Elizabeth Warren, Bagehot and Banking 301

Elizabeth Warren (D - MA) spends time working on "Too Big to Fail" with David Vinter (R - LA).  I applaud their efforts in general.

Elizabeth Warren spends a lot of time obfuscating the needed discussion rather than clarifying it.  In a recent interview at Cato, she said, "Nine Trillion Dollars - your money, nine trillion tax dollars - went out the door to just three financial institutions..."  Implying that it shouldn't have without ever saying that it went to insolvent institutions.   She also said, "The issue around 'too big to fail' is too big for politics."  Politics is how we run our government.  She seems to prefer to be a dictator based on an amorphous promise to work for 'the American people.'  I think those are the same people who vote.  She spends time promoting the reintroduction of Glass-Steagall, which is irrelevant to the problem at hand.

In short, she isn't helping, though I think she understands the real issues.

Philosophically, we need to let failed institutions fail.  For those of you who don't spend so much time in the Financial Institutions space, lets talk about bank failure.  For those of you who already know this stuff, bear with us.

Banks borrow your money through on demand checking accounts - that's on demand, as in now, as in very short.  Then they lend it to people on 3, 7, 10 and 30 year loans.  That's long.

We allow our banks to engage in 'fractional reserve' banking.  Under current regulation, they hold roughly just under 10% (or should and arguably should hold more like 20%)  of the short money in cash for each dollar they lend - reserves.  This lets them take many long positions with your short term checking balance.  The folks you lent the money to for 10 years cannot pay it back now.  They can and will over the agreed 10 years.

In the face of uncertainty, Keynes' shift in animal spirits, this has always made banking a business with risk in its model.  But it fills a need we have by channeling savings to productive investment.

Illiquidity is when you can't pay your bills - meet your demands - right now.  Because of the model in banking, it happens.  Insolvency is Bankruptcy is, if you could liquidate would you be able to pay all your demands.  Generally, in banking, this is very rare.  If you could call all the loans, could you pay the checking account holders their cash?  Usually.  You just can't do it now.

This is where that old saw of the Fed, or any central bank, as lender of last resort comes in.  Walter Bagehot, the founding editor of the Economist newspaper, studied and wrote a famous treatise on this,  Lombard Street: A Description of the Money Market (1873), which said, in much simplified form, lend like mad to the illiquid, let the insolvent go.

This should still be our philosophy of what we want to happen today.

As you might imagine, all this gets very much more complex in the real world.  To really judge insolvency of a bank you have to judge whether the outstanding loans will be paid back.  The bank does that all the time, but now, when you need to make your judgement, the economic landscape is changing for all the borrowers.  Which of these loans are still good?  That's no easy task.  If you add to that basic issue the many and various complex finanical instruments that fall on the checking, liability, side of the balance sheet and, loan, or asset, side of the balance sheet, it gets really hard.

Nevertheless, raised reserve requirements while maintaining a focus on lending in a crisis to illiquid institutions but not insolvent institutions is the right policy.  The rest is just window dressing.  Implementing such a policy is hard and requires a decision on the regulatory strategy involved.  Do you inspect every transaction so you can make or second guess loan quality decisions in place of bank management, or do you arrange the right incentives and inspect the results?  Working out this scheme is hard.  But it will never happen if we spend all our time dealing with populist obfiscation of the real issues we're trying to deal with.

If you raise the reserve requirement enough, the return on capital in the banking business will decline and it will become a more sedate backwater unable to attract the best, brightest and most aggressive risk takers.  This might be good for risk. 

Accurate Reality:  The right call on 'too big to fail' is lend like mad to the illiquid and let the insolvent go.  Reserve requirements should be raised to make the business both safer and less competitive for capital and shove it further down into the middle of the pack of comparative industry returns.  Elizabeth Warren and the other politicians should focus on these hard tasks and slow or still the shrill rhetoric on populist side issues.  Congress needs to direct the regulators on the right regulatory principal.