Making the financial system safe - a bad goal?

[Neu Leonstein]

Or a strawman? Let me apologise for the thread title in advance: there are of course plenty of things that could be made safer about our modern financial system. But I'd like to focus on what seems to me like an underlying notion that drives a lot of the rhetoric and some of the laws (ie the Volcker Rule and the Vickers Reforms in the UK).

Basically, the notion is that banks need to be stopped from taking risks, primarily by stopping them from engaging in proprietary trades that take risk onto their own balance sheets. And if those trades involve derivatives, then that's arguably even worse.

Now, the Volcker Rule is being criticised by its erstwhile supporters that it is too complicated, leaving too many loopholes and is taking too long to implement. Some even accuse the process of having been hijacked of Wall Street lobbyists. To those people, we should just have a short thing than bans "prop trading":

I’d write a much simpler bill. I’d love to see a four-page bill that bans proprietary trading and makes the board and chief executive responsible for compliance. And I’d have strong regulators. If the banks didn’t comply with the spirit of the bill, they’d go after them.

I think that's misguided. People think of financial market risk as being this artificially created thing that banks generate to make money at the taxpayers' expense. But here is a different perspective, much closer to my own, courtesy of the excellent dealbreaker: http://dealbreaker.com/2011/09/lets-jus ... ters-evil/

Let’s say you are at a bank, and you are on a flow desk or, whatever, not a “prop” desk. Let’s say it’s the delta one desk. And a person comes to you and is like “hi, I would like to be short one million shares of UBS, because that seems like a wise thing to do, but I don’t want to mess around with borrowing those shares because all these politicians keep talking about boiling short sellers alive, so just write me a swap where in one year if the stock is below $12, you pay me the difference, and if it’s above $12, I pay you the difference,” and you’re like, yeah, that sounds fair, and so you write the swap.

So you’ve now got a trade where you’re long one million shares of UBS. And you obtained that trade in a normal, market-making, non-”prop” way. Now what do you do?

A thing that you probably do is go borrow one million shares of UBS and sell them short. This is a sensible thing to do. Why is it sensible? Well, for one thing, your desk is called “delta one,” and you’ve written a derivative, and you want to delta hedge that derivative, and so you pull out a Black-Scholes calculator and plug in a lot of variables and get stuck but then you look at your business card and you’re like, oh, shit, the answer is “one,” and so since you soldbought 1mm shares of exposure at 1 delta you need to go buysell 1mm shares to be delta hedged. So the math checks out.

But the other reason that it’s a sensible thing to do is that you’re a “flow” trader, or something – you’re not a “prop” trader, anyway – so you aren’t really necessarily in the business of being long 1mm shares of UBS for a year. If you don’t hedge, and at the end of the year UBS is at $24, then you made $12mm and people are like “sweet but also we’re gonna keep an eye on you because that was kind of not in your mandate.” And if at the end of the year UBS is at $0, then you lost $12mm and you’re sitting in a conference room at 1am with people saying “you might want to clean up anything embarrassing on Facebook, Kweku, because the police will be here shortly.” So you hedge.

Okay. So now you’ve done this thing where you’re short 1mm shares of UBS stock and long 1mm shares on swap with a person. Great. Now you have no risk, so you go home and come back in a year and settle up. Right?

Maybe not though. Here are some other things you might think about:

1. You have borrowed that stock and sold it short, and you have some cash, and that cash is getting paid some interest, and that interest is a floating rate that is based on fed funds or whatever. And you think to yourself “that creates interest rate exposure – if fed funds goes up, then I make more money, but if it goes down [just pretend, okay?], then I make less money.” So maybe you do something – buy a bond, say, or enter a rates swap – to lock in the rate that you’re getting paid.

(Or you might say “screw that, holding cash that is getting paid a floating market rate doesn’t create any rates exposure,” to which I say, you have yet to meet a rates salesman. You have some rates exposure no matter what you do in life, it’s just a question of whether you want to be fixed or floating or somewhere in between.)

2. You have credit risk against the person on the other side of the trade. In a year, if the stock is at $0, you owe him money, and you’re good for it. If it’s at $24, he owes you money. Is he good for it? You probably collateralized your swap, but you don’t take infinite collateral from him – so if the stock jumps up there’s some chance of uncollateralized exposure. You could hedge this if you want. You could buy CDS on the person. Then you have credit risk to the additional person who sold you CDS. Turtles all the way down.

3. You could have currency risks. Imagine that you write the swap at USD12, you sell UBS shares in Switzerland at like CHF10 (I’m gonna get this concept I promise), you collect CHF10mm, and you keep that in the (Swiss) bank. At the end of the year, let’s say that UBS is still at CHF10, so you can buy back your short for the CHF10mm you have in the bank – but now the franc is only worth $1, so the US trading price of the stock, which you used to strike the swap, is now just USD10. So you owe the person $2mm on your swap. Even though your stock was hedged. Some speculation about the Kweku Katastrophe is that he sold a silver ETF that had Swiss franc exposure and then forgot to hedge that exposure.

4. You could have event or contract or just goofball risks. UBS could announce a big dividend that you’re liable for on your short shares, but the swap might not pass through dividends. Stock borrow could get more expensive. UBS could move to Mbabane change its name to “Union Bank of Swaziland” and your shares could remain the same but your swap has a termination event if the company leaves Europe. You can hedge these risks by writing the contract well, or you could enter into separate arrangements to hedge the ones you worry about.

So you could spend a lot of your time worrying about all your other risks. And you could hedge all the ones you can think of, which is not all of them, as perfectly as possible, which is not perfectly. Nor is it free.

In short, the distinction between risks created as part of the "normal" provision of market services and risks taken as "prop bets" is so loose as to be non-existent. Every trade involves two sides, and if a someone does a trade with someone else, they are automatically exposed to an unlimited universe of risks. Some of these risks can be hedged (either by taking a position purely for the bank's book, or by sending salesmen to sell something the bank wants to get rid of to someone else - and we know how that can end up). Others are precisely why banks exist in the first place: they are maturity transformation and credit allocation machines and if they took no risks, they wouldn't exist.

Nor can you just go ahead and appeal to some sort of "spirit of the law" on these issues: if people don't know ahead of time what they are supposed to comply with, then I don't think it's justifiable to punish them after the fact for non-compliance.

So while the Volcker Rule was a nice idea in theory, it has since become a monstrosity, trying to pin definitions to any kind of trading activity that might be conceivable. In the process it might shut down some markets more or less entirely (whether non-banks want to legitimately invest in it or not), while the main, biggest risks on banks' balance sheets will remain untouched.

So, would you agree with some or all of the above? Would you ban banks from "taking risks", and if so, how would you define them?

[Norsklow]

The Banks exist to keep track of the Beans.
If they want to make a few Beans themselves, that is fine and very well,
but if they let making Beans take precedence over tracking the Beans,

then surely the time has come to inflict butt-hurt so that they may learn to stay more tightly focussed in the future.

[Seleucas]

Trying to make the financial system safe at this point is like making sure a dead man isn't going to get sick; it is now a fundamentally broken system that is simply waiting for its expiration. The only real question is how long can its implosion and subsequent restructuring be put off before it inevitably comes about. And no, I wouldn't ban banks from taking risks, I would just make it so they cannot socialize their costs.

[Renegade Island]

Fractional Reserve banking should be abolished, for a start.

In the UK the groups "Positive Money" and "The Lawful Bank" have some good ideas.

[Seleucas]

Fractional Reserve banking should be abolished, for a start.

YES. There needs to be some serious deleveraging, which is the root of this clusterfuck. More transactions need to be based on equity rather than the debt house of cards.

[Norsklow]

If you don't feel your money is safe in a bank, why do you use it?

( I see way too much Governmental pressure to make use of banks, electronic payments, credit cards and such. I'm certainly not arguing for gold, but I am certainly in favour of more use of chartal money. Bank notes. )

[Tubbsalot]

Gee, this thread has been incredibly informative in terms of making me realise I know almost nothing.

My opinion would have been that an important function of the financial system is to take risks, as not taking risks was what lead to the illiquidity earlier in the recession.

Fractional Reserve banking should be abolished, for a start.

:| And how exactly do you expect banks to function otherwise?

[Renegade Island]

Gee, this thread has been incredibly informative in terms of making me realise I know almost nothing.

My opinion would have been that an important function of the financial system is to take risks, as not taking risks was what lead to the illiquidity earlier in the recession.

Fractional Reserve banking should be abolished, for a start.

:| And how exactly do you expect banks to function otherwise?

By putting up something that they actually own instead of inventing a theoretical liability?

[Ostroeuropa]

Fractional Reserve banking should be abolished, for a start.

:| And how exactly do you expect banks to function otherwise?

Sunshine and unicorn farts presumably. It's all in the Labour Party Manifesto.

[Norsklow]

Gee, this thread has been incredibly informative in terms of making me realise I know almost nothing.

My opinion would have been that an important function of the financial system is to take risks, as not taking risks was what lead to the illiquidity earlier in the recession.


:| And how exactly do you expect banks to function otherwise?

By putting up something that they actually own instead of inventing a theoretical liability?

So far so good. I'm with you so far.

But what do you do when Government ( and society in general, let's be complete here ) insists that Credit should be available? What if National Savings consistently outstrips demand for Credit?

[Tubbsalot]

:| And how exactly do you expect banks to function otherwise?

By putting up something that they actually own instead of inventing a theoretical liability?

Right. Well, I mean, again, a primary problem of the recession was that the banks severely constricted lending activity to compensate for the increased risk of [various things]. They weren't lending enough money, because they considered that the money they held at the time wasn't sufficient to allow taking on the usual amount of risk. That's what quantitative easing is about - sinking a load of new money into the banks so they become more willing to lend.

So given that the problem is that banks weren't lending enough, why do you consider we'd benefit from massively reducing the ability of the banks to lend?

[Ostroeuropa]

By putting up something that they actually own instead of inventing a theoretical liability?

So far so good. I'm with you so far.

But what do you do when Government ( and society in general, let's be complete here ) insists that Credit should be available?

If i'm a farmer, literally growing money, i should be able to get a loan on my crop yield and buy a tractor to decrease time spent on the field harvesting, which allows me to expand by raising more cattle and increasing profits.
If not only because the government insures it, so i am GUARANTEED to be able to pay back the money.
What's your argument against this?

[Renegade Island]

By putting up something that they actually own instead of inventing a theoretical liability?

Right. Well, I mean, again, a primary problem of the recession was that the banks severely constricted lending activity to compensate for the increased risk of [various things]. They weren't lending enough money, because they considered that the money they held at the time wasn't sufficient to allow taking on the usual amount of risk. That's what quantitative easing is about - sinking a load of new money into the banks so they become more willing to lend.

So given that the problem is that banks weren't lending enough, why do you consider we'd benefit from massively reducing the ability of the banks to lend?

The problem isn't that the banks weren't lending enough.

The problem is that the banks lended money that literally didn't exist, and then charged their customers interest on that money (which also didn't exist) and then collapsed once the actual wealth could no longer sustain them.

What exactly do you think inflation is?

[Ostroeuropa]

Right. Well, I mean, again, a primary problem of the recession was that the banks severely constricted lending activity to compensate for the increased risk of [various things]. They weren't lending enough money, because they considered that the money they held at the time wasn't sufficient to allow taking on the usual amount of risk. That's what quantitative easing is about - sinking a load of new money into the banks so they become more willing to lend.

So given that the problem is that banks weren't lending enough, why do you consider we'd benefit from massively reducing the ability of the banks to lend?

The problem isn't that the banks weren't lending enough.

The problem is that the banks lended money that literally didn't exist, and then charged their customers interest on that money (which also didn't exist) and then collapsed once the actual wealth could no longer sustain them.

What exactly do you think inflation is?

Inflation is where we've all agreed that coca cola cans are what the economic exchange unit are.

There are 4 coke cans in existance.

I buy your house for one coke can, and discover a coke can under the sofa.

Suddenly everyones coke cans are worth 1/5 instead of 1/4 of all wealth currently in existance.
Just because you increase those numbers to insane amounts 1/3 trillion or something, doesn't negate this principle.

...
*sips his coke*

[Norsklow]

So far so good. I'm with you so far.

But what do you do when Government ( and society in general, let's be complete here ) insists that Credit should be available?

If i'm a farmer, literally growing money, i should be able to get a loan on my crop yield and buy a tractor to decrease time spent on the field harvesting, which allows me to expand by raising more cattle and increasing profits.
If not only because the government insures it, so i am GUARANTEED to be able to pay back the money.
What's your argument against this?

None, of course. I fully understand the reason for restricting banking to equity,
but my question is : so what do you do when bank equity is less than the demand for credit?

[Tubbsalot]

The problem isn't that the banks weren't lending enough.

The problem is that the banks lended money that literally didn't exist, and then charged their customers interest on that money (which also didn't exist) and then collapsed once the actual wealth could no longer sustain them.

What exactly do you think inflation is?

What are you talking about?

You can't lend money that doesn't exist. I suppose you could trade an IOU, but presumably it would be backed by something, and if that something wasn't actual collateral there's only so far IOUs could go. Nor can individuals pay a bank in non-existent money. That's even stricter. You're not going to get a bank accepting an IOU from a private individual. And the banks collapsed because there was a global bank run, which has nothing to do with 'not having any wealth'. It does have something to do with fractional reserve banking, but the benefit we derive from it is less than the damage we suffer from it, which is why it's allowed.

And inflation is an increase in the number of currency units required to purchase goods or services. I have no idea how that relates to anything you just said.

[Norsklow]

Right. Well, I mean, again, a primary problem of the recession was that the banks severely constricted lending activity to compensate for the increased risk of [various things]. They weren't lending enough money, because they considered that the money they held at the time wasn't sufficient to allow taking on the usual amount of risk. That's what quantitative easing is about - sinking a load of new money into the banks so they become more willing to lend.

So given that the problem is that banks weren't lending enough, why do you consider we'd benefit from massively reducing the ability of the banks to lend?

The problem isn't that the banks weren't lending enough.

The problem is that the banks lended money that literally didn't exist, and then charged their customers interest on that money (which also didn't exist) and then collapsed once the actual wealth could no longer sustain them.

What exactly do you think inflation is?

Too much money chasing after the same goods.

Works equally well with a bullion-based economy.
(The gold of the New World caused the Spanish economy to collapse!)

[Ostroeuropa]

If i'm a farmer, literally growing money, i should be able to get a loan on my crop yield and buy a tractor to decrease time spent on the field harvesting, which allows me to expand by raising more cattle and increasing profits.
If not only because the government insures it, so i am GUARANTEED to be able to pay back the money.
What's your argument against this?

None, of course. I fully understand the reason for restricting banking to equity,
but my question is : so what do you do when bank equity is less than the demand for credit?

Pass some legislation to trick people into thinking everything is fine, naturally.

[Renegade Island]

The problem isn't that the banks weren't lending enough.

The problem is that the banks lended money that literally didn't exist, and then charged their customers interest on that money (which also didn't exist) and then collapsed once the actual wealth could no longer sustain them.

What exactly do you think inflation is?

Inflation is where we've all agreed that coca cola cans are what the economic exchange unit are.

There are 4 coke cans in existance.

I buy your house for one coke can, and discover a coke can under the sofa.

Suddenly everyones coke cans are worth 1/5 instead of 1/4 of all wealth currently in existance.
Just because you increase those numbers to insane amounts 1/3 trillion or something, doesn't negate this principle.

...
*sips his coke*

Which is fine with coke cans because they are real things that have real value.

Fractional Reserve Money has no real value because there is nothing real with value attached to it. It's a faith based economic system (it only has value because people believe it has value,) and the people are losing the faith.

[Ostroeuropa]

The problem isn't that the banks weren't lending enough.

The problem is that the banks lended money that literally didn't exist, and then charged their customers interest on that money (which also didn't exist) and then collapsed once the actual wealth could no longer sustain them.

What exactly do you think inflation is?

Too much money chasing after the same goods.

Works equally well with a bullion-based economy.
(The gold of the New World caused the Spanish economy to collapse!)

Too much money may be misleading.
You need some inflation unless you have the power of seeing into the future and printing PRECISELY the amount of money we need to avoid deflation, which is far worse.
And even stagnation may not be desirable.

[Ostroeuropa]

Inflation is where we've all agreed that coca cola cans are what the economic exchange unit are.

There are 4 coke cans in existance.

I buy your house for one coke can, and discover a coke can under the sofa.

Suddenly everyones coke cans are worth 1/5 instead of 1/4 of all wealth currently in existance.
Just because you increase those numbers to insane amounts 1/3 trillion or something, doesn't negate this principle.

...
*sips his coke*

Which is fine with coke cans because they are real things that have real value.

Fractional Reserve Money has no real value because there is nothing real with value attached to it. It's a faith based economic system (it only has value because people believe it has value,) and the people are losing the faith.

It has value because it is valued.
If people value money less, that's because of inflation.
If I replace coke cans with bits of green paper with my signature on them, that's fine too.
It isn't faith based, it's value based. If people stopped valueing coke cans, that'd have the same effect.

[Norsklow]

Inflation is where we've all agreed that coca cola cans are what the economic exchange unit are.

There are 4 coke cans in existance.

I buy your house for one coke can, and discover a coke can under the sofa.

Suddenly everyones coke cans are worth 1/5 instead of 1/4 of all wealth currently in existance.
Just because you increase those numbers to insane amounts 1/3 trillion or something, doesn't negate this principle.

...
*sips his coke*

Which is fine with coke cans because they are real things that have real value.

Fractional Reserve Money has no real value because there is nothing real with value attached to it. It's a faith based economic system (it only has value because people believe it has value,) and the people are losing the faith.

Quoting myself:

Too much money chasing after the same goods.

Works equally well with a bullion-based economy.
(The gold of the New World caused the Spanish economy to collapse!)

The absence of real value? We can leave it out of the equation. Why?

Because the same condition holds up just as well when you have non-fiat money that people continued to believe in - such as pure gold.

[Norsklow]

Which is fine with coke cans because they are real things that have real value.

Fractional Reserve Money has no real value because there is nothing real with value attached to it. It's a faith based economic system (it only has value because people believe it has value,) and the people are losing the faith.

It has value because it is valued.
If people value money less, that's because of inflation.
If I replace coke cans with bits of green paper with my signature on them, that's fine too.
It isn't faith based, it's value based. If people stopped valueing coke cans, that'd have the same effect.

You are stating an equivalency as a consequence.

[Tubbsalot]

It's a faith based economic system (it only has value because people believe it has value,)

Right, and that's definitely not also A True Thing with gold. I'm sure the current price of like - what - ~$1,300 per ounce? - is definitely down to how useful it is to the people who have it. Why, you can use it for so many things! You can use a little bit for jewelery, and an almost negligible amount for high-end electronics... er... yeah, come to think of it, there's no other uses for gold, is there. It's mostly just a unit of currency. Much like fiat.

Gold is worth something because people will give you things for it. This is always the case. Fiat is worth something because people will give you things for it. This is always the case in a country.

I fail to see the distinction.

[Ostroeuropa]

It's a faith based economic system (it only has value because people believe it has value,)

Right, and that's definitely not also A True Thing with gold. I'm sure the current price of like - what - ~$1,300 per ounce? - is definitely down to how useful it is to the people who have it. Why, you can use it for so many things! You can use a little bit for jewelery, and an almost negligible amount for high-end electronics... er... yeah, come to think of it, there's no other uses for gold, is there. It's mostly just a unit of currency. Much like fiat.

Gold is worth something because people will give you things for it. This is always the case. Fiat is worth something because people will give you things for it. This is always the case in a country.

I fail to see the distinction.

Sunshine and rainbow farts, as I said.
Apparently people feel more comfortable if it's exceedingly difficult to combat deflation as opposed to easy and dependable for some reason. "We should dig up our exchange units in a massive operation and tether it to finite units!" VS "We should just print some."
Mostly because the rich prefer having the poor get absolutely fucked over each time we hit a deflationary spiral to their savings becomming worth less and less over time.

INDUSTRIAL REVOLUTION TIEM
"Can you please dig up 4000% more gold every day?"
HURRRR


"Why should I buy stuff today, when tommorow it'll be cheaper? Lol, i'll wait."
"I need to buy my food and pay my rent, even though the money will be worth more tommorow, I can't wait."

VS

"I'd better buy more stuff instead of sitting on a pile of money now, or invest it, because it's rotting in value."