…and then there were none.
This evening, Goldman Sachs and Morgan Stanley both received approval from the Fed to convert from investment banks to bank holding companies. With this, the great majority of the US investment banking sector has effectively re-regulated itself. To quote Tyler Cowen, “Whew! I’m sure glad they repealed the Glass-Steagall Act.” The repeal of Glass-Steagall has had the interesting effect of allowing firms to choose between two very different institutions: the laissez-faire system of market discipline imposed through availability of funds on the money market, and the government-backed system of more highly-regulated depository institutions. For the moment at least, it seems that firms are willing to sacrifice flexibility and submit to greater oversight in exchange for public sector guarantees and access to more stable financing.
I don’t think that this is a temporary shift. It’s my opinion that markets tend to systematically underestimate risk for a number of reasons, not least of which is a lack of data. By way of example, it turns out that while it’s relatively easy to estimate the probability of a 100-year flood, it’s much more difficult to estimate the term risk of massive defaults on a package of securitized 30-year loans, because the data we have available simply doesn’t allow for a sample of similar width, nor do we have data for a similar length of time. Given this, and given how closely intertwined the world’s financial institutions are, a phenomenon augmented by the proliferation of instruments to distribute risk– the fact is, none of the major investment banks could actually state its net position at any given point in time– it’s silly to expect that sufficient information exists in the market to accurately price in those events on the tails of the probability distribution. Moreover, the lack of transparency in the shadow banking sector, due in part to the complexity of the instruments being used, but also in large part due to the fact that the instruments are traded primarily in bilateral agreements rather than in an open market, further complicates efforts to understand any one firm’s exposure to a given form of risk, let alone the ripple effects that could occur as a result.
If I’m right about the above, then it’s worth considering also that the same interdependence that frustrates any attempt at isolating a single firm’s risk profile also means that when one firm is in need of capital to remain solvent, it’s likely not the only one. The availability of funds through repo loans and other standard instruments is thus prone to feedback loops that can amplify any disturbances larger than some (unknown) magnitude. As a result, I’d argue that the entire model of investment banking that finally vanished this evening was inherently unstable, and that while we will see a return of many of its elements, they will not take on the same form as they did before. Most notably, we should look for more transparency in formerly opaque instruments, possibly including a central clearinghouse for many types of transactions, and a much more conservative approach to debt financing. While I can’t pretend to know what the future regulatory environment will look like, I do think that such changes would be a positive step in reducing the risks posed to the greater economy as a result of disturbances in the financial sector.