How to fix the US financial system
I had a very interesting conversation with Bob Pozen yesterday evening; his new book is out now, and I highly recommend it. It’s the first crisis book to make a detailed series of specific recommendations about what needs to be done going forwards — or, in the words of the book’s subtitle, “how to fix the US financial system”.
These recommendations are sprinkled liberally throughout the book, and are helpfully presented in bold type. Whenever I came across one, I scribbled the page number on the back flap of my copy, in one of four columns. The first column was recommendations I agreed with, or which were at least a step in the right direction; the next two columns were for recommendations I thought didn’t make complete sense or were questionable, and the final column was for recommendations I thought were bad ideas. The final tally looked like this:
As you can see, Pozen seems to be right (or at least in broad agreement with me) the overwhelming majority of the time. And as you can also see, he makes a lot of recommendations, on everything from accounting standards to insurance regulation. Tyler Cowen is quite right to give the book a rave review.
I’m not in agreement with Pozen on everything: he thinks, for instance, that it’s crucially important to get the securitization market up and running again — complete with tranche structures which require sophisticated modelling — while I think that securitization is inevitably going to be used to shove risk into tails and appeal to investors who don’t fully comprehend what they’re buying.
I’m also not fully convinced by one of Pozen’s big ideas, which is that banks should have small and professional super-boards which, rather than simply rubber-stamping the decisions of the CEO, take a much more active interest in the way the bank is run; Pozen has in mind here the governance structures at companies owned by private-equity shops. (Indeed, he wants to encourage more private equity companies to own and invest in banks.)
My view is that the rates of return targeted and required by private-equity investors are far too high for banking, which should be a boring industry, and that even if safeguards are put in place to stop PE-owned banks from lending to sister companies, management at such institutions will try as hard as they can to bend the rules to maximize leverage and profits. And that they will be positively encouraged to do so by their small super-boards.
Pozen, on the other hand, is fundamentally bearish on the business of banking, telling me that “if all you do is make traditional loans, you will lose money and you will go bankrupt”. I don’t think that’s true, but insofar as it is true of banks, it’s also true of investors who buy securitized loans originated by banks — so securitization is not really a solution to the problem. More generally, I don’t like the idea of creating a banking system where banks run around trying to make money on clever innovations because they’re losing money on their core loan products. It sounds like a recipe for disaster to me.
Some of Pozen’s other ideas are really good, though, like capping FDIC guarantees on bank debt at 90%. He also thinks that AIG Financial Products should declare bankruptcy, perhaps along with the parent company, which would give its counterparties a lot of incentive to settle their claims at say 70 or 80 cents on the dollar.
What’s pretty obvious though is that most of Pozen’s recommendations will not be enacted. Which raises the obvious question: if we don’t do this, what’s going to happen to the financial system and the economy? Pozen’s answer: we will have more crises, they will be increasingly severe, and they will be increasingly frequent. I agree.
One of the tragedies of the current crisis is that far too many people consider it to be an anomaly, a once-in-a-century event. It isn’t. The recipe for this crisis — a complex global financial system with large imbalances and inadequate controls — remains in place today. And financial crises are common things: even if you exclude emerging markets, there’s generally one somewhere in the world every year or two.
We can’t afford the trillions of dollars it would cost to rescue the world from the next crisis — yet at the same time we’re doing very little to minimize its effects or the probability of it happening. It’s a very risky game that we’re playing, and it’s liable to end in tears. Which is one reason why I’m so keen on Paul Volcker’s idea that we should eliminate the tax-deductibility of debt interest. That’s a big one: so big, indeed, that Pozen doesn’t dare even consider it in his book. But that’s the kind of ambition that we need to have if we’re going to seriously curtail crisis risk in the global economy.
Update: Pozen writes to say that he thinks some of his proposals — like regulating hedge funds and derivatives, as well as reforming loan securitization — will indeed happen. He also adds:
I was exaggerating when I said that traditional commercial loans would lead to bankruptcy as a way to driving home my point that traditional unsecured loans have a terrible risk-return relationship — with no upside and a lot of downside.
Still, if that’s true of the loans, it’s true of the securities made from them, too. So it’s hard to see how securitization is the great solution that Pozen thinks it is.