “bubble” in characterizing that cycle but I prefer the approach taken in this new NBER paper by Guillermo Ordoñez of Penn (free version here), both because it mathematically formalizes that basic model of regulation and counter-regulation in an interesting way, and because it is congenially cynical. As he puts it, “banks can always find ways around regulation when self-regulation becomes feasible, and it is indeed efficient for them to do so.” Bankers, of course, always think that it would be efficient for them to find ways around regulation. They only do so when they can find someone to trade with them.

The gist of the formalization is that banks can invest in “safe,” regulator-approved assets; in “superior risky” assets, which have a higher return than the safe assets for the same risk but which are not blessed by regulators1; or in “inferior risky” assets which have a higher upside but more risk than risky assets and are mainly a way for banks to implement moral hazard. Good banks want to invest optimally and care about the future, bad banks don’t care about the future and sort of maximize moral hazard. How they invest depends on economic fundamentals: if things are good then they invest optimally because there’s no need to take excessive risks; if things are terrible then they want to take excessive risks.2

Banks are constrained by two things. One is reputation: investors will trust a bank with a good reputation – that is, an observed history of taking good risks – and will fund it using unregulated shadow banking. The other is economic fundamentals, which investors can observe too: if fundamentals are bad and everyone knows banks will take excessive risks, then everyone demands the safety of deposit insurance (and regulation):

Why do investors agree on participating in shadow banking if they understand that banks are trying to avoid regulation that provides a safety net against excessive risk-taking? A potential answer is that indeed regulation and capital requirements are useless. However, if this were true, why would investors run from shadow to traditional banking when they become concerned about the quality of collateral?

I argue that reputation concerns lie at the heart of both the growth and the fragility of shadow banking. Shadow banking spurs as long as outside investors believe that capital requirements are not critical to guarantee the quality of banks’ assets, since reputation concerns self-discipline banks’ behavior. When bad news about the future arise, reputation concerns collapse because reputation becomes less valuable, and investors stop believing in the self-discipline of banks, moving their funds to a less efficient, but safer, traditional banking.

Like I said I find this paper very congenial but that’s in part because I feel like some people won’t. It rests in part on the assumption that bankers can observe superior-versus-inferior risky assets, and that regulators can’t. This is pretty intuitive – bankers are paid (more!) to make optimal investing decisions, regulators are paid (less!) to prevent risky investing decisions – and perhaps empirically supported – but, y’know, bankers are wrong sometimes too.

Also fun is Ordoñez’s proposal for a solution that steers between the dangers of unregulated banking and the inefficiency of blunt-instrument regulation:

Another, ideal but unfeasible solution, is to just give a high subsidy to all banks, regardless of their reputation φ, conditional on their repayment of the loans [i.e. conditional on their not defaulting] …. This naturally increases the cost of default for all banks and then allows for more self-regulation. This solution has the same effects as an exogenous increase of μ [i.e. expected economic conditions], but how does one finance these widely available subsidies?

Hahaha that’s “the best way to make banks safer is to give them such huge subsidies that surviving and getting the subsidies is more appealing than taking the risk of failing and losing the subsidies.” That seems … politically challenging,3 and so Ordoñez has some other proposals.4

I don’t know, I stopped there. Today’s bank lobbying – against increased regulation, higher capital requirements, and reduced too-big-to-fail subsidies – seems pretty uninspiring after that, doesn’t it? The real challenge would be convincing regulators that what’s needed are bigger and better subsidies for banks. I’m sure somebody’s working on that.

Sustainable Shadow Banking [NBER, ungated February version]

1. This is the condition “bankers are smarter than regulators.”

2. That is:

For all fundamentals [below some minimum threshold] banks take excessive risk, even if … reputation suffers a lot from taking risks. Intuitively, future prospects are so poor that reputation concerns are irrelevant. Similarly, for all fundamentals [above some maximum threshold] banks invest optimally, even if … reputation does not improve from investing optimally. Here, future prospects are so good that firms are afraid of defaulting and getting a zero continuation value.

3. Though also, like, true? Cf. Gary Gorton on how banks historically accepted regulation in exchange for a “franchise value” coming from their monopoly on banking activity, and how shadow banking erodes that franchise value, as in this summary:

The second insight of Gorton’s on which this paper builds is the importance of statutory franchise value for the business model viability of at least some kinds of regulated financial entities. Where competition from unregulated entities is permitted, whether explicitly or de facto, capital and other requirements imposed on regulated firms may shrink margins enough to make them unattractive to investors. The result, as in the past, will be some combination of regulatory arbitrage, assumption of higher risk in permitted activities, and exit from the industry. Each of these outcomes at least potentially undermines the original motivation for the regulation.

4. Viz. to have bad-reputation banks pay for the subsidy (since they can’t shadow-bank anyway) and give it to the good-reputation banks (who do shadow-bank), which I don’t really understand (how does the regulator measure reputation?) but whatever that’s a minor quibble.

Other posts from Dealbreaker:

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Comments on “Who Would You Rather Trust: Bankers Or Regulators?”

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Jay (profile) says:


I always wonder why people make the economy seem so much harder than it has to be.

We faced this exact problem in 1929 with Hoover who made the mistake of listening to Andrew Mellon:

“Liquidate labor, liquidate stocks, liquidate the farmers, liquidate real estate. It will purge the rottenness out of the system. High costs of living and high living will come down. People will work harder, live a more moral life. Values will be adjusted, and enterprising people
will pick up the wrecks from less competent people.”

People were benefitting from a false prosperity where borrowed money was used to buy stocks and necessities.

The problem was solved by FDR doing something amazing. He changed the tax bracket from 35% to 94%:

FDR and his New Dealers wanted to finance the war equitably, with stiff tax rates on high incomes. How stiff? FDR proposed a 100 percent top tax rate. At a time of ?grave national danger,? Roosevelt told Congress in April 1942, ?no American citizen ought to have a net income, after he has paid his taxes, of more than $25,000 a year.? That would be about $350,000 in today?s dollars.

The year before, steel exec Eugene Grace had grabbed $522,537, over $8 million today, in 1941 salary.

But conservative lawmakers would quickly reject FDR?s plan. Four months later, Roosevelt tried again. He repeated his $25,000 ?supertax? income cap call in his Labor Day message.

Congress shrugged that request off, too. FDR still didn?t back down. In early October, he issued an executive order that limited top corporate salaries to $25,000 after taxes. The move would ?provide for greater equality in contributing to the war effort,? Roosevelt declared.

In other words, forcing the bankers to pay for their mistakes did a lot better for the nation than anything that regulators could do.

Still, the fact is that the financiers have gotten away with running Congress for the last 30 years since they helped to elect Reagan who helped increase the national debt with Voodoo economics. So if we want to pay it down, then we need to just tax the rich and corporations.

You know, the same ones that want the rest of us to tighten our belts while they get all the money? Those austerics are just insane.

Anonymous Coward says:

Re: Re: Re:

The banks were the ones causing the market decline. Neither Bush nor Obama were responsible for the crash when it happened…it was bankers accepting loan applications from people with bad credit ratings.

The Democrats in Congress under Bush, whom held both house and senate, started the bailout process and Obama signed it in…the bailout was supposed to fix the issue but Obama’s spending habits soon kicked in.

Jay (profile) says:

Re: Re: Re: Re:

It was a systemic crash. The bankers did what they did and people, with very money or hope borrowed money to finance their needs and those of a future for their children.

Honestly, we’ve had a crash under every president since FDR where their policies don’t address the needs of the nation.

While that’s happening, we have a capacity utilization rate, or how much technology is being utilized, of 80%. In other words, we aren’t doing anything efficiently.

And no, Obama has not spent money and it’s just amazing how people don’t realize that the government has to spend money to get its way out of debt. You spend more on investments such as roads, bridges, and public services. If you cut those away, the nation suffers.

Anonymous Coward says:

Re: Re: Re: Re:

“it was bankers accepting loan applications from people with bad credit ratings”

Yes – it can all be blamed upon the little people who took out loans they could not afford. You see, this then caused the banks to start selling financial instruments known to be full of risky investments, collaborating with the ratings firms in order to sell them to unsuspecting investors as low risk, shorting the stock of those who bought said instruments …. oh – and did I mention laundering drug cartel money?

Yes, those damn people who were suckered into loans with ridiculous terms – it is clearly all their fault.

“Obama’s spending habits soon kicked in”

LOL, you really are naive. GOP is the party of small government … hahaha that’s a good one. Small enough to fit in your uterus.

Anonymous Coward says:


They are both too incompetent or corrupt to trust. Bankers have had some of the most horrendous lending practices. Regulators have never caught on to them. Worse still, they have done nothing to punish the behaviour. HSBC only got fined for laundering drug money. The LIBOR scandal has only resulted in fines on the order of 1 one-millionth of the money involved. Those rating agencies got away with calling bad debt Triple-A debt by saying “It was only our opinion”.

ChrisB (profile) says:

Re: Neither

The obvious solution to a system with regulatory capture is LESS REGULATION and smaller government. If the government didn’t bail out the bad banks, we would have had severe short term pain, but we’d be out of the woods now. Instead, we have been limping along while the fed dump insane amounts of money into the system trying to shock it to life. All it is accomplishing is a stock bubble.

Speaking of rating agencies, the government made it mandatory that the SELLERS have their crap rated. How does this make sense? If you are buying a house, to you believe the SELLERS home inspector? No, the government messing with the system, then bailing it out is a huge contributor to the problem.

By the way, corporations love regulation. Why do you think no one was charged in the 2008 meltdown? Because all the regulations were followed.

Zakida Paul (profile) says:

I would never in a million years trust the bankers. They are just far too corrupt, self serving and way too powerful.

The problem with the regulators is that they have no teeth, no real power to come down hard on those who do wrong, which I guess comes back to the bankers being far too powerful. It is a sad state when the regulated have power over the regulators.

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