In JPMorgan’s latest shareholder newsletter (p. 30-34), Jamie Dimon walks through a narrative of the next financial crisis and why we should be worried about it. But instead of worrying, I think it points to interesting details of what we’ve learned from the last crisis, what we evidently haven’t learned, and where we should go next.
Here’s Matt Levine’s summary. Dimon makes two arguments: First, the new capital requirements, especially the liquidity coverage ratio (LCR) that requires banks to fund themselves with enough liquidity to survive a 30-day crisis, will be procyclical. This means they will bind the financial sector more tightly in a crisis and prevent it from being a backstop. This is made even worse by his second argument, which is that there’s a safe asset shortage. Each individual bank is much safer than before the crisis, but using safe assets to meet the LCR means there will be fewer out there to provide stabilization when a crisis hits.
To use Dimon’s language, “there is a greatly reduced supply of Treasuries to go around – in effect, there may be a shortage of all forms of good collateral” in a crisis. Meanwhile, new capital requirements, especially the LCR, mean that in a crisis banks won’t want to lend, roll over credit, or purchase risky assets, because they would be violating the new capital rules. As such, “it will be harder for banks either as lenders or market-makers to ‘stand against the tide’” and to serve as “the ‘lender of last resort’ to their clients.”
What should we make of the fact that Dimon’s target is the LCR, an important new requirement under constant assault by the banks? Four points jump out.
The first is that the idea that we should weaken capital requirements so banks can be the lender of last resort in a financial crisis is precisely what was disproven during the 2008 panic. One reason people use the term “shadow banking” to describe this system is that it has no actual means of providing liquidity and the backstops necessary to prevent self-fulfilling panics, and that was demonstrated during the recent crisis.
Rather than financial firms heroically standing against the tide of a financial panic, they all immediately ran for shelter, forcing the Federal Reserve to stand up instead and create a de facto lender-of-last-resort facility for shadow banks out of thin air.
It’s good to hear that Dimon feels JPMorgan can still fulfill this function in the next crisis, if only we weakened Basel. But we’ve tried before to let financial firms act as the ultimate backstop to the markets while the government got out of the way, and it was a disaster. Firms like AIG wrote systemic risk insurance they could never pay; even interbank lending collapsed in the crisis.
This is precisely why we need to continue regulating the shadow banking sector and reducing reliance and risks in the wholesale short-term funding markets, and why the Federal Reserve should actually write the rules governing emergency liquidity services instead of ignoring what Congress has demanded of it. No doubt there needs to be a balance, but if anything we are counting too much on the shadow banking sector to be able to take care of itself, not too little.
As a quick, frustrating second point, it’s funny that regulators bent over backwards for the financial industry in addressing these issues with LCR, and yet the industry won’t give an inch in trying to dismantle it. That LCR is meant to adjust in a crisis and that the funds would be available for lending was emphasized when regulators weakened the rule under bank pressure, and it is explicitly stated in the final rule (“the Basel III Revised Liquidity Framework indicates that supervisory actions should not discourage or deter a banking organization from using its HQLA when necessary to meet unforeseen liquidity needs arising from financial stress that exceeds normal business fluctuations”).
If risk-weighting is too procyclical, which requires several logical leaps in Dimon’s arguments, the solution is to adjust those rules while raising the leverage ratio, not to pretend that the financial sector would be a sufficient ultimate backstop. Bank comments on tough rules like LCR are less give-and-take and more take-and-take.
But the third point is more interesting. Beyond whether or not the rules are too procyclical and unnecessarily restrictive in a crisis, there’s Dimon’s claim that there aren’t enough Treasuries to go around. If that’s the case, why don’t we simply make more Treasury debt? If the issue is a shortage of Treasuries needed to keep the financial sector well-capitalized and safe, it’s quite easy for us to make more government debt. And right now, with low interest rates and a desperate need for public investment, strikes me as an excellent time to do just that. Dimon is correct in his implicit idea that the financial markets, with enough financial engineering and private-market backstopping, can produce genuinely safe assets is a complete sham. This is a role for the government.
And for fun, a fourth point from Ben Walsh: Dimon says one of the biggest threats to the financial markets is that there isn’t enough U.S. debt. From January 2011: “Dimon Says Government Deficits, Spending Are New Global Risk.” We are risking a major rise in interest rates in the years following 2011 if we have trillion-dollar deficits, Dimon warned. How did that turn out?
Imagine how much worse shape we’d be in if we’d listened to Dimon.
So just as a friendly reminder: not only would more federal debt issued at incredibly low rates do cool things like rebuild schools, fix bridges, and give money to poor people, it would also serve as an important element of reducing the risks of the next financial crisis. This federal debt seems like a pretty useful thing to have around.