On July 25, Miami-Dade Florida circuit judge Teresa Pooler dismissed money-laundering charges against Michell Espinoza, a local bitcoin seller. The decision is a welcome pause on the road to financial serfdom. It is a small setback for authorities who want to fight crime (victimless or otherwise) by criminalizing and tracking the “laundering” of the proceeds, and who unreasonably want to do the tracking by eliminating citizens’ financial privacy, that is, by unrestricted tracking of their subjects’ financial accounts and activities. The US Treasury’s Financial Crimes Enforcement Network (FinCEN) is today the headquarters of such efforts.

As an Atlanta Fed primer reminds us, the authorities’ efforts are built upon the Banking Secrecy Act (BSA) of 1970. (A franker label would be the Banking Anti-Secrecy Act). The Act has been supplemented and amended many times by Congress, particularly by Title III of the USA PATRIOT Act of 2001, and expanded by diktats of the Federal Reserve and FinCEN. The laws and regulations on the books today have “established requirements for recordkeeping and reporting of specific transactions, including the identity of an individual engaged in the transaction by banks and other FIs [financial institutions].” These requirements are collectively known as Anti-Money-Laundering (AML) rules.

In particular, banks and other financial institutions are required to obey “Customer Identification Program” (CIP) protocols (aka “know your customer”), which require them to verify and record identity documents for all customers, and to “flag suspicious customers’ accounts.” Banks and financial institutions must submit “Currency Transaction Reports” (CTRs) on any customers’ deposits, withdrawals, or transfers of $10,000 or more. To foreclose the possibility of people using unmonitored non-banks to make transfers, FinCEN today requires non-depository “money service businesses” (MSBs) – which FinCEN defines to include “money transmitters” like Western Union and issuers of prepaid cards like Visa – also to know their customers. Banks and MSBs must file “Suspicious Activity Reports (SARs)” on transactions above $5000 that may be associated with money-laundering or other criminal activity. Individuals must also file reports. Carrying $10,000 or more into or out of the US triggers a “Currency or Monetary Instrument Report” (CMIR).” Any US citizen who has $10,000 or more in foreign financial accounts, even if it never moves, must annually file “Foreign Bank and Financial Accounts Reports (FBARs).”

In addition, state governments license money transmitters and impose various rules on their licensees.

When most of these rules were enacted, before 2009, there were basically only three convenient (non-barter) conduits for making a large-value payment. If Smith wanted to transfer $10,000 to Jones, he could do so in person using cash, which would typically involve a large withdrawal followed by a large deposit, triggering CTRs. He could make the transfer remotely using deposit transfer through the banking system, triggering CTRs or SARs if suspicious. Or he could use a service like Western Union or Moneygram, again potentially triggering SARs. For the time being, the authorities had the field pretty well covered.

Now come Bitcoin and other cryptocurrencies. Cash is of course still a face-to-face option. But today if Smith wants to transfer $10,000 remotely to Jones, he need not go to a bank or Western Union office. He can accomplish the task by (a) purchasing $10,000 in Bitcoin, (b) transferring the BTC online to Jones, and (c) letting Jones sell them for dollars (or not). The authorities would of course like to plug this “loophole.” But the internet, unlike the interbank clearing system, is not a limited-access conduit whose users can be commandeered to track and report on its traffic. No financial institution is involved in a peer-to-peer bitcoin transfer. Granted, Smith will have a hard time purchasing $10,000 worth of Bitcoins without using a bank deposit transfer to pay for them, which pings the authorities, but in principle he could quietly buy them in person with cash.

In the recent legal case, it appears that this possibility for unmonitored transfers was noticed by Detective Ricardo Arias of the Miami Beach Police Department, who “became intrigued” and presumably alarmed upon learning about Bitcoin at a meeting with the US Secret Service’s Miami Electronic Crimes Task Force. Detective Arias and Special Agent Gregory Ponzi decided to investigate cash-for-Bitcoin sales in South Florida. (I take details about the case from Judge Pooler’s decision in State of Florida v. Michell Abner Espinoza (2016).) Arias and Ponzi went to local​bit​coins​.com to find a seller willing to make a cash sale face-to-face. Acting undercover, Arias contacted one Michell Espinoza, apparently chosen because his hours were flexible. Arias purchased $500 worth of Bitcoin at their first meeting in a Miami Beach coffee shop, and later purchased $1000 worth at a meeting in a Haagen-Daaz ice cream shop in Miami. Arias tried to make a third purchase for $30,000 in a hotel room where surveillance cameras had been set up, but Espinoza rightly suspected that the currency offered was counterfeit, and refused it. At that meeting, immediately after the failed purchase, Espinoza was arrested. He was charged with one count of unlawfully operating a money services business without a State of Florida license, and two counts of money laundering under Florida law.

Judge Pooler threw out all three charges. Evaluating her arguments as a monetary economist, I find that some are insightful, while others are beside the point or confused. On the charge that Espinoza illegally operated an unlicensed money services business, she correctly noted that Bitcoin is not widely accepted in exchange for goods and thus “has a long way to go before it is the equivalent of money.” Accordingly, “attempting to fit the sale of Bitcoin into a statutory scheme regulating money services businesses is like fitting a square peg in a round hole.” However she also offered less compelling reasons for concluding that Bitcoin is not money, namely that it is not “backed by anything” and is “certainly not tangible wealth and cannot be hidden under a mattress like cash and gold bars.” Federal Reserve notes are money without being backed by anything, and bank deposits are money despite being intangible. Gold bars are today not money (commonly accepted as a medium of exchange).

Judge Pooler further correctly noted that Espinoza did not receive currency for the purpose of transmitting it (or its value) to any third party on his customer’s behalf, as Western Union does. He received cash only as a seller of Bitcoin. Nor, she held, does Bitcoin fall into any of the categories under Florida’s statutory definition of a “payment instrument,” so Espinoza was not operating a money services business as defined by the statute. Bitcoin is indeed not a payment instrument as defined by the statue because it is not a fixed sum of “monetary value” in dollars like the categories of instruments that are listed by the statute. It is an asset with a floating dollar price, like a share of stock.

Here Judge Pooler accepted a key defense argument (basically, “the defendant was not transmitting money, but only selling a good for money”) that was rejected by Judge Collyer in U.S. v. E‑Gold (2008). In the e‑gold system, Smith could purchase and readily transfer to Jones claims to units of gold held at e‑gold’s warehouse. Federal officials successfully busted e‑gold for “transmitting money” without the proper licenses. Judge Collyer accepted the prosecution’s argument that selling gold to Smith, providing a vehicle for him to transfer it to Jones, and buying it back from Jones is tantamount to transmitting money from Smith to Jones. Of course the Espinoza case is different in that Espinoza did not provide a vehicle for transmitting Bitcoin to a third party, nor did he buy Bitcoin from any third party.

On the charge of money laundering, Judge Pooler found that there was no evidence that Espinoza acted with the intent to promote illicit activity or disguise its proceeds. Further, Florida law is too vague to know whether it applies to Bitcoin transactions. Thus: “This court is unwilling to punish a man for selling his property to another, when his actions fall under a statute that is so vaguely written that even legal professionals have difficulty finding a singular meaning.”

I expect that FinCEN will now want to work with the State of Florida, and other states, to rewrite their statutory definitions of money services businesses and money laundering to reinforce their 2013 directive according to which Bitcoin exchanges must register as MSBs and so submit to “know your customer” and “file reports on your customer” rules. If even casual individual Bitcoin sellers like Espinoza must also register as MSBs, that will spell the end to legal local Bitcoin-for-cash trades.

[Cross-posted from Alt‑M.org]

Last summer I contributed a post about the Liquidity Coverage Ratio (LCR), a new regulation that is part of the latest international Basel Accords (Basel III) and that is being imposed on U.S. banks and other financial institutions. As I explained in that post, the LCR requires banks to hold “high quality liquid assets” (HQLA) sufficient to cover potential net cash outflows over 30 days. Both George Selgin and I have pointed out that the LCR probably contributes to the continuing desire of banks to maintain such a high level of reserves.

Two economists who have severely criticized the LCR are Gary Gorton, noted for his work on bank panics, and his co-author, Tyler Muir. Earlier this year they published online a short version of a much longer unpublished paper that scrutinizes the potential impact of the LCR. Whereas my post, appropriately entitled “Reserve Requirements Basel Style,” compared the LCR to the traditional but now largely abandoned reserve requirements imposed on banks, Gorton and Muir compare it to the bond-collateral (or bond-deposit) requirement of the national banking era, prevailing from the Civil War until creation of the Federal Reserve. They conclude that the LCR will cause the same sorts of problems that, ironically, the Fed was supposed to solve.

For those unfamiliar with the bond-collateral requirement, it was a feature of the system of nationally chartered banks established by Congress. Congress imposed a tax that suppressed the banknotes of state-chartered banks, but national banks could still issue banknotes, with a requirement that tied their quantity to the banks’ holdings of Treasury securities. Although nominally national banknotes were the liability of the issuing bank, they were in fact fully guaranteed by the government. The system thus created what was referred to as an “inelastic currency,” in which widespread demands to convert bank deposits into more liquid banknotes led to financial stringency and bank panics. This problem became the justification for the creation of the Federal Reserve as a lender of last resort.

Today the LCR counts both reserves and Treasury securities as the most highly liquid assets. So thinking about the LCR as either a modern modified reserve requirement and thinking of it as a modern modified bond-collateral requirement are complementary, particularly since reserves now pay interest and therefore have become like Treasury securities that only banks can hold. Gorton and Muir recognize this similarity in their online article when they state that “the LCR then requires that government money (Treasuries) must be used to back bank money – i.e., short-term debt, a kind of narrow banking [emphasis mine].”

Gorton and Muir’s concerns about the LCR can be briefly summarized in two points. First, despite the growing U.S. national debt, the worldwide liquidity demand for Treasury securities will severely impinge on their general availability. As they put it, “the LCR may result in a shortage of safe debt because too much of the Treasuries is tied up.” Second, this “shortage of safe debt” may encourage “other forms of [privately issued] short-term debt to emerge, making the financial system riskier.” Here they are drawing an analogy to the way restrictions on banknotes during the national banking era not only encouraged the increasing use of bank deposits but also contributed to financial instability.

I am not convinced by all parts of Gorton and Muir’s argument. Indeed, their characterization of bank deposits as the “shadow money” of the national banking era, by implication, gets the causes of the inelastic currency exactly backwards. The panics and financial stringency of this period did not result from too little regulation of deposits but instead from too much regulation of banknotes. Moreover, Gorton and Muir’s fear of a new form of shadow money seems to cut against their enthusiasm for the widespread use, prior to the financial crisis of 2007–2008, of repurchase agreements and asset-backed commercial paper. Nonetheless, their overall point is sound. Given the universally conceded failure of the bond-collateral requirement during the national banking era, why in the world are regulators going back to the same kind of system with the LCR? It did not work then; why should it work now?

HT: Bruce Tuckman

[Cross-posted from Alt‑M.org]

On June 23, Britain voted by a margin of 52 to 48 percent to leave the European Union (EU). Much ink has already been spilled on the policy implications of that vote and, indeed, its long-run consequences may prove quite profound. When it comes to financial regulation, however, it is difficult to see any significant changes emerging in the short- to medium-term. There are a couple of fundamental reasons for this.

The first stems from the fact that the British financial sector is desperate to maintain its current access to the European Economic Area (EEA), also known as the “single market.” As things stand, a process known as “passporting” allows British financial firms to do business throughout the single market, whether on a cross-border basis or by establishing branches, without having to get separate regulatory approval in every jurisdiction. This arrangement is important to the industry and — given that financial services produce 8 percent of the UK’s output — the British government is likely to make its continuation after Brexit a priority.

But how can they bring that about? The most straightforward path is for Britain to leave the EU, but remain a member of the EEA. This approach, often referred to as the “Norway option,” would see Britain exit the EU’s centralized political institutions, while still participating fully in its “four freedoms” — that is, the free movement of goods, services, capital, and people. There is much to commend such a settlement, as I’ve written before. But if it did come to pass, Britain’s financial sector would clearly be subject to EU rules in much the same way as it is now.

There’s also a political problem with EEA membership: namely, it wouldn’t allow the British government to pursue its stated aim of controlling immigration from the EU. That suggests that the obvious alternative — a bilateral, post-Brexit trade treaty — might be the more likely outcome of Britain’s eventual withdrawal. Such a treaty could, theoretically, protect the British financial sector’s passporting rights. However, the quid pro quo for market access of that sort would undoubtedly be regulatory equivalence — that is, the European Commission would have to deem British regulation equivalent to EU rules before any passporting could take place. The handful of existing EU directives that provide “third country” financial firms access to the single market work in precisely this way. Ultimately, then, there are unlikely to be any major reforms to British financial regulation so long as the British financial services industry maintains access to the single market.

What if the Brexit negotiations do not result in single market access for British financial firms? This is by no means an improbable outcome: the UK will have to give something up if it wants to restrict EU immigration, and EU negotiators may consider financial services trade the best area in which to extract their pound of flesh (not least because Paris, Amsterdam, and Frankfurt are ready to capture any business that Britain loses). In those circumstances, the British government might just consider a program of regulatory reform, designed to make the City of London more competitive against light-touch financial centers like Hong Kong and Singapore.

But I wouldn’t count on that, because it’s not just the desire for continued single market access that suggests British financial regulation is unlikely to change much after Brexit. In fact, one of the most important — and perhaps least remarked upon — developments in post-crisis financial regulation is that it increasingly starts at the global level. Take the EU’s Capital Requirements Directive IV (CRD IV), which sets out prudential rules for banks, building societies, and investment firms: prima facie, that’s EU legislation, which the UK might no longer be bound by after Brexit; in reality, though, CRD IV mostly implements the Basel III agreement, which means the essence of that directive would continue to apply to Britain whatever happens at the EU level. And CRD IV is just the tip of the iceberg: from insurance to accounting standards, more and more financial regulation is coming from global institutions.*

Britain, moreover, has been an enthusiastic participant in the globalization of financial regulation—so much so that Mark Carney, the governor of the Bank of England (and Britain’s de facto chief financial regulator), is also the chairman of the G20’s Financial Stability Board, which coordinates the regulatory work of national authorities and international standard-setting bodies. As a House of Lords report on the post-crisis EU financial regulatory framework put it, “it is likely that the UK would have implemented the vast bulk of the financial sector regulatory framework had it acted unilaterally, not least because it was closely engaged in the development of the international standards from which much EU legislation derives.” None of this bodes well for those hoping Brexit will lead to liberalization.

There is, however, a larger point to be made here, and that’s that it isn’t at all clear globalized financial regulation is a good thing. There’s nothing wrong with regulators sharing best practices, of course, and still less to object to in efforts to eliminate regulatory barriers to trade. Nevertheless, the global harmonization of financial regulation may actually pose a threat to financial stability, since it tends to impose a single view of risk on financial firms around the world, and therefore encourages herding around particular investments and business strategies. If the regulators’ view of risk turns out to be wrong (let’s imagine that globally-agreed rules encourage banks to invest in, say, mortgage-backed derivatives, or Greek sovereign debt), you may end up with a systemic, global crisis on your hands—precisely the opposite of what regulatory harmonizers set out to achieve. Financial regulators would do better, I think, to let a thousand flowers bloom — both domestically, and internationally.

Sadly, I wouldn’t bank on Brexit doing anything to advance that point of view.

_______________

*Chapter 16 of “Flexcit: A plan for leaving the European Union” offers a helpful analysis of the extent to which EU financial regulation has international origins. This report, originally authored by Richard A. E. North, is also where I discovered the quote from the House of Lords European Union Committee that I have reproduced and linked to above.

[Cross-posted from Alt‑M.org]

(Originally published on November 27, 2013 .)

There are, I’m sure, some parts of the Scottish National party’s recent blueprint for an independent Scotland to which the British government might reasonably take umbrage. But the plan’s call for Scotland’s continued use of the pound sterling, which has drawn the most criticism, isn’t one of them.

The pound sterling has been Scotland’s monetary unit since 1707, when the Act of Union led to its adoption in place of the Pound Scots. Scotland’s actual paper currency, on the other hand, has mainly consisted of sterling-denominated notes supplied by several of its own commercial banks. The nationalists’ proposal is therefore largely (though not entirely) a call for adhering to the status quo, and a rejection of the alternatives of either adopting the Euro or having Scotland once again establish an independent monetary standard.

How has such a seemingly reasonable and innocuous plan managed to ruffle Parliament’s feathers? According to The New York Times, the British government

says it is unlikely to agree to share the pound with an independent Scotland, citing the problems experienced by the 17-nation euro zone to illustrate the dangers of a common currency without political union. London says it would be difficult to have the Bank of England act as guarantor of the pound if Scotland had a different fiscal policy from Britain, for example. Nationalists hint that if Scotland cannot keep the pound, it will not accept its share of Britain’s debt.

Now I’ve no dog in the fight over Scottish independence, but it seems to me that the folks who are saying this hae git thair bums oot the windae. For starters, an independent Scotland would hardly need the British government’s permission to go on using the pound sterling: it’s hard to imagine how the U.K.-sans-Scotland could prevent Scottish citizens and banks from continuing to use the pound without resort to such Draconian legislation as would make U.S. money-laundering laws seem toothless in comparison. In both England and Scotland today, for example, it’s perfectly legal for banks to offer foreign currency demand deposit accounts, not to mention other sorts of foreign currency services. Just how would a truncated British government contrive to prevent, and to justify preventing, an independent Scotland from continuing to enjoy the right to offer such services, while adding the pound sterling to the list of “foreign” currencies to which the right pertains?

If the Brits were really willing to play hardball, I suppose they could try placing an embargo on shipments of Bank of England currency to Scotland, like the one the U.S. imposed, as part of its effort to topple Manuel Noriega’s government, on shipments of fresh Federal Reserve notes to Panama. But whereas Federal Reserve notes had long been the only form of paper currency known in Panama’s dollarized economy, the Scots, as I’ve already observed, have long managed without Bank of England notes, and could easily continue doing so, especially once freed from British-imposed banking regulations. Settlements and redemptions of Scottish bank balances would presumably have to be done using London funds. But unless the Brits wanted to impose severe exchange controls, which besides being embarrassing would harm English citizens no less than Scottish ones, that option would pose no great difficulty.

And the Eurozone comparison? A load of mince! The reason the Eurozone is a mess is because the Euro isn’t the German mark–that is, because it’s a multinational currency supplied through a multinational central bank, rather than a national currency that happens to be employed by several nations. Creditors to profligate Eurozone nations, or to irresponsible Eurozone banks, have therefore had reason to hope that the ECB might ultimately come to their aid, and especially so since the Growth and Stability Pact became a dead letter in 2003. Creditors to dollarized countries, on the other hand, have no reason to count on Fed bailouts. Were either Ecuador or El Salvador unable to service its debt, or were a Panamanian bank teetering at the brink of insolvency, it would be of no concern to the Fed, or the FDIC, or any other U.S. government agency. Dollarized or not, Ecuador, El Salvador and Panama have to manage on their own.

And how have those countries been doing despite having no lender of last resort to turn to in a crisis? Just dandy, as a matter of fact. Indeed, it seems that not having a lender of last resort has proved to be something of a boon to dollarized economies, because, by doing away with, or at least greatly limiting, any prospect of a bailout, it has caused creditors and banks to behave more prudently.

If the experience of dollarized countries can be relied upon, Scotland, besides not needing England’s permission to go on using the British pound, would be better off not having such permission. It stands to benefit, in other words, by steering clear of any formal arrangements that might appear to make the Bank of England, or any other non-Scottish authority, responsible in any way for the safety and soundness of Scottish bank liabilities or government securities. Let the Scots follow the example of Ecuador and El Salvador, and “poundize” unilaterally. If the British Parliament refuses to cooperate, so much the better. Who knows: Scotland could even end up with a banking system as good as the one it had before 1845, when Parliament, which knew almost as little about currency then as it does now, began to bugger it up.

George Selgin’s latest monetary policy primer was a very good explanation of the money multiplier in fractional reserve banking systems. He also suggested that a number of factors may be affecting the current surprisingly low level of the multiplier; a fact that prompted a number of endogenous money theorists to (wrongly) assert that the multiplier was “dead.”

In this post, I wish to elaborate on the reasons behind the low multiplier. And those reasons are, in my view, related to banking mechanics and regulatory dynamics.

Let’s first start with a little bit of history to put things in perspective. Some time ago, and following one of my blog posts on the topic, Levi Russel from the Farmer Hayek blog – who is much better than I am at manipulating FRED data – kindly sent me the following chart representing the M2 multiplier (“MM”) since 1920:

As you can see, the MM also experienced a huge fall during the Great Depression. It then took about forty years for the MM to progressively get back to its pre-Depression level.

Independently of regulatory frameworks, there is a simple underlying reason behind this long recovery time: banking mechanics. As corporations, banks are subject to operating constraints that limit the short run supply of credit. Banks employ a number of bankers, analysts, risk experts and so forth that are in limited numbers and already working full time to extend loans to creditworthy customers in adequacy with the bank’s risk appetite. The client onboarding process, the analysis of his risk, as well as the negotiations of legal agreements, aren’t instantaneous. The funding process itself isn’t either: despite what endogenous money experts assert, extending new loans still require looking for additional non- central bank funding before or shortly after putting the credit line in place.

At any point in time, it is likely that banks are close to the microeconomic equilibrium ideal of having marginal revenues equal to the marginal economic costs of employing staff and retaining adequate levels of capital and liquidity, and that its managers decided not to extend credit further on purpose: additional revenues were not attractive enough to justify the costs of acquiring them.

The implication of a fall in the MM is that liquidity (under the form of bank reserves/high-powered money) is now abundant in the system relative to the amount of bank money in circulation. Liquidity cost not being an issue anymore, banks nevertheless remain subject to operational and credit risk constraints, implying that they cannot put this liquidity to work rapidly.

Indeed, this situation is amplified during a crisis, as the number of creditworthy borrowers falls and banks lay off some of their employees to offset the fall in revenues and rising loan losses. Moreover, liquidity costs also rise and banks decide to hold on to higher liquidity buffers than they used to, mechanically lowering the MM. Consequently, there is no way the MM can rapidly rise. It takes time.

And this was the mistake made by a number of economists who wrongly predicted that hyperinflation would strike in the years following the implementation of quantitative easing policies. Credit cannot mechanistically and instantaneously grow. The financial system is a source of sticky constraints and rigidities. Of course we did see periods of above average MM growth (like just before the Depression or between 1980 and 1987*). But even if those particular growth rates were applied to today’s world, it would take more than twenty years for the MM to get back to its pre-crisis level.

Some could reply that banks don’t need extra resources to invest their liquidity into government bonds. While this is true some constraints remain in place: 1. the supply of government bonds is limited, and buying large quantities of them would become uneconomical for banks’ margin as bonds yield fall towards zero; 2. only a handful of governments have top credit ratings, and this rating fall as they issue more debt; 3. banks want to diversify their portfolio and certainly do not wish to only be exposed to sovereign risk.

The description above effectively applies to banking systems free of exogenous regulations. But regulatory dynamics can dramatically hinder the money creation process and hence the return of the MM to more normal levels.

Following the 2008/9 crisis, the Western world has been quick at altering regulatory requirements despite the weak economic recovery. In the decade following the crash, Basel 3 (implemented in the US under Dodd-Frank and in the EU under CRD4) built on previous versions of the Basel framework to progressively tighten operating restrictions – thereby reducing banks’ ability to generate marginal revenues – as well as capital, liquidity and funding requirements.

This regulatory package made it even more complex for bank to engage in lending. These are some of the steps that bankers now typically have to take in order to set up a new committed credit line:

1. Client onboarding/Know-Your-Customer, which is getting increasingly tightened by authorities due to international sanctions, tax evasion and terrorism
2. Credit analysis/​risk assessment facility type/​comparison with risk appetite and internal risk management guidance
3. Estimate what the regulatory liquidity (LCR) and funding (NSFR) requirements are going to be for this specific credit facility.
4. Estimate the cost of getting hold of the specific liquid assets and funding instruments (which both are in limited supply on the market and hence costly to acquire) that rules require
5. Estimate the amount of regulatory capital (also in limited supply) required for such a facility
6. Estimate total risk-adjusted revenues of the new credit facility (plus any other revenues from this customer), deduct total costs, and compare with required regulatory capital
7. If return on capital too low vs. management policy, decide whether or not to extend credit based on relationship
8. Negotiate loan agreement/​covenants

Those steps require human resources in relationship management, risk management, legal and treasury. As the process has been lengthened and complexified by Basel 3 in the post-crisis years, it is unsurprising that banks, already facing declining revenues and costs-cutting (i.e. staff), haven’t been able to grow their balance sheet as rapidly as bank reserves were flowing into the system. Moreover, faced with harsher capital regulations and unending litigation costs in a world of low or negative interest rates, banks found it extremely hard to find remunerative lending opportunities. Consequently, many banks have now entirely exited a number of lending products whose marginal costs have been pushed up by regulation above their marginal revenues. They have deleveraged in order to be compliant with capitalization rules rather than raise capital to avoid diluting shareholders already suffering from zero return (therefore at risk of exiting their investment altogether). I guess I don’t have to explain that a deleveraging banking system is antithetical with a rising MM.

Finally, I shall include monetary policy in the “regulatory dynamics” category, and more particularly the decision by a number of central banks to pay interests on excess reserves. It is not the purpose of this post to focus on this rather strange monetary tool; George Selgin wrote plenty of excellent posts deconstructing its rationale.

A last note however. While we’ve mostly been describing the factors influencing the supply of credit, let’s not forget to factor in the other side of the equation: demand for credit. During or following a credit crisis, borrowers often attempt to repair their balance sheets by deleveraging, affecting the demand for new loans.

In the end, it looks unsurprising to see the money multiplier remaining so low and taking decades to recover following a rapid fall. As history shows, this is a recurring fact, dictated by the day to day operating rigidities of the business of banking, and with consequences for the bank lending channel of monetary policy. Our dear multiplier isn’t dead; it is just sleeping and merely unlikely to reach pre-crisis levels for another few decades.

___________________

*Such rapid growth rate in the 1980s is probably linked to banks trying to add more remunerative lending to their portfolio as rapidly as possible. This is because, as both nominal interest rates and inflation were shooting up, banks’ margins were becoming rapidly compressed due to legacy lending extended in earlier periods of lower nominal rates.

[This article originally appeared on Spontaneous Finance]

Futures Unbound, this year’s Cato-CMFA Summit on Financial Regulation, took place in Chicago on June 6^th. The event consisted of lectures from five speakers; Congressman Blaine Leutkemeyer, CMFA’s Thaya Brook Knight and George Selgin, the Federal Reserve’s Thomas Sullivan, and University of Chicago Law Professor Omri-Ben Shahar. Here, I supply synopses of these talks. Complete podcasts can be found here.[1]

Congressman Blaine Leutkemeyer (R‑Missouri) reported that every financial services professional he has recently spoken to, from large firm executives to community bankers, is complaining about the increasing onerousness of federal regulation. Although insurance is mostly regulated at the state level, Dodd-Frank dramatically increased the Federal government’s role in insurance, transferring “a third of the insurance industry to federal supervision.” Leutkemeyer also mentioned a notable Dodd-Frank statistic, that the percentage of checking accounts with free checking dropped from 75% to 35% since that law was enacted. He closed by calling attention to the FDIC/DOJ’s Operation Choke Point, which he described as a “shadow regulatory system” that intimidates banks.

Negative reactions to financial speculation have a long history. Old Testament, New Testament, Roman, and other ancient and classical sources decry speculatory practices. Why does speculation have such a “bad rap?” Thaya Brook Knight compared a common view of speculators to the dog in the “dog in the manger” parable. Speculators do not produce mangers, but they do take hay away from wolves that actually need them. Even today, proclamations against speculation persist. Pope Francis recently blamed speculators for high food prices, and many commentators blamed the ‘07-‘08 crisis on speculation.

Commodities and securities market regulation attempts to discourage speculation. In securities markets, speculation is regulated through the tax code. Short term investments are taxed at a higher rate than long term investments. In commodities markets, the law differentiates between legitimate hedging by producers and excessive speculation by investors. This election cycle, candidates and advocacy groups proposed reducing speculation via a financial transactions tax.

Knight showed that many of the commonly assumed negative characteristics of speculation are actually beneficial. Speculation stabilizes prices, not only because of the well known ability for say, agricultural producers to hedge against seasonal fluctuations, but also because of the role speculation plays in price discovery. What about speculating during a commodity shortage? As the pejorative term “price gouging” demonstrates, betting on shortages is often thought of as a particularly immoral form of price destabilization.[2] Knight counters that price gouging is an incentive for the production increases necessary for shortages to clear. What about in securities markets, does speculation disrupt the pricing mechanism by driving bubbles? Knight suggests we consider what equity markets would look like if all investors “bought and held,” news about a company’s health and development be damned. In general, traders’ ability to react to information and change positions frequently leads to more accurate pricing.  

George Selgin discussed clearinghouses’ role in the pre-Fed American financial system, which came to include providing liquidity during panics. After the failure of the Ohio Life and Trust Insurance Company in 1857 led to a system wide suspension of specie payments in New York, the recently formed New York Clearing House issued temporary loan certificates to member banks for use in settling transactions. This emergency measure prevented a complete halt in the flow of payments and credit during the Panic of 1857. Financial turmoil only became more frequent after the Civil War due to the National Currency Act, which tied bank note issue to the quantity of government bonds a bank held as reserves. As in the 1857 case, the clearinghouse dealt with post-bellum panics by providing troubled banks with loan certificates. These certificates were a way for banks to extend credit to one another. Participating banks essentially stretched their collective reserves and dispersed risk throughout the system. Clearinghouses, as mere facilitators of credit between member banks, did not assume any centralized risk.

Selgin emphasized that clearinghouses did not provide emergency loan certificates to every troubled bank. Clearinghouses made sure that banks receiving the loans were solvent, and that banks using the certificates to meet obligations would be forced to eventually pay a high, “penalty” interest rate. Also, clearinghouses ensured that banks stayed open during crises, even if specie payments were suspended. This meant that disastrous complete closures of banks, like those that characterized the worst periods of the Great Depression, were avoided.

Selgin closed by noting the advantages of the 19^th century’s spontaneous and private clearinghouses relative to today’s government imposed and run versions. In addition to the Fed, Dodd-Frank’s mandated central clearinghouses for OTC derivatives will socialize risk and create moral hazard, removing an incentive for the private sector innovation that might actually improve payments and settlement in the derivatives market.

Omri Ben-Shahar investigated mandated disclosure in regulatory regimes. While his presentation covered American regulatory law in broad, disclosure has a particular importance to capital markets, where Louis Brandeis’s idea that “sunlight is the best disinfectant” has underpinned regulation since the Securities Act of 1933. Asking “are we doomed to drown in disclosure?” Ben-Shahar points out disclosure’s absurdities and questions whether mandated disclosure is ever necessary.

Some of the most egregious examples of the disclosure overload are on the Internet. By law, a website’s terms and conditions and privacy policy must be disclosed to users. Ben-Shahar notes that not only are such notices rarely skimmed, from a practical standpoint it is essentially impossible for anyone to closely read them. An average Internet user would have to spend three months out of the year reading privacy notices to actually understand what each “I agree” click means.

Are the Internet’s disclosures simply an outlier? What about nutrition product labels, or medical informed consent? Even if these disclosures seem more intuitively necessary, research shows we don’t read these disclosures either, nor do they affect our behavior. Disclosure, therefore, should no longer be used as a de-facto regulatory solution to information asymmetry problems. Fans of disclosure, energized by Cass Sunstein’s “nudge” ideas, think disclosure can affect behavior if done simpler and smarter. Ben-Shahar cautions against viewing simplification as a panacea. Simplified, nudge style disclosures, designed to be easily understood and to encourage a desired outcome, like nutrition labeling, often don’t change behavior. Since mandatory nutrition labeling, for example, Americans eat less calories per meal but eat more meals, which comes out to a slight overall increase in calorie intake.

In close, Ben-Shahar warns that any future attempts by policymakers to mandate the disclosure of information would represent “the triumph of hope over experience.”

Again, you can find more information about Futures Unbound and links to all available audio here!

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[1] Unfortunately, we do not have a written or audio version of Sullivan’s remarks.

[2] This view has been held even by some of world history’s best regarded thinkers, for example Knight’s PowerPoint included a reference to the great medieval philosopher Maimonides, who argued that prices should never deviate by 1/​6th due to temporary changes in supply.

On Tuesday, John Allison, chair of CMFA’s executive advisory board, former president of Cato, and 20-year CEO of BB&T, testified before the House Financial Services Committee. The hearing was on the recently proposed Financial CHOICE Act, which aims to reform Dodd-Frank. Beyond discussing the potential efficacy of that bill, Allison’s testimony pithily describes the connection between financial regulation, monetary policy, the financial crisis, and today’s low economic growth. For our readers benefit, his written testimony is reproduced below. A clip of Allison’s oral testimony can be found here. For the hearing in its entirety, see here.

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I was the longest serving CEO in the US of a major financial institution, BB&T, at the time of the recent financial crisis. BB&T went through the financial crisis without experiencing a single quarterly loss. I had the unique experience and perspective of leading BB&T’s lending business during the severe correction of the early 1980’s and was CEO during the early 1990’s recession.

The Federal Reserve’s monetary and regulatory policies were major contributors to the 2007–2009 Great Recession. On the regulatory side an excessive focus on Sarbanes-Oxley, the Patriot Act, and the Privacy Act created a total lack of safety and soundness regulation. Investors, rightly so, assumed bank regulators were controlling industry risk and the investors were lulled to sleep. Without the perception that regulators knew what the risk were, investors would have studied the industry far more carefully. The market was fooled by banking regulators.

In addition, the implementation by the banking regulators of the Basel capital standards increased leverage (less capital) in large financial institutions. Using extremely complex mathematical models,large banks, with support from the banking examiners, convinced themselves they could take high risk with little capital because they could manage the risk. In addition, banking regulators were motivated to underestimate risk for political purposes. A financial institution was required to hold half as much capital for an affordable housing (subprime mortgage) as for a loan to Exxon. In Europe, banks were not required to hold any capital for a loan to Greece.

The financial industry regulators seriously mishandled the 2007–2009 economic correction which is continuing to negatively impact economic growth. The regulators made the correction far worse than it needed to be. During the early 1980’s and 1990’s recessions the bank examiners let unhealthy banks and savings and loans fail. However, they did not interfere with healthy banks’ lending practices. They allowed healthy financial institutions with rational lending standards to continue to make loans and support their customers and also to finance good customers who were leaving unhealthy banks. Unfortunately, this time, the examiners forced healthy institutions like BB&T to unnecessarily put out of business many small businesses who we would have supported and who would be in business today. These businesses would be creating good jobs and economic growth. The regulators destroyed many entrepreneurs unnecessarily.

The banking regulators tightened lending standards at exactly the wrong time. They closed the barn door after the horse was out of the barn. These very tight lending standards remain in place for venture capital small business loans. Venture capital small business loans are when the lender while considering the financial projections primarily makes the loan based on a judgement of the borrower and the concept. In the current regulatory environment, while existing slow growing small businesses can often obtain financing, small business startups are frozen out of the market and highly innovative aggressive expansion plans for existing small firms will not be financed significantly slowing the growth of the firms.

I began my banking career as a small business/​middle market lender. I was fortunate to help a number of small businesses which have expanded significantly and created thousands of jobs. These loans which were critical to the growth of these firms could not be made today. Bernie Marcus, the founder of Home Depot, has told me on several occasions that he could not have started and grown Home Depot in the current regulatory environment.

The lack of small business venture capital funding from banks and the inability of banks to finance the expansion of more aggressive entrepreneurs has slowed innovation (in all industries except technology)and thereby significantly reduced competition. Because of the lack of competitive pressure existing firms are not motivated to invest for the future. They would rather cut cost and buy back shares of stock. The effect is to slow the growth in productivity which ultimately determines economic well being because we cannot consume more than we produce. In the financial services industry, firms are focused on compliance instead of innovation and productivity.

One tragic irony is that by tightening lending standards the Federal Reserve has undermined its monetary policy. They cannot get the money supply to grow because the velocity of money (the money multiplier) has slowed because bank’s are only making loans to large businesses. The Federal Reserve is effectively subsidizing large firms.

Unfortunately, Dodd Frank and the related regulatory regime has not only slowed economic growth, it has not effectively dealt with the issues which caused the financial crisis. The “too big to fail” problem has not been solved.

We all want a safe and sound financial system. However, history shows that it is naive to believe that excessive regulation will accomplish this goal. The Federal Reserve economist and the banking regulators did not foresee the recent financial crisis. In fact, they made the crisis much worse by using Basel capital rules and risk weighting assets for political not economic reasons (affordable housing,Greek debt). Why would anyone believe regulators will not make the same mistake in the future or the opposite mistake which they are making today by requiring excessively tight standards for small business loans? Markets participants make mistakes, but they pay the price. Government regulators force all firms to make the same mistakes and the whole economy to pay the price.

History has consistently shown that the best method to reduce the risk of bank failures is strong capital positions. During the recent correction, which was the worst recession since the Great Depression, very few properly capitalized banks failed. In my 40 plus year career, I do not know of a single case where banking regulators knew a bank was in trouble before we did and few cases where properly capitalized banks could not handle economic corrections.

By far the most important aspect of this proposed legislation is the provision which allows properly capitalized banks to opt out of the regulatory nightmare which is paralyzing the industry and slowing innovation, creativity and thereby economic growth. Lower income individuals are the most negatively damaged by this sad situation.

For those primarily focused on safety and soundness, there can be a debate about which is the best capital standard. However, it is enlightening to note that after massive regulatory cost and intrusion over almost 8 years, Citigroup has a leverage ratio according to their recent quarterly report of only 6.4%. If I were CEO of Citi I could not sleep at night with this low of leverage ratio. I will state with certainty after many years in the banking industry that raising Citi’s leverage ratio to 10% would reduce the risk of Citi failing far more then hiring 5,000 or 10,000 more regulators to micromanage the company. It is important that the capital ratio be reasonably simple and understandable or large banks will game the system.

Also, for those who want to break up large banks logically raising capital requirements is a far more rational approach then arbitrarily deciding on a maximum size. Economic analysis will force the banks to decide to divest business segments which do not earn satisfactory returns which will significantly enhance the allocation of resources in the economy.

However, there must be a trade off between regulatory cost and stronger capital. Financial institutions cannot survive with the stifling cost of Dodd Frank and higher capital. Interestingly, the regulators know this even those they will not admit it. Why have they not insisted on more capital already? Because they know the regulatory cost/​capital equation implied in Dodd Frank will not work. They have chosen more regulation over more capital because that is their job and expands their perceived importance.

The opt out provision instead of a forced strategy is an optimal concept. I believe that markets will quickly conclude that those institutions which do not opt out are weak. Who would voluntarily participate in the regulatory quagmire of Dodd Frank? The opt out process will increase capital in the industry thereby reducing risk. The reduced regulatory cost will make financial intermediaries far more efficient and encourage innovation in the industry. Core financial institutions, such as community banks, will be able to get back to their business of growing their communities.

There are no examples of healthy economies without healthy banks.