The recent spasm of White House and Congressional initiatives to limit bank risk taking flies in the face of demands for more loan origination, and for good reason: lending is all about taking risk. This point may be lost inside the Beltway, but not in Beijing.
For example, the Obama Administration’s proposal to eliminate bank’s proprietary trading would sharply reduce the ability to take positions offsetting exposure created by a variety of customer financings, potentially increasing the riskiness of banks. Further, driving banks out of trading deprives them of a revenue stream which may have low or even negative correlation with returns on lending, removing a stabilizing counterbalance. Case in point: Phibro, the commodity trading firm formerly owned by Citigroup, produced earnings that lowered the funds Citi required from the TARP by hundreds of millions of dollars (regulators pushed the bank into selling Phibro to Occidental Petroleum for less than one year’s earnings, so we as Citi’s taxpayer-shareholders no longer have the benefit of that diversification – see “Taxpayers Saved from Morally Corrosive Profits As Citi Sells Phibro”). Private equity and hedge funds, two other businesses from which Obama would bar banks, also played no significant role in banks’ losses in the crisis, in some cases offsetting hits to loan portfolios.
Meanwhile, the White House plans to tax banks assets less Tier 1 capital and FDIC-insured deposits, which in plain English means a levy on the banks’ lending risk. The President claims his aim is to recover TARP funds. Leaving aside the fact that the big banks have already repaid those funds with interest, why would you tax lending at a tine when you are trying to increase it? As I’ve noted before, there’s a strong rationale for taxing banks to fund deposit insurance (see “You Don’t Want To Pay Deposit Insurance Premiums A Year In Advance? Fine – Then Pay Three Years Worth! You Wanna Try For Six?”). But both experience and academic research (including my own) demonstrate the time to increase that tax is when the economy is strong and lending risk is high, since it’s during a boom that a downturn is most likely. Increasing levies a period of economic weakness and low risk-taking delays and attenuates recovery. This crisis demonstrated a need to insure banks against runs on short-term liabilities beyond deposits, meaning a broader financial stabilization fund is in order, but the time to tax remains the same: during expansions, reigning in risk when banks are not undercapitalized, as they are now. Of course, the President’s tax would be used not for systemic insurance but to fuel federal spending, drawing capital out of banks just when more of it is needed to fund the lending required for recovery.
Then of course there’s the Congressional proposal to force lenders to retain a piece of every mortgage they originate. The idea is that they’ll be more careful in their lending if they have to keep some of every loan they make. But as demonstrated in a study I co-authored, the effect of restricting loan sales is ambiguous: origination may be more cautious, but when a downturn inevitably does come, those loans the banks were forced to retain will still go south, meaning a bigger bailout than if those assets had been sold. Restricting sales can thus actually lead to riskier banks.
How should bank risk-taking be regulated? The key is to recognize control is achieved not by eliminating risk taking but by making sure institutions are in a position to manage the risk they take on, and that means properly using tools like trading and secutization now under attack from Washington. It also means being responsive to economic conditions. For a more constructive approach, one might look across the Pacific, where China’s central bank waited until that nation’s recovery was in full swing (growth hit 10.7% last month according to Beijing) before increasing bank reserve requirements and tightening lending standards so as to dial down risk and deflate nascent bubbles.
Perhaps it’s unrealistic to expect this Administration and Congress to listen to council from capitalists (even the liberal-leaning Warren Buffet criticized Obama’s bank tax); populist bank-bashing is just too tempting, especially in the wake of a rebuke like that the President received in Massachusetts this week/ All I’m really asking for is regulatory policy less wrong-headed than that of the Communist Party of the People’s Republic of China.