Verizon, Vodafone, and Measuring FDI

Recently back from APSA in Chicago, I've been reflecting on the state of our knowledge about FDI (or perhaps more accurately, cross-border management stakes in enterprises). That, and working on my dissertation, applying for academic jobs, and teaching. Oh, and telling everyone who'll listen about my Optimus Prime sighting on Michigan Ave.

Anyway, I find a post-conference review of the discipline is generally a good way to consider potentially fruitful lines of new inquiry. In my experience, the quality of papers at conferences can be rather hit-or-miss. This generally fits into my view of conferences as important sources of external deadlines for getting drafts done as well as interacting with other scholars in more informal settings such as the hotel bar/lobby/over-crowded coffee shop. And, I think that's enough to ask out of a conference.

However, there are generally one or two papers every conference that catch my eye in meaningful ways. They are often more conceptual pieces that challenge traditional approaches to measurement or quantitative analysis. Andrew Kerner's "What we talk about when we talk about foreign direct investment" was the stand out paper for me this year. According to his website the paper is under review and I'm not sure if he's widely circulating a draft at this time. Hopefully this piece will be published somewhere good soon because its well worth the read. The gist is that measures of FDI derived from balance of payment measures are grossly inadequate measures of the kinds of economic activity political scientists are generally interested in when we study the phenomenon frequently referred to as FDI. Not only do countries often have different definitions of FDI, but FDI flows bounce around for all sorts of reasons that are far removed from decision over making fixed, long-term investments in capital stock. Even worse, FDI flow data are reported in net terms, which makes it impossible to differentiate between a country that experienced a lot of inward direct investment concurrent with an equal amount of outward investment and a country that experienced no direct investment flows at all.

The recent news about Verizon's buy-out of Vodafone nicely illustrates some of the problems with current measures of FDI. Vodafone is a British company, so Verizon's decision to buy out Vodafone's share will register as a massive repatriation to the UK. The size of the deal is so large ($130B!) that it's going to influence measures of global FDI flows for 2013. For context, UNCTAD reports global FDI inflows last year were $1.35 trillion. That means this one mega deal is worth 10% of all total FDI net inflows last year! I doubt any political scientists would argue the Verizon-Vodafone deal reflects any underlying change in assessment of political risk in the US. But, that one deal will dominate 2013 measures of global FDI.

Kerner's entreaty is to use data sources that differentiate between flows of cash and real fixed capital investments. One limitation of such as strategy is that it limits us to modeling the investment decisions of either US or Japanese firms (since the US and Japan are really the only countries that make available such detailed data about the investment decisions of their foreign affiliates), and the investment behavior of firms from these countries might differ in important ways from firms headquartered in other countries.

Given the tendencies of those writing on this blog, as well as our co-authored academic work elsewhere, it may not be surprising that I'm partial to another tactic. It seems that all this semi-liquid investment caught up in measures of FDI might not be so easily captured through an obsolescing bargaining mechanisms (though, as Rachel Wellhausen pointed out in discussion, even cash can be effectively illiquid if there are restrictions on repatriation), but the flow of these investments across borders does influence banking systems, the growth of the money supply, the availability of credit both globally and domestically, and therefore the propensity for crisis. Perhaps one way forward here is to consider more explicitly the relationship between different kinds of financial flows and how their interaction affects both political and economic outcomes.

Regulation Is More Complicated Than You Think

Some of my research involves the regulation of bank capitalization, including the use of risk-weights. One of the things I constantly emphasize is that there are many misconceptions in the academic and policymaking communities about the relationship between banks and regulations. Here, for example, is Per Kuwoski complaining about the international Basel capital accords:

The first fact is that since banks are allowed to hold less capital, and therefore to leverage the risk-adjusted margins more on their capital, and therefore to obtain much higher expected returns on equity when lending to what is perceived as “safe” than when lending to what is perceived as “risky”, current regulations are completely distorting our financial system. 

That has caused banks to create excessive exposures to what was erroneously perceived as risky [ed.: I think he means "safe"], like in AAA rated securities, Greece, real estate, and to refrain from lending to those in the real economy perceived as “risky”, like small businesses and entrepreneurs.

The second fact is that the first fact is not even mentioned, much less discussed.

The point is that prior to the crisis banks were doing what they were supposed to do. The epicenter of the crisis was located in some of the safest categories of financial instruments: OECD sovereign debt and highly-rated securities, both of which were privileged in the risk-weighting scheme under the Basel accords. The crisis didn't occur because of junk bond trading; it occurred in part because everyone (including the banks themselves, apparently) thought banks were acting safely when they were actually concentrating evermore risk at the center of the global financial system. This means that increasing capital requirements under the current regulatory structure is likely to increase the exposure financial institutions have to these types of assets, these types of risk, and thus the sort of crisis that we've just experienced.

Was the risk-weighting system gamed? Of course it was*, particularly by the mid-2000s when the world's demand for "safe" financial assets denominated in dollars massively out-stripped supply. Safe financial assets were defined by the regulatory code, so there was quite a lot of money to be made by creating assets which would be considered safe by regulators and selling them. Was there outright fraud? Some, yes, although it's hard to find solid evidence that this was as pervasive a feature of the financial system prior to the crisis as many assume; it's even harder to demonstrate that fraud led to (or even contributed to) the crisis. It's much easier to see how gaming of the system could have.

But what banks were not doing is "racing to the bottom". That is, they were not bumping up against their minimum regulatory requirements by taking on as much risk as they were legally allowed to do*. Instead, they were piling into "less risky" assets because those were rewarded by the regulatory code. And the more that these types of assets are rewarded (or required) by the regulatory code, the more banks will game the system in increasingly opaque ways. It's what they're being asked to do, after all.

What is to be done? Some, like Kurowski and also Vice-Chairman of the FDIC Thomas Hoenig, want to abandon the risk-weighting system altogether. Their views are represented by new bipartisan legislation which was introduced into Congress by Brown and Vitter last week, which has the support of everyone from community bankers to Simon Johnson. The gist: force banks to fund some percentage of their investments with equity rather than debt, but let them (and their investors and counterparties) determine what assets are risky and what are not. Keep the system simple; the more complicated it gets, and the more beneficial it is to pursue profit through regulatory arbitrage, the more it will be gamed.

But so far the political discussion of this has often reduced to a simple lobbying story: banks don't want to be regulated, and they've got the power, so the regulation will be weak. This is both an incredibly simplistic view of regulatory politics, it is also wrong in at least some cases. Banks don't like some kinds of regulation, it is true, but bank preferences are not homogenous. All regulations have distributional consequences, so some firms will support them while others oppose them. We're seeing that with Dodd-Frank and Brown-Vitter and we've seen it in previous rounds of the Basel accords.

The point is that banks (and other financial firms) have asymmetric interests, and that these interests are conditioned by the regulatory environment. Just making the regulatory environment "tougher" won't necessarily punish large financial institutions (it'll often help them), and may concentrate risk in opaque parts of the financial system. This is arguably the worst possible result. Unfortunately, it may be the most likely under current policy.

*If by "game the system" you mean doing essentially what the regulatory code wanted them to do: invest in sovereign debt and asset-backed securities.

**If you doubt me, I can prove it. Part of the work is forthcoming in peer-reviewed form; other parts will hopefully find a home soon.

A Shameless Plug

While the world of economics is busy debating Jeremy Stein's recent argument that the Fed can -- and sometimes should -- use monetary policy as a de facto regulatory tool (see here for a recent discussion and links), I figure I should use the opportunity to plug a paper of mine which analyzes a similar question in a cross-sectional context. My conclusion is that banks respond to institutional incentives, not just actual central bank policies.

The gist: Copelovitch and Singer found that monetary policy is fundamentally different when central banks are also regulators. Specifically, they argue that when central banks are regulators they tailor monetary policy towards the needs of the firms they regulate. I build off of their framework to show that banks respond to these differences in predictable ways: they act more riskily when central banks are regulators, and note that this effect is independent from actual monetary policies themselves.

The paper is currently in the "revise and resubmit" phase at a journal (it has been revised and resubmitted and I am awaiting a decision), but a previous version is here.

This Looks Important: The Inefficient Markets Hypothesis

But I haven't read it yet:

The Inefficient Markets Hypothesis: Why Financial Markets Do Not Work Well in the Real World
Roger E.A. Farmer, Carine Nourry, Alain Venditti
NBER Working Paper No. 18647
Issued in December 2012

Existing literature continues to be unable to offer a convincing explanation for the volatility of the stochastic discount factor in real world data. Our work provides such an explanation. We do not rely on frictions, market incompleteness or transactions costs of any kind. Instead, we modify a simple stochastic representative agent model by allowing for birth and death and by allowing for heterogeneity in agents' discount factors. We show that these two minor and realistic changes to the timeless Arrow-Debreu paradigm are sufficient to invalidate the implication that competitive financial markets efficiently allocate risk. Our work demonstrates that financial markets, by their very nature, cannot be Pareto efficient, except by chance. Although individuals in our model are rational; markets are not.

 I think Munger gets it wrong when he writes:

An objection to the ability of markets to get the rate of time discount "correct." My question: as compared to what? Compared to legislators with a two year time horizon (okay, six in the Senate, right after an election)? Why don't people make fun of the "efficient governments" hypothesis? The libertarian argument is not that markets are perfect, it's that politicians are even more short-sighted.

Again, having only read the abstract, I don't see this as saying that the actors aren't discounting correctly, but that they are discounting differently. This paper is still making pretty strong assumptions -- complete markets and no transaction costs -- but simply showing that with heterogenous agents financial markets are not Pareto-optimal. This is a big deal! It is also in line with things Steve Randy Waldman has been writing about for awhile (e.g.).

I don't think it implies quite what Munger thinks it implies; inefficient/irrational markets could still be more efficient or more rational than politicians. In fact, I imagine that the model would show that the market with a larger number of actors performs better than it would if it were controlled by a smaller number of actors, e.g. a government. But maybe not. I'll have to read it first. 

Update on FinReg Politics

Awhile back Thomas and I wrote a chapter for a Research Handbook summarizing positive theory in political economy on global financial regulation. (The book is here; an ungated draft version of our chapter is here.) As we were writing many governments were revising their regulatory standards in response to the global financial crisis, and the international standards created by the Basel Committee were undergoing revision as well. We were pleased that most of our speculations -- which came directly from a variety of researchers in the IPE literature -- were borne out by later developments. It was one of the few validations of IPE work that emerged from the crisis. But things can change, and the politics of financial regulation doesn't stay still for long.

One of the key arguments that we made was that the revisions to the Basel accords were highly likely to benefit banks in the US. Indeed, the U.S. government left capital regulation out of the Dodd-Frank Act almost entirely, choosing the international forum. Previous IPE research suggests that this is done in order to advantage domestic US firms, which should only be expected since all regulations involve redistribution, and thus creates both winners and losers. It's seemed pretty obvious that the winners would be US firms, and the losers would be firms in Continental Europe and Japan. (I've blogged about this before.) In the chapter Thomas and I wrote we explained how this was just a continuation of a dynamic going back to the creation of the first Basel accord in the mid-1980s.

Fast-forward a few years and the same dynamics appear to be in force:

THE European Banking Authority (EBA) released its second report monitoring compliance with Basel III regulations on September 27. The big finding is that the aggregate European banking sector needs about 338 billion euros of additional equity capital to comply with the rules. While firms have several more years to adjust their balance sheets and raise funds, this seems like a tall order, especially given what has happened to bank share prices [wkw: which have declined dramatically since 2008].

In the US, which are generally better-capitalized than their European and Japanese competitors, the new international rules are likely to harm small banks more than big banks, as the new standards increasing the complexity involved in compliance. Perhaps this is why large US banks have remained relatively quiet about their new Basel obligations, unlike many of the provisions in Dodd-Frank, while smaller banks have screamed bloody murder. The increase in complexity rewards large firms with the technical capacity to navigate the system. The new Basel demands for more capital hurt firms with less capital, and for whom it is more expensive to acquire it. On both dimensions, large US banks are in a better position than their smaller domestic rivals or competitors in other jurisdictions.

On these points it is interesting to read Felix Salmon's take on Sheila Bair's new book (which I've not read), in which we find:

Tim Geithner involved himself quite deeply in Basel III negotiations. Bair can’t stand Geithner, and ascribes malign intent to everything he does. Geithner asks questions about Basel III without explicitly saying what his own opinion is? “It wasn’t clear whether Tim was trying to build consensus among the U.S. regulators or trying to stir the pot.” Geithner agrees to push for higher capital standards — exactly what Bair wanted all along? Well, that’s just his way of trying to marginalize her:

Bair sees the entire episode as a power play by Geithner. She argues he was trying to blow up the meeting between international regulators so that the issue would be kicked higher to the Group of 20 finance ministers who were set to meet in November. If the G-20 took over negotiations, Geithner would be leading the U.S., not Bernanke. The FDIC would have little say in the final number.

I'm more sensitive to the idea that Geithner's involvement was a power play than Salmon, although more likely Bair was less Geithner's target than Bernanke. And I doubt that Geithner ever wanted to leave the Fed out of the process -- that would be absurd and it didn't happen -- rather than ensure that he remained actively involved in the process. Geithner is routinely accused of pushing for policies that benefit the US banking sector, both in his time at Treasury and before when he was at the US Fed. I think many of the more moralistic of these criticisms are a bit much -- after all, shouldn't a healthy banking sector should be a goal for regulators? -- but the general drift seems to fit the data fairly well. There's no doubt that things would look a bit different if Bair, or Elizabeth Warren, was in charge.  And this fits in with the general tenor of the story I'm trying to tell: US policymakers have the well-being of US firms in mind when they go into international negotiations. Or, as Salmon puts it:

[I]t’s entirely natural that Geithner, who moved straight to Treasury from the presidency of the New York Fed, would take an interest in Basel III: after all, the New York Fed generally provided most of the frontline negotiators hammering out details far from the view of principals like Bair. And, it’s worth noting, the New York Fed was actually very aggressive in the Basel negotiations — much more aggressive, actually, than the higher-level negotiators from Washington. That was the culture Geithner came from, and if he was more sympathetic to Citi and BofA than Bair was, he was also well aware that the tougher the capital-adequacy standards, the better the competitive position of US banks in general, vis-a-vis their woefully undercapitalized European counterparts.

In this particular case this is good from the perspective of those hoping for a stricter regulatory state, since the US (along with the UK and Switzerland) were the ones pushing for tighter capital and liquidity requirements, while the Germans, French, and Japanese resisted. Needless to say the Americans won on most points, with the major concession being a longer phase-in period to give European banks a chance to play catch-up. Many major US banks are already in compliance.

This narrative complicates usual regulatory capture stories. For example, if US firms push US regulatory authorities to impose stricter regulations in order to lock in an advantaged market position, should those who favor the regulatory state approve? Well, that's a tricky one isn't it. But this tends to happen following regulatory innovations: incumbents are advantaged, while new entrants and possible competitors are disadvantaged. And indeed, the Too Big To Fail banks have only gotten bigger since the crisis.

This is something that a political economy approach can, and does, help us understand.

Global Finance and Comparative Advantage in Trade

I've blogged repeatedly* that if we are to understand recent developments in the US and global economies pertaining to inequality, stagnation, regulatory capture, and electoral influence we need to do two things at least:

1. Embed the financial system within the broader US economy.

2. Embed the US economy within the broader global economy.

If we do these two things we will likely conclude, as I did in one recent post, that:

The cumulative effect of [opening of capital accounts and trade developments via GATT/WTO] both forced encouraged the US to pursue its comparative advantage in high-skilled service labor (e.g. finance) and increased the market into which the US could sell its comparative advantage. The result is thus entirely predictable: finance becomes a bigger size of the US's economy, while comparatively disadvantaged sectors shrank.

Some people, e.g. a commenter on that post, seem to have difficulty grasping this point. But Emmanuel recently noted something interesting:

the WTO has for the most part ruled in favour of the United States in its case against China over discrimination against international payment card transaction firms in the RMB-denominated arena

I.e., US financial firms -- in this case credit card companies -- want access to the Chinese market. The Chinese blocked them. The US government took China to the WTO and won. This is precisely the behavior we would expect if the US was trying to open up a market for its comparatively-advantaged sector, while China was trying to close off that market to protect its comparatively-disadvantaged sector.

I'm not genius for making this case... it's the simplest materialist explanation of trade politics that we know. But sometimes the simple theories work quite well.

*I am sure there are dozens more posts in a similar vein to the one linked above. Searching the blog for relevant terms should turn them up.

Why Has US Finance Grown? Because The World Is Not a Monad

Guesting at Noah Smith's place, Dan Murphy seeks to explain why the financial sector grew to be such a large component of the US's economy during the 2000s. He offers three possibly explanations: finance became better at "making markets" by matching buyers and sellers, the need to manage risk became more important, and that people became convinced that employing financiars would help them boost their investment portfolios. Murphy suggests that the first two are not good explanations because they are static variables unable to explain change. He doesn't seem to think the third is as well, although it seems that way to me.

I don't think this is the right way to think about this. Instead, I'd rather embed finance into the broader US economy and then embed the broader US economy into the broader global economy. What changes have been taking place in the global economy over the past decade-plus that could help explain this? Two prominent things immediately come to mind:

1. The opening of capital accounts around the world, which began in the 1990s but accelerated dramatically during the 2000s.

2. Changes in the global trading system, particularly the expansion of the GATT -- which added many new members following the end of the Cold War -- and the transition from the GATT to the WTO.

The cumulative effect of these two factors both forced encouraged the US to pursue its comparative advantage in high-skilled service labor (e.g. finance) and increased the market into which the US could sell its comparative advantage. The result is thus entirely predictable: finance becomes a bigger size of the US's economy, while comparatively disadvantaged sectors shrank. Factor in positive feedback dynamics in global financial markets and this isn't much of a mystery at all.

Potential Consequences of the EU's Proposed Regulatory Changes

The European Union is considering a dramatic revision of the current institutional arrangement concerning banking regulation and supervision. Currently, members of the EU must implement international capital standards -- the Basel accords -- but regulation of domestic financial sectors is left up to national governments. Some governments choose to have their central banks regulate, others give that authority to a separate agency; each is fine under current EU rules.

That may change. Given the instability in the EU banking markets, and the fact that EU members must allow free movement of capital within the EU, the institution is considering moving supervisory authority to the transnational level:

The leaders of France, Germany, Italy, Spain and Austria are willing to back a powerful supranational supervisor, and a decision to relinquish national control over cross-border banks is being prepared for next week’s EU summit, according to senior officials. One said the new-found political impetus was “astonishing”.

The "astonishing" political impetus has come from the fact that the EU is currently experiencing a number of bank runs, capital flight from the periphery to the core, and a general lack of trust in the solvency of many of its financial institutions. To shore up confidence, many in the EU would like to create a "banking union" that would involve continent-wide deposit insurance for EU banks. In exchange for that guarantee, states would have to give up sovereignty to a higher body, which would presumably be heavily influenced by the core European countries (in this case, Britain, Germany, and France).

What would the effect of this be? It turns out that I've done some research on that question.* That work suggests that the answer is: it depends. Specifically, it depends on who the regulator would be. The top two choices appear to be the European Central Bank and the European Banking Authority. Why does it matter?

My research, building off of some work by Copelovitch and Singer, argues that giving regulatory authority to central banks alters the policymaking incentives that central bankers face. Without getting too wonky, it incentives central banks to privilege the needs of the banking sector when choosing monetary policy, as financial instability could lead to the loss of their authority. This, in turn, incentivizes banks to behave more riskily, as they expect to receive preferential treatment from sympathetic central banks, so long as they stay above the statutory requirements. The cumulative result is a more bank-friendly monetary regime (the Copelovitch and Singer result) and a more risk-friendly banking sector (my result, supported by a ton of statistical tests). This may not be what the EU currently has in mind.

On the other hand, regulatory central banks may be better able to prevent financial instability in the first place by tailoring policy to the needs of the financial sector. I do not explicitly study this question, and I doubt it is strictly true, but central bankers have argued according to this logic in the past. Alternatively, unifying regulatory and monetary authority could reduce institutional competition and lead to better-coordinated policies. Of course, if that coordination is in a direction that rewards greater risk-taking by EU banks then that might not be the best thing.

*Currently under review so no link, but interested parties can e-mail me for a copy.

Not Quite Crony Capitalism?

I haven't read this yet, but Lucas Puente -- a PhD student at Stanford -- has an interesting-looking article in the new PS (I don't see an ungated version). Abstract:

I investigate one mechanism through which financial institutions could have used political influence to receive preferential treatment in the US Department of the Treasury-administered “bailout.” I find that neither proxies of political influence nor other political variables, such as public interest in specific deals, can explain variance in the sale price of warrants (a type of financial asset) Treasury acquired through TARP's Capital Purchase Program. Moreover, I find that the more politically active the firm is, the more likely Treasury is to auction its warrants (thereby receiving fair market value). This conclusion is not consistent with recent studies investigating the role of such variables in the initial administration of TARP and can be interpreted as good news for American taxpayers.

PS summary (bold added):

In the wake of the recent global financial crisis, many have suggested that the US government's administration of the taxpayer-funded rescue of the financial industry offered disproportionate benefits to politically active firms. However, quite the opposite occurred. Puente's research into Treasury's handling of the disposition of warrants (assets similar to stock call options) acquired through the Capital Purchase Program (CPP) shows that, at least in this phase of the "bailout," political variables did not matter. That is, lobbying expenditures, campaign contributions, and connections with Secretary of the Treasury Geithner, among other independent variables, cannot explain variance in the percentage of market value Treasury received for these warrants. Moreover, according to Puente, the more politically active a firm is, the more likely Treasury is to auction its warrants (thereby receiving fair market value). This suggests that Treasury is attempting to counter-act allegations of preferential treatment. Taxpayers should be pleased. By insulating itself from politics and making efforts to maximize the taxpayer return on the warrants, Treasury may have prevented billions of dollars in taxpayer losses.

I personally don't find this very surprising. Nor would I find it surprising if preferential treatment came mainly through less transparent channels, e.g. the Fed. It looks like Puente might be investigating that question in his ongoing research.

Why Theories of Regulation Are Inadequate

Here are some assumptions shared by the most prominent theories of regulatory politics*:

1.a. Strict regulations in one country will generally hurt the competitiveness of firms in that country.  

1.b. Unless those regulations confer rents to domestic firms. 

2. Because banks are a concentrated, influential interest group, this means that states will generally not unilaterally regulate. Therefore, new regulations must come in the form of a credible international standard -- generally originated by a powerful state with agenda-setting power -- that ensures that foreign competitors will have to abide by the same restrictions. 

3. States attempt to use their power and influence to affect the parameters of regulations in ways that benefit their firms. This may involve an international redistribution of rents, from firms in a less-powerful country to firms in a more-powerful country. Such a redistribution may, but does not have to, fall along the Pareto frontier.

Now let's look at some news from the past month:

-- Philipp Hildebrand, head of the Swiss central bank, is enforcing stricter capital standards for Swiss firms than those required in the international Basel III agreement.

-- Japan and Canada are asking U.S. regulators to not regulate U.S. firms more strictly.

-- Joe Nocera -- no lackey for the financial sector -- joins JP MorganChase CEO Jamie Dimon in protesting that the number of new regulations is potentially destabilizing and will lead to arbitrage opportunities for the type of large firms they are supposed to curtail, while agreeing with Dimon that simple rules like capital standards should be strengthened.

None of these would be expected by the dominant theories in the literature, despite the fact that none of these dynamics are especially new. In 2006, more than 40% of the governments surveyed by World Bank researchers reported that their capital regulations were stricter than the Basel requirements. There were similar responses in two previous surveys, conducted in 1999 and 2003. Only a handful (I believe it was three or four) of countries reported that their regulations were weaker than the Basel minima, despite the fact that accession to the Basel accords has not been mandatory outside of the G-10 (and later the EU). That means that, if existing theory is to be believed, 40% of the world's governments were putting their firms at a competitive disadvantage by having stronger regulations than the international standard. That means that, if existing theory is to be believed, nearly 100% of governments responding to the World Bank survey were refusing to take an opportunity to give their firms a competitive advantage by staying out of Basel**.

These empirical patterns suggest that we need to do more hard thinking about what regulations actually do and how they impact markets. Once we have a better understanding of these, we might be able to get a better sense of how interest groups form preferences over regulatory policy and how comparative and international political processes work.

I have some ideas along these lines, but this is getting long enough already. If you're interested stay tuned; I'll be posting somewhat regularly on this topic over the next year.

*I'm most familiar with theories specifically applied to financial regulation, but I believe these hold true more generally. The two main categories of regulatory theory in the political science and economic literatures are joint-gains functionalism and rent-seeking public choice. Despite having different conclusions about the outcomes of regulatory policies, they share many fundamental assumptions about the ways that regulations work and different interest groups' attitudes over regulations.

**There is certainly some "mock" compliance, where states claim to be in compliance but are not. Since Basel has no monitoring or enforcement mechanism other than market discipline, this may happen quite a bit. Indeed, Andrew Walter extensively documented some examples in East Asia. Still, the World Bank surveys have been public for years, and the researchers actively encourage people to report discrepancies between de facto and de jure policies. To my knowledge few revisions have been necessary.

(There Can Be No) Flight to Safety Uh-Oh GOTD

Yikes. Clear here for bigger image. Discussion here, including this:

Historically, a Triffin Dilemma — and that’s kinda what this is — leads to funky innovations in the shadow banking system and all the complications that such innovations bring. Will the whispers of new kinds of financial alchemy get louder?

You can see in the chart that before the crisis, US Treasuries were an important but minority amount of the world’s stock of safe haven assets. Treasuries are now the vast majority of such assets. But this is because of the extraordinary decline in the other kinds of assets and because of quantitative easing by the Fed, not because the outstanding stock of Treasuries has increased by so much.

Perhaps the outstanding stock of Treasuries should increase.

Via Counterparties.

Moral Hazard FOTD

Banks that took bailout money acted more riskily.

Ran Duchin and Denis Sosyura of the University of Michigan looked at the U.S.’ Capital Purchase Program. ... 

Duchin and Sosyua looked at a sample of 529 public firms that were eligible for CPP and slotted them into categories based on whether they applied, whether they were approved and whether they ultimately took the money. They controlled for non-random selection (via measures of the banks’ financial condition, performance, size and crisis exposure); for changes in national and regional economic conditions; and finally for potential distinctions in credit demand. 

They then viewed the banks’ CPP participation status in comparison with their subsequent risk appetite as demonstrated by (1) their consumer mortgage credit approvals or denials (viewed on a risk-profile controlled, application-by-application basis); (2) their participation in syndicated corporate loans for riskier credits and; (3) the risk profile of their investment asset portfolios. What did they find? ... 

Moving from this granular level to a bank-wide basis, the authors found that the CPP banks increased asset risk (using ROA & earnings volatility as proxies) while decreasing their leverage (perhaps because they knew that regulators would be keeping an eye on this metric in addition to the capitalization ratio.)

Here's the paper. This part of the abstract is very important:

Our difference-in-difference analysis indicates that after the bailout, bailed banks approve riskier loans and shift investment portfolios toward riskier securities. However, this shift in risk occurs mostly within the same asset class and, therefore, has little effect on the closely-monitored capitalization levels. Consequently, bailed banks appear safer according to the capitalization requirements, but show a significant increase in market-based measures of risk. Overall, our evidence suggests that banks’ response to capital requirements may erode their efficacy in risk regulation.

So of course global -- and many domestic -- regulations focus on capital and leverage ratios.

Financialization and Inflation Rates

While looking for something else I came across this paper by Gerald Epstein from 2002. Here's the abstract:

"Financialization" refers to the increasing importance of financial markets, financial motives, financial institutions, and financial elites in the operations of the economy and its governing institutions, both at the national and international levels. This paper considers one aspect of financialization: the increased use by central banks of "inflation targeting". An extensive review of the literature shows that there is little evidence that inflation targeting reduces the costs of fighting inflation. Moreover, I present new evidence that, with respect to moderate rates of inflation – under 20% -- there are few macroeconomic costs of inflation. Hence, central banks' focus on inflation targeting cannot be explained by a "rational" social cost/benefit calculation and therefore, political economy analysis must be employed to explain its widespread use. The paper explores a "contested terrain" approach to understanding central banks' preoccupation with inflation fighting, an approach which concentrates on the relative interests of finance, industry and labor with respect to macroeconomic policy. I suggest that, in the case of the United States, financialization during the 1990's led to a closer alignment of large industrial and financial firms in the U.S., leading to a greater emphasis by Alan Greenspan and the U.S. Federal Reserve on financial asset appreciation as a goal of monetary policy. In the conclusion, I explore the contradictions and limits of this as a basis for sustained, expansionary monetary policy for the U.S.

We've discussed this sort of thing regularly on this blog, so some readers may find it of interest.

Dodd-Frank's First Birthday

Mike "Rortybomb" Konczal interviewed Economics of Contempt to discuss Dodd-Frank one year on. There's some good stuff in there. Most relevant for readers of this blog are these parts:

The big financial firms have been coordinating [lobbying efforts] well with each other on some issues and throwing each other under the bus on other issues. Due to the sheer range of issues being addressed in the Dodd-Frank rulemaking process, this was inevitable. Big foreign banks have different incentives than big US banks on some issues (e.g., extraterritoriality), but they’re aligned on other issues (e.g., clearinghouse ownership). To be honest, I’ve seen more coordination between the major banks than I expected, but I think that’s primarily because the trade associations (SIFMA, Financial Services Roundtable, ISDA, etc.) have been so eager to get paid and stay involved.

The fact that firms in the same sector would have different preferences (at least in some areas) is an area that political scientists haven't spent enough time on. I presented an early draft of a paper at ISA this spring that tried to get at some of that, but I haven't gotten very far just yet. The role of the trade associations in actively seeking to coordinate behavior would not surprise those who study institutions and institutional behavior.

As you say, the “Dodd-Frank didn’t go far enough” crowd tends to think that one of the main reasons why the major banks should be broken up is that they have a dangerous amount of political power. I think that the big banks’ political power, especially after the crisis, is massively overrated by pundits, and I think the interchange vote proved this. The big banks spared absolutely no expense in trying to roll back the Durbin Amendment (i.e., the interchange rules). The big banks mounted an all-out, eight-month lobbying campaign against the Durbin Amendment, and they even had the powerful community banks on their side. But they still lost the vote.

It's easy to come to the conclusion that Goldman Sachs is a vampire squid (or is it evil octopus?) whose tentacles rules the world. And the banks do have more influence in D.C. than most, and there are a whole host of programs and policies that benefit them. But that influence still has limits. In the past year or so, we've seen the enaction of Dodd-Frank, which is a significant re-regulation of the domestic financial system, and the agreement of the new Basel accord.

One of the problems with lamenting the “financialization” of the US economy is that no one ever explains what they would consider a successful de-financialization. Finance is a global industry and US financial institutions provide significant financial services to foreign investors. It’s also fair to say that the US has a comparative advantage in financial services. So given that comparative advantage, and the global nature of the financial industry, where is the line between a healthy US financial industry and the unhealthy “financialization” of the US economy?

This is true. The US does have a comparative advantage in finance (and other high-end services), and specializing in your comparative advantage is what every econ textbook says to do. This can lead to other problems -- including shifting political influence from labor to capital, increasing income inequality -- but any call for a definancialization of the US economy must include some argument about what can replace it and still be successful in a global marketplace. In other words, it has to make the case that the US has some other comparative advantage that it is not exploiting. And I don't know what that would be.

In another interview, Rob Johnson is less sanguine:

For Wall Street, [the year since Dodd-Frank passage] has gone swimmingly. They have the process tied in knots and at the same time can complain about the muddle to further weaken government. For the rest of us, a weak bill is getting diminished further. It is the fate of money/lobby-driven political machinations to make everyone disenchanted with government. ...

It will be compromised and weakened regardless of whether Democrats or Republicans hold power. ...

It will have been a reflection of how powerful the financial sector was. Finance is too strong in politics, bailouts, and corporate governance imperatives. They are like a tax that descends upon society, collected for the bonus pool and used to defray the losses from past carelessness. The social contract between the financial sector and society is a pendulum rocked very far to one side. This tepid set of reforms in the aftermath of a colossal crisis will underscore how far the power of finance dominates our political economy. Inside Job indeed!

We're Missing A Mechanism

Felix Salmon:

The big-picture thing to remember when looking at this chart is something which I’ve said many times before — that it wasn’t an excess of greed and speculation which led to the financial crisis, but rather an excess of overcaution, with an attendant surge in demand for triple-A-rated bonds. On a micro level, triple-A securities are safer than any other securities. But on a macro level, they’re much more dangerous, precisely because they’re considered risk-free. They breed complacency and regulatory arbitrage, and they are a key ingredient in the cause of all big crises, which is leverage.

Much more at the link including the mentioned chart. Brad DeLong has made similar points in the past, and Tyler Cowen links to related discussion of how demand for AAA assets shifted to sovereign debt when it became clear that much AAA-rated ABS wasn't in fact AAA. Now of course there is a lot of trouble with sovereigns.

What we don't have a clear sense of is the mechanisms driving all of this. Is it a global movement towards safety beginning in the 1990s? Is it regulatory response, since both high-quality securities and OECD sovereign debt are privileged in the Basel accords?

From an IPE perspective, there appears to be insufficient supply of risk-free assets, which the US Treasury used to be able to provide. Unfortunately, the debt ceiling political theater has reduced that capability, which could have an adverse effect on the global economy and financial, not just the US economy and financial system. I'm very nervous about the state of the world right now.

QOTD

From Ezra Klein, upon watching Inside Job:

It was an excellent documentary for people who don’t want to understand the financial crisis but want to believe they would’ve seen it coming. Watching it, you’d think that the only people who missed the meltdown were corrupt fools, and the way to spot the next one is to have fewer corrupt fools. But that’s not true. ...

There’s a lot to dislike about Wall Street. The pay. The culture. In many cases, the people. But that doesn’t explain what happened in 2007 and 2008. ...

What’s remarkable about the financial crisis isn’t just how many people got it wrong, but how many people who got it wrong had an incentive to get it right. Journalists. Hedge funds. Independent investors. Academics. Regulators. Even traders, many of whom had most of their money tied up in their soon-to-be-worthless firms. “Inside Job” is perhaps strongest in detailing the conflicts of interest that various people had when it came to the financial sector, but the reason those ties were “conflicts” was that they also had substantial reasons — fame, fortune, acclaim, job security, etc. — to get it right.

And ultimately, that’s what makes the financial crisis so scary. The complexity of the system far exceeded the capacity of the participants, experts and watchdogs.

Extreme ignorance is still an underrated explanatory variable in models of the crisis.

I've previously written about a few of Inside Job's deficiencies here and here and here. A general rule is that smug explanations of the crisis are wrong.

Basel Is Political

Wonky technical point with large ramifications:

This year has seen some improvement. Data submitted by banks in May were subject to “peer review” by a committee of experts from the European Banking Authority (EBA), a pan-European college of regulators, which is administering the tests. The committee concluded that some banks had been over-optimistic in their self-assessment. In some cases different banks had estimated very different probabilities of default and losses on similar underlying assets. Results were meant to be out this month, but all banks have now been asked to do their sums again and resubmit by the end of July.

National regulators have not taken kindly to this. Germany’s regulator, BaFin, has been involved in a public war of words with the EBA over its definition of capital. The EBA has adopted the Basel III standard for Tier 1 capital. That excludes “silent capital”, bond-like instruments which Germany used to recapitalise its banks. Germany has pointed out that banks have several years to be Basel-III compliant. But so far the EBA has resisted German demands to recognise silent capital.

Why is this provision in Basel? Because US and UK banks don't use silent capital to pad their ratios, so if US/UK regulators were going to up the statutory capital requirements for their banks, they wanted to make sure those banks weren't competing against firms (esp in Germany and Japan) that were gaming the system, and gaining a competitive advantage from it. Basel III looks the way it does for a reason, and that reason isn't simply technocratic.

Over-Regulation Isn't Surprising

Yves Smith:

Something very peculiar is afoot. Well after the bank regulatory reform debate was supposedly settled, central bankers seem to be reopening that discussion. It’s puzzling because the very reason the banks won so decisively was that central bankers were not prepared to get all that tough with their charges.

I’m not clear what has led central bankers to get a bit of religion. Is it the spectacle of the Bank of England talking about breaking up the banks (they won’t get their way thanks to bank lobbyist working over the Independent Banking Commission, but no one doubted their sincerity)? Or the Swiss National Bank imposing 19% capital requirements, which as we discussed, is likely to lead to the investment banking are of UBS being domiciled elsewhere (assuming a country capable of bailing it out will have it)? Or perhaps it is central bankers being forced to recognize that their Plan A of extend and pretend and super low interest rates simply won’t lead banks getting to meaningfully higher capital levels when the staff continues to take egregious amounts out in compensation? Or have they realized how bad bank balance sheets are in the Eurozone and how tight the linkages still are among the major capital markets players, and they belatedly realize they need them to be much more shock resistant?

The bottom line is that various central bankers have taken the surprising step of insisting their banks meet more stringent requirements for the biggest banks than those originally planned to be to be included in Basel III.

Basically, the point is that some countries' regulators are considering implementing stricter regulations than those agreed in the multilateral Basel accords. How "peculiar" is this? Not very. The above heat map* shows capital-to-asset requirements for about 140 countries in 2006. The data come from this World Bank survey, which was the third of its kind. The darker the color, the higher the minimum ratio required by governments. (White countries are missing data, which means non-respondents to the survey.) At the time, the Basel requirements were 8% capital, of which 4% needed to be equity capital, represented by the beige color of the United States. The interesting thing about this is the number of countries that had tighter restrictions than those minima. It's nearly half of the sample**.

This might surprise some, who believe that absent a tough international standard national governments will "race to the bottom" in order to give their firms a competitive edge. But that doesn't tend to happen. Nor does it happen much in the private sector. Banks routinely over-comply with capital requirements, as doing so signals to investors that they are safe firms, which in turn lowers their borrowing costs. Pre-crisis almost all of the major banks had capital ratios that were not only well above the Basel II requirements, but also above the proposed Basel III requirements as well***. Rather than push up against the regulatory capital minimum, banks tried to signal credibility by maintaining capital ratios that were often twice as large as legally required. In some cases, banks lobbied their governments for stricter regulations, especially if those could also be applied to their foreign competitors or otherwise shield them from competition. Note that the countries with darker colors above, i.e. those with stricter regulations, are most often middle income countries most in need of signaling credibility.

Obviously this over-compliance didn't do much good in 2008, but that doesn't mean it wasn't happening.

I presented some preliminary research on this at this year's International Studies Association meeting. It's not yet in suitable shape for me to post the paper, or to report any firm conclusions, but one thing I think is fairly clear: popular commentators, and most academics, have been thinking about the relationship between firms' and governments' preferences over regulatory policies in some pretty wrong ways. It isn't just a race to the bottom. There's more going on.

*Created using the wonderful, free Open Heat Map web program. Click for larger image.

**43%, if I remember correctly. And that doesn't include other "pseudo-regulations", like the US' requirement of 10% capital to be considered "well-capitalized" by the FDIC, that operated as de facto requirements.

***At least in terms of capital; leverage and liquidity is another thing entirely.

The BIS Misses Monetary Moral Hazard

That's the "Bank for International Settlements", the group comprised of central bankers from the leading world economies. Here's what they're saying:

However on one key issue the Bank of England’s FPC [Financial Policy Committee] appears to fall short. The potential trade-offs between monetary policy and financial stability are not addressed. In an opinion piece today, the former Bank of England Monetary Policy Committee [MPC] member Sushi Wadwhani has highlighted the dilemma.

For example, suppose we have an emerging house price bubble and the FPC increases capital requirements which, through widening lending margins, slow the economy, and this leads the MPC to expect inflation to undershoot the target over the next two years. Under the proposed structure, it is envisaged that the MPC would lower interest rates in order to keep inflation at target. If so, would this not largely offset the actions of the FPC and keep the house price boom going?

The BIS report concedes that the short-term interests of monetary policy and financial stability policy may occasionally diverge. Mr Wadwhani argues this means a single committee should be responsible for both monetary policy and financial stability. While BIS accepts that would facilitate coordination and force policy makers to confront the trade-offs at stake, it concludes that responsibility for the two policies can be separated, as long as it is clear which takes priority.

What does this mean? In England, the the Monetary Policy Committee is tasked with conducting a monetary policy that will keep the economy on a path of steady growth with low and stable inflation. The Financial Policy Committee is tasked with maintaining financial stability. But there is an important tradeoff between monetary policy goals, which are counter-cyclical, and financial regulatory goals, which are pro-cyclical. Having two separate institutions pursuing opposite goals can be self-defeating, which is why Sushi Wadwhani suggests having a single institution responsible for both. And the BIS seems to agree:

The logic for central bank involvement is well established. The financial crisis showed that central banks are ultimately lenders of last resort to the financial system, and so should pay proper attention to its overall health. Moreover central banks’ primary policy mandate, monetary policy, has a strong influence on financial stability; think quantitative easing today, or the consistently low interest rates in America that encouraged a bubble in real estate prices in the 2000s.

The BIS wants all central banks to be given legal responsibility for financial stability, arguing that macroprudential regulation requires the same autonomy as monetary policy. ...

For now though, the direction of travel is clearly towards legally defined responsibilities for financial stability and the centralisation of power within central banks. Unusually that points towards emerging market structures, rather than American or European ones.

So the BIS wants a single institution -- the central bank -- to be responsible for both monetary policy and financial stability. It acknowledges the tradeoff between the two, but does not specify how that tradeoff is likely to be resolved. Note the bolded portions above. But what are appropriate ways to resolve the tradeoff? How do we make it "clear which [goal] takes priority"? Which goal should take priority?

I've argued in my research (currently under review and previously discussed here), building off of prior work by Copelovitch and Singer, that the tradeoff is resolved by central banks that also regulate in a way that the BIS might find perverse: by privileging banks' interest. Copelovitch and Singer find that regulatory central banks allow higher inflation -- i.e. more access for banks to cheap funds, which then fuels economic expansions -- than nonregulatory central banks. I extend that by arguing that banks respond to this policy dynamic by acting more riskily when regulated by central banks, because they believe that they'll have access to those funds in times of need. I call this "monetary moral hazard", distinct from the fiscal bailout moral hazard involved with TBTF firms, and support for such a relationship shows up in the data.

In other words, the BIS (and Bank of England) are correct that there is an important tradeoff between macroeconomic management and financial stability. But resolving that tradeoff by locating regulatory authority in central banks resolves the tradeoff in a way that may not promote financial stability, instead creating monetary moral hazard. One possible way to get around this dynamic (that I do not explore in the paper) is via much stricter statutory regulations by removing discretion from regulators, which is more or less the opposite of what the BIS is proposing. Many in England and elsewhere have called for stricter laws along these lines, and while the international Basel III agreement has taken a step in that direction, it's not a very large one.

Finance, Trade, and Growth Through History

New NBER paper:

Historical Evidence on the Finance-Trade-Growth Nexus
Michael D. Bordo, Peter L. Rousseau
NBER Working Paper No. 17024
Issued in May 2011

We study linkages between financial development, international trade, and long-run growth using data since 1880 for seventeen now-developed “Atlantic” economies and a set of cross-country and dynamic panel data models. We find that finance and trade reinforced each other before 1930, but that these effects did not persist after the Second World War. Financial development has positive effects on growth throughout the sample period, while trade affects growth strongly and independently after 1945. We attribute the rising importance of trade in explaining growth to major post-World War II changes in tariffs and quantity restrictions associated with the GATT, the establishment of the European Common Market, and the gradual elimination of capital controls after 1973. The findings are robust to the use of ‘deep’ fundamentals such as legal origin and indicators of the political environment as instruments for financial development and trade. Financial development, however, is more closely linked to these fundamentals than trade.

When all the debate over whether financial innovation added any value to society was going on, and folks like Volcker were saying that there was no evidence that it did, I always wondered what the evidence was. I've always thought that countries with deep, liquid financial markets had better economic performance than those that did not. I've always thought that financial innovation helped to create deep, liquid financial markets. Not sure this paper will settle that question, but it's worth a look.