Wednesday, November 7, 2018

Housing: Part 328 - Bank Capital and the Crisis

John Cochrane has an interesting post up today about the role of bank capital in the financial crisis.  He is referencing some recent work from Laurence Kotlikoff.
Larry puts it all together nicely by starting with the 2011 Financial Crisis Inquiry Commission report:
"There was an explosion in risky subprime lending and securitization, an unsustainable rise in housing prices, widespread reports of egregious and predatory lending practices, dramatic increases in household mortgage debt, and exponential growth in financial firms’ trading activities, unregulated derivatives, and short-term “repo” lending markets, among many other red flags. Yet there was pervasive permissiveness; little meaningful action was taken to quell the threats in a timely manner. "
Larry then takes apart each of these non-culprits, as below.

In my view, the understanding that the crisis was a run, that without a run there would have been no crisis, somewhat like the 2000 tech stock bust, and that lots and lots more capital is the only real answer, has emerged slowly over the last 10 years. Larry's essay is good for putting all the others to rest.

The point of this is to suggest stronger capital requirements for banks, and I basically agree with all of that.  In an age where there are money market funds, securitized mortgage securities, fintech, etc., is there a reason to subsidize and support a banking system built around a mismatch between assets and liabilities?  I don't think so.  There are a number of potential ways to change that system, and people with much more expertise than me will debate what the best way is.

The two-cents I will add here is simply that, in order to get to the conclusion that a systemically unstable banking system was the cause of the crisis, Kotlikoff and Cochrane dismiss many of the same supposed causes that I have also dismissed.  They have already basically come to the same conclusions I have about the causes of the crisis, but their focus is on bank capital rather than on what caused the stresses on bank capital.

Eighty percent of my job is done here, I think.  I would only ask them to take one step back and to consider that if so many of the supposed causes of the financial crisis are not particularly compelling, then maybe the stresses on the banking system were not inevitable.

Sure, given the stresses that the banks ended up taking on, a better banking system would have responded better.  But, those stresses should have never happened.  Both can be true.  It can be true that those stresses revealed weaknesses in the banking system, and it can be true that reasonable attempts at broad stabilization in 2007 and early 2008 would have prevented those stresses from ever developing.

I fear that for those who are advocating for a more stable banking regime, the idea that a fragile regime was a root cause of the crisis is a powerful point to promote, and that it would feel like making a rhetorical compromise to agree that the crisis could and should have been averted, even with the banking regime we had.  Yet, they already have come to conclude that the evidence underlying the presumption of inevitability is weak.  It will be interesting to see how they respond to a new narrative.


  1. OT, but interesting.

    I have long wondered about housing stock becoming obsolete, and this guy has some stats. So instead of 1.2 or 1.3 million new housing units a year, the US is producing maybe 900k net new units.

    At present, the number of residents per housing unit is rising.

    1. Len does good work. For some reason the graphs in his posts aren't showing up for me. Maybe I'll check back later.

  2. BTW, great post and I thought of your work while reading Cochrane, and the dovetailing.

    I agree the 2008 Great Recession need never have happened. The Fed just needed to live for 3% inflation for a couple of years.

    I wonder: Would a central banker rather "endure" 4% inflation for two years, or the Great Recession? A tough call.

    I am sad to say most of the macroeconomic community is right back to issuing dark warnings about inflation, again. They seem to think the financial system is more stable now, so the Fed can really crank it down, but Cochrane and others have warned that is not true. Some marginal increases in capital requirements and lots of red-tape.

    Meanwhile, the nation is suffocating the supply of housing.

  3. The destruction of the commercial paper market which backed off balance sheet banking, forced the banks to take the loans onto their books. That seems to me the real final straw, yet, the Fed waited to supply liquidity and in fact supplied IOER which stopped banks from lending. According to George Selgin the Fed makes the argument that it was loosening monetary policy while in fact that dead money, IOER, was useless in loosening monetary policy. Selgin felt betrayed, something someone as astute as he is and in the position that he is in, is very extraordinary.