Streetwise Professor

October 18, 2012

Do as O Says, Not As He Does

Filed under: Military,Politics — The Professor @ 11:59 am

Bloomberg has a very long article about the Obama Administration’s use of the World War I-era Espionage Act to go after leakers.

This is jawdropping, when you also consider the outrageous and highly damaging leaks about natural security emanating from the very highest levels of the administration (e.g., leaks about Stuxnet).

I guess the operative rule is that leaking is OK if it makes Obama look like a warrior stud.  If not: hope you like the weather in Leavenworth (and that’s assuming you get yard time).

October 17, 2012

Ignorance Plus Arrogance on Energy

Filed under: Commodities,Economics,Energy,Politics — The Professor @ 12:53 pm

The jaw-to-jaw square up moment during last night’s Presidential Debate was over energy policy, of all things.  Politicians discussing energy is usually less than edifying, and last night was no exception.  But Obama took the prize for ignorance, complete with a huge dollop of arrogance-always a charming combination.  But it is his métier, non?

Specifically, in response to Romney’s attacks on administration policy regarding drilling leases on public land, Obama lauded the administration’s move to “use-it-or-lose-it” leases.  So let’s get this straight, absent his genius, oil companies would spend money to buy leases, and just sit on them out of spite?  Or something.

A lease is essentially an option.  It is an option to explore, develop, and produce.  There is optionality within each of these steps.  For instance, a leaseholder can undertake some preliminary exploration, and conditional on the results of that, decide to engage in additional exploration.

The value of this option depends on its maturity.  It also depends on the uncertainty regarding the geology.  Crucially, it depends on market prices-the price of oil or gas, the price of inputs needed for exploration, development, and production.  It also depends on the volatilities of these prices-which is true of any option.  It also depends on the amount of time required for each “sub-option”, e.g., each step of the exploration process.  This depends on the particular property at issue.

Use-it-or-lose-it basically means to shorten effective lease terms.  This reduces the value of the option.   By how much depends on all the factors I just mentioned.

So to the extent that “use-it-or-lose-it” means anything, it means that the administration is shortening the effective maturity of leases.   This reduces the value of the option . . . which reduces the amount companies will pay for leases . . . which reduces government revenue.  So Obama is bragging about a policy that reduces government revenue.  Got it.

Indeed, some companies will figure the leases are worth zero under the restrictions.  So leasing will decline.

There’s another way to see why this policy is so wrongheaded.  The E&P business is pretty competitive.  And E&P companies are not in the business of leaving money lying around.   If there’s money to be had by leasing a property and developing it optimally, a lot of companies will compete to do that.  In this competitive environment, lease prices will reflect pretty well the value of the property and the value of the options to develop it.  Inefficiently constrain those options, and competition will force down the prices of leases.

But we know that Obama has no clue as to how businesses, competition, and markets work.  This is just another superfluous data point in that empirical exercise.

That’s not all.  When you look at output, and the pattern of output over time, inefficient restrictions on the terms of options will lead to lower production, and inefficient exploitation of resources over time.  Some resources will be developed too quickly.  Others too slowly, or not at all.

This will, in turn, tend to increase prices.

And a bonus: inefficient production of hydrocarbons fro public lands will reduce government royalties from production.  Another revenue hit.

In summary: Obama bragged about a policy that is completely counterproductive.

But he is the smartest president EVAH.  Just ask him!

Idiocy updates: Some other Obama energy gems from last night.

The complete dodge on the Keystone XL pipeline:

And with respect to this pipeline that Governor Romney keeps on talking about, we’ve — we’ve built enough pipeline to wrap around the entire earth once.

That’s called bait-and-switch: asked about one thing, he answers about something else.  Furthermore, the other pipelines are neither here nor there.  Keystone should be evaluated on its own merits, which are quite strong.  And who is this “we” he is talking about?  Are he and Valerie and Michelle moonlighting on pipeline construction crews?

Favoring throwing good dollars after bad renmibi and Euros.  With respect to renewables, he said:

Because China, Germany, they’re making these investments. And I’m not going to cede those jobs of the future to those countries.

Yeah, they’re making these investments.  And losing money hand over fist on them.  Note to Barry: you don’t gain “jobs of the future” by taxing people engaged in wealth-creating activities to pay subsidies to those who engage in wealth-destroying activities.  Yeah, you might see the guy working on the wind farm (but don’t look at the dead bats!) but you don’t see the people who aren’t working, or who are working less, or who are working less productively because of the deadweight losses of taxes needed to finance the Green Unicorns.

It is beyond pathetic that solar companies-in China, the US, German, Spain, wherever-can’t make money even if they are subsidized.

This is something to imitate?  No.  This is something to observe-and avoid like the plague.

But the Genius President knows bettah.

October 16, 2012

Pick Your Poison

This afternoon I attended the Working Group on Financial Markets at the Chicago Fed.  The scintillating topic was segregation models.  Really!  It was scintillating!  For a certain kind of geek, of which I am one.

It was scary, actually.

Segregation of customer money has been a subject of discussion post-Frankendodd, and I have written several posts on the subject.  Segregation has received even more discussion post-MF Global (AKA Corzine-gate, but since he’s a made man I guess he will skate).  The model that has been implemented for cleared swaps, and which (according to clearing maven John McPartland of the Chicago Fed) is likely to be adopted for cleared futures is LSOC-legally segregated, operationally commingled.

Back in the summer of 2011, I wrote that segregation could make the markets more fragile, because it would tend to reduce credit (mainly intraday credit) used to finance variation margin.  This is important, because the markets depend on using credit to fund margin payments.  If this credit freezes up, the markets will freeze up.  Indeed, a cleared system works on such tight deadlines that an interruption of credit can be catastrophic.  If margin calls aren’t met in a timely fashion, absent credit, margin payments don’t flow to those on the winning side of trades.  When this happens, the clearing system breaks down.  And in a Frankendodd world dependent on clearing, a breakdown in clearing means a meltdown in the markets.

Indeed, even delays of hours or even minutes in making margin payouts, or doubts that CCPs will make margin payments in a timely fashion, can be catastrophic.  Almost exactly 25 years ago, on 19 October, 1987, the mere rumor that the CME would not pay out variation margin led to a run on FCMs and the CME clearinghouse that almost brought the market to a crashing halt.

One of the speakers at today’s event, Barclays’ Kevin Murphy, noted that under segregated models FCMs don’t have a lien on  the collateral in customer accounts.  Which means they won’t extend credit to customers because there is no collateral backing the loans.  Murphy said that broker intraday credit is likely to be a thing of the past under greater segregation.

Think of the consequences on a day when markets move a lot.  Those on the winning side are expecting to receive variation margin payments.  Those on the losing side will be scrambling for cash to meet their VM obligations.  Where will they get it?  Not from their FCMs.  From their banks?  Uncertain-even if the customers arrange credit lines, banks can often find reasons to delay providing the credit, or not providing it at all.

This all means that there is a risk that VM owes will not be paid in time.  With no credit being extended, or the amount of credit being sharply constrained, there is a serious risk that VM pays will not be made on time.   If that happens, particularly during a period of market stress, all bets are off.  Almost literally.  People will fear that CCPs are insolvent, and there will be runs on them-people will liquidate positions to recover their margin money.

That would be very ugly indeed.  Again, a cleared system is very tightly coupled, more tightly coupled than OTC markets.  Tightly coupled systems are more prone to going non-linear, and failing catastrophically.  Segregation increases the tightness of the coupling.   Connect the dots.

Of course, markets don’t stand still.  People will recognize the need for contingent liquidity, and make arrangements for it.  But will those arrangements be as robust as the system we have now?  There is serious room for doubt.  If more robust alternatives are available, why weren’t they chosen before?  I know this argument is not dispositive, given the coordination issues involved, but there are strong incentives to adopt better systems.   We should be very leery of changes that implicitly assume that market participants with large amounts of money and risk in the game systematically choose wrong.

The whole move to clearing has been intended to wring credit risk from the derivatives markets.  But every move to reduce credit risk-including moves to greater segregation-almost always involve creating greater liquidity risk.

If given a choice between credit and liquidity risk, I would choose credit risk every time .

In other words, you have to pick your poison: credit risk or liquidity risk.  Yeah, credit risk may be like arsenic.  But liquidity risk is more like cyanide.

I know which one I would choose.

Goring Oxen in Natty Gas

Filed under: Commodities,Derivatives,Economics,Exchanges,Regulation — The Professor @ 3:08 pm

Jerry Dicolo of the WSJ has a piece on allegedly disruptive high frequency trading strategies that have been employed in the natural gas futures markets immediately surrounding the release of the weekly storage report.  Exactly what is going on here is hard to surmise, but what makes most sense to me is that the HFT traders at issue are gunning the stops.  That is, they are entering big orders to blow through the standing limit orders, moving prices, hoping to trigger buy stops (if they are buying) or sell stops if they are selling: the triggering of the stops creates the kind of short term momentum that the HFT traders can profit from by taking the other side of the stops.

Another example, as if one is needed, of the dangers of stops.

And it should be noted that gunning the stops is not the product of this newfangled electronic trading.  It happened on the floor with some frequency.  There are manipulation cases from the 1960s, if memory serves, related to gunning stops.

It’s also worth noting that there is exactly one data point in the story, August 16th.  It would be worthwhile to see if similarly allegedly anomalous price action took place prior to late-2006 when the market migrated to the screens.  I’m betting you could find more than one.

The article suggests that what is attracting HFT to the gas market is not the opportunity to play games for a few minutes once a week.  Instead, entry of HFT is being spurred by wide spreads in the gas market, as compared to equities.  HFT competition has narrowed spreads to virtually nothing in equities, so HFT traders are looking for markets with fatter margins.  Which is why they are moving into commodities:

High-frequency firms—whose activities can range from market-making on behalf of clients to trading for their own accounts—have wrung profits from the stock and other markets for years. But recently, their increased action in commodities, natural gas in particular, is spooking some veteran traders. That could leave the market reliant on computerized trading systems and potentially reduce liquidity when it is most needed.

“We can fight over fractions of a penny in stocks, or full pennies and more in natural gas,” said a programmer at a New York high-frequency trading fund.

Uhm, that’s the way markets are supposed to work.  Entry reduces prices and drives returns to just cover the cost of capital.  Which is exactly why some “veteran traders” are “spooked.”  They can’t compete against HFT.  Their oxen are being gored, just as traditional market makers’ oxen were gored in equities.

The new entrants may play shenanigans like gunning stops-but “veteran traders” did that too-another reason for “veterans” to resent HFT, for elbowing in on their racket.  Such shenanigans should be addressed by more targeted deterrents, rather than Euro-esque attempts to hamstring HFT.

I expect that spreads in natural gas, and commodities generally, will narrow as HFT technology and capital moves into those markets.  As for fears that this liquidity will dry up when it is needed most, again, this is not unique to electronic markets or HFT.  It is a feature of market making general.  Market makers reduce their supply of liquidity when they suspect order flow is toxic, or when risk is rising substantially.  It was so when market makers wore handle bar mustaches and button up shoes and stood in trading pits.  It will be so when market makers are co-located servers.  It’s inherent in the nature of market making, not in the technology.

Cliches are Cliches Because They Are True

Filed under: Military,Politics — The Professor @ 1:28 pm

Susan Rice has doubled down on her claims that she relied on intelligence reports when claiming, 5 days after the Benghazi attacks, that the assault was a spontaneous response to the Mohammed video.  She now says that she received daily reports, and that she did not “cherry pick” from them.

This has to be false.  There are numerous timelines showing that various intelligence entities had said that the attacks were premeditated terrorist acts between the time they occurred and the time Rice appeared on all the Sunday talk shows.  Indeed, the State Department has said it never  bought into the Video Days of Rage explanation.  Since Rice only gave one explanation, she had to have cherry picked.  And she picked wrong.  And she picked the story that had credence for about a day, before being revised even by the intelligence agency that originally promulgated it.

Hillary attributes the confusion to “the fog of war.”  Yes, that cliche is common, because it is accurate.  There is a fog of war.  But that fog is thickest at the initiation of an action.  It would have been defensible for Hillary and Rice and Obama to have cited the “fog of war” in the early days as a justification for not advancing a definitive narrative.  But that’s not what they did.  Instead of being circumspect and cautious in their conclusions,  they adamantly and definitively blamed the attacks on the video, and denied they were pre-planned terrorist acts.  It is outrageous to hide behind the fog of war now when they acted as if it didn’t exist in the days following 11 September.

There is another cliche about war that is true: “In war, truth is the first casualty.”  We are seeing that cliche acted out before our very eyes.

October 14, 2012

Are Commodity Trading Firms TBTF? No, Dammit.

Filed under: Commodities,Derivatives,Economics,Financial crisis,Politics,Regulation — The Professor @ 3:08 pm

In response to Bank of Canada Deputy Governor Timothy Lane’s speech about the systemic importance of major global commodity trading firms (GCTFs), the FT’s Javier Blas asks: “Has Glencore become ‘too big to fail’?

And I answer: hell no.

I will write much more on this subject-much more-when a few things clear.  For now, a few of my reasons:

  • GCTFs-even the biggest, like Glencore, Cargill, and Koch-just aren’t that big.  Glencore, the biggest, has about the same amount of assets as Kraft and Fiat and Hitachi and Fubon Financial Group (assuming you’ve heard of it).  Are those TBTF too?  The biggest GCTFs have asset values an order of magnitude smaller than the banks that have been designated SIFIs by the Financial Stability Board.  Again: not that big, in systemic terms.
  • GCTFs aren’t highly leveraged.
  • GCTFs don’t engage in extensive maturity transformation.  Indeed, current assets and current liabilities are closely matched, and for many firms the maturities of their liabilities exceeds that of their assets.
  • Commodity trading firms, e.g., Enron, have failed without significant knock-on effects.  Indeed, an entire commodity trading sector-the merchant energy sector in the US-imploded without disrupting the financial system, or the trade in physical power and gas.
  • GCTFs weathered the 2008-2009 financial crisis fairly well.
  • Even if a large firm were to fail, disrupting commerce in commodities for which it accounts for a significant fraction of the trade, (a) the quantity of trade in these commodities is very small relative to total international trade or GDP, (b) other firms are likely to be able to fill the gap quickly, in part because the assets used in commodity trade can be redeployed quickly, and (c) disruptions in trade have few knock-on effects on global or even regional GDP.  As an example, the 2011 Japanese earthquake and tsunami severely interrupted trade in electronics and auto parts, but the effects on GDP in Asia were small and transitory, and the effects on GDP outside of Asia negligible.

This is not to say that GCTFs are always on the side of the angels: definitely not.  Nor is it say or that some additional regulation (notably in the nature of disclosure, and better anti-manipulation laws) is not worth consideration.  It is just to say that we don’t need to add them to the list of too big to fail enterprises.  We should be looking to pare that list, not expand it, and GCTFs do not pose the systemic risks that warrant SIFI designation.

Again, more to come in the weeks to come.

A Bear in the China Shop

Filed under: China,Economics,Energy,Financial crisis,Politics,Regulation — The Professor @ 2:15 pm

I have long been a bear on China.  Prior to 2008 because of the shakiness of its banking system; post-Crisis, because of my deep skepticism about the effects of the huge stimulus program-including its impact on the banking system, or more properly, the shadow banking system.

I am not alone.  The Bank of China is warning about the country’s shadow banks:

A senior Chinese banking executive has warned against the proliferation of off-book wealth management products, comparing some to a Ponzi scheme in a rare official acknowledgement of the risks they pose to the Chinese banking system.

China must “tackle” shadow banking, particularly the short term investment vehicles known as wealth management products, Xiao Gang, the chairman of the board of Bank of China, one of the top four state-owned banks, wrote in an op-ed in the English-language China Daily on Friday.

“Unsurprisingly, although Chinese banks’ non-performing loans are at a low level of 0.9 percent, the potential risks are worse than the official data suggest,” Xiao wrote, adding that a problem could come as indebted borrowers face cash flow problems or enter default, straining the banking system.

“The music may stop when investors lose confidence and reduce their buying or withdraw from WMPs,” he said, referring to wealth management products.

He warned of a mismatch between short-term products and the longer underlying projects they fund, adding that in some cases the products are not tied to any specific project and that in others new products may be issued to pay off maturing products and avoid a liquidity squeeze.

“To some extent, this is fundamentally a Ponzi scheme.”

Xiao’s op-ed is in line with similar warnings issued by outsiders, particularly the Fitch Ratings agency whose China banking analyst Charlene Chu has long warned of a maturity mis-match and the threat to the Chinese banking system of products with various terms and interest rates.

Moreover, there is a widespread belief among investors in these products that banks are offering liquidity puts:

Although the products are technically more risky than deposits, most investors believe they are backed by the banks’ implicit guarantee and they are marketed aggressively in bank branches nationwide. Xiao acknowledged this perception posed a risk for banks’ bottom line.

“The rollover of a large share of WMPs could weigh heavily on formal banks’ reputations, because many investors firmly believe that banks won’t close down and they can always get their money back,” Xiao said.

In June, People’s Bank of China vice governor Liu Shiyu said many banks are not transparent enough about the risks wealth management products carry.

“China’s shadow banking system is complex, with a close yet opaque relationship to the regular banking system and the real economy,” Xiao concluded by saying.

“It must be tackled with care and sufficient flexibility, but it must be tackled nonetheless.”

Recall that the movement of SIVs back onto bank balance sheets was a major channel by which problems in the shadow banking sector were communicated to US banks.

These “wealth management” products grew up as a direct result of the intervention of the supposedly wise direction of the Chinese state.  It wanted to restrict bank lending that had been stoked by the 2009 stimulus, in a step-on-the-gas-whoops-step-on-the-brakes maneuver so common to attempts to “fine tune” economies.  The bank credit was basically redirected to the informal sector.

I’m sure it will work out swell.

For more background on the crazy-quilt Chinese banking sector, and all its fragility, this is a decent source.

Another reason for my bearishness is my innate skepticism-based on long experience-of state efforts to guide resource allocation.  Case in point: China has gone all out to promote investment in renewables, and has been awarded with huge losses:

hina in recent years established global dominance in renewable energy, its solar panel and wind turbine factories forcing many foreign rivals out of business and its policy makers hailed by environmentalists around the world as visionaries.

But now China’s strategy is in disarray. Though worldwide demand for solar panels and wind turbines has grown rapidly over the last five years, China’s manufacturing capacity has soared even faster, creating enormous oversupply and a ferocious price war.

The result is a looming financial disaster, not only for manufacturers but for state-owned banks that financed factories with approximately $18 billion in low-rate loans and for municipal and provincial governments that provided loan guarantees and sold manufacturers valuable land at deeply discounted prices.

China’s biggest solar panel makers are suffering losses of up to $1 for every $3 of sales this year, as panel prices have fallen by three-fourths since 2008. Even though the cost ofsolar power has fallen, it still remains triple the price of coal-generated power in China, requiring substantial subsidies through a tax imposed on industrial users of electricity to cover the higher cost of renewable energy.

The outcome has left even the architects of China’s renewable energy strategy feeling frustrated and eager to see many businesses shut down, so the most efficient companies may be salvageable financially.

Well played.  Remind me again why should we compete by throwing good dollars after bad renmibi?

(As an aside, to illustrate the absurdity of subsidy politics, Solyndra is suing Chinese solar panel makers for predatory pricing.  Predatory pricing suits are almost always meritless.)

A substantial fraction of measured Chinese growth in the recent past has been accounted for by investment.  But the relevant question is whether this investment is going to pay dividends, or whether it has been misdirected into white elephants.  The solar (and wind) experience suggests the latter.  Historical experience with politicized investment suggests the latter.  The influence of corruption and the political influence of the elite on the investment prices also suggests the latter.  I’m going with the latter.

The WSJ has a long piece on a Chinese economist who is similarly skeptical about the ability of the Chinese state to direct investment:

Mr. Zhang’s academic colleagues were all praise for the “China Model,” but in 2009 he was giving speeches entitled “Bury Keynesianism.” Then a top administrator at Peking University, where he now teaches economics, he argued that since the financial crisis was caused by easy money, it couldn’t be solved by the same. “The current economy is like a drug addict, and the prescription from the doctor is morphine, so the final result will be much worse,” he said.

. . . .

Ultimately, Beijing’s stimulus fed a false investment boom that stoked asset bubbles—then the morphine wore off while the government tightened. Officials claim the economy grew at 7.6% year-on-year between April and June this year. Skeptics think the real number is closer to 4%. (One London research house says 1%.) Meanwhile, industries dominated or favored by the state, such as steel or solar power, are idling from overcapacity. Countless sheets of copper are reportedly stacked in warehouses, blocking doorways and exemplifying Hayek’s notion of “malinvestment.”

It’s actually worse than merely Hayekian/Austrian malinvestment, IMO.  That arises from decisions made on the basis of false price signals that result from monetary stimulus.  That is surely present in China in spades.  But there is also a good deal of state-directed investment, or investment channeled to state enterprises, or investment influenced by corrupt and connected members of the elite.

A good analysis of these issues is to be found at Michael Pettis’s blog, including examples like this post.  He aims the following, trenchant questions at China bulls:

  1. How much debt is there whose real cost exceeds the economic value created by the debt, which sector of the economy will pay for the excess, and what is the mechanism that will ensure the necessary wealth transfer?
  2. What projects can we identify that will allow hundreds of billions of dollars, or even trillions of dollars, of investment whose wealth creation in the short and medium term will exceed the real cost of the debt, and what is the mechanism for ensuring that these investments will get made?
  3. What mechanism can be implemented to increase the growth rate of household consumption?

All very good questions.  China’s recent GDP growth has really been driven by what are properly considered costs: the amount of money invested.  The relevant issue is the value produced by those investments.  Given the state domination of the process of making these investments-either directly, or via distortions of the price system through monetary stimulus and financial repression that distorts interest rates-I am dubious, in the extreme, that these investments will pay.

October 12, 2012

Happy Sorcerer’s Apprentice Day: Frankendodd Now Rules

So today, 12 October, 2012, is the day when many Frankendodd rules go into effect.  Swap dealer registration for instance: but not position limits!

Yes.  848 pages of legislation (or 2319 pages, depending on how you count)-where commas matter-that spawned thousands of pages of rules (over 9k as of July, and where commas will also matter) that will spawn thousands more pages of interpretations, no action letters, legal rulings, etc.  All in an attempt to re-engineer a devilishly complex, interconnected financial system.  A system that will not stand still, but which will change in response to the law and the regulations, thereby producing myriad unintended consequences.

I’m sure it will turn out just swell.  Timmy! and GiGi and their successors have everything under control.  They’re from the government and there to help you!  Trust them on this!  Don’t you worry your pretty little head over it.

JK.  In reality, Mickey Mouse (how appropriate) gives you a better idea of how things are likely to turn out.

I fearlessly predict that the next financial crisis will follow directly from Frankendodd. It is a monster, which like Frankenstein’s, will escape its master’s control and wreak havoc. Mark my words.

Railroaded, or Official Dedovshchina

Filed under: Military,Politics,Russia — The Professor @ 2:45 pm

The Russians have identified the culprit behind the Orenberg ammo premature detonation: some schlub private, Alexander Kasatkin:

The Main Military Investigative Department has filed charges against a private, Alexander Kasatkin, for violating a ban on smoking while handling explosives, officials said Thursday. A discarded cigarette butt apparently ignited a fire that caused 4,000 tons of ammunition to detonate Tuesday morning outside Orenburg, in southern Russia. Private Kasatkin, who survived, admitting to smoking while unloading ammunition from a train, Russian news media reported.

I get the sneaking suspicion this guy is a scapegoat.  The speed with which Kasatkin was identified makes me suspicious, for one thing.  Russian investigations usually take forever, allowing incidents to fade away without anyone being held accountable.  (For instance: What is the status of the investigation of the Sukhoi Superjet crash?  The investigation into the submarine Yekaterinburg fire?)

And one cigarette butt?  How did that start a fire that could burn long enough to ignite 4 freaking kilotons of ammunition?  What was the butt thrown into?  It would be totally negligent to have other flammable materials (e.g., paper trash) near ammunition.  So did Sad Sack Kasatkin throw a smoldering cigarette on powder bags?

I dunno.  It seems like this guy is being railroaded for causing an ammo explosion on a train.  I think a poor conscript is being made to wear this, in an act of official dedovshchina. The official story seems about as plausible as Peg Leg Sullivan or Mrs. O’Leary’s cow causing the Great Chicago Fire (which occurred, ironically, almost exactly 141 years to the day before the Orenburg explosion).

We Agree More Than You Let on, David

Filed under: Derivatives,Economics,Financial crisis,Politics,Regulation — The Professor @ 11:59 am

The always thoughtful and considerate David at Deus ex Macchiato responds to my post on ring-fencing.  He concurs in part, and dissents in part.  Or he claims to dissent, but I think we’re more in agreement than he lets on.

His disagreement relates to my claim that entities outside the ring-fence could be too big to fail, and are reliant on fragile funding and hence vulnerable to destabilizing runs.  He basically argues that there are regulatory/supervisory responses to this, e.g., collateralization of OTC derivatives trades, higher capital charges on firms outside the fence looking in, rules intended to reduce the risk of runs on money market funds.

In essence, my interpretation is that David is arguing that it is possible to increase the stability of the shadow banking system through such supervisory/regulatory changes.  I wish I were so sanguine.

But it does provide a good way to frame the trade-off that is involved.  Ring-fencing increases reliance on wholesale funding and shadow banking by preventing the funding of certain activities with stickier deposits.

That’s what makes me concerned.  I think these wholesale/shadow banking funding structures are a source of vulnerability.  That’s basically the interpretation that Gary Gorton gives in his forthcoming book.

Given that, I think we should be very, very concerned about “reforms” that increase reliance on wholesale/shadow bank funding.  As David notes, this must be accompanied by other changes that address the fragility of these funding mechanisms.  I am much more skeptical than David, apparently, that such changes are likely to occur.  And this is the source of my concern about ring-fencing.  Especially about ring-fencing that is not bundled with measures that reduce the fragility of the wholesale/shadow bank funding mechanism.  That’s why ring-fencing alone is particularly worrisome. My priorities would be the reverse: focus on shadow banking and wholesale funding first.

But like I said, I think David is more aligned with me than he lets on.  For he says:

After all, as SWP points out, it wasn’t the universal banks who were most vulnerable: having deposit funding reduced their liquidity risk during the crisis. So perhaps there are systemic benefits to having casino and retail banking mixed? Surely that is something that we should settle before ring fencing.

Abso-effing-lutely.  That’s exactly what we need to settle first: that’s what I meant about “my priorities would be the reverse.”  That’s exactly why the fetishization of ring-fencing as a solution, or at the very least the first step in a solution, is highly dangerous.

To put it differently.   We need a back-to-basics rethink on what activities should be funded by insured deposits or some other form of guarantee; which should rely on wholesale mechanisms; and what can be done (short of some sort of insurance mechanism) to make the wholesale/shadow bank system more stable.  Is there a compelling economic reason why only traditional commercial banking activities should have access to insured funding?  This seems as much of a historical artifact as anything else, something that grew out of the banking system as it was in the 1930s.

Before lunging ahead with structural reforms that seem rooted more in nostalgia than economics, it is imperative that we think a lot more seriously about the right match between funding and the activities that are being funded, and what system of insurance or guarantees can improve the functionality of this match.  After all, during the crisis there was a massive ad hoc extension of guarantees to a wide variety of shadow banking and wholesale funding activities.  Wouldn’t it be better to think about that in advance, instead of making it up as we go along?

And again, that’s what worries me about the focus on ring-fencing.  It punts on this extremely vital issue; potentially force-feeds the shadow banking system; and puts us at risk of more ad hoc bailouts of this system in the future.  Which is precisely why I believe that it is naive-foolish, actually-to believe that ring-fencing protects taxpayers.  It could well put them at greater risk.

So on this big point, I think we agree, David: “Surely that is something that we should settle before ring fencing.”

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