Should Banks Just Buy Treasuries?

May 15, 2012

by Chidem Kurdas

There’s a widespread impression that the $2 billion-plus trading loss JP Morgan Chase announced a few days ago strengthens the case for more regulation of banks.  Below  Jerry O’ Driscoll makes this argument more thoughtfully than I’ve seen any where else.

Two basic facts are worth remembering.

Fact number one is that in 2010 Congress passed the gigantic Dodd-Frank financial regulation law, which is being translated to thousands of specific rules by coteries of government bureaucrats. The Volcker rule against bank proprietary trading is the least of it. There are numerous new rules. None of these could have prevented the JP Morgan loss or even moderated it, as best I can tell. The trading was meant to protect the bank from market shocks emanating from the European debt crisis. Evidently it went awry.

Fact number two is that all investment, indeed economic activity in general, carries with it risk of loss. The risk varies with the type of activity but never disappears. A hotdog seller can lose money. The only way not to take the risk is not to engage in the activity. This is like saying getting out of bed is risky – well it is, you might be hit by a truck! – and therefore you should stay in bed all day. If we took that advice, we would not have much of a life.

Banks could minimize risk by investing only in Treasury bonds. Over time this won’t be safe because rates will rise and bonds will lose value but for now it is a relatively low-risk investment. It is also a very low-return investment, that being the other side of the same coin. Low risk typically means low return.

Banks could not make money by keeping their assets in Treasuries. If that’s what they had to do, then they would cease to exist. This goes for commercial banks as well as investment banks. Hundreds of commercial banks failed in the past several years in large part because of loans made for real estate development that went under.

As long as there are banks, they will continue to make loans. Every now and then they will lose money. They will try to hedge their bets and on occasion get it wrong. This will happen regardless of how extensive and stringent regulation is.

Certainly, the reasons for a loss should be investigated and measures instituted to avoid mistakes. But we need to take it as a given that sometimes human beings will make errors and sometimes businesses will lose money.

In view of that reality, it is absurd to call for further regulation every time a bank makes a loss. By such logic every regulatory failure to prevent loss will lead to further regulation, with the result of explosive regulatory expansion. The logical end point would be to forbid the taking of any risk, at which stage most of the financial industry would have to shut down.

But why stop there? There are risks everywhere. One could argue for more regulation in all areas. That picture is not far fetched. Between Dodd-Frank and the similarly gigantic healthcare law, the amount of new red tape generated is so immense as to act as a drag on the American economy.

The truly systemic danger we face is paralysis by regulatory overreach.

12 Responses to “Should Banks Just Buy Treasuries?”

  1. Dave Pullin Says:

    It seems to me that the free market advocates that visit this forum do a poor job in advocating genuine free market, non-interventionist policies.

    So here’s a free market, non-interventionist solution to this problem.

    (a) abolish all regulations that attempt to control or limit the risks banks take.
    (b)make the individuals, and their bosses, executives, bank shareholders and anyone who would gain if these bets are successful 100% responsible for losses, without limitation.

    Sure you can bet $2B but if you lose you will spend the rest of your life living in a cardboard box under a bridge, as will your boss, all the bank executives, and may be the shareholders.

    Then the shareholders and the executives can decide what risks they want to take and what regulations and rules they apply to their traders. I’d guess those rules and regulations would make the government imposed ones look tame.


  2. I appreciate the compliment from Chidem. I’ll try to keep my reply pithy.

    The central issue is not risk, but property rights. In a world of well-defined property rights and rivalrous behavior (competition), the owner of the bank is the residual claimant. He receives economic profits and losses.

    If losses exceed equity in the bank, creditors will bear losses. In a resolution, creditors may become the new owners. If losses are sufficiently large, all creditors could also be wiped out.

    The policy of bailouts for large banks traslates into bailing out bank creditors and shareholders. So now the residual claimant function is bifurcated. Shareholders appropriate profits, while the ultimate bearer of losses is the taxpayer.

    It is privitization of profits and socialization of losses. In this world, the bank’s business becomes the taxpayers’ business. And regulating the risk-taking appetite of bankers is justified by even classical liberal principles. It protects the property rights of taxpayers against the aberrant behavior of privileged stockholders and senior management (whose interests may also diverge).

    Along with every serious person that I know, I consider DFA to be hopeless. It suffer from error of omission (Fannie & Freddie aren’t addressed), and commission (burdesome regulation to no effect).

    I liked the idea of the Volcker Rule, but it has been hopelessly muddied up by industry lobbying. (By the way, the Rule has not been promulgated.)


  3. Pardon me for jumping in again. As it turns out, there is an op ed in tomorrow’s WSJ that is very much on point.

    http://online.wsj.com/article/SB10001424052702304371504577406023330005352.html?mod=WSJ_Opinion_LEADTop

    It is by Tom Frost, the former CEO of Frost Bank. He was a very impressive banker. Frost Bank was the largest bank to survive the Texas banking crisis intact.

    In the op ed, he decrise “too big to fail” and running casino baking operations in institutions with insured deposits. He makes my point with the wisdom of experience.

  4. chidemkurdas Says:

    Dave Pullin–
    Certainly those responsible for such debacles should return bonuses they’ve received. I think there was mention that JP Morgan can claw back the bonuses.

    It’s no picnic for the people involved. Three have already lost their jobs and there may be more. It can’t be that they brought this public outrage upon themselves deliberately.

  5. chidemkurdas Says:

    Jerry O’Driscoll–
    So losses should not be socialized. The government should make a credible commitment not to bail anybody out and pursue a plan of orderly dissolution when a bank fails. The FDIC says it will be able to do this & sell off the US assets of the bank while the non-US businesses continue to operate. Probably not the best plan but better then bailouts.

  6. chidemkurdas Says:

    I should add that in the Bear Stearns case shareholders were not bailed out, only bondholders. The shares lost most of their value.

  7. butos Says:

    Nice post, Chidem. It also perhaps bears mention that regulatory rules do not apply to the government or the Fed. If we want to talk about risk-taking and the creation of risk, it seems necessary to focus on non-market institutions. J.P. Morgan’s antics to hedge risks – a very normal thing for banks to do – ran afoul of the “Greek Circus” and the policy mess out of Europe? These are Big Players problems; not market ones.

    Bill.


  8. @Bill,

    What evidence do you have that it was a hedge? As opposed to a bet? Since taxpayers are ultimately liable for losses of major banks, do banks have a right to place risky bets?

    @Chidem,

    How does the governement make a credible commitment not to bailout in the future? How does it overcome the time inconsistency problem?

    @Bill and Chidem,

    Are you either of your willing to state affirmatively, in these very words, that there is a free market in banking and financial services? As opposed to crony capitalism?

  9. Ryan ruppert Says:

    This talk of risk is nonsense (sarcasm) since the new mandate of the Fed is to guarantee near zero risk along with near zero interest rates. Can’t forget guaranteed lavish bonuses for every participating bankster!

    http://www.zerohedge.com/news/biderman-and-bianco-bury-bernankes-bond-bull-market-backbone

  10. chidemkurdas Says:

    Butos–
    “These are Big Players problems; not market ones.” Important point. The big picture tends to get left out of the media coverage.

  11. chidemkurdas Says:

    Jerry O’Driscoll–
    Re “How does the governement make a credible commitment not to bailout in the future? How does it overcome the time inconsistency problem?”

    Yes that is a huge problem. But it’s barely discussed. The public needs to hear a lot more about that and make political choices accordingly.

  12. chidemkurdas Says:

    Re “Are you either of your willing to state affirmatively, in these very words, that there is a free market in banking and financial services? As opposed to crony capitalism?”

    Never claimed that. But don’t see how adding more opportunities for cronyism will help.


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