It Depends on What The Meaning of the Word “Bank” Is
Justin Fox says:
If you borrow short and lend long, you’re effectively a bank. It’s becoming ever less clear to me what justification there is for nonbank borrow-short-lend-long-institutions other than regulatory arbitrage.
Brad DeLong retorts that if it lends like a bank, it just is a bank:
Not just “effectively” a bank. You are a bank. Not until the twentieth century did we have organizations that borrowed short and invested long that did not call themselves “banks.” The emergence of non-bank banks has always been the result of attempts at regulatory arbitrage.
But of course there’s the rub — you don’t need a justification besides regulatory arbitrage, that’s all the reason people need to start up something potentially quite lucrative. What’s needed are, somehow, better regulations that it’s not as easy to slip from.
28 Responses to “It Depends on What The Meaning of the Word “Bank” Is”
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October 12th, 2008 at 10:14 am
Not until the twentieth century did we have organizations that borrowed short and invested long that did not call themselves “banks.”
That’s just false, but I’m sure DeLong is correct in his larger point.
October 12th, 2008 at 10:33 am
“Regulatory arbitrage” is a banker’s euphemism that’s not particularly accurate. It should be called something like “regulation dodging” or “regulation evasion.”
October 12th, 2008 at 10:44 am
Marshall:
Not disagreeing but “this is just false” works so much better if you give an example.
October 12th, 2008 at 10:57 am
Matt, can you ask John Bolton what he thinks of our new deal with North Korea? Thanks. PS Enjoy your new digs.
October 12th, 2008 at 11:06 am
If that were “lent out money long” it might sort of be true, but long investments financed by short borrowing covers a lot of organizations, including most firms that rely on trade credit and commercial paper (and don’t tell me holding inventory complementary to your permanent business is a short investment [for the size of credit shock inability to roll over debt is]).
The deal with short borrowing is that it gives a lot of power to the short lender to call the borrowing organization into bankruptcy, much stronger than long borrowing bond covenants that need to set specific criteria for default. With short borrowing not being able to roll over the debt leads to default. That’s it. The point is to shift power and discretion to the short lender. The borrower doesn’t need to be a bank and often is not.
Finally, in general you get two types of firms borrowing short: very weak ones (think credit cards) since they cannot get credit otherwise and very strong ones (think high rated Fortune 500 firms and, well, banks and insurance companies like AIG) who can show how creditworthy they are to get better terms by exposing them self to rollover risk. The problem is that this can convert strong borrowers into subprime borrowers in systematic crises.
October 12th, 2008 at 11:11 am
I agree with the above comment.
http://culturedecoded.wordpress.com/2008/10/10/barack-obama-and-the-party-that-cant-lose/
October 12th, 2008 at 11:13 am
Similarly, naming financial instruments “credit default swaps” rather than calling them “insurance” was “regulatory arbitrage” which in turn is simply “avoidance of regulation.”
We also ended the separation of commercial and investment banking by repealing Glass-Steagel with the Gramm-Leach-Bliley “Financial Services Modernization Act .”
This is the kind of weaseling that is so characteristic of the dishonesty of our present financial system. We need to denounce this sort of approach and jail its practitioners.
October 12th, 2008 at 11:27 am
Arnold,
I would say that the history of banking is the history of various liquid agents trying to undercut the state- (or otherwise-) sanctioned lending authority. A three-way dance consistently takes place between the debtor (usually the state), the established lender, and the upstart. That was true under the Plantagenets, when Edward I needed financing to get around parliament, so he used Jews and other foreign merchants, then proceeded to expel them and repudiate debts. Philip II did the equivalent thing by first depending on Genoese merchant-bankers as a way of remaining independent of the traditional local authorities in his kingdoms, and then when Genoa became too powerful, he repudiated those debts and borrowed from the northerners (whom he was ostensibly at war with).
Successive lenders are not victims here of royal malfeasance. They’re willing agents who profit by meeting the political needs of wealthy clients. The usual upstart is an established merchant family that realizes the business of sovereign lending carries political risk but not the commercial risk that required them to keep liquidity on the books in the first place. The family puts that liquidity in government loans to balance the risk of trade. Pre-existing networks of trade provide natural syndicates, so the upstart can offer better terms to the client and protect himself by spreading the risk of any one default.
The point about not calling themselves “banks” is that the upstart was an attractive supplier of liquidity to the treasury precisely because he was independent of the incumbent holders of sovereign debt and the king could therefore divide and dominate. I would analogize that to the current crisis because the regulators so clearly desired an unregulated banking system. Exactly why they did is a bit obscure (in relation to the incentives facing Philip II, for instance)–perhaps their post-official paychecks played into it, plus the bribes that finance wizards funneled to the regulators’ political overlords.
October 12th, 2008 at 11:31 am
Yeah, “regulatory arbitrage” is a cute, pseudo-technical way of saying “shopping for weak regulations”. It’s the same as registering corporations in Delaware, registering credit card companies in South Dakota, registering corporations in the Caymans, classifying SUVs as trucks, hiding money in Switzerland, and registering ships in Liberia.
So as I understand, what DeLong is saying is that much of the global financial structure since 1995 or so has been shaped by deregulation and the attempts of finance to escape regulation, and that the current collapse is at least in part the result of that.
Elite liberals still have a bad habit of speaking only to each other. There are easy-to-understand, demagogic ways of saying “regulatory arbitrage” which would be politically effective without being false or inaccurate, but liberals hate the masses. Republican populism is fake, but Democratic elitisim is real.
October 12th, 2008 at 11:56 am
Another component to this entire mess is the fact that globalization further complicates the role of regulators. One of the under reported aspects of our current flight towards globalization is that is undercuts the ability of regulators to regulate, as firms or entities can simply move to other jurisdictions. For example, credit default swaps are not regulated in the United States as of now and are not required to be traded on an open exchange. So you have $62 trillion out there in notional value without anyone really understanding who is at risk. But China does not allow such newfangled, unregulated financial instruments. Now, in a non-integrated world, China would be in a pretty good position right now. However, in a non-integrated world, China is still at risk for the US’s inability to regulate and control this risk.
It is pretty clear that Paulson, Rubin and the rest of these high-flyers on Wall Street fully understood that globalization was a good deal for them, as it allowed them to further pressure regulators in any jurisdiction where they operated. Markets need capital, and the risk of capital leaving for less regulated jurisdictions put tremendous pressure on law makers and regulators to put on the kid gloves. In addition, many of the people in the position to regulate and make laws bought into the rationale actor theory of capitalism, which adheres to the very idea that no one would put themselves at such risk, from sheer rationale behavior. I think we can put that to bed right about now.
So this leaves us with the current situation, where I fear that no matter what we do, there will always be a Cayman Islands or Dubai willing to turn a blind-eye in the interest of attracting capital, making regulation of financial products and instruments all the more difficult. In addition, the United State’s position of power to mandate regulation is dwindling as we become a less wealthy nation. In the past, we could have barred firms from selling in the US, making their flight to less regulated jurisdictions a much more difficult cost-benefit decision. However, as the US loses wealth, and the rest of the world gains it, our leverage to regulate declines, making any future regulations less effective at reducing the world’s risk.
October 12th, 2008 at 11:59 am
Sorry – the first paragraph should read:
“However, in an integrated world, China is still at risk for the US’s inability to regulate and control this risk. “
October 12th, 2008 at 12:00 pm
I hope that John Emerson means that some set of elite or upper class or politically powerful liberals hate the masses, because the liberals I know have always preferred them not get screwed over, including opposing the party we usually vote for when required, whereas no one hates America and ordinary working and middle-class people like Republicans.
Every single politico-economic decision made by Republicans is made to undercut the economic and political power of ordinary people.
Nobody, but nobody hates America like Republicans.
October 12th, 2008 at 12:02 pm
Marshall:
The point about not calling themselves “banks” is that the upstart was an attractive supplier of liquidity to the treasury precisely because he was independent of the incumbent holders of sovereign debt and the king could therefore divide and dominate. I would analogize that to the current crisis because the regulators so clearly desired an unregulated banking system.
I’m not sure what this means. King Edward wanted a source of funds other than Parliament. You’re saying the US Treasury Dept. wanted a source of funds other than the US’ lenders at the time and deregulation provided that? Who are the new lenders in this analogy?
October 12th, 2008 at 12:08 pm
So this leaves us with the current situation, where I fear that no matter what we do, there will always be a Cayman Islands or Dubai willing to turn a blind-eye in the interest of attracting capital, making regulation of financial products and instruments all the more difficult.
It seems to me this road ends up at a formal global regulatory regime. The only question is how long does that take. Not this crisis. Maybe next crisis, and every crisis from now on makes the establishment of a formal global body to regulate capital more likely. I expect to see one in my lifetime.
October 12th, 2008 at 12:10 pm
Arnold,
That isn’t quite what I meant. The analogy is not that parliament was the incumbent lender; parliament is the tax-raising authority through which the king gets funds to pay off loans. The analogy is that instability in the pool of lenders is a constant feature of the history of banking, and it arises because states want it.
The difference between the sixteenth century and our own is that Philip wanted it then because he was the debtor, whereas now it’s obscure why the state wants that instability. But the instability, which is what DeLong means by not calling a lender a bank, is the constant feature. DeLong makes it sound as though up until the current free-wheeling era, banks acted like banks. My point is that lots of other things acted like banks too, always at the connivance of the authority.
October 12th, 2008 at 12:27 pm
Not kidding: Just listening to the BBC World Service (shortwave & internet) News Hour, and on this morning’s program on U.S. elections and folksiness, whom does correspondent Kevin Connally ask about “Joe Sixpack” but…
…Megan McArdle
http://www.bbc.co.uk/worldservice/meta/tx/nb/newshour1200_au_nb.ram
25 minutes in.
PS — Matt, if you contact the news departments of agencies like the BBC World Service, CBC, Radio Netherlands, Radio France, and other major international broadcasters, they will keep your contact information for call-ups for features just like these. If you don’t, we’re forced to hear from the same U.S. pundits we always hear from.
October 12th, 2008 at 12:37 pm
Oooh…one for the ages.
October 12th, 2008 at 1:01 pm
Marshall:
Then by your analogy, I don’t see a bright line between established lenders and upstarts. For Edward, was it that Jews were the established lenders and other foreign lenders were the upstarts, or was it that some Jews were lenders and other Jews were upstarts with the same case for other foreign lenders?
Why would all of the established and upstart lenders not have been “banks” and which of the lenders was not called “bank” or some equivalent?
And what are you saying the states want? Do they want independent sources of funds who compete against each other or are you saying they want them to compete against each other and operate by different rules? Why is operating by different rules important? Or are you saying the state wants some to fail so it can keep the money? Are you saying that is what the Treasury Dept is doing?
October 12th, 2008 at 1:18 pm
Then by your analogy, I don’t see a bright line between established lenders and upstarts
That’s exactly the point. Let me try to explain further.
I’m sorry if I introduced too many variables by historical examples that could be taken in a number of directions. I’ll also confine my explanation to the sixteenth century. I shouldn’t have brought up Plantagenet fiscal policy because all I know about it was that Edward I needed money, he borrowed it from foreign merchants and Jews, and then he kicked them out.
The other point that might be unclear is that I’m not alleging that the US Treasury is trying to get out of debts. The fact that the Treasury carries a lot of debt is irrelevant to this explanation–in my view the Treasury’s own debt would find a market without all the agents that the SEC and the Fed regulate.
The key point is this: in the sixteenth century, Philip II entertained an ever-changing lineup of liquid agents at his court and arranged for them to be able to do business in Spain and elsewhere in his dominion. That happened for various reasons. Also for various reasons, the regulatory regime in this country made it possible for anyone who wanted to act like a bank without any supervision. I’m comparing these two things because DeLong alleged that by failing to discriminate among liquid agents, the current regime was uniquely lax. I think that’s wrong because I think that regimes have historically enabled and benefited from competition among lenders at the expense of ensuring soundness in lending, again for various reasons.
October 12th, 2008 at 2:12 pm
The “established” way for the US government to receive money, for example to finance its wars, would be through levies passed by Congress on the taxpayers. The “established” ways for companies to receive money would be through their operating profits, gained through selling products to US citizens.
Now introduce the increase in inequality in the US since the 1970s. The wealthy class become too powerful to be taxed. The middle class, with incomes stagnating even after households go from one to two wage earners, are too hard pressed to be further taxed, more taxes would lead to a visible decline in their standard of living and undercut the “greatest nation on earth” propeganda. The American middle class can’t afford to buy the products of American companies without going into debt themselves. So alternate forms of financing are needed.
The regulated financial sector worked in the 1950s since the middle class could be used to fund government and corporations, put pressure on the middle class and you need “instability” to encourage the upstarts.
October 12th, 2008 at 4:16 pm
We also ended the separation of commercial and investment banking by repealing Glass-Steagel with the Gramm-Leach-Bliley “Financial Services Modernization Act .”
However, commercial banks’ subsequent attempts to buy or build investment-banking operations were generally quite unsuccessful, sometimes spectacularly and expensively so (For example numero uno, google “MCColl Weisel” and read the “Never Underestimate Thom Weisel) pdf that comes up). And the crux of the current problem–bad mortgages originated by non-bank mortgage companies and packaged and traded by Wall Street firms — didn’t need the repeal of Glass-Steagal to happen. The biggest benefit for brokerage firms is that they could now own banks and offer their retail/private-client customers bank services without depending on some convoluted joint venture with an unrelated commercial bank
October 13th, 2008 at 12:05 am
Similarly, naming financial instruments “credit default swaps” rather than calling them “insurance” was “regulatory arbitrage” which in turn is simply “avoidance of regulation.”
If this is accepted as true, it merely demonstrates the failures of three sets of regulators, first 50+ state insurance departments, who failed to recognize that there was a new form of casualty insurance being sold in their midst, which should be subject to reserve requirements, capital adequacy requirements & periodic examination of financial condition, among other things.
The second and third regulators that failed are state securities regulators that gleefully regulated de facto insurance products as derivative securities.
Now for the $64,000 dollar question? Are these things insurance. An insurable event has 5-7 elements (depending on the author), among them being, the loss event is definite as to time and amount, happens by chance, the event causing loss is outside the control of the insured, is relatively infrequent in occurrance and significant in amount, involves the chance of loss or no loss (not loss or gain) and the chance of loss is known or estimable mathematically.
Although my initial reaction is the CDS has some characteristics that make it much like a “surety bond”, or a contract which indemifies an insured against non-performance by an insured, the crtical problem with the idea that CDS’ are insurance is the inestimability of the chance of loss and the apparently greater frequency of ocurence, and its apparent relation not only to chance, but to macro-economic forces. Additionally, there would be a question of the “morale hazard”, that is, would collection efforts be abbreviated by the mere fact that the lender has a CDS in place.
Of course, the NY insurance department, known for its regulatory zeal is treating CDS instruments as insurance. I guess the courts will have the last word.
October 13th, 2008 at 12:08 am
Although my initial reaction is the CDS has some characteristics that make it much like a “surety bond”, or a contract which indemifies an insured against non-performance by a THIRD PARTY
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