Streetwise Professor

October 12, 2012

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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