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Capital markets, network effects, and too big to fail

Yves, taking down Tall Paulie, has a fantastic post that looks into exactly what kind of "bigness" we're looking at with "big banks," and why that matters. I think she's right, but I'd like somebody with real CAS and scale-free network chops to salt this post away and do some thinking about it (that would be you, lets). That said:

The part that Volcker keeps skipping over in his various statements is the thorniest problem from a policy standpoint: what to do with global capital markets firms. We have had an over twenty-year shift in practice. By most measures, the amount of lending that winds up being held by banks has fallen by more than 50%. Geithner, in a 2007 speech on financial innovation, noted that US banks were responsible for a mere 15% of non-farm, non-financial debt outstandings. The rest takes place via what Geithner calls “market based credit” or what others call the “originate and distribute” model (although Geithner also clearly includes credit default swaps in his use of “market based credit”).

Now even assuming we wanted a partial reversal (more on balance sheet lending), this is not an quick process. It is costly (as in banks on average would have to have much bigger balance sheets, hence vastly more equity than they possess now. Think of what it would take to reduce the use of plastic by 50% because we now know plastic has nasty environmental consequences. Going back to considerably more on-balance sheet lending would be a similarly large undertaking).

The consequence of this system of “market based credit” is that those markets have significant scale economies (network effects, high minimum scale required to be competitive, etc.). The result is a comparatively small number of firms have made themselves crucial.

Depending on how "crucial" is to be defined.) Translations: These banks are robber barons and they've got their chain across the river at a chokepoint. And we're all paying whenever we move our money up or down the river.

[T]his crisis extended a safety net under these global trading operations. More important, the industry recognizes full well how it is now situated. These origination and market-making operations will not be allowed to seize up. Before, they merely played with other people’s money. Now they play with other people’s money and a guarantee. Having the officialdom say it ain’t so or pretend it is working towards a solution when it does not yet have one does not fool anyone who understands the real issues.

It is not acceptable in a democracy to give the Treasury the near-unlimited check-writing authority to deal with systemic failures of highly-connected firms.
While [Volcker] mentions in passing the problems of connectedness, there is not enough focus on it here (and as we have discussed in earlier posts, the initial derivatives reform proposal did not do enough to address the real problem, credit default swaps, and its watered-down version looks certain to leave this product as hazardous as it was before). ....

I believe this problem is solvable, but it requires even more intrusive measures than Volcker contemplates. The lesson of the Great Depression was that firms that benefited from government guarantees had to be kept on a very short leash, and regulated in such a way that if they stayed within the rules and were competent, they would earn decent, but far from spectacular, profits.

The world has evolved so that many market making activities are now as essential to commerce as deposit gathering and lending. Those activities are de facto backstopped; there is simply no ready way back here (trust me, even if there were, it would take twenty years, and we’d still need an interim solution). We need to regulate those activities aggressively, including requiring much more capital to support them, and strict limits as to how much and what type of credit these firms can extend to hedge fund and other speculative investors.

The unintended message of Volcker’s op ed may be that even someone as tough-minded as he is may not recognize the magnitude of structural change needed to limit the extent of government guarantees to the financial sector and contain officially-backstopped risk-taking. It would be better if I were wrong, but we may need yet another crisis to produce the needed political will.

Hold on to your hats. Because the same people who created the last crisis are still in charge, haven't changed anything, and the crisis was very profitable for them. Before, they didn't' have a guarantee; now they do. What will the next Shock Treatment bring?

NOTE Yves, understands Canada, where the big banks are highly concentrated and did not go crazy with greed and crash the world's financial system. Why? Regulation. Saner establishment figures recognize this, and agree that another crisis will surely come:

The problems that led to the last crisis have not yet been addressed, and in some cases have grown worse, says Neil Barofsky, the special inspector general for the trouble asset relief program, or TARP. The quarterly report to Congress was released Sunday.

"Even if TARP saved our financial system from driving off a cliff back in 2008, absent meaningful reform, we are still driving on the same winding mountain road, but this time in a faster car," Barofsky wrote.

Since Congress passed $700 billion financial bailout, the remaining institutions considered "too big to fail" have grown larger and failed to restrain the lavish pay for their executives, Barofsky wrote. He said the banks still have an incentive to take on risk because they know the government will save them rather than bring down the financial system.

Barofsky also said his office is investigating 77 cases of possible criminal and civil fraud, including crimes of tax evasion, insider trading, mortgage lending and payment collection, false statements and public corruption.

When you think about it, the same degree of interconnectedness that created financial contagion is likely to create the contagion of criminal prosecution as well -- If Obama alllows the cases to go forward. (Having the so-called Department of Justice give Bush's torture lawyers a Get Out of Jail Free card is not encouraging in that regard.) I doubt that will happen, since the criminals are also Obama's owners, and they own Versailles as well.

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