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May 7, 2009

Economist's View - 5 new articles

"How Useful Were Recent Financial Innovations?"

Was recent financial innovation productive? Adam Posen and Marc Hinterschweiger have a hard time finding evidence that it was:

How Useful Were Recent Financial Innovations? There is a Reason to be Skeptical, by Adam S. Posen and Marc Hinterschweiger: Who could be against innovation? That is the argument used by industries that wish to avoid regulation, that excessive government oversight will diminish incentives to innovate ... and we all will be worse off for it. And in the broad, this is a valid concern. ...

But not every innovative product is safe, let alone productive. Unlike pharmaceuticals, aerospace, and a host of other technical fields, financial innovations have been allowed to proliferate unscrutinized and untested for safety or effectiveness. Yet the negative spillovers on the public at large from faulty financial engineering and toxic products have now been clearly demonstrated to be enormous. ...

Like most innovations, the theory behind the most-recent financial developments made sense.... Th[e] mantra of Wall Street investors and financial economists alike implied that expansion in the use of newer derivatives and the like would lead to an expansion in the country's capital stock, and that these financial products would be useful to nonfinancial companies, not just to banks.

The growth of derivatives and real-sector investment in the United States tell a different story (figure 1).

Figure 1 Notional amount of derivatives and US gross fixed capital formation, 2000–2008

figure 1

Source: Bank for International Settlements (BIS), International Financial Statistics, via Datastream (IFS) Office of the Comptroller of the Currency (OCC

Between 2003 and 2008, US gross fixed capital increased by about 25 percent, a reasonable number during an economic expansion, but hardly a boom. During the same five-year period, the global amount of over-the-counter (OTC) derivatives increased by 300 percent, while derivatives held by the 25 largest US commercial banks rose by 170 percent. ... There only seems to be a weak link, if any, between the growth of the newest complex—and now proven dangerous if not toxic—financial products and real corporate investment.

Another way to assess the presumptive benefits ... of these products is to analyze who made use of derivative instruments. ... Only 11 percent of all counterparties were nonfinancial costumers. Hence, almost 90 percent of all derivative contracts took place between financial institutions. Had their usage by financial institutions generated either a boom in productive lending or a more resilient financial system, then, even if unused by nonfinancial companies directly, these new products could still have been productive. Since we have clearly seen the opposite over this time period, it is a revealing indicator that the nonfinancial companies for whom these products were prescribed did not themselves use them.

Figure 2 OTC derivatives by counterparty as of June 2008 (BIS)

figure 1

Source: Bank for International Settlements (BIS)

Going forward, the US Congress and its international counterparts will have to decide how much to increase regulation and supervisory oversight of financial institutions. We are already hearing warnings from the financial industry that government should be careful not to overreach in its attempts at reform, for fear of harming financial innovation. While that is a worthy principle, our belief is that the record of recent financial innovations acts as a warning to be skeptical... In fact,... even if many financial innovations are beneficial, all of them need to be monitored over the long term, as well as scrutinized before issuance, by regulators for their safety and effectiveness. ...

Geithner: How We Tested the Big Banks

Timothy Geithner explains how the stress tests were conducted:

How We Tested the Big Banks, by Timothy Geithner, Commentary, NY Times: This afternoon, Treasury, the Federal Deposit Insurance Corporation, the Office of the Comptroller of the Currency and the Federal Reserve will announce the results of an unprecedented review of the capital position of the nation's largest banks. ...

We ... chose a strategy to lift the fog of uncertainty over bank balance sheets and to help ensure that the major banks, individually and collectively, had the capital to continue lending even in a worse than expected recession.

We brought together bank supervisors to undertake an exceptional assessment of the strength of our nation's 19 largest banks. The object was to estimate potential future losses, and ensure that banks had enough capital to keep lending even in the face of a deeper recession.

Some might argue that this testing was overly punitive, while others might claim it could understate the potential need for additional capital. The test designed by the Federal Reserve and the supervisors sought to strike the right balance.

The Federal Reserve marshaled hundreds of supervisors to spend 45 days rigorously reviewing the banks' detailed loan data. They applied exacting estimates of potential losses over two years, along with conservative estimates of potential earnings over the same period, and compared them with existing reserves and capital. The results were then evaluated against strict minimum capital standards, in terms of both overall capital and tangible common equity.

The effect of this capital assessment will be to help replace uncertainty with transparency. It will provide greater clarity about the resources major banks have to absorb future losses. It will also bring more private capital into the financial system, increasing the capacity for future lending; allow investors to differentiate more clearly among banks; and ultimately make it easier for banks to raise enough private capital to repay the money they have already received from the government.

The test results will indicate that some banks need to raise additional capital to provide a stronger foundation of resources over and above their current capital ratios. These banks have a range of options to raise capital over six months, including new common equity offerings and the conversion of other forms of capital into common equity. As part of this process, banks will continue to restructure, selling non-core businesses to raise capital. ...

Banks will also have the opportunity to request additional capital from the government through Treasury's Capital Assistance Program. Treasury is providing this backstop so that markets can have confidence that we will maintain sufficient capital in the financial system. For institutions in which the federal government becomes a common shareholder, we will seek to maximize value for taxpayers and enable these companies to attract private capital, thereby reducing government ownership as quickly as possible.

Some banks will be able to begin returning capital to the government, provided they demonstrate that they can finance themselves without F.D.I.C. guarantees. In fact, we expect banks to repay more than the $25 billion initially estimated. This will free up resources to help support community banks, encourage small-business lending and help repair and restart the securities markets. ...

This is just a beginning, however. Our work is far from over. The cost of credit remains exceptionally high... The ultimate purpose of these programs is to ensure that the financial system supports rather than impedes economic recovery.

We have not reached the end of the recession or the financial crisis, but the bank stress tests should advance the process of repairing our financial system and provide a better foundation for recovery.

I've given a lot of tests over the years, and I can pretty much make the mean on a test come out how I want through the design of the questions and how I score the answers. If I want a mean of 70, or around there, I can get it, and if a mean of 50 is the target, that's possible too. The other thing that I've learned is that the relative rank of students in the class doesn't change much, the A, B, C, D, and F students will line up pretty much as they always do. But a mean of 50 will lead to much more complaining, lower evaluations, and general dissatisfaction with the course than a mean of 70 even if you grade on a curve so that the grades are identical. So, since I learn the same thing either way in terms of relative understanding of the material, targeting a mean of 70 works out better.

But you have to be careful since there is also an absolute standard to worry about. Someone who gets the mean score and a grade of, say, C, is being stamped with a particular level of competence, and the questions cannot be so easy that a C is awarded to students who do not have this minimal level of understanding.

The people designing the stress tests have the same freedom. Depending on the "questions" they ask the balance sheets, and how the "answers" are scored, they can get whatever mean they desire (e.g. how are assets that cannot be valued in the marketplace are "scored" makes a crucial difference in the outcome). If we choose a score of "70" as the dividing point between being solvent and being insolvent, then the percentage of banks passing the test is a function of the difficulty of the stress test how the items on the balance sheets - the answers to the questions - are interpreted.

That's where, as with the class and awarding a passing grade of C, an absolute standard comes in. If the test is just hard enough, but not too hard, if it hits the Goldilocks sweet spot, or close enough anyway, then the results can be trusted. But does anyone know for sure what that absolute standard is? And if we don't, what do the tests really mean? There will always be uncertainty.

There is a way out of this box, I suppose, and that's to give a test that everyone can plainly see is hard, no doubt about it, and then have most of the banks still pass it. So if officials can convince everyone that this was, in fact, a really, really hard test and banks did well anyway, that could work. But that's not what they did, they sought balance and in doing so, Geithner explicitly admits they are open to the criticism that the test was too easy (of course, if they had designed a hard test and many banks failed, they'd be accused of trying to use a biased test to force politicians to support nationalizing troubled banks).

And there are other problems too. Again, how did they value the toxic assets that nobody has been able to find a way to value? Were the questions biased, i.e. was it proper to apply the same test to the different institutions that were forced to take it, or should the test have been varied to fit the profile of particular banks? A big part of the problem with bank balance sheets is the things we cannot see, do not know about, and cannot predict. How were those things accounted for in the stress tests? If we had such a hard time predicting how bank balance sheets would change until now, then what changed that makes the tests credible? Why should we believe we can now predict what we haven't been able to predict previously? Why did the government negotiate the outcome with banks and how lenient were they in those negotiations? There are always students who want to argue about the result of a test, to have sections regraded, and how you respond to attempts to "negotiate" a grade can affect the percentage passing the class, particularly when - as with the stress tests - there aren't a lot of students/banks taking the test.

I don't think there's an outcome here that is all that helpful. If banks pass the test, for the most part - as government officials are assuring us they will - people will argue the test was too easy, or biased, or invalid for some other reason. If many banks fail (an unlikely event given the rosy talk from Fed and Treasury officials), that will cause even more fear and uncertainty in markets and the tests, which were supposed to bring certainty and calm to financial markets, will backfire (a reason to avoid this outcome as you are scoring the stress test results). I hope I'm wrong and Treasury can, in fact, convince people that the tests are credible, and the outcome is optimistic, but with all the uncertainty surrounding this process, that won't be easy to do.

"If Only"

Richard Posner lists the lessons he thinks we should learn from the economic crisis:

Capitalism in Crisis, by Richard A. Posner, Commentary, WSJ: ...It's not too soon ... to derive some important lessons from the economic crisis:

First, businessmen seek to maximize profits within a framework established by government. ... Rational businessmen will accept a risk of bankruptcy if profits are high... Given limited liability, bankruptcy is not the end of the world for shareholders or managers. But a wave of bank bankruptcies can bring down the economy. The risk of that happening is external to banks' decision-making and to control it we need government. Specifically we need our central bank, the Federal Reserve, to be on the lookout for bubbles, especially housing bubbles... Our central bank failed us.

The second lesson is that we may need more regulation of banking to reduce its inherent riskiness. ... Finally, let's place the blame where it belongs. Not on the bankers, who are not responsible for assuring economic stability, but on the government officials who had that responsibility and failed to discharge it. They failed even to develop contingency plans to deal with what everyone knew could happen in a context of escalating housing prices (it had happened in Japan in the late 1980s and the 1990s). Lacking such plans, the government responded to the crisis with spasmodic improvisations, amplifying uncertainty and mistrust and thus retarding recovery.

And let's not forget to apportion some of the blame to the influential economists who assured us that there could never be another depression. They argued that in the face of a recession the Federal Reserve had only to reduce interest rates and flood the banks with money and all would be well. If only.

"A Strong Safety Net Encourages Healthy Risk-Taking"

The social safety net is old, tattered, and in need of repair:

A Strong Safety Net Encourages Healthy Risk-Taking, by Jacob Hacker, Commentary, The American Prospect: Remember the "ownership society"? Just an election cycle ago, conservatives were urging Americans to give up their antiquated social-insurance programs--Social Security, Medicare, unemployment insurance--in favor of tax-subsidized individual accounts... Thankfully, the most extreme elements of that agenda failed, and the vision behind it ... is now discredited.

Yet while the ownership society was a practical and intellectual failure, it was more of a political success than commentators generally acknowledge. Even before the financial crisis, the broad set of economic protections that arose in the Great Depression and expanded in the decades after --sometimes called the "safety net,"...-- lay in tatters. ...

If ever there were a time for an alternative to the reigning orthodoxies of risk management, this is it. Now is the time to adopt a vision ... of all of us providing the common foundation for economic prosperity and advancement through smarter and broader sharing of risk..: a new public-private partnership that builds upon and extends the basic underlying principle of the New Deal. That principle ... is that security is not opposed to opportunity but essential to it. In a dynamic and flexible economy, well-designed policies of economic security are critical if workers are going to have the confidence they need to invest in and achieve the American dream. ...

In every facet of Americans' economic life -- their health care, their pension plans, their job security, their family finances -- risk and responsibility have shifted from the broad shoulders of government and corporations onto the fragile backs of workers and their families. In an era of partisan polarization and gridlock, we have failed to update our nation's safety net to reflect the changing economic and social realities of our nation. We still have strong benefits for the elderly, but we do very little to help the millions of young Americans struggling to gain a foothold in the job market or buy a home or start a business--the future of our economy and society. Our safety net emphasizes short-term exits from the work force, even though long-term job losses and the displacement and obsolescence of skills have become more common. And some of our social polices still embody the antiquated notions that family strains can be dealt with by a parent, usually a mother, who can easily leave the work force when there is a need for someone at home.

Above all, our safety net is based on the dying belief that job-based health and retirement benefits can easily fill the gaps left by public programs, when it is ever more clear that they cannot. ... Once again, economic common sense and social justice both argue for moving away from our present mess toward the broader and more direct pooling of risk. ...

"Risk" may be the word on people's lips today, but most understand it far too narrowly. Risk does not simply concern the breakdown of our nation's financial institutions; it concerns the breakdown of our nation's social contract. If we are to fix that contract -- and our economy -- we will have to do more than socialize risk for those at the top of the economic ladder. We will need to reclaim the twin ideals of security and opportunity for all Americans.

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