The Great Debate

– Robert R. Bench, a former deputy Comptroller of the Currency, is a senior fellow at the Boston University School of Law Morin Center for Banking and Financial Law. The views expressed are his own. –

Financial institutions inherently are fragile.

As intermediaries, they are exposed to both exogenous and endogenous threats. The 2007-2008 financial crisis was caused by endogenous forces.  Simply, financial institutions were poorly governed, taking-on extreme liabilities and gambling them into high risk activities.  The meltdown of the financial system fed contractionary forces into the real economy, causing our “great recession,” creating negative exogenous loops back into financial institutions.

The roots of the financial crisis were poor underwriting of credit.  However, the crisis happened because that credit risk was amplified through abusive underwriting, distributing, and trading of debt-backed financial instruments.  The abuse was driven by “heads I win, tails you lose” compensation schemes.  Wall Street won, Main Street lost.

Reform of the financial system requires restoring the social utility of deposit-taking institutions while eliminating the casinos within them.  The Volcker-Obama proposals move in that direction, by limiting the degree of gambling at deposit-taking companies.  In essence, Volcker-Obama addresses the very basic question: What do we want the financial institutions to do for society?  We do not want them focused on fast profits through proprietary trading.  We do want them focused on how to finance the needs of households, commerce, and governments.

We need to separate the “financial markets industry” from the “financial services industry.”  The former complicates and confuses the latter when both are located in one financial services company.  Market trading makes for an active balance sheet and exponentially increases counterparty interconnectedness.  Unless walled-off or spun-off, regulating and supervising financial holding companies is difficult.  The financial services industry culturally  is a public utility, essential to our modern way of life, which is why we rescue it when trouble appears.  Unless we separate proprietary trading from the public utility, the high-roller financiers continue to free-ride the taxpayer.

– Robert Bench, a former Deputy Comptroller of the Currency in the Reagan administration, is a senior fellow at the Boston University School of Law Morin Center for Banking and Financial Law. The views expressed are his own. –

Financial Institutions inherently are fragile, simply because they are intermediaries exposed to both exogenous and endogenous forces.

Externally, they are vulnerable to wars, weather, or worn-out economic conditions. Internally, they always are susceptible to excessive risk takings as well as inadequate controls over operations.

John Taylor has maintained that it was the government's reaction to Lehman that freaked out financial markets. Now Luigi Zingales and John Cochrane make a similar pitch in the WSJ:

On Sept. 22, bank credit-default swap (CDS) spreads were at the same level as on Sept. 12. (CDS spreads are the cost of buying insurance against default.) On Sept. 19, the S&P 500 closed above its Sept. 12 level. The Libor-OIS spread—which captures the perceived riskiness of short-term interbank lending—rose only 18 points the day of Lehman's collapse, while it shot up more than 60 points from Sept. 23 to Sept. 25, after the TARP testimony. (Libor—the London Interbank Offer Rate—is the rate at which banks can borrow unsecured for three months.)

Why? In effect, these speeches amounted to "The financial system is about to collapse. We can't tell you why. We need $700 billion. We can't tell you what we're going to do with it." That's a pretty good way to start a financial crisis.