Friday, September 18, 2009

The Federal Reserve: Bank Nationalizer, Income Atomizer

The nationalization of the banking system continues. Even as healthier banks repay their TARP funds, the Fed is now proposing comprehensive regulation of banker compensation. It's not talking only about executive pay. It means to cover compensation arrangements down to mid-levels and perhaps even lower. The idea is to prevent banks from creating and accumulating the outsized and uncontrolled risks that led to the current economic mess. All the annoyed bank vice presidents out there have AIG-Financial Products to thank for the comprehensive scale of the proposed regulation. AIG-FP was one of many subsidiaries of AIG, the grand bailee of the financial services industry. FP, all by its little old lonesome, sold so many credit default swaps, and thusly saddled AIG with so much risk, that the U.S. financial system almost blew up when FP's counterparties began to demand collateral that it couldn't provide. As we all know, the American taxpayers, generous to a fault and holding bankers dear to their hearts, rushed forward with more than $100 billion to save AIG from bankruptcy.

Because the federal government, through its now engraved in stone too-big-to-fail doctrine or through federal deposit insurance, is on the hook for virtually all liabilities of all banks, there is a logic to comprehensive regulation of bank risk taking. After all, the banks' own signal failure to manage risk created the mess we're in, and there's not a lot of evidence that they've changed their ways. Indeed, bank risk levels now seem higher than before the economic crisis. (See

The Fed wants to ensure that banks have sensible pay policies. Can't argue with that. But government agencies don't regulate simply by prescribing policies. They have to follow up and verify that the banks are following their policies (that's called enforcement of the rules). Federal examiners would have to routinely review compensation of, say, bank vice presidents (those would be the folks that open checking and savings accounts, and make mortgage loans). We'd practically have the government managing the banks--all of them. Admittedly, many are the bankers that deserve a trip to the wood shed from which they would return with tenderized butts. However, having federal officials countersign bank employee paychecks implicates the government really deeply in the doings of the banks. The next time there is a banking crisis--and you can bet your last penny that there will be more banking crises--the federal government will bear even more blame than it has been smacked with this time.

Back in the bad old days of 3-6-3 savings and loan mortgage lending, cars had big fins and lousy mileage, too many martinis were consumed at lunch, meals were high in saturated fat and tasty, the real estate market grew steadily if not spectacularly, and the financial system was pretty stable. The government got this result by limiting the financial products that banks and similar institutions could offer and invest in. Banking was a dull industry with moderate profitability. But recessions tended to be short and recoveries tended to be fast. America was an optimistic nation.

Perhaps the unstated reason for the proposed comprehensive regulation of banker compensation is that the Fed doesn't want to admit error and re-regulate the types of financial products that banks can play around with. In the last 20 years, the Fed has led the charge for the deregulation of banking. It's wanted to allow banks to do anything they want, take any risk they want. No need to recap the result of all that. A simpler way to solve the problem of bank risk levels would be to again limit the products the banks play with. No more CDOs or CDOs squared. No more credit default swaps. No life insurance settlement backed bonds or other financial engineering of doubtful social value. If these products truly have social utility, some not-too-big-to-fail, not federally insured or guaranteed company will come along and offer them. If none does, those products will be revealed to be the sophisticated forms of gambling they appear to be.

Federal regulation of banker compensation is meant to prevent the morally hazardous status quo, where taxpayers cover losses while bankers bank big bonuses. That's a laudable goal but we ought not overly complicate the task of bank regulation.

Speaking of simple points, the Fed holds another periodic meeting next week, where it will decide basically to change nothing. Short term interest rates will be kept at zero and other accommodative measures will be kept in place, with only the gentlest of suggestions that they may ever so gradually be withdrawn but not if the financial services industry lets out even a mere whimper. As a not-so-academic exercise, one might consider what would have been the case if the Fed had, instead of moving interest rates to zero, just lowered them to 2%. A fed funds rate of 2% would have been quite accommodative by historical levels but would have been less conducive to inflation (not a threat at the moment) and to asset bubbles (whoops, please don't look at the stock market, whatever you do). There are a lot of people who hold savings in money market funds and bank accounts, and whose interest income has fallen sharply because of the Fed's indulgences for bankers (i.e., providing a zero percent cost of funds which the banks can turn around and lend at tidy profits). How much income have these unfortunate holders of capital lost? It's hard to say, but we can guestimate.

About $3.5 trillion is held in money market funds. Something like $5.5 trillion is held in bank money market accounts, savings accounts and other interest bearing accounts. That's $9 trillion right there, which multiplied by 2% equals $180 billion per year. Then add federal interest paying investments that effectively have variable rates, like U.S. Treasury bills, TIPS, and U.S. Savings Bonds, which may total in the range of $3 trillion. Multiply this by 2% and you get an additional $60 billion. Then, there are those very unfortunate auction rate securities and perhaps some commercial bonds held by individual investors, and the aggregate income lost from having a zero rate instead of 2% probably totals over a quarter trillion dollars.

A quarter trillion dollars may not seem all that big in America's $14 trillion economy. But ask retailers if they'd like customers to have an extra $250 billion to spend. Granted, not all such interest income, if it were received, would be spent. But even if some of it were saved, those savings would probably have a wealth effect that would make recipients feel a little looser with other income.

Clearly, America's savers cannot look forward to very much interest income for a long time. Thus, the Fed constrains consumer spending even as it tries to foster it with its ultra cheap money that banks don't lend to consumers.

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