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.

Baking Banking Instability into the European Cake

Apologies for the long absence. The past few weeks have been extraordinarily busy on several fronts. I think I'll be able to get this place back into fighting shape pretty quickly.

The decision of S&P to downgrade more or less the whole of Europe has made a lot of headlines, but I'm not sure how much it matters. The plan for Europe before that happened isn't much affected by the downgrade: the ECB prints money and gives it to the banks, accepting EMU sovereign debt as collateral. The banks use the funds to buy sovereign debt. The banks get financing for sure, and if all goes well so do the governments. As far as I can tell, for regulatory purposes all OECD sovereign debt still counts as "risk-less" -- meaning that banks are not forced to hold any capital against it -- under the Basel accords, so there is a regulatory incentive for banks to buy some of this stuff.

There's something absurd about all of this... every step in the chain is an attempt to hear no evil by sticking fingers in one's ear. But if the eurozone is going to survive the European banking system has to stand upright and be able to finance governments. That requires ECB support.

JP MorganChase CEO Jamie Dimon, who often says things in public that are more revealing than he perhaps realizes, recently claimed to believe that there is no banking problem in Europe:

“It eliminates bank liquidity or funding problems for at least the next year, that’s a pretty powerful statement,” Dimon said today after his company reported a drop in fourth-quarter net income. “That was the biggest single risk of an uncontrollable surprise right there, so if that’s taken off the table, that’s a good thing.” ... 

“Europe is trying mightily to solve its problems. I still think the likely outcome is they will muddle through,” Dimon said. “The longer you wait, the higher you run the risk of something disorderly that you can’t really control. I think the ECB took off the worst outcome, i.e. a bank failure.”

Dimon might be right about Europe being able to muddle through, although I still have my doubts. He might even be right that a bank failure is the "worst outcome" in Europe, although I can think of some worse outcomes. But what he doesn't say, indeed what no one has much talked about, are the negative effects this will likely have in the European banking sector if the plan works.

The problem that the new ECB policy is supposed to resolve is this: banks won't lend to needy European governments except at punitive rates. Why? Because those governments are highly likely to default. This is exactly what we want a responsible, healthy banking sector to do.* What we don't want is what we're now hoping to get, which is to say that we don't want a banking sector whose investment behavior is skewed by political institutions pursuing dubious policy goals. We don't want a banking sector that has an expectation of future support if their investments go bad, and we don't want a banking sector that cannot discipline either itself or those to whom it lends.**

We don't, in short, want a situation in which government interventions make Jamie Dimon smile. (Or interventions that make him rich.)

Is this road less bad than the one Europe was on previously? In short run, surely. In the medium-to-long run it's hard to say. Perhaps we think that once the crisis is resolved the ECB can make a credible future commitment to be more standoffish towards the European banking sector. Perhaps we think that we can rein in banks and national governments in other ways, via strict capital standards for the banks and "Hard Keynesianism" for the governments. But I have little confidence that those things are likely. They cut against almost every identifiable political current.

The only way it works is if this crisis really scares everybody so much that a significant (and durable) shift is made in the regulatory and fiscal infrastructure of Europe. While not impossible, I remain highly skeptical that that will happen. I believe it's more likely that policymakers will conclude that the institutions in place are pretty resilient already -- "How else could we have pulled through this crisis?" -- particularly when coupled with a more activist ECB that will support the banking sector when needed.  I believe the banks will conclude that the ECB is their friend, and will therefore count on support when needed, particularly if the cause of the trouble are the member nations of the EMU. That is a recipe for a lot of future financial instability.

The ECB cannot, and should not, be in the business of resolving Europe's political problems. Forcing it into that role is likely to make things worse in the long run.

*The "we" here being an imagined societal consensus in possession of the general will, which reflects more-or-less center-left neoliberal technocratic principles. Yes, I know this "we" does not exist in nature.

**I have a paper, currently R&R, that argues that when banks expect preferential policies from governments they act less prudently. Simple argument, I know, but it's not in the literature yet. I find statistical support. I'll post it if/when it gets accepted somewhere; if someone wants it sooner e-mail me.

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.

The Fed Is Political

I meant to write about Rick Perry's idiotic "treasonous" comment but was occupied with other things. In any case, what Karl Smith said.

Perry's comments aren't completely out of the blue. Over the past few years we've increasingly seen how politicized the Federal Reserve is and how that can affect macroeconomic and regulatory policy. In mid-2009, polls showed the Fed was the least-popular major US agency, below even the IRS. Late last year a majority of Americans wanted the Fed audited or abolished.

Among elites, Fed-bashing is practically a cottage industry on both sides of the ideological spectrum. Obviously Ron Paul and the anti-inflationistas hit the Fed hard from the right for debasing/devaluing/inflating or something, while progressives like Yglesias and others advocate a Fed more dedicated to fighting unemployment. Part of this politicization comes from the Fed's dual mandate and the classic Phillips-curve inflation/unemployment tradeoff that tends to separate the right from the left*.

The Fed has also come under fire from both right and left over its role as regulator. The left finds the Fed completely derelict in its duty during the housing and derivates booms of the 2000s. The right accuses the Fed of regulating the banking system too much and favors various versions of free (or freer) banking. The left attacks Greenspan and Bernanke for being to laissez-faire. The right attacks Bernanke (a Republican and Bush appointee) for being too activist and trying to get Obama re-elected. International regulatory requirements such as the new Basel accord may not be fully implemented as pressures on American and European banks persist. Now Bank of America may be going down again.

These political battles have arguably hamstrung the institution. Peter Diamond, a Nobel Prize-winning economist, withdrew his nomination to the Fed when it became clear that he wouldn't receive approval in the Senate because he prioritized unemployment in his academic work. Obama has responded to the political climate by simply refusing to nominate anyone to fill key seats on the Board of Governors, despite the fact that the Fed is under greater pressures now than at any point in the past 30 or more years at least. Some on the right (eg Sumner) and left (eg Krugman) believe that Bernanke's prior academic work suggests that he would pursue a much different monetary policy were it not for opposite from the Board of Governors and, possibly, politicians.

Not all of these politics are clearly partisan. Both the far right and the far left strongly oppose the bank bailouts that heavily involved the Fed, and we found out yesterday that they were larger than previously thought. (Typical response: "[T]he Fed's secret bailout comes out to the same amount U.S. homeowners currently owe on 6.5 million delinquent and foreclosed mortgages. The progressive take on this story will be that the Fed has preferenced Wall Street over Main Street by using its exceptional authority to extend trillions in loans to banks without offering similar guarantees to underwater home owners.") Even worse for populists on both sides of the aisle is the fact that the Fed offered plenty of funds to non-American firms.

And yet we hear all the time about how the Fed is a technocratic institution, supposedly insulated from politics so it can set perfect policy from a dispassionate distance, thus correcting time inconsistency problems associated with the democratic election calendar. We hear it from academics who do empirical work on macroeconomics and politics, from government officials, and from our textbooks. We hear it from centrists who want to believe that it's true.

But it's not. The Fed is not only politicized; it is political. Every action taken benefits some group in society, often at the expense of another. Every policy choice has distributional consequences. Since the Fed is ultimately responsible for the health and well-being of the financial system, we can generally assume that the Fed will prioritize actions that benefit financial firms over other goals. And then they do. And then we claim to not understand what they're thinking. But that's the job that they've been given.

All of this is even more true of the European Central Bank.

*There's lots of work in political science and economics on this. See, eg, the classic Nordhaus (1975) article, Hibbs (1977), Alesina (1988), Milton Friedman's 1976 Nobel lecture, and plenty of others. There are some problems with this literature, but as a crude first-cut at monetary politics it's a good starting place.

No One Could Have Predicted This

Today we see that banks are worried about their exposures to sovereign debt from Europe, especially now that Italy is wavering.

Yesterday, we saw that banks owned so much sovereign debt because it was well-rewarded in the regulatory code. Of course that happened because governments write the regulatory rules, and governments want to stack the deck to make sure they have access to plenty of cheap funds with which to fund spending programs. They do that by privileging sovereign debt in the regulatory requirements, specifically the risk-weights given to debt assets in the capital adequacy standards.

This is no surprise, but it's worth taking a step back every now and then to consider what's going on.