The Term Solution

Tyler Cowen, the libertarian leaning economics professor at George Mason, riffs on an argument about financial regulation made by Edward Conrad — the now slightly infamous former Bain Capital employee who has turned into a high profile defender of economic inequality:

I would stress that the real problems come when the overwhelming majority of banks go heavily long on some fairly simple assets — usually real estate — in an overly optimistic way. Think Ireland, Iceland and the United States during the last crisis, among many other instances. Once the short-term debt behind those banks starts to unravel, all hell breaks loose and the central bank can at best limit but not stop the carnage. That is the main problem financial regulation should be trying to address and it isn’t easy.

I am much less worried about “rogue trades” or “rogue investments” at individual banks (or non-banks), even very large ones. Such trades surely exist: think LTCM or even Continental Illinois. Ex post, there is usually a way to plug the gap, if only by having the Fed backstop a deal. After all, the rest of the banking system is sound in these scenarios. Prop trading may increase the chance of this second problem, but arguably it decreases the chance of the first and larger problem.

Basically the problem is that the financial system (which, importantly, includes many non-banks) is both systematically long certain assets — not just real estate, but usually corporate debt as well — and has come to rely more and more on short-term funding for their activities.

To provide an illustrative contrast, JPMorgan’s big trading loss came from a division of the bank funded from deposits, which are not the one-day funds that drove,say, Lehman Brothers’s bubble-fueled and bubble-fueling action in just about every part of the mortgage market, from funding mortgages to securitizing them and moving them to investors.

So, while the actions of JPMorgan’s Chief Investment Office are certainly damaging to the bank and raise serious questions about its risk management, the combination of optimism on housing prices and very short term funding almost destroyed the world financial system.

This does not so much eliminate the case for rather intensive regulatory reform; instead, it changes the focus. For example, Morgan Ricks, a former Treasury Department adviser, has written on precisely the issue of getting banks to embrace longer-term financing.