“The U.S. financial system remains fragile and banks subjected to additional economic stress might need as much as $76 billion in capital, according to the results of International Monetary Fund stress tests.”

We at CERF have been long concerned about the strength of our financial sector.  In fact I suspect that the IMF study may be understating the severity of the situation.  That would be a problem.  Ask the Japanese what a weak banking sector can do to an economy.  The weakness of their financial sector, and their failure to correct those weaknesses, were a significant contributor to their 20 years of economic malaise.

Failure to promptly deal with our weak financial sector can have similar consequences for us.  You may think the new financial regulation fixes our banks.  It doesn’t.  It creates a new regulatory environment but it does nothing to address the problems that are keeping our banks from fully participating in our economy, inadequate capital and bad assets on their books.

The FDIC reports that 83 banks have been closed so far this year. While there were 140 bank failures in 2009, we are on track (based on a simple extrapolation of current trends) to experience at least 160 bank failures in 2010. This is down from my month-ago extrapolation of 180 failures.

These failures are occurring while the Fed is paying interest on excess reserves, which has the effect of removing or tightening credit in the banking system. One would think that in this recessionary environment the Fed would implement a credit relaxing policy rather than a credit tightening policy. Rather, the Fed is pursuing this policy because there are a lot of banks out there that they are worried about.

The three month Libor rate has remained high, indicating that banks remain worried about the credit worthiness of various institutions around the world. See the chart below.

We closed 16 banks in May so far, with 73 so far this year according to the FDIC. There were only 36 bank failures through May of 2009. While there were 140 bank failures in 2009, we are on track (based on a simple extrapolation of existing trends) to experience about 180 bank failures in 2010.

We finally have updated gross charge-offs data, and 2010 quarter 1 was $57 billion. Gross charge-offs were $57 billion in 2009 quarter 4 as well. This is an alarming number. Typical gross charge-offs run around $10 billion, this is the average from 1999 quarter 1 through 2007 quarter 4.

The three month Libor rate has been rising steadily since mid-March of this year, indicating that banks are becoming increasingly worried about the credit worthiness of various institutions around the world. See the chart below here.

We have maintained here in our columns and in our publications that risks to economic growth continue, and these data are part of why we hold this view.

• Keep it simple. Simple regulation is cost-effective regulation. Simple regulation minimizes both regulatory costs to the government and compliance costs to the regulated firms, costs eventually borne by consumers or taxpayers. Complicated regulation invites lawsuits and encourages efforts to avoid the regulation.

• Regulate the smallest possible number of firms. Regulation is a market distortion and tends to limit innovation. Because of the September 2008 collapse, some people are not convinced of the benefits of financial innovation. This is unfortunate. Financial innovation is, on net, positive. Consider the Farmer who hedges against bad weather by using futures or the airlines that hedge against higher gasoline costs. We need to encourage financial innovation.

• Preserve incentives. We’ve all encountered either government monopolies or government regulated monopolies. The DMV, the Post Office, and utilities come to mind. We’ve also seen the innovation that followed the elimination of the phone monopoly. Bad regulation provides perverse incentives. Good regulation maintains incentives for quality, service, and innovation.

• Maximize market feedback. Markets have built in incentives that are beneficial to society. Where possible, we should allow that feedback to do its magic. It is the cost-effective way to preserve incentives.

• Minimize moral-hazard problems. Moral-hazard issues result from free or under-priced insurance. It is currently pervasive, and it is our single largest source of unnecessary systematic risk. The too-big-too-fail concept in particular has resulted in excessive risk taking, with disastrous results. Similarly, FDIC insurance was under-priced, as evidenced by the FDIC accelerating the collection of future premiums, and the results are self-evident.

• Minimize political influence. Political influence in economic matters is counterproductive. It is clear to me that the vast majority of political types are trying to optimize something other than economic activity or efficiency. Whether the political objective is maximizing the likelihood of reelection, rewarding supporters, or simply greedy corruption, we need to avoid the results.

• Regulation is not protection. Regulators often become partners with the regulated. Sometimes this is because the regulator expects to be eventually employed by the regulated. The regulator may have been employed by the regulated, or may become friends with the regulated, or may be corrupt and accept bribes. In all cases, we are ill served when the regulator is protecting the regulated.

• Regulation should not be adversarial. The purpose of regulation is not to punish the regulated. We have a legal system to provide punishment when it is needed. Adversarial regulation will encourage evasion. The best approach is arms-length, fair, and firm.

The problem with regulating capital ratios is that the capital ratio is not a sufficient measure of the firm’s risk. The firm’s risk is a function of both the capital ratio and the riskiness of the assets it holds, and that poses serious regulatory challenges.

A firm has a preferred risk profile. If you limit the capital ratio, the firm can achieve its target risk profile by increasing the riskiness of its assets. This means that if you want to regulate the riskiness of a firm using a capital ratio, you must also control the riskiness of its assets. No problem there.

Well, actually, there is a problem. Controlling the riskiness of a firm’s assets is impossible.

If regulation is to have any impact, the firm has a big financial interest in having riskier assets than the regulators would prefer—an interest that is only made larger by free (too-big-to-fail) or under-priced (FDIC) insurance—and the regulators have only a limited interest. Therefore, the firm will succeed in working around any constraints, and they will always be at least a step ahead of the regulators. The regulators are just no match for a determined firm with a big financial incentive.

Even if regulators could control the risk of firms’ assets, they still could not control the risk of the firm, because risk is dynamic, changing over time. In my banking days, we had a saying: In good times you don’t need capital; in bad times you will not have enough capital.

The problem is that in bad times, everything goes bad. We say the covariance goes to one. It may seem farfetched that a New York grocer, a Los Angeles realtor, and a Chicago lawyer would have economic prospects that were related, and that is true in most states of the world. This is the argument for geographic diversification. However, in a big event like we saw in September 2008 the grocer, the realtor, and the lawyer were all in the same boat. The probability of each of them failing to meet obligations has gone up, but more importantly, the probability of all of them defaulting has gone way up.

There must be a better way to regulate financial companies.

• Keep it simple
• Preserve correct incentives
• Minimize political influence
• Maximize market feedback
• Minimize moral hazard issues
• Regulation is not protection

Our friends at KERN Economics have come up with a plan that meets all of my criteria. It also has the desirable characteristic of having successful working examples, examples that were unfazed by 2008’s meltdown. Good original thinking. Read it here.

How will the Fed raise the short-term market interest rate? The old-fashioned way of tightening monetary policy is to shrink the amount of reserves outstanding by selling assets. Over the past one and a half years, the Fed has piled on securities with long maturities and exposed itself to credit risk. If it sold those assets, it would post considerable losses, deadly to the institution’s already fragile reputation in the current political climate. Instead, the Fed will raise the rate it pays on excess reserves (or deposits of banks at the Fed). Banks will pull up interest rates in the money market as the alternative use of reserves—parking them at the Fed—becomes more remunerative.

Who at the Fed will raise the short-term market interest rate? Congress explicitly gave the authority to raise the interest rate on excess reserves to the Board of Governors (or the seven appointed officials who work in Washington), not the Federal Open Market Committee (FOMC, or the board governors and a subset of reserve bank presidents who normally vote on reserve conditions). Thus, the balance of power within the Fed will shift toward the governors when the instrument of policy becomes the interest rate on reserves. (Bernanke elided this issue in his recent testimony when he left the impression that the FOMC will still set policy in conjunction with the board. In fact, the Federal Reserve Act prohibits the board from delegating monetary policy to others.) This matters because two slots on the board are currently open, giving the White House an important opportunity to shape monetary policy through future nominations. Indeed, given natural turnover among governors, President Obama will probably be able to appoint a majority of the board in a single term of office.

In the first paragraph, Vince highlights the flipside of quantitative easing. The Fed bought a bunch of long-term financial assets, the value of which will go down when interest rates go up. Now, owning these assets is a constraint on Fed actions. There is already plenty of pressure to reduce the already-compromised “Fed independence.” Selling those assets at a loss will further increase pressure for more congressional oversight.

This means the Fed will control inflationary pressure by increasing the rate they pay on excess bank deposits at the Fed. That will work, but it will likely have a more negative impact on economic activity than traditional methods. With high risk-free yields at the Fed, banks, already under regulatory pressure, undercapitalized, and risk averse after the 2008 meltdown, will have no incentive to lend. Small business, which traditionally funded growth with bank loans, will have difficulty obtaining capital. Big business, with direct access to debt and equity markets, will have easier access.

Economic growth, therefore, will probably be slower than under traditional Fed tightening, and it will be biased toward big business. Small business, handicapped by an uneven playing field, will almost surely decline as a percentage of business activity.

The second paragraph is important, because it implies that Fed policy will become more political. Given current and projected United States debts levels, political pressure to monetarize the debt will be strong. As debt levels and interest rates increase, interest costs will soar, as will the pressure to inflate. Will a more politicized Fed resist that pressure? I wouldn’t bet on it.

Jeff isn’t buying any of this. He says:

It seems peculiar to me that the Fed would conduct its monetary policy with a major constraint being the effect on its own profitability. While it might be embarrassing to sell some securities at a loss, it would be even more embarrassing to have a portfolio like the thrifts in the 1980s: long-term fixed rate assets funded with short-term liabilities in a rising rate environment. That would look really stupid.

Good point. We’ll see.

Scheer doesn’t give his reasons for supporting a new Glass Steagall, but he quotes McCain extensively. McCain’s comments are essentially a populist rant against “fat cat bankers on Wall Street.”

That’s a problem. I’m all for a new Glass Steagall, but let’s get the reasons right. Populist rants only confuse things.

The Glass-Steagall Act, passed in 1933, was part of the response to the Great Depression. The component relevant to today’s debate was the restrictions on the breadth of financial institutions’ operations. Investment banks were restricted from commercial banking, and commercial banks were similarly restricted from investment banking. An investment bank engages in transactions involving capital, securities, mergers and the like. Commercial banks take deposits and make loans.

The repeal of Glass-Steagall, in November 1999, was supported by both political parties. The arguments for repeal were that it would reduce risk by diversification and that advances in financial technology meant that risk was low.

Right.

The diversification argument sounds reasonable: Banks could diversify, and if one business was in trouble, the other probably won’t be in trouble. But, there is a problem with that argument. Financial theory and experience is clear. Stockholders can diversify for themselves. Businesses should concentrate on their core competency, the one where they maintain a comparative advantage.

The diversification argument also implicitly assumes a relatively low correlation between the returns from the various businesses. Financial panics throughout history have demonstrated that when things go bad, the correlation goes to one. When things go wrong, they go wrong everywhere.

The argument that financial technology has improved, and we now know how to do things with low risk is an old one. I refer readers to Reinhart and Rogoff’s book This Time is Different: Eight Centuries of Financial Foll. In it, these respected economists document the plethora of financial panics this type of thinking has created.

We do need to reinstate the separation of bank business. Let’s do it for sound reasons. While we’re at it, let’s limit the maximum size of any corporation. We also need to get rid of the Too Big To Fail concept.

Banks can borrow from the Fed at rates near zero. Then, they can purchase Treasuries for about three percent. Voila, banks have a three percent risk-free return, and no incentive to lend to business.

The conclusion is that the Fed has rates too low.

I disagree.

First, we need to acknowledge that many banks are in no condition to be taking risks, and many of their customers are in no condition to be assuming additional debt. Also, the Fed is paying interest on excess deposits, which is silly, and it complicates the analysis. However, even if banks could lend, borrowers could borrow, and the Fed didn’t pay interest on excess reserves, I don’t think the above analysis is correct.

The easiest way to think about the situation is to ask: what would the banks be doing if there were no Treasuries to buy? They would be investing in something else, something like loaning to businesses and consumers. This is pretty much the definition of crowding out.

The fact is that downside risk still dominates the forecast, and the Fed needs to keep interest rates low, at least for a while longer. If our banks were healthy, this would be a clear-cut example of crowding out. The banks aren’t healthy, but I’m thinking some crowding out is definitely happening.

I’m as concerned as anyone about total government spending and the deficit. I’m probably more concerned than most about bank lending to business. But, conspiracy isn’t the problem.

Part one of Melloan’s theory is that the Fed is causing banks to be excessively risk averse. He says “The Federal Reserve, which supervises some 7,000 banks, has been telling bankers that they must cut risk.”

The FDIC reported today that there are 552 banks on their problem list. Banks have been charging off $40 to $50 billion per quarter in loans for a year now. Capital has been eroded, and banks are way overleveraged, in part because of excessive risk taking. You think that maybe banks should be more risk averse today? You think that maybe there is a rational reason for banks to lend less to business and purchase more government securities?

The real problem is not some government conspiracy. The real problem is the government’s quiescence.

Too many of our banks are zombies, and we face something like Japan’s lost decade if we don’t fix them. This is the single most serious United States problem today. It drives me crazy that we are wasting huge amounts of resources and political capital on second-order problems while ignoring the bank problem.

Robust recovery requires banks lending to businesses. Banks can’t lend to businesses until they are adequately capitalized, and the bad assets are off the books. We will not have a robust recovery and put people back to work until our banks are fixed.

Bankruptcy is one way to clean up our banks. Since the FDIC fund is currently upside down, -8.2 billion, this would require external funds to the FDIC. The other option is the one successfully used by Sweden. They nationalized the banks, cleaned them up, and resold them. This would also require an investment.

Either way, fixing the banks is a far better use of money than some Stimulus 2 program or even the unspent portion of the current stimulus program.