Laurence Kotlikoff, economics professor at Boston University, writes an open letter to Lord Turner, chairman of the UK’s financial regulator, the FSA. Lord Turner examines Prof Kotlikoff’s proposal for a radical reform of the institutional structure for credit extension in a new book, The Future of Finance. This is the second of a two-part open letter. You can read the first part here.
The essential challenge indeed is that the tranching and maturity transformation functions which banks perform do deliver economic benefit, and that if they are not delivered by banks, customer demand for these functions will seek fulfillment in other forms.
As previously indicated, tranching (some investors taking more risk than others within a fund) is part of limited purpose banking. Indeed, CDOs are, to repeat, effectively mutual funds with this property. The fact that so many CDOs invested in toxic loans is because the loans were fraudulent, not because the loans were risky. We don’t say that stocks are toxic, even though the stock market has fluctuated dramatically since its peak. We say mortgage-backed securities are toxic because borrowers’ incomes were misstated, collateral values were misstated, and credit worthiness was misstated. Furthermore, tranching is just one way for some people to take more risk than others. A simpler way is for more risk-averse people to simply invest in mutual funds that purchase safer asset. I.e., tranching is not the end all and be all of risk allocation in the economy.
As for maturity transformation, the liquidity risk-sharing featured in the Diamond-Dybvig model can be achieved by households simply holding a portfolio of mutual funds some of which specialise in short-term bonds and others that invest in long-term bonds, I.e. a model with such investments provides the same risk sharing as their model. But it does so without the risk of a bank run. The Diamond-Dybvig paper claims that governments can insure deposits to avoid the bank runs associated with their mechanism of having banks return deposits on demand. However, their paper assumes real deposit insurance when only nominal deposit insurance exists in the real world and it girds this assumption with the assumption that the output of the economy is unaffected by bank runs, which is clearly not the case.
We need to find safer ways of meeting these demands, and to constrain the satisfaction of this demand to safe levels, but we cannot abolish these demands entirely.
Again, LPB permits tranching within any given mutual fund and liquidity risk-sharing (the raison d’être of maturity transformation) via diversified holding of short- and long-term fixed income mutual funds.
There is therefore a danger that if radicalism is defined exclusively in structural terms — small banks, narrow banks, or the replacement of banks with mutual loan funds — that we will fail to be truly radical in our analysis of the financial system and to understand how deep-rooted are the drivers of financial instability.
The truly deep root of financial instability is the use of the claim of proprietary information to conceal the production and sale of fraudulent securities. The assets we call toxic today have that title for a reason.
An exclusive focus on structural change options, indeed, reflects a confidence that if only we can identify and remove the specific market imperfections, which prevent market disciplines from being effective, then at last we will obtain the Arrow-Debreu nirvana of complete and self-equilibrating markets.
This is the last thing I believe. I don’t believe we’ll achieve any Arrow-Debreu nirvana. LPB will fix some huge problems and restore the rule of law to the financial system. It will do great good. It’s worth taking very seriously.
In the words of George Shultz it’s “simple, clear, and, most of all, effective.” In the words of George Akerlof, LPB “offers an amazingly simple financial fix to prevent an even worse crash,” in the words of Edmund Phelps, LPB “is one of the best visions to surface so far,” in the words of Simon Johnson, LPB “is beyond appealing; it is compelling,” in the words of Niall Ferguson, LPB “is clearly the best available remedy,” in the words of Kenneth Rogoff, LPB “is a blueprint for how to fix it (the financial system) from the ground up,” in the words of Jeff Sachs, LPB is “a powerful reform that stops banks from gambling and restricts them to their legitimate purpose,” and in the words of Martin Wolf, in endorsing LPB, “cautious reform is the risky option.”
None of these and other prominent economists who have stuck out their necks in extremely strong support of LPB are naïve or believe that it would produce Arrow-Debreu nirvana.
If instead we believe that liquid financial markets are subject for inherent reasons to herd and momentum effects, that credit and asset price cycles are centrally important phenomena, that maturity-transforming banks perform economically valuable but inherently risky functions, and that the widespread trading of credit securities can increase the pro-cyclicality of credit risk assessment and pricing, then we have challenges which cannot be overcome by any one structural solution.
I also believe each of these things and a lot of other things about the current system. That said, LPB combines a large number of structural solutions in one simple system. What I don’t believe is that this statement and the one about Arrow-Debreu nirvana are serious critiques of LPB.
Adair, let me conclude by connecting what it seems you are advocating in your paper (which I generally like very much) to LPB.
- You raise the need for financial disclosure. LPB provides full disclosure.
- You raise concern about too big to fail. LPB has small banks (the individual mutual funds) none of which can fail.
- You say we need non-conflicted credit rating. LPB provides non-conflicted credit rating, appraisals, third-party custody, income and employment verification, etc.
- You advocate higher capital requirements. LPB has 100 per cent capital requirements.
- You want credit originators to have skin in the game. Under LPB the investors have all the skin in the game. And they get to see on the web in real time precisely where this skin is invested.
- You say the market wants simple, transparent structures. LPB provides the simplest and most transparent structure.
- You want firewalls so that one financial intermediary doesn’t bring down another. LPB has a firewall around each mutual fund. Losses of any mutual fund have no impact on any other mutual fund.
- You want securitisation, but simpler securities. Mutual funds are, themselves, very simple securitisations. And since the Federal Financial Authority would rate complex securities as more risky, they would likely disappear form the market.
- You want financial stability. LPB offers financial intermediaries who cannot fail. I.e., it puts a definitive end to the banking crises that have plagued global economies for hundreds of years.
- You oppose radical change. But the current financial system is not safe at any speed. Tens of millions of unemployed workers and newly broke retirees can attest to this. They are looking for real change, not maintaining the status quo with some minor tweaks (a la Dodd-Frank), which is as radical as it gets.
Adair, climb onto the ramparts. We need you.
Best,
Larry
