Comments on Alan Greenspan's "The Crisis"

I just returned from the spring meeting of the Brookings Papers on Economic Activity, where I was a discussant for Alan Greenspan's new paper on "The Crisis," which has gotten a bit of media attention. I thought blog readers might enjoy reading my comments on the paper.  Here they are:

This is a great paper. It presents one of the best comprehensive narratives about what went wrong over the past several years that I have read. If you want to assign your students only one paper to read about the recent financial crisis, this would be a good choice.

There are, however, particular pieces of the analysis about which I am skeptical. But before I get to that, let me begin by emphasizing several important points of agreement.

To begin with, Alan refers to recent events in the housing market as a “classic euphoric bubble.” He is certainly right that asset markets can depart from apparent fundamentals in ways that are often hard to understand. This has happened before, and it will happen again. When the bubble bursts, the aftershocks are never pleasant.

Next, Alan points out that our political process, rather than reducing the risks associated with the bubble, helped contribute to them. In a footnote, Alan points out that in October 2000, in the waning days of the Clinton administration, the U.S. Department of Housing and Urban Development finalized rules that expanded the affordable housing goals of the government-sponsored enterprises (Fannie Mae and Freddie Mac). As a result, the GSEs expanded substantially their holdings of subprime mortgages. While neither Alan nor I would suggest that the current crisis is primarily the result of misguided housing policies, we both believe that these policies served to make a bad situation worse. This fact is important to keep in mind not to assess blame; there is more than enough of that to go around. Rather, in judging how much policy can accomplish going forward, we should be mindful of how imperfect the political process is.

When considering what future regulations can do to reduce the likelihood of future crises, Alan emphasizes that whatever rules we promulgate cannot be premised on our ability to anticipate an uncertain future. In my view, this is particularly wise. There are some people who think that the main cause of the recent crisis is that policymakers failed to anticipate the bursting of the housing bubble. If only we had central bankers with greater prescience, the argument goes, all this could have been avoided. In my view, and I believe Alan’s as well, this is wishful thinking in the extreme. It indeed would be nice if somehow those individuals guiding our national economy had superhuman powers to see into the future. (Nouriel Roubini, for example.) In reality, however, our national economic leaders are likely to be mortals and share the same biases and flaws in perception as market participants.

So what then can we do to make the financial system more crash-proof? Alan offers several good suggestions.

First, and most obviously, we should have higher capital requirements. This is truer now than it has ever been. By bailing out almost every major financial institution that needed it, as well as a few that didn’t, the U.S. federal government has raised the expectations of future bailouts, thereby turning the entire U.S. financial system into, in effect, a group of government-sponsored enterprises. Going forward, creditors to these institutions will view them as too safe, and so they will lend to them too freely. The financial institutions, in turn, will be tempted to respond to their low cost of debt by leveraging to excess. Higher capital requirements are needed to counteract this newly expanded moral hazard.

Second, I like Alan’s idea of “living wills” in which financial intermediaries are required to offer their own plans to wind down in the event that they fail. The advantage to this idea is that when future failures occur, as they surely will, policymakers will have a game plan in hand. How well that will work, however, is hard to say. Like real wills, these financial wills may well be contested by next-of-kin when they are about to be applied. For this plan to work, the living wills had better be widely publicized—say, by putting them on a centralized webpage—to discourage counterparties from complaining after the fact that they thought they had more legal rights in the event of liquidation than they do.

Third, and perhaps most important, I like the idea of requiring contingent debt that will turn into equity when some regulator deems that a firm has insufficient capital. Essentially, this debt would become a form of preplanned recapitalization in the event of a future financial crisis. But most importantly, the recapitalization would be done with private rather than public money. Because the financial firm would pay for the cost of these funds, rather than enjoying taxpayer subsidies, it would be incentivized to make itself less risky, for instance, by reducing leverage. The less risky the firm, the less likely the contingency would be triggered, and the lower the interest rate the firm would need to pay on this contingent debt.

This brings me to one part of Alan’s paper where I disagree with his conclusion—or, at least, I was not sufficiently persuaded by his arguments. The issue concerns the importance of leverage to the viability of a financial intermediary.

Alan proposes raising capital requirements and reducing leverage, but he suggests that there are limits to how much we can do so. If we reduce leverage too much, he argues, financial intermediaries will be not be sufficiently profitable to remain viable. He offers some back-of-the-envelope calculations that purport to show how much leverage the financial system needs to stay afloat.

When I read this part of the paper, my first thought was: What about the Modigliani-Miller Theorem? Recall that this famous theorem says that a firm’s value as a business enterprise is independent of how it is financed. The debt-equity ratio determines how the risky cash flow from operations is divided among creditors and owners. But it does not affect whether the firm is fundamentally viable as an on-going concern. It seems to me that, as least as first approximation, the logic of this theorem should apply to financial intermediaries as well as other types of business. If not, we need some explanation as to why.

I have a hunch as to where, from the Modigliani-Miller perspective, Alan’s calculations go awry. Alan assumes that the rate of return on equity must be at least 5 percent. But this number should be endogenous to the degree of leverage. If a bank is less levered, its equity will be safer. (It will be like a combination of today’s equity and bonds.) As a result, the required rate of return should fall.

Indeed, I think it is possible to imagine a bank with almost no leverage at all. Suppose we were to require banks to hold 100 percent reserves against demand deposits. And suppose that all bank loans had to be financed 100 percent with bank capital. A bank would, in essence, be a marriage of a super-safe money market mutual fund with an unlevered finance company. (This system is, I believe, similar to what is sometimes called “narrow banking.”) It seems to me that a banking system operating under such strict regulations could well perform the crucial economic function of financial intermediation. No leverage would be required.

One thing such a system would do is forgo the “maturity transformation” function of the current financial system. That is, many banks and other intermediaries now borrow short and lend long. The issue I am wrestling with is whether this maturity transformation is a crucial feature of a successful financial system. The resulting maturity mismatch seems to be a central element of banking panics and financial crises. The open question in my mind is what value it has and whether the benefits of our current highly leveraged financial system exceed the all-too-obvious costs.

To put the point most broadly: The Modigliani-Miller theorem says leverage and capital structure are irrelevant, while undoubtedly many bankers would claim they are central to the process of financial intermediation. A compelling question on the research agenda is to figure out who is right, and why.