A Tale Of Two Failures: A Model Of Financial Regulatory Reform

By Chandrashekar (Chandra) Tamirisa, (On Twitter) @c_tamirisa

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(This paper of mine has formed a basis for my financial regulatory reform proposal. I had submitted this academic paper to American Economic Association journals and to the Finance and Economics Discussion Series-FEDS-of the Board of Governors of the Federal Reserve System in November 2009 where I was employed in a non-economist position.)

This paper[1] creates a simple model of financial regulatory reform with the aim of introducing a first resort self-financed buffer between the financial sector and the central bank. The motivation for the paper has been the moral hazard created by the Federal Reserve’s ex ante policies to unconditionally extend liquidity in the event of firm failures. This deficiency is addressed by taking a micro-economic perspective of monetary policy with the aim of rehabilitating the last resort lender function of the global central banks. The absence of counter-cyclicality in the Basel regime is also adequately addressed.

Introduction

Professional economists are trained to think through the lens of models. Most of the time those lenses are to enhance the appeal of economic science, similar to cosmetic eye wear. Sometimes, they are useful to correct sight defects. On those rare occasions economic models can help clarify reality.

Government failure and market failure[2] seem to have conspired against the United States at the same time, just as nature had against the unlucky dinosaurs millions of years ago, and the continued survival of the American flavor of capitalism hangs in the balance. The current reality of exacerbated confusion in the financial markets may require the lens of a model to see the simplicity of the problem, to cut through the haze of the smog that has enveloped the highways of finance for the past two years.

Those who were opposed to the passage of Gramm-Leach-Bliley (GLB) in 19993 have jumped on the pathos of the crisis to point out that they have been right all along. They are reiterating that Glass-Steagall should not have been repealed because the wall between commercial banking and the rest of the risk takers on Wall Street was inherently containing “excessive” risk taking. They want to put it back up by un-repealing it.

The Chairman of the Monetary Policy Committee (MPC) of the Bank of England (BOE), Mervyn King, a usually commonsensical countryside voice in the City of London who likes to speak about money in the parlance of cricket, is also implying the same for his country4. And the British conservatives, the Torys, who had merged all of finance in the United Kingdom (U.K), with an election staring in their faces, are mute. They like it the way it is for now because without knowing how to change regulations for the better, they cannot appear to be supporting the mess, especially when the U.K cannot have that much of an impact on the future of financial regulations around the world. The burden of change thus falls on the shoulders of the United States which caused the debacle because it did nothing after GLB to change regulations to suit the new Wall Street.

The Gramm-Leach-Bliley advocates, who had followed the example of the U.K in the United States to “unleash” finance, want better regulation. Not a return to the balkanization of Wall Street. At stake is a tale of two failures both perceived to be too big to fail: the Wall Street behemoths and the American elephant. Both are deep in debt up to their eye balls and dependent on the rest of the world to save them. And the rest of the world is asking, “are you really too big to fail?”

The rest of the world seems to be of the mind to prop up neither Manhattan nor the American main streets, but gradually make the United States a spoke in the wheel of the global economy, much as they are, rather than a hub that cannot seem to be able to carry the wheel. Perhaps Wall Street and Washington, after the spectacular explosions on 9/11, need controlled implosions, not unfamiliar to New York City’s ever changing skyline, to clear up the debris. Diversification is elementary finance and it has not happened on Wall Street since the crash of 1987. And now the rest of the world wants to diversify out of dependence on the United States. There is nothing that is too big to fail. What is the United States to do?

Description of the Model

If we imagine a world with only one private bank and one central bank, with the central bank supplying money to the private bank to lend to the rest of the economy, we have a model of a behemoth and an elephant, similar to two heavenly bodies suspended in nothingness and hanging together only because of an unseen force. The central bank sets a base interest rate by fiat, much as it prints the money also by fiat, in a world with no other private banks, for the one bank to determine the interest rates on all other forms of borrowing. For most part the government relies on the bank to manage how it lends, to whom and when as long as there is equal opportunity in the availability of credit in the society. There is no antitrust regime in finance. To earn more revenue it is in the interest of the monopoly private bank to keep on making loans to a larger base of borrowers in the society at an affordable rate of interest.

Because there is only one bank, should the central bank worry that the bank is too big fail? Yes. It is too big to fail, for without it the blood line of money supply to the economy would be shut down. It does not matter whether such a bank is owned by the government itself or exists as a private entity. The government must still figure out how to prepare for possible failures.

So, it then decides to ask the private bank to save for a rainy day, much as the states in the United States do. When times are bad, those monies can prevent it from faltering. But the rainy day savings, it says, should be deposited with the central bank to be returned with an accumulated, compounded rate of the fiat interest it periodically sets when there is a crisis. The central bank also has its supervisors visiting the private bank to look at its books to raise red flags when necessary.

The “too big to fail” bank in the society agrees to pay the government the “rainy day savings tax”[13] annually out of its revenues. It is always spring when the borrowers are responsible and the bank has more successful loans than failures. It is always spring when the bank lends responsibly upfront to ensure that this is the case. All the flags are green.

Because the government does not really interfere with the bank’s business, bad loans begin to crop up when the economic weather turns for the worse and because the bankers want to keep on earning with no concern for the changing climes. The central bank supervisors then caution about the gathering storm. When the bank does not pay attention, the government raises the amount of the rainy day savings.

The bank teeters on failure one day and the government returns the accumulated rainy day savings with the promised interest and some by reducing the fiat rate of interest. The bankers have learned their lesson and return to business as usual until tempted by greed again and the cycle goes on.

The private bank was both not too big to fail because it did, and too big to fail because it should not. It is and/both, not either/or.

If more banks then enter the market, similar to more stars in the night sky, it can be a prettier sight because the “seen” forces of a more transparent, sensible and simple regulation by the government at the hub of the wheel can then hold the economic universe together.

Mathematical representation

Mathematical Representation of the Contingency Reserve Model

Cr = Contingency reserve
f(f)r = Fiat rate or the federal funds rate
Fed[sub b]= The federal reserve asset base on its balance sheet
M[sub nb] = A member bank’s asset base on its balance sheet
d^2[sub b] = Square of the “distance” of a member financial institution to the Fed, primary dealers are the closest at the shortest distance and community banks are farthest at the longest distance, “distance” being some proxy measure that is dependent on the structure of the financial market relationships via-a-vis the Fed.
K = The product f(f)r*Fed[sub b] which has the highest inertia and can therefore be assumed to be relatively constant.

The final form of the equation is similar to Newton’s second law of motion, Force (or the contingency reserve that holds the member bank to the Fed) equals the mass of the Fed (the product of the federal funds rate or the fiat rate, whichever is the operational monetary policy regime, and the Fed’s asset base). As long as K is constant, the economy can be expected to move at a steady rate, following the first law of motion.

If the rate of change of the “force” K is to be calculated analytically, it becomes a partial derivative of the function with three variables f(f)r, Fed[sub b] and M[sub nb] because d^2[sub b] is a constant, given a structure of the financial markets.

Some Conjectural Implications for Economic Theory

When K is constant it should yield the steady state growth, Y*, of the Solow Growth Model[5] to complete the integration of money and real growth[6]. Technical change, as in the Solow Growth Model, is still assumed to be exogenous.

A constant K can also imply a constant growth rate of money, dK/dt, to be consistent with the implications of the quantity theory of money: MV = PY[7].

The late Milton Freidman’s conjecture that inflation is always a monetary phenomenon must be stated differently, because of 1 and 2 above, as inflation and more broadly price stability being always a real phenomenon and a monetary phenomenon only in so far as the inability of fiat money to reflect real prices.

The policy irrelevance proposition of Robert Lucas is invalid because of the intrinsic quantum duality of “too big to fail” as demonstrated by the above model. The nature of the exogenous perturbation is ex ante unknown to even remotely render the theoretical possibility of policy irrelevance under perfect information. Rational expectations cannot reasonably be expected to expect the perturbation[8]. If it did, there would be no need for white noise or ε in econometric models. Even endogenous perturbations in well-defined closed or open systems are difficult to determine ex ante and can therefore, produce unanticipated shocks.

Barring unforeseen shocks, monetary or real, the endogenization of technical change, a severe limitation of neoclassical economics, by policy and hence the intended economic structure can help smooth the business cycle[9], validating Kydland and Prescott[10] and diminishing the variable lags in unemployment, though, albeit usually lagging behind economic recovery[11], the rate of decrease of unemployment can be a leading indicator of economic recovery in some cases when the recovery is incumbent upon structural change.

Conclusion

It is clear from the above application of the Newtonian equation of the universal law of gravitation that large banks pay more in contingency reserves Cr and small banks pay less Cr which is the expected objective of the financial regulatory reforms under consideration. Cr can be modeled as a model of taxes and the disposable income or revenue (working capital) of the financial institutions[13]. The model satisfies the countercyclicality condition which is currently absent in the more complicated models in the Basel regime[12]. The Basel regime would no longer be necessary under the recommendations of the model presented in this paper, even for cross-border banks.

References

[1] The text portion of this paper was submitted as an opinion piece to the Wall Street Journal on October 26, 2009 by the author.
[2] Tullock, Gordon. 2002, “Government Failure: A Primer in Public Choice (Paperback).”
[3] Gramm-Leach-Bliley Act. 1999. Public Law 106-102.
[4] King, Mervyn. 2009, Speech to Scottish business organisations, Edinburgh.
[5] Solow, Robert M. 1956, “A Contribution to the Theory of Economic Growth.” The Quarterly Journal of Economics, 70(1) 65-94.
[6] Blanchard, Olivier. 1980. “The Monetary Mechanism in the Light of Rational Expectations.” Rational Expectations and Economic Policy, 75-116. National Bureau of Economic Research (NBER).
[7] Friedman, Milton. Various presentations in literature of the modern mathematical form of the quantity theory of money.
[8] Lucas, Robert. 1995. “Monetary Neutrality.” [Nobel] Prize Lecture.
[9] Tamirisa, Chandrashekar A.S. (expected 2011), “Financial Globalization and Endogenizing Technical Change” http://www.tamirisa.net.
[10] Kydland, Finn and Prescott, Edward. 1982. “Time to Build and Aggregate Fluctuations” Econometrica, 50(6) 1345-1370.
[11] Blanchard, Olivier and Summers, Lawrence. 1989, National Bureau of Economic Research working paper No. 2035.
[12] Bank for International Settlements. 2008, “Principles for Sound Liquidity Risk Management and Supervision.”
[13] Tamirisa, Chandrashekar A.S, “Bank contingency reserves as taxes.” Working paper.

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About Chandrashekar (Chandra) Tamirisa

http://www.thecommonera.com/Common_Era/Me.html
This entry was posted in Economics, Financial Regulation, Politics, Transformations LLC and tagged . Bookmark the permalink.

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