Let Markets Be Markets

Joseph Stiglitz is a Nobel-prize winning economist. He is also a former Chief Economist of the World Bank. He resigned / was forced out in 2000 because of his criticism of IMF and US Treasury policies in forcing “free-market fundamentalism” onto developing and emerging market countries in the 1990’s. He has been a sharp critic throughout his career of the free-markets-are-always-right view that has often characterized the “Chicago boys”. Indeed, the theoretical work for which he was awarded the Nobel Memorial Prize demonstrates how markets will not achieve desirably outcomes without some forms of government regulations and institutional restrictions.

In this short video (8 min) he talks about how U.S. financial markets aren’t really “free markets” – they don’t meet the conditions for a functioning “market”.

Against Monopoly: Most of the big banks are insolvent

via Against Monopoly.

The steady drip of details about the financial crisis continues. PBS News Hour has Paul Solman interviewing an ex-bank regulator, William Black who now teaches at the University of Missouri link here. Points Black makes that are worth thinking about:

  • Following the S & L collapse, more than 1000 executive insiders were convicted and jailed for fraud. No one has been charged in the current mess, much less convicted or jailed.
  • The financial system began to crumble in 2007, when the FBI was already aware that mortgage fraud was rampant and was perpetrated because it was in the interest of the banks to make more and more loans.
  • The banks got out of having to mark their bad loans to market by pressuring the Congress to tell the Financial Accounting Standards Board to change the rules or it would be put out of business. Currently, the do not have to recognize losses until the loans are taken off the bank’s books.
  • Fitch, the accounting firm, did a study of mortgage loans which concluded that the vast bulk of the mortgages were fraudulent, and was easily detected.
  • The 19 largest banks are insolvent if their assets were marked to market. They can get away with it and pay enormous salaries and bonuses for now–but that will end with the next

Moral Hazard and How to Reform Our Financial System – NYTimes.com

Former Chair of Federal Reserve, Paul Volcker notes both the need for banking industry regulatory reform and that one of the needs to address the “moral hazard” that currently exists in the system.  Moral hazard occurs when a party insulated from risk may behave differently than it would behave if it were fully exposed to the risk” according to Wikipedia.  In the case of banks, it is the phenomenon of “heads the bank wins, tails somebody else loses”.  Since widespread bank failures have economy-wide effects (see Great Depression), society, through the government, has an interest in making sure banks don’t fail.  But, knowing that failure is effectively “insured” against, banks will typically take on more risk than they otherwise would.  Figuring out how to insure depositors against loss and widespread bank failures without creating excessive moral hazard is one of the goals of any financial regulatory reform program.

PRESIDENT OBAMA 10 days ago set out one important element in the needed structural reform of the financial system. No one can reasonably contest the need for such reform, in the United States and in other countries as well. We have after all a system that broke down in the most serious crisis in 75 years. The cost has been enormous in terms of unemployment and lost production. The repercussions have been international.

Aggressive action by governments and central banks — really unprecedented in both magnitude and scope — has been necessary to revive and maintain market functions. Some of that support has continued to this day. Here in the United States as elsewhere, some of the largest and proudest financial institutions — including both investment and commercial banks — have been rescued or merged with the help of massive official funds. Those actions were taken out of well-justified concern that their outright failure would irreparably impair market functioning and further damage the real economy already in recession.

A large concern is the residue of moral hazard from the extensive and successful efforts of central banks and governments to rescue large failing and potentially failing financial institutions. The long-established “safety net” undergirding the stability of commercial banks — deposit insurance and lender of last resort facilities — has been both reinforced and extended in a series of ad hoc decisions to support investment banks, mortgage providers and the world’s largest insurance company. In the process, managements, creditors and to some extent stockholders of these non-banks have been protected.

via Op-Ed Contributor – How to Reform Our Financial System – NYTimes.com.

More On Banking Regulation: How To Do It Right

If we are to avoid another crisis and melt-down of the banking/financial sector such as we had in 2008, then we must change the rules of the game.  There must be institutional change.  Canada avoided much of the financial crisis.  Why?  Well, part of it is regulation (something Canadians are more comfortable with than Americans) and part of it is just plain culture.  For more see:

Paul Krugman via Op-Ed Columnist – Good and Boring – NYTimes.com.

In times of crisis, good news is no news. Iceland’s meltdown made headlines; the remarkable stability of Canada’s banks, not so much.

Yet as the world’s attention shifts from financial rescue to financial reform, the quiet success stories deserve at least as much attention as the spectacular failures. We need to learn from those countries that evidently did it right. And leading that list is our neighbor to the north. Right now, Canada is a very important role model.

Or see Christia Freeland in the Financial Times:

This tendency to react to the mere mention of Canada with either yawns or guffaws may be why, as the world struggles to figure out what went wrong in 2007 and 2008, not much international attention is being devoted to figuring out what went right in Canada. Canada is the only G7 country to survive the financial crisis without a state bail-out for its financial sector. Two of the world’s 15 most highly valued financial institutions – a list dominated by China – are Canadian and a recent World Economic Forum report rated the Canadian banking system the world’s soundest. Even Barack Obama, on the eve of a visit last year to Ottawa, the Canadian ­capital, admitted: “In the midst of the enormous economic crisis, I think Canada has shown itself to be a pretty good manager of the financial system and the economy in ways that we haven’t always been.”

One of the most important policy debates today – particularly in countries hardest hit by the crash, such as the US and UK – is what caused the crisis and what should be done to prevent a repetition. Inevitably, the discussion is hypothetical: even if we could agree on exactly what went wrong, no one can prove that any recommended policy changes would have averted the meltdown. That’s where Canada comes in. It is a real-world, real-time example of a banking system in a medium-sized, advanced capitalist economy that worked. Understanding why the Canadian system survived could be a key to making the rest of the west equally robust.

The first argument you are likely to hear when you start asking what made Canada different is cultural. Depending on your degree of fondness for Canucks, this thesis comes down to the notion that Canadians are either too nice or too dull to indulge in the no-holds-barred, plundering capitalism that created such a spectacular boom, and eventual bust, in more aggressive societies. A senior official in Ottawa likes to say that Canadian bankers are “boring, but in a good way. They are more interested in balance sheets than in high society. They don’t go to the opera.”

Canadian facts and figures

• 6 big banks, approximately 73 banking institutions in total

• The big banks are all universal – offering retail, commercial and investment banking services. Some boutique investment and commercial banks exist but they are relatively small

• Banks have minimal off-balance-sheet holdings

• Banks’ return on equity generally 13% to 20%

• Home ownership rate: 68.4% of the population

• Subprime less than 5% of the mortgage market

• Relatively low penetration of derivatives and securitisation
(27% of mortgages repackaged and sold as bonds)

• Mortgage default rate less than 1%

Source: McKinsey
Dates: 2008 & 2009, except Canadian home ownership figures, which come from the 2006 census.

Canadian facts and figures

• 6 big banks, approximately 73 banking institutions in total

• The big banks are all universal – offering retail, commercial and investment banking services. Some boutique investment and commercial banks exist but they are relatively small

• Banks have minimal off-balance-sheet holdings

• Banks’ return on equity generally 13% to 20%

• Home ownership rate: 68.4% of the population

• Subprime less than 5% of the mortgage market

• Relatively low penetration of derivatives and securitisation
(27% of mortgages repackaged and sold as bonds)

• Mortgage default rate less than 1%

Source: McKinsey
Dates: 2008 & 2009, except Canadian home ownership figures, which come from the 2006 census.