Yves Smith on regulation

Yves Smith woke up on the wrong side of the bed this morning and starts railing against the banks, calling for their 'beheading'! Essentially he claims "the banks are wards of the state" and it is time we acted accordingly.

From Naked Capitalism:

My short list (some of them cribbed or adapted from a proposal by Amar Bhide) of what to do would be:

1. Force as much OTC activity as has reasonable trading volume onto exchanges. That means at a minimum interest rate swaps, currency swaps, and credit default swaps. Yes, this will require standardization and some buyers will lose access to variants they might have liked. Too bad. Protecting the economy and the taxpayer is more important than indulging every investor's pet need.

This of course will also considerably lower the profitabilty of the industry. Again, too bad. They screwed up and cost the populace a ton of dough. There are consequences for mistakes of that magnitude. They should consider themselves lucky not to have been subject to public beheadings.

Lower profits for banks has positive consequences. It means less talent and other resources are sucked into the FIRE economy (and remember, the FI in that equation are at best service providers to the real economy, and worse, when they become too large, parasites).

2. Prohibit off balance sheet vehicles.

3. Prohibit Level 3 assets; allow only Level 1 and strictly defined and audited Level 2 assets. This means regulators will not have anything overly arcane to assess; they ought to be able to get a clear picture of risks, processes, and exposures if they are dogged.

4. Prohibit these regulated institutions from lending, providing other funding, or investing in concerns that have Level 3 assets.

Hedge funds would continue to be unregulated. I might also prohibit any unregulated entity from going public. Speculators playing with investors' money is tempting enough; having them have even less skin in the game via a public floatation makes it easier for them to get so large as to pose a danger. Yes, this can create problems of succession, but Wall Street dealt with it for a hundred years or so. These guys ought to be smart enough to figure it out.

The first one, the open exchange proposal seems like a winner and is a lot of folks favorite.

Assume there is an open exchange of currently OTC products. Assume you set a debt to capital ratio and limit lending in the investment banks, like is done today for commercial banks.

then some interesting points on 2-3-4 follow:

On 2- Off balance sheets vehicles were designed to bypass these artificial limitations legislated eons ago. With an update of these numbers, the whole banking system will lose interest in using these tricks anyway. The need for off-balance sheets almost disappears. Banning it adds to the point emphatically but it is almost redundant.

On 3- prohibit level 3 assets. This is the whole mark to market issue. The whole point of level 3 assets is that they are long-lived and thus hard to price on a every day basis. That is what banks (i-banks and c-banks) DO for a living. They provide the "borrow short/lend long" service. This proposal of prohibiting level 3 assets is both radical and counter-nature. The problem is not the existence of these assets it is the leverage associated with them. Too much leverage and noise is enough to wipe out equity on a mark-to-market basis. Again this could be taken care of by setting the amount of leverage at the primary brokers.

4- prohibit lending to entities that hold level 3.
I assume not all level 3 assets are toxic and the notion of "long assets" should not be affected by noise. Again, restricting who holds it and the leverage associated with it may be a better compromise. You can have regulated investment banks for example, that are allowed, even encouraged, to hold onto level 3 asset while you ban the unregulated ones from dealing in too illiquid an asset. To me this is primarily an accounting issue, I don't really lose sleep over it. Saying this is saying "I don't lose sleep over bank-runs". Which I don't. Not while the FED is around at least.

Yves' last point about hedge fund is that they should be left un-regulated but prohibited from ever going public. The rational is that the profession is so biased to take risks with your money, they are simply too toxic to be allowed to float publicly. It may prove an artificial restriction.

Hedge funds are statistical animals by definition, and thus benefit from de-regulation as, as a whole, they occupy more of the "configuration space". But that statistical distribution says that some of them will take the position of "make a bit of money for a long time until I blow up". With leverage they will give great public returns until by definition of statistical distribution, they blow up. Unlike regular "industry", they don't have a "going concern" as some of them are supposed to exist until their number is up. It is relevant to point out that the existence of a public market for these complex derivative products could shed light on the books of the hedge-funds and provide insights into capital to debt ratios and risk profiles. The configuration space would still be the creation of the legislators.

Monetary policy can be implemented that way and M2 controlled at those primary broker choke points. Which is all a fancy way of saying "10 was too low, 30 is too high, maybe we set legal leverage at 24 and see what happens?"