Speed limit signs set a minimum and a maximum speed, yet I always see drivers careening along on icy roads at the posted maximum. They must have more faith in planners than I do, as I try to determine how icy the road is and go at a safe speed.
I don't think financial regulations are any different, but unfortunately most people take the fact that a firm is regulated to mean that it's totally safe. Similarly, many foods that will result in an early death are perfectly legal and consistent with the USDA food pyramid.
To be clear: you are suggesting that banks have kept low reserves because they took their government requirements as a sign of what was prudent to lend. Rather than asking their many teams of risk analysts, they made lending decisions based on an arbitrary number set by the government, despite the fact that this level has not been raised or lowered in decades, is uniform across all banks, takes no heed of the current financial situation and has never prevented a crash in the past.
If this were true (and it certainly is not!) then the market really would be just as incompetent as its critics say it is.
In an environment where the government decides what is prudent, there is no incentive for a bank to say "We are sounder than our competitors because we keep more reserves". Why not? Because they would be competing against the government for their definition of soundness.
Sure it could happen theoretically, but it would be a tremendous competitive disadvantage.
The way it is today, any bank that is legally allowed to operate is considered equally sound by borrowers and investors, and banks have no incentive to try to prove to customers that they are actually more sound than their competitors.
In a highly regulated environment, that works for all banks because they know that if there is a major economic downturn everyone will get bailed out.
Notice that all banks were required to accept TARP loans whether they needed them or not. Why? To avoid SIGNALING which banks were hurting and which were not. Why? To avoid capital flowing to the banks that were actually sound!
Why? Well, partly because government wants to avoid a crash, and partly to keep the status quo going strong. Also, consider what all of the major industry players in banking want... what does any firm want? No competition. They were all happy to share a big market and to have as few as possible attributes on which to have to compete for business.
Simple, smart, behaviorally sensible regulations make sense, but the SEC has been notoriously behind the curve for years. The missing piece has been to regulate appropriately while allowing there to be an incentive for banks to actually compete on the basis of soundness. The decision not to let the concept of bank soundness enter the brains of mere citizens must be a knee-jerk reaction to the great depression.
Instead, in exchange for various political concessions, banks were given every incentive to be extremely leveraged. Consider the impact of the GSEs on housing prices, MBS prices, etc? The implicit guarantee of Fannie and Freddie alone probably led to banks thinking (rightly, it turns out) that any housing related crash's impact on banks would be bailed out.
Side note: Are the banks going to be better off after the bailout? Of course they will be. The desired "sweet spot" for most firms is to be in a heavily regulated, heavily protected industry, as it means that there are huge barriers to entry and the profits (though sometimes essentially set by regulators) roll in year after year. See the military industrial complex for an example of the idealized sort of model.
Market forces have been very far from banking for a long time. Why else would financial services be the biggest donors to both parties. Libertarians are not opposed to regulations, just not ones that create perverse incentives and lead to massive bailouts! Any time a firm would rather spend its money on lobbyists and campaign contributions rather than innovation, there is a big problem.
> First, note that if it weren't for regulators deciding on the amount of reserve capital Citibank was required to hold, the market would probably have demanded that it hold much more.
This was your original point. Let's stay on track.
Your claim that regulators decide how big Citibank's reserves should be is false. They set a minimum, not a maximum.
You then tried to draw an analogy between speeding and regulation, one that, as I have explained, is totally inappropriate.
You then claimed that "most people take the fact that a firm is regulated to mean that it's totally safe", which is a massive exaggeration. If that were true, bank bonds would be considered as safe as government bonds and bank runs would never happen. All other regulated industries would be exactly the same. Also, you are confusing reserve requirements with broader regulation as a whole.
You then claim that banks raising their reserves would be "competing against the government for their definition of soundness", despite the fact that no government has ever claimed any 'definition of soundness'. This appears to be something that you have invented.
You then give an argument as to why other forms of regulation encourage banks to hold lower reserves. This contradicts your original point, which was that if reserve requirements were abolished then the market would force banks to raise reserves. What you have demonstrated is that the market, bail-outs and broader regulation would actually force reserves to even lower levels in the absence of reserve requirements. You have changed your argument from one about reserve requirements to one about broader regulation, and bail-outs such as TARP.
I don't think you have refuted my speeding analogy. Do you ever drive in an area with ice on the roads? I recommend that you observe the phenomenon before you dismiss it.
I do not think you have refuted my claim that regulation leads to people suspending critical judgement about risks.
Reserve requirements are a good example of this effect. Industry lobbyists try very hard to have the limit decreased while benefiting from the public perception that the regulator has assured that the bank's assets are sound.
If you don't buy my argument then you probably believe that people are so stupid that without regulation banks would hold $0 in reserves.
The alternative view of humanity is that people are sensible enough to demand sound practices from institutions they deal with on important matters.
My argument is that banks don't use reserves as a way to win customers the way they would if regulators weren't giving an A+ to every bank that holds the minimum :)
One exception is Goldman Sachs. It did not need TARP funds to remain solvent. Yet Treasury forced all banks to accept the funds. What did Goldman do? It immediately paid a huge dividend to its investors.
What happened? Goldman actually had more sound practices than the rest of the industry and was not in danger of failing. It would probably have waited for bankruptcy proceedings and picked through the assets of the other banks, strengthening its already strong balance sheet.
Regulators did not want more money to flow to the firm that had good practices, so it insisted on bailing everyone out. This was to hide information from investors and customers. Goldman angered regulators by paying out the dividend right away, but managed to signal its health.
To understand the point of libertarians on this issue, consider the world in 10 years from today. We might have had a world where chastened investors and customers looked a lot more carefully at the risk management practices of banks before trusting them. Instead, we have a world in which our government owns 30% of all banks and regulators are being hailed as the saviors of the banking industry.
Do you want to live in a world where people act based on reality, or one where taxpayer money is appropriated without congressional approval and given to selected industries, and the appropriators are hailed as heroes that helped the little guy keep his job, prevented another great depression, etc.
It all comes back to the burden that people take upon themselves to assess the riskiness of the decisions they make. Industry loves to have its status quo practices rubber stamped by regulators, to add additional credibility. It all works out well as long as there can be another bailout, etc., but it's not based on reality and represents the slow transfer of wealth from the most productive companies to the ones with the most effective lobbying.
>I don't think you have refuted my speeding analogy.
My point was that you analogy doesn't apply. Pointing to ice on the roads is completely missing the point: that the analogy doesn't hold in the first place.
>I do not think you have refuted my claim that regulation leads to people suspending critical judgement about risks.
I did not say this! I said that specifying a reserve requirement does not reduce bank reserves. Please keep this argument to reserve requirements, not general regulation.
>If you don't buy my argument then you probably believe that people are so stupid that without regulation banks would hold $0 in reserves.
The UK does not have reserve requirements and they don't have zero reserves. But they did not raise their reserves to safe levels either, refuting your original point.
Incidentally, it's you that's arguing that regulation encourages banks to hold lower reserves than they would without reserve requirements. You are constantly conflating reserve requirements and general regulation, moving an argument about one to a conclusion about the other.
You then go on to talk about TARP again, illustrating my point.
The ice on the roads creates a risk of the car going out of control. Unanticipated volatility in the market creates the risk of a bank being insolvent.
To manage the risk of your car going out of control, you choose a safe speed.
To manage the risk of a bank becoming insolvent, it chooses an amount of capital to keep in reserve.
I seriously doubt you take exception with any aspect of the analogy so far...
A speed limit sign suggests a speed that is safe to drive. However like any regulation it is only an imperfect estimate. Yet people seem to drive at that speed under adverse weather conditions completely irrationally.
A reserve requirement suggests an amount of reserve capital that is safe for operation of a bank. However like any regulation it is an imperfect estimate. Few banks carry reserves in excess of those set by the requirement.
These are completely identical scenarios. In each case, humans cluster around the regulation without exercising independent judgment. Drivers slide off of the road all the time, and a bit of recent price volatility sent many banks into insolvency.
Your example about the UK is noteworthy but I would argue that due to the dominance of US banks (and US regulations) in financial markets, UK banks are inclined to mirror US policies in order to remain competitive with US banks. Analogously, a Russian firm may adopt some US accounting practices if it wishes to attract investment from the US.
There are two factors: The first is the way that the bar is set by the regulation in the first place. T
he second is the grouping/incentive effect. If your competitor has too few reserves then you are at a disadvantage for not copying that behavior unless the economy crashes (such that your competitor goes out of business and you don't).
>A reserve requirement suggests an amount of reserve capital that is safe for operation of a bank.
In one case we have members of the public who have passed a driving test. In the other, we have the foremost experts in the field, using the latest theories of risk, working with millions of dollars of modelling and statistical equipment, with their jobs on the line. For what good reason would a single one of them look at the reserve rate and say "Although the government doesn't claim that this is a safe rate for banks to operate at, but instead sets it completely arbitrarily, and admits to the fact that it's totally arbitrary, and has not changed this rate in several decades because it is an obsolete tool of monetary policy, I am nevertheless going to take it to 'suggest' a safe level of reserves, totally ignore all of my models and education, and just pick that number on a completely irrational basis."
That just makes my point even better. Experts set safe speed limits for non-experts to follow. Minimum reserves are set arbitrarily and experts that decide actual reserve levels will not pay them any attention.
risk compensation is an effect whereby individual people may tend to adjust their behaviour in response to perceived changes in risk. It is seen as self-evident that individuals will tend to behave in a more cautious manner if their perception of risk or danger increases. Another way of stating this is that individuals will behave less cautiously in situations where they feel "safer" or more protected.
Mirrlees also did highly theoretical work on another incentive problem: “moral hazard.” As is well known to those who study insurance, insurance coverage gives the beneficiary an incentive to take more risks than would be optimal. This is called “moral hazard.” Mirrlees’s insight, based on a complex mathematical model, is that the problem can be solved with an optimal combination of carrots and sticks. Insurance payments are essentially a carrot. But “sticks” could be designed also, so that an insured person who takes risks pays a penalty for doing so. With this combination of carrots and sticks, the insured person acts almost as if he is uninsured, and the insurer acts almost as if he were the insured.
I don't think financial regulations are any different, but unfortunately most people take the fact that a firm is regulated to mean that it's totally safe. Similarly, many foods that will result in an early death are perfectly legal and consistent with the USDA food pyramid.