John Cochrane has a post today about the potential for Dodd-Frank reform. The short version is: it would be a good development if we could find a compromise where banks are less regulated in exchange for requiring higher capital requirements.
I agree with this, but really, I think this is simply the what any real deregulation looks like. I think the GSEs really help to bring clarity to this issue. They are similar here to commercial banks. They have very low capital requirements, which worries a lot of observers. Along with those capital requirements is de facto government backing for their debt and issued securities.
So, banks have FDIC insurance, which provides safety for depositors. This means that as banks take in deposits (which are liabilities for banks), the interest rates required by those depositors don't react to the risks created by leverage, since FDIC insurance is basically like a credit default swap for the depositors. Any non-financial corporation would naturally remain less leveraged, outside of crisis situations, because they would have to pay higher interest rates for debt as their leverage increases. Since FDIC insurance undermines this basic market source of moderation, banks have to be regulated so that they don't become too leveraged. They are forced to keep a minimum level of capital.
But, the minimum level of capital required has to be less than what the natural market level of capital would have been. Otherwise, what's the point? And, banks would simply be out-competed by non-regulated substitutes if they were forced to hold capital levels above the natural market level.
I'm not an expert on the repo market, but it seems to me that we created a similar problem by inventing the accounting fiction that repos are not loans, which also makes the interest rate on repo financing non-responsive to leverage risk.
In any case, there is a natural pairing between capital requirements and regulatory restraints. As regulation and public insurance of various kinds ratchet up, capital requirements naturally decline. If banks were completely deregulated, they would naturally hold more capital.
I wonder if commercial banks, as they exist today, are an anachronism anyway. If they were deregulated, I wonder if they would mostly go away. Is the central intermediation that they engage in - borrowing short and lending long - even necessary today? Is the regulatory framework that supports this intermediation actually maintaining a risk in the economy that isn't even necessary today? Would money market funds, REITs, investment banks, and a host of other financial agents rise up in ways that would match asset-liability maturities within each institution?
This is really clear when thinking about the GSEs. If they didn't have federal backing, their business model would probably be ineffective. And, if their capital requirements were set too high, their business model would probably be ineffective. Both of those factors need to be in place for the GSEs to exist, and those factors come as a pair. What point is there of having capital requirements if there is no guarantee? The bondholders would not be accepting a discounted interest rate in that case, and they would be perfectly able to demand their own bankruptcy terms if there was no federal backing. Imagine how awkward it would be to have the capital requirement without federal backing. If the bondholders held securities that had become impaired, or where there was a probability of future default, they would naturally be in communication with the boards of the GSEs to manage the firms in everyone's best interest. Imagine if, without giving them any support, the federal government stepped in and imposed a settlement on them that neither the equity holders or the bondholders had invoked. What would be the point? The capital requirement without the guarantee would do nothing but add risk. That's what is so strange about how so many policymakers still pretend like there was never a government guarantee on GSE debt. Of course there was. There had to be. And, it was invoked in 2008, if there was ever any doubt.
In the book, I walk through the argument that there should not be GSE debt, but that there should be a government guarantee of GSE MBSs. It would be a public good which really can only be provided publicly. That's a story for another day. But, clearly, in the case of the GSEs we can see that, in and of itself, regulatory insurance and capital requirements go together, and they can induce institutional forms that increase systematic risk. Public insurance increases systematic risk. Maybe that is counterintuitive.
It seems to me that many people assume that deregulation somehow helps insiders and powerful institutions, and that, if we did deregulate banks, those same people would quite naturally and quickly, shift toward getting mortgages from privately funded REITs, investment banks, and MBS investors and toward putting their short term savings into money markets that invested in commercial paper and short term treasuries, and it would never occur to them that they were intimately involved in the devolution of power from previously regulated institutions.
Cochrane's idea of deregulating and raising capital requirements seems like a step in the direction of simply deregulating, which is all for the best. But, if there was only some deregulation, then the capital requirements would still have to remain lower than what the completely deregulated market would provide. In fact, it seems like what we see in the marketplace of substitutions for commercial banks are many forms of saving that don't particularly use leverage at all. This would be even more the case if we stopped giving debt tax advantages over equity.