3 ms·

Regulation sets a minimum reserve, not a maximum one.

grandalf 18y ago
Speed limit signs set a minimum and a maximum speed, yet I always see drivers careening along on icy roads at the posted maximum. They must have more faith in planners than I do, as I try to determine how icy the road is and go at a safe speed. I don't think financial regulations are any different, but unfortunately most people take the fact that a firm is regulated to mean that it's totally safe. Similarly, many foods that will result in an early death are perfectly legal and consistent with the USDA food pyramid.
- cchooper 18y ago
  To be clear: you are suggesting that banks have kept low reserves because they took their government requirements as a sign of what was prudent to lend. Rather than asking their many teams of risk analysts, they made lending decisions based on an arbitrary number set by the government, despite the fact that this level has not been raised or lowered in decades, is uniform across all banks, takes no heed of the current financial situation and has never prevented a crash in the past. If this were true (and it certainly is not!) then the market really would be just as incompetent as its critics say it is.
  - grandalf 18y ago
    Not at all. In an environment where the government decides what is prudent, there is no incentive for a bank to say "We are sounder than our competitors because we keep more reserves". Why not? Because they would be competing against the government for their definition of soundness. Sure it could happen theoretically, but it would be a tremendous competitive disadvantage. The way it is today, any bank that is legally allowed to operate is considered equally sound by borrowers and investors, and banks have no incentive to try to prove to customers that they are actually more sound than their competitors. In a highly regulated environment, that works for all banks because they know that if there is a major economic downturn everyone will get bailed out. Notice that all banks were required to accept TARP loans whether they needed them or not. Why? To avoid SIGNALING which banks were hurting and which were not. Why? To avoid capital flowing to the banks that were actually sound! Why? Well, partly because government wants to avoid a crash, and partly to keep the status quo going strong. Also, consider what all of the major industry players in banking want... what does any firm want? No competition. They were all happy to share a big market and to have as few as possible attributes on which to have to compete for business. Simple, smart, behaviorally sensible regulations make sense, but the SEC has been notoriously behind the curve for years. The missing piece has been to regulate appropriately while allowing there to be an incentive for banks to actually compete on the basis of soundness. The decision not to let the concept of bank soundness enter the brains of mere citizens must be a knee-jerk reaction to the great depression. Instead, in exchange for various political concessions, banks were given every incentive to be extremely leveraged. Consider the impact of the GSEs on housing prices, MBS prices, etc? The implicit guarantee of Fannie and Freddie alone probably led to banks thinking (rightly, it turns out) that any housing related crash's impact on banks would be bailed out. Side note: Are the banks going to be better off after the bailout? Of course they will be. The desired "sweet spot" for most firms is to be in a heavily regulated, heavily protected industry, as it means that there are huge barriers to entry and the profits (though sometimes essentially set by regulators) roll in year after year. See the military industrial complex for an example of the idealized sort of model. Market forces have been very far from banking for a long time. Why else would financial services be the biggest donors to both parties. Libertarians are not opposed to regulations, just not ones that create perverse incentives and lead to massive bailouts! Any time a firm would rather spend its money on lobbyists and campaign contributions rather than innovation, there is a big problem.
    - cchooper 18y ago
      > First, note that if it weren't for regulators deciding on the amount of reserve capital Citibank was required to hold, the market would probably have demanded that it hold much more. This was your original point. Let's stay on track. Your claim that regulators decide how big Citibank's reserves should be is false. They set a minimum, not a maximum. You then tried to draw an analogy between speeding and regulation, one that, as I have explained, is totally inappropriate. You then claimed that "most people take the fact that a firm is regulated to mean that it's totally safe", which is a massive exaggeration. If that were true, bank bonds would be considered as safe as government bonds and bank runs would never happen. All other regulated industries would be exactly the same. Also, you are confusing reserve requirements with broader regulation as a whole. You then claim that banks raising their reserves would be "competing against the government for their definition of soundness", despite the fact that no government has ever claimed any 'definition of soundness'. This appears to be something that you have invented. You then give an argument as to why other forms of regulation encourage banks to hold lower reserves. This contradicts your original point, which was that if reserve requirements were abolished then the market would force banks to raise reserves. What you have demonstrated is that the market, bail-outs and broader regulation would actually force reserves to even lower levels in the absence of reserve requirements. You have changed your argument from one about reserve requirements to one about broader regulation, and bail-outs such as TARP.
      - grandalf 18y ago
        I don't think you have refuted my speeding analogy. Do you ever drive in an area with ice on the roads? I recommend that you observe the phenomenon before you dismiss it. I do not think you have refuted my claim that regulation leads to people suspending critical judgement about risks. Reserve requirements are a good example of this effect. Industry lobbyists try very hard to have the limit decreased while benefiting from the public perception that the regulator has assured that the bank's assets are sound. If you don't buy my argument then you probably believe that people are so stupid that without regulation banks would hold $0 in reserves. The alternative view of humanity is that people are sensible enough to demand sound practices from institutions they deal with on important matters. My argument is that banks don't use reserves as a way to win customers the way they would if regulators weren't giving an A+ to every bank that holds the minimum :) One exception is Goldman Sachs. It did not need TARP funds to remain solvent. Yet Treasury forced all banks to accept the funds. What did Goldman do? It immediately paid a huge dividend to its investors. What happened? Goldman actually had more sound practices than the rest of the industry and was not in danger of failing. It would probably have waited for bankruptcy proceedings and picked through the assets of the other banks, strengthening its already strong balance sheet. Regulators did not want more money to flow to the firm that had good practices, so it insisted on bailing everyone out. This was to hide information from investors and customers. Goldman angered regulators by paying out the dividend right away, but managed to signal its health. To understand the point of libertarians on this issue, consider the world in 10 years from today. We might have had a world where chastened investors and customers looked a lot more carefully at the risk management practices of banks before trusting them. Instead, we have a world in which our government owns 30% of all banks and regulators are being hailed as the saviors of the banking industry. Do you want to live in a world where people act based on reality, or one where taxpayer money is appropriated without congressional approval and given to selected industries, and the appropriators are hailed as heroes that helped the little guy keep his job, prevented another great depression, etc. It all comes back to the burden that people take upon themselves to assess the riskiness of the decisions they make. Industry loves to have its status quo practices rubber stamped by regulators, to add additional credibility. It all works out well as long as there can be another bailout, etc., but it's not based on reality and represents the slow transfer of wealth from the most productive companies to the ones with the most effective lobbying.

Speed limit signs set a minimum and a maximum speed, yet I always see drivers careening along on icy roads at the posted maximum. They must have more faith in planners than I do, as I try to determine how icy the road is and go at a safe speed. I don't think financial regulations are any different, but unfortunately most people take the fact that a firm is regulated to mean that it's totally safe. Similarly, many foods that will result in an early death are perfectly legal and consistent with the USDA food pyramid.

cchooper 18y ago
To be clear: you are suggesting that banks have kept low reserves because they took their government requirements as a sign of what was prudent to lend. Rather than asking their many teams of risk analysts, they made lending decisions based on an arbitrary number set by the government, despite the fact that this level has not been raised or lowered in decades, is uniform across all banks, takes no heed of the current financial situation and has never prevented a crash in the past. If this were true (and it certainly is not!) then the market really would be just as incompetent as its critics say it is.
- grandalf 18y ago
  Not at all. In an environment where the government decides what is prudent, there is no incentive for a bank to say "We are sounder than our competitors because we keep more reserves". Why not? Because they would be competing against the government for their definition of soundness. Sure it could happen theoretically, but it would be a tremendous competitive disadvantage. The way it is today, any bank that is legally allowed to operate is considered equally sound by borrowers and investors, and banks have no incentive to try to prove to customers that they are actually more sound than their competitors. In a highly regulated environment, that works for all banks because they know that if there is a major economic downturn everyone will get bailed out. Notice that all banks were required to accept TARP loans whether they needed them or not. Why? To avoid SIGNALING which banks were hurting and which were not. Why? To avoid capital flowing to the banks that were actually sound! Why? Well, partly because government wants to avoid a crash, and partly to keep the status quo going strong. Also, consider what all of the major industry players in banking want... what does any firm want? No competition. They were all happy to share a big market and to have as few as possible attributes on which to have to compete for business. Simple, smart, behaviorally sensible regulations make sense, but the SEC has been notoriously behind the curve for years. The missing piece has been to regulate appropriately while allowing there to be an incentive for banks to actually compete on the basis of soundness. The decision not to let the concept of bank soundness enter the brains of mere citizens must be a knee-jerk reaction to the great depression. Instead, in exchange for various political concessions, banks were given every incentive to be extremely leveraged. Consider the impact of the GSEs on housing prices, MBS prices, etc? The implicit guarantee of Fannie and Freddie alone probably led to banks thinking (rightly, it turns out) that any housing related crash's impact on banks would be bailed out. Side note: Are the banks going to be better off after the bailout? Of course they will be. The desired "sweet spot" for most firms is to be in a heavily regulated, heavily protected industry, as it means that there are huge barriers to entry and the profits (though sometimes essentially set by regulators) roll in year after year. See the military industrial complex for an example of the idealized sort of model. Market forces have been very far from banking for a long time. Why else would financial services be the biggest donors to both parties. Libertarians are not opposed to regulations, just not ones that create perverse incentives and lead to massive bailouts! Any time a firm would rather spend its money on lobbyists and campaign contributions rather than innovation, there is a big problem.
  - cchooper 18y ago
    > First, note that if it weren't for regulators deciding on the amount of reserve capital Citibank was required to hold, the market would probably have demanded that it hold much more. This was your original point. Let's stay on track. Your claim that regulators decide how big Citibank's reserves should be is false. They set a minimum, not a maximum. You then tried to draw an analogy between speeding and regulation, one that, as I have explained, is totally inappropriate. You then claimed that "most people take the fact that a firm is regulated to mean that it's totally safe", which is a massive exaggeration. If that were true, bank bonds would be considered as safe as government bonds and bank runs would never happen. All other regulated industries would be exactly the same. Also, you are confusing reserve requirements with broader regulation as a whole. You then claim that banks raising their reserves would be "competing against the government for their definition of soundness", despite the fact that no government has ever claimed any 'definition of soundness'. This appears to be something that you have invented. You then give an argument as to why other forms of regulation encourage banks to hold lower reserves. This contradicts your original point, which was that if reserve requirements were abolished then the market would force banks to raise reserves. What you have demonstrated is that the market, bail-outs and broader regulation would actually force reserves to even lower levels in the absence of reserve requirements. You have changed your argument from one about reserve requirements to one about broader regulation, and bail-outs such as TARP.
    - grandalf 18y ago
      I don't think you have refuted my speeding analogy. Do you ever drive in an area with ice on the roads? I recommend that you observe the phenomenon before you dismiss it. I do not think you have refuted my claim that regulation leads to people suspending critical judgement about risks. Reserve requirements are a good example of this effect. Industry lobbyists try very hard to have the limit decreased while benefiting from the public perception that the regulator has assured that the bank's assets are sound. If you don't buy my argument then you probably believe that people are so stupid that without regulation banks would hold $0 in reserves. The alternative view of humanity is that people are sensible enough to demand sound practices from institutions they deal with on important matters. My argument is that banks don't use reserves as a way to win customers the way they would if regulators weren't giving an A+ to every bank that holds the minimum :) One exception is Goldman Sachs. It did not need TARP funds to remain solvent. Yet Treasury forced all banks to accept the funds. What did Goldman do? It immediately paid a huge dividend to its investors. What happened? Goldman actually had more sound practices than the rest of the industry and was not in danger of failing. It would probably have waited for bankruptcy proceedings and picked through the assets of the other banks, strengthening its already strong balance sheet. Regulators did not want more money to flow to the firm that had good practices, so it insisted on bailing everyone out. This was to hide information from investors and customers. Goldman angered regulators by paying out the dividend right away, but managed to signal its health. To understand the point of libertarians on this issue, consider the world in 10 years from today. We might have had a world where chastened investors and customers looked a lot more carefully at the risk management practices of banks before trusting them. Instead, we have a world in which our government owns 30% of all banks and regulators are being hailed as the saviors of the banking industry. Do you want to live in a world where people act based on reality, or one where taxpayer money is appropriated without congressional approval and given to selected industries, and the appropriators are hailed as heroes that helped the little guy keep his job, prevented another great depression, etc. It all comes back to the burden that people take upon themselves to assess the riskiness of the decisions they make. Industry loves to have its status quo practices rubber stamped by regulators, to add additional credibility. It all works out well as long as there can be another bailout, etc., but it's not based on reality and represents the slow transfer of wealth from the most productive companies to the ones with the most effective lobbying.