Wednesday, April 23, 2014

An Equity Financed Banking System

Via the University of Chicago:

Toward a run-free financial system
John H. Cochrane 
April 16 2014
Abstract 
The financial crisis was a systemic run. Hence, the central regulatory response should be to eliminate run-prone securities from the financial system. By contrast, current regulation guarantees run-prone bank liabilities and instead tries to regulate bank assets and their values. I survey how a much simpler, rule-based, liability regulation could eliminate runs and crises, while allowing inevitable booms and busts. I show how modern communications, computation, and financial technology overcomes traditional arguments against narrow banking. I survey just how hopeless our current regulatory structure has become.I suggest that Pigouvian taxes provide a better structure to control debt issue than capital ratios;that banks should be 100% funded by equity, allowing downstream easy-to-fail intermediaries to tranche that equity to debt if needed. Fixed-value debt should be provided by or 100% backed by Treasury or Fed securities.
1.Introduction and overview
At its core, our financial crisis was a systemic run.The run started in the shadow banking system of overnight repurchase agreements, asset-backed securities, broker-dealer relationships,and investment banks. 
Arguably, it was about to spread to the large commercial banks when the Treasury Department and the Federal Reserve Board stepped in with a blanket debt guarantee and TARP (Troubled Asset Relief Program) recapitalization. But the basic economic structure of our financial crisis was the same as that of the panics and runs on demand deposits that we have seen many times before.
The run defines the event as a crisis. People lost a lot of money in the 2000 tech stock bust.
But there was no run, there was no crisis, and only a mild recession. Our financial system and economy could easily have handled the decline in home values and mortgage-backed security(MBS)values—which might also have been a lot smaller—had there not been a run.
The central task for a regulatory response, then,should be to eliminate runs. Runs are a pathology of specific contracts, such as deposits and overnight debt, issued by specific kinds of intermediaries. Among other features, run-prone contracts promise fixed values and first-come first-served payment....
...MUCH MORE (50 page PDF)

HT: Points and Figures blog:

It Wasn’t A Financial Crisis; It Was A Systemic Run