Joe Nocera admitted yesterday, building on previous opinion and research, that Dodd-Frank, the financial reform law, was essentially too complex to work.
The crucial difference between the Glass-Steagall Act, the landmark banking reform law that was passed during the Great Depression, and Dodd-Frank, is that the former had an appealing simplicity that Dodd-Frank lacks. Glass-Steagall did one basic thing. It forced banks to get rid of their investment banking arms. Dodd-Frank, by contrast, accepts the complexity of modern banking — and then adds to that complexity with its thousands of pages of regulations. That complexity is something to worry about.
That is why I wrote a recent column about a persuasive paper by Karen Petrou, a banking expert, in which she argued that Dodd-Frank was creating a new kind of risk that she labeled “complexity risk.”
Nocera devoted much of the rest of the op-ed to this article on how to fix banks by Sallie Krawcheck. She noted that the complexity of the trades JPMorgan Chase’s Chief Investment Office made led to the bank misunderstanding and mismanaging the risks. Aside from banks being too big to fail, her comments lead to the conclusion that mega-banks are actually too complex to manage. The two concepts go hand-in-hand – you don’t worry as much about risk management when you have a backstop guarantee from the government.
Krawcheck has a number of innovative ideas to scale back this complexity. One is to pay bank executives in debt, at the same level as the bank’s leverage ratio. The others have to do with dividend payouts, earnings and the composition of boards of directors. But these are exotic ways to get at the central problem – banks dabbling in risk they do not understand and cannot manage.
Entities who want to really take on credit risk are called banks, and they do so by lending. People who sell credit protection in the markets, by contrast, are traders and speculators who trust in the liquidity of the CDS market and who are sure that they will be able to get out quickly if things turn against them. And thus is the CDS market used shunt risks off, unseen, into the tails [...]
Activity in the CDS market, on this view, is a sign of weakness, not strength: it’s a sign that the bank doesn’t have much faith in its own relationships and underwriting standards, and is reduced to having to buy protection from speculators in order to feel comfortable with the risks that it’s taking. Since those speculators, by definition, don’t have remotely as much information about the bank’s borrowers as the bank does, and since they certainly can’t put covenants into loans protecting them from profligacy at the borrower, such trades make very little economic sense in theory.
Regulators should remember this the next time a bank starts boasting about its sophisticated, state-of-the-art risk management systems. Most of the time, those systems involve complex bets in a zero-sum-game derivatives market, where the bank’s counterparties charge a premium for the fact that they’re on the wrong side of an information asymmetry. At best, in such cases, the bank is merely abdicating responsibility for its risks, rather than properly managing them. And at worst, it thinks that it has gotten the credit risk off its books, when in fact it’s just pushed that risk into the tails, where it’s bigger than ever.
Roger Lowenstein argues that this all pushes in the direction of banning credit default swap trading. Perhaps. But it certainly means that banks shouldn’t have anything to do with them. There’s plenty of profit to be made in banks taking deposits and lending out to their customers, combined with sound underwriting of the loans. If they can’t make that into a profitable business, maybe they shouldn’t be in it.
…I recognize that at some level, this is all a fantasy. But the first step to getting the bank system we need is to figure out what it should look like. The alternative banking group at Occupy Wall Street is basically engaged in this process.