One of the unintended consequences of the financial reform movement I’ve witnessed (been guilty of actually) is what I call making the world safe for financialization. This is the reform culture that argues what finance needs is better regulation, a super cop or some new regulatory authority to secure finance. This is the ‘bring-back-Glass-Steagall’ cry, Dodd-Frank, Volcker Rule, Capital Requirement Directive, Financial Stability Board, Basel and other similar regulatory initiatives, each of which has come into prominence in the aftermath of the crisis, a period that has witnessed bank concentration and leverage in the form of notional value of derivatives increase to record levels.
Financial stability is the objective of financial regulation. Only a rent seeking opportunist hoping to exploit vulnerabilities in the financial system would argue that the objective of regulation is something other than financial stability. Thomas Baxter, Jr. argues that financial stability prior to 2008 was a “penumbra” for the Federal Reserve. If he’s right the financial crisis proves regulation doesn’t work or supervision pre-crisis was ineffective.
Fundamentally, there are two ways the financial system can provide the economy with financial intermediation. Financialization is one way. It often goes by names such as sell-side, orginate-to-distribute and securitization among others. At its core, financialization brings buyers of capital together with users of capital to create an obligation resulting in a financial transaction. A contract is written, the obligation is funded, follow-on administration is often out-sourced, the instrument is packaged together with other similar obligations and re-sold to third parties, generally through the facilities of an after-market, specifically created for trading this particular financial instrument.
The reselling or recycling of financial obligations is the principal characteristic of sell-side finance and represents the vast majority of industry practice today. In modern book-based markets reselling of financial obligations is only restricted by the legal language to create new, innovative contracts and the production of electrons – both of which have proven to be inexhaustible. Sell-side rhetoric is prominent in the language of the financial industry. This is the ‘all-market-liquidity-is-good-liquidity’ argument one hears when industry lobbyists attempt to justify large bank complexes, scale efficiencies and regulatory flexibility.
The other way the economy can produce financial intermediation is through the buy-side of financial commerce. It often goes by names such as the bank channel, balance sheet lending, merchant banking, private equity and others. In this case, the financial contract is written in house, the obligation is funded internally and remains on the books of the institution until retired. It is not resold. There is no after-market.
There are few institutions left in the U.S. whose business model is based primarily on balance sheet lending. The economics of in-house lending has been crushed by the scale efficiencies of book-based finance, modern computer markets and global communications. There are some notable exceptions, however, such as Frost Bank in Texas, which is a model of sterling loan performance and enjoys a local trading area that would be the envy of any local planner. These firms are the quiet, low risk operators who largely missed the ‘financial crisis’ and bypassed the bailout theatrics of the High Street financial districts. Allowing for the ‘opportunity cost’ of the financial bailout and housing crisis, balance sheet lenders in the U.S. are a model for financial stability and supervision.
I don’t believe the problem in finance is one of more or better regulation. On the contrary, regulation results in arbitrage and opportunities for greater sell-side innovation, as we have seen with the recent increase in bank concentration and in the growth of derivative swap transactions, which I estimate have grown at a rate of a trillion dollars a week since the crisis, approaching an alarming $1 quadrillion notionally or approximately 14 times larger than the largest conceivable underlying risk in the world, global GDP. This is directionally betting on an unconscionable scale and is permitted under recently enacted financial reform including the Volcker Rule. These are some of the unintended consequences of financial reform I discussed at the opening of this piece.
The industry model in finance is broken, and industry risk is out of control. Sell-side finance is practiced, in one form or another, by nearly every banking institution in the U.S. and around the world. It represents a gigantic over-concentration of business risk in the industry.
Annual restitution, enforcement and fines in the industry are a tiny fraction of annual industry surplus (profit), implying near full industry compliance. Regulators do not enjoy subpoena power, are frustrated by the complexity and enforcement is all but an impracticality. The courts are little help. The problem in finance is not a rhetorical, regulatory or legal problem. It is a lack of effective supervision and regulatory discretion to reduce industry risk.
The Federal Reserve has within its authority the means to provide funding to member banks on terms, conditions and requirements it alone determines. It is well past time to begin shifting industry risk back onto the balance sheet of financial industry participants and not taxpayers through the balance sheet of the Federal Reserve. The discount system can be used to encourage banks to hold and manage risk internally. The Fed can do this by providing low-cost funding to balance sheet lenders and thereby begin to rebalance the competitive dynamic in the industry. Looking of your assistance to lobby the Federal Reserve on behalf of prudent industry risk management and an enhanced role for balance sheet finance.