Without True Price Signals, Finance Lacks Meaning

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When you criticize the current state of economic affairs, there is a tendency to make generalizations for the sake of expedience. That is, of course, true of nearly everything we do and think about, but it can lead to misunderstanding that actually decays your argument. In the context of the current monetary regime, quarrelling vehemently about the state of financial relationships in the US and elsewhere captures not just basic policy but also its structure and operation.

In reasoning that the primary economic impediment now is too much monetarism, leading to the case of financial dominance, the legitimate functions of finance can be ignored. In many cases, and I am very much guilty of this habit, the countervailing of monetaristic domination sounds like it precludes any and all finance. We demonize the big banks, particularly too big to fail, but not all banking is bad. There certainly exist legitimate and very productive roles for Wall Street and finance in general - and they do lie within the confines and constraints of free markets and capitalism.

I have used the warehouse example before, where primary dealers use their balance sheet capacity in intermediation between primary debt markets and retail investors in secondary markets. That is a very useful financial function, as we want flexible and stable debt markets to operate as efficiently as possible. A warehouse bank performs true intermediation because it has to reasonably judge how much it can take in directly from obligors to sell out later to the broader markets. That includes pricing, interest rate estimations and the size of deals - thereby making a market determination of debt scale and cost for real economic participants. These are all market characteristics where a specialized firm performs a value added service.

It crosses the line, however, when that service is bastardized into prop trading and proprietary positions for a bank. I see that as an illegitimate function of finance, and one of the primary factors in the near collapse of 2008. Banks that started by hedging warehouse inventory, and there is no argument against that, went incrementally so far beyond pure hedging and deep toward unbridled speculation - and solely for the benefit of the bank. There was no economic aid rendered due to this extreme form of speculation, only a gain of finance; an unrelenting quest to expand the balance sheet for the sake of expanding the balance sheet. As profits from speculating accumulated and appeared inordinately stable, that only led to more and more speculative excesses.

Another legitimate function of the banking system is clearing. That is about as rudimentary as it gets for banks, operating a payment system to match cash balances between payers and those claiming payments. The most fundamental concept of any economy that moves beyond barter is its ability to conduct commerce without fraud and double payment.

That was far easier to do, in some respects, when money was real and consisted of property. In those systems, currency or cash functioned as the financial equivalent of money, but it was always understood that currency was a secondary claim on property (money). When a bank acts as nothing more than a custodial agent for property, the role of the bank is diminished so drastically as to be nearly inconsequential. If that bank, as purely custodian, ultimately fails it can easily be replaced with the next firm in line. It is only when banks venture into the realm of finance that this arrangement shifts into the bank's favor.

The old quote attributed to J. Paul Getty is that, "if you owe the bank $100 that's your problem, but if you owe the bank $100 million it's the bank's problem" doesn't quite measure the full extent of financialism today. In other words, $100 million (or multiple billions as is now customary) is not just the bank's problem; it has become a systemic problem. So the array of bank functions in this strict sense runs from completely unimportant (strict custodial) to somewhat problematic (hybrid custody and finance) to wholly entangling of all society (mostly, if not all, finance).

The market, the real market as is its wont, has attempted redress of this difficulty. The clearing function of the payments system, given technological progression through mobile telecom and computing power, as well as encryption and security, really does not necessarily need banks to perform payment processing and clearing. PayPal is the most evident example of removing a monetary function from the tangle of banking finance. It's not a pure standalone, as PayPal is really just another network functioning outside of the banks though connecting to them, but its existence has raised more than a few thorny examinations about the contours of financialisms.

On the eve of PayPal's IPO in February 2002, the company disclosed in SEC documents that it was being run out of Louisiana by state banking regulators. The company was also notified by New York regulators that it was running an "unlicensed banking business." Though New York had not threatened a ban as Louisiana did, these moves highlighted some of the problems in separating bank functions from bank"ing".

This is not meant to be a commercial for PayPal's services, only to highlight that there are non-finance bank functions and market attempts to establish them and use them. The banking system itself does more than a fair job operating a clearing system, as the Fedwire handled $73 trillion of transactions in March 2014 (latest figures) without major dissatisfaction. The payment system is not so much a problem nor a hefty source of criticism for banks, it is the ultimate entanglement with the financial end that corrupts.

Who is to say whether market attempts at removing basic functions from the capture of finance are to succeed or fail? As we know from PayPal's earlier days regulators will endeavor to determine whatever it is they need to satisfy their own curiosity and function. And that is not an argument against all regulation, either, as clearly there exists a public interest and the current state of political affairs demands some role. But is that because PayPal is ripe for abuse, or that we have been conditioned that banks are systemically important due to the overwhelming nature of 21st century monetarism?

If the answer is the latter, then we are doing it wrong. What PayPal demonstrates is that there exist capabilities for replicating, if not replacing, bank services through other means. Just the thought of that makes most people highly squeamish, but that is because their sense of banking is colored, darkly, by the financial functions that on their own may not be necessary.

Fortunately for them, I don't get to make that determination. What I believe is irrelevant almost entirely. I may be completely wrong and unduly critical about the overwhelming nature of finance in the real economy, and that speculation to this enormous degree is actually necessary, legitimate and even very productive. The ultimate determination over that question should lie with the actual free market.

Profitability should eventually decide what resources get dedicated to what uses. But that is the catch - profitability of finance is not being determined by market forces but by intentional policy. Banks are afforded the gilded pedestal because they perform a "vital" function toward monetarism's obsessive drive for the misguided "aggregate demand" concept. Therefore, banks achieved financialism through artificial means of an artificial price of risk.

The elegance of the profitability function is as true of the real economy as it is in money and banking. Reduced profits guarantee fewer resources dedicated to that task or business. The one exception in the age of fiat currency, where central banks attained their long-sought measure of flexibility and freedom to manipulate, is banking. Banks have been supplemented by the modern creations of leverage. The end of the depository system opened the doors to mountainous opportunity in partnership with central bank hubris toward the idea of economic control (soft central planning).

Banks have complained about depositors since the advent of deposits. Nothing so restricts a financial firm's activities in finance as its duty to cater to depositor needs in fractional lending. That is not to say that due care was always exercised, it clearly wasn't, but that is precisely the point. The bank that did not restrain itself or pay close attention to its deposit liability (in the strictest sense of the word) was systemically restrained in a run. Its failure was determined by what is to the bank an outside force.

When an accumulation of irresponsible behavior was evident systemically, the banking system as a whole suffered a widespread panic that accomplished exactly the same. Modern economists began to fret about "good" banks being destroyed with the "bad" (going so far as to help create the modern liability markets to mitigate that end), but what panic accomplished was an extremely painful admonition on what was really illegitimate banking. The primary takeaway of the Great Depression episode was not that overwrought subsidy of speculation by the Federal Reserve's gold sterilization led to an immense bubble, it founded the modern concept of moving beyond deposits, first as a means to separate the "good" banks from the "bad."

The rise of liability markets, beginning almost by accident in federal funds in 1920, held such promise. While it was never designed to be a substitute for the deposit banking model (they never end up as designed), that is exactly what has taken place since the S&L crisis of the late 1980's. The S&L debacle was the last gasp of depository banking and marked the full ascension of investment/wholesale/shadow banking. In this model, if your depositors don't like your policy and begin to withdraw, so what? You can replace depositors by wholesale liabilities restrained instead by the very fungible concept of equity capital. We have even gone so far as to create and allow the operation of banking with no deposits whatsoever.

We know how fungible equity capital is because the banking industry itself dedicated almost every "innovation" in the past four decades to exploiting it. The entire premise of off-balance sheet is to circumvent the "limitation" of capital ratios. The creativity of mark-to-model is likewise. "Gain on sale" accounting is not explicitly a workaround of capital constraints, but it ends up in exactly that fashion at the same time bolstering immensely bank accounting of profitability.

And that is the point I am trying to make. That the end of exogenous limitations on banks (the people's veto of banks through depository restriction) would never have taken place, and certainly not to the incredible and dangerous scale that it achieved, if the cost of doing all this had been determined by market pricing of risk. The movement to interest rate targeting by central banks, particularly the Fed sometime in the 1980's, undercut the market determination about allocating resources to financialism. That was further cemented by the adoption of Basel framework's asset side focus, and the re-orientation of bank regulations throughout the 1990's.

From that point forward, banks attained and asserted functions that may or may not have been totally legitimate. I think a strong case has been made and determined by the re-imposition of market forces, if only temporarily, in the collapse of massive asset bubbles. The bubble destruction is, to me, a heavy rebuke against the removal of prior systemic limitations, not the least of which was market-based profitability. The end of Glass-Steagall is often cited as proximate cause of the asset bubbles, but I think, ultimately, it never would have been an issue if financial profits were purely based on market prices.

The primary means through which the profits of speculation were (and still are) enhanced via central bank intrusion was leverage. In the mortgage space, for example, mortgage lending profits are no longer determined by the quaint notion of making money on lending to someone with their house as collateral.

Mortgage profitability is accrued through MBS trading tied to leverage. When a mortgage originator sells a pool of loans to a GSE (gain on sale accounting boosting profits and thus capital right there), what comes back into the marketplace is what looks like a dramatically less risky security. In terms of leverage, however, the GSE-approved security is very liquid, so as to be repo-able and acceptable for broad rehypothecation. That achieves both funding leverage and regulator leverage (as the pool of mortgage loans by themselves would render a much higher capital charge on a bank's balance sheet versus the "highly rated" GSE MBS security).

Take away that intention policy aid in the leverage opportunities and I sincerely and highly doubt the mortgage-driven housing bubble ever happens. It simply would not have been profitable to speculate to that level. Intermediation died as a theory of prior banking systems that no longer held a place in the modern concept of achieving aggregate demand through debt. Central banks don't care, though they pretend really hard to, about how financial firms create debt and credit, only that they do so to whatever "target" the central bank sets. And the central bank will subsidize profitability to whatever level is needed so that banks can operate the "printing press" to that end.

As long as the price of risk is not market-determined, we have no idea what functions of finance are actually legitimate (i.e., profitable and therefore productive). It doesn't take much intuition to expect that the level of financial profits through speculation (in all of finance) would be far, far lower in a true market-determined pricing system. And if that were the case, then the yield of speculation would be reduced to the point that its appeal would return to something more productive rather than dominating. With resources dedicated elsewhere, and by true price discovery, the role of banking in such a system would be reduced back toward something more relatable and efficient. No more bank pedestal and too big to fail, and perhaps a real economic recovery that is efficient and self-sustaining.


Jeffrey Snider is the Chief Investment Strategist of Alhambra Investment Partners, a registered investment advisor. 

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