Banks Begin To Exhibit Consequences of New Regulations

Yesterday I wrote this post concerning David Malpass' recent insightful Wall Street Journal editorial, and his subsequent defense of it, if that's the right word to describe the one-sided conversation Malpass had on CNBC that day with the network's faux-economic reporter Steve Liesman.

My mind had more or less blocked out the details of that discussion, until I read two articles in yesterday's Journal concerning bank earnings and capital requirements.

The two articles concerned Goldman's recent earnings, which were down 40% from last year. It's not a big secret what happened. In the anticipation of the eventually-passed Congressional financial regulation bill, the firm trimmed its proprietary trading activities and began to keep capital more liquid, earning less, in reaction to the looming regulatory and capital requirement uncertainties.

Right underneath that article on page C3 in yesterday's Journal was one entitled Banks Confront Weight of Risk. That piece discussed the consequences of the new Basel III bank capital rules. In Goldman's case, the firm's CFO explained that regulatory capital would need to rise from $451B to $750B. Elsewhere in the article, it was explained that the new Basel rules increase capital ratios on risky assets, while simultaneously reducing the types of liabilities which are allowed to count as capital. One example of the first effect was an estimate that "Morgan Stanley's risk-weighted assets will jump 80% under the new Basel rules."

Any way you look at it, Basel III alone will begin to rein in decades of profligate, risky banking behavior by many firms which either were, or became, federally-backed institutions.

This isn't a bad thing, in my opinion. As I've contended in earlier posts, banking, in its totality, should never have become a growth industry. Sure, individual businesses, such as mortgage lending, consumer finance, or various structured instruments, might grow at elevated rates for short periods of time. But overall, banking is an economically derivative sector. It can't, in total, over time, grow faster than the economy it serves, without essentially taking more risks.

Again, as I've written in prior posts, there are and, now, will certainly be cases in which bank managers can't profitably deploy all the risk capital assigned to their positions, when capital costs are included in those profits. In short, properly risk-adjusted returns will fall, capital will shrink, and aggregate bank total returns will probably become appropriately more sluggish.

If anything, this regulatory change will push more risky finance business into the privately-held sector. Which, if you think about it, is a regulatory response to the decades-long trend of investment and commercial banks taking excessive risks while selling the ownership of such risk to the public. Looks like riskier financial business is headed back to private partnerships, as it was prior to the 1970s.

What does this have to do with David Malpass and yesterday's post?

Well, as my memory of his comments recovered, I recall his arguing that it isn't high interest rates that is holding back US economic recovery, but, rather, uncertainty on many fronts- regulatory, legislative, fiscal and monetary policy. In response, the economically unschooled Liesman repeated various platitudes about 'no double dip,' gradual recovery, etc., etc., etc.

Goldman's explicit statements about reining in activity in anticipation of greater regulatory burdens, the exact nature of which is as yet uncertain, supports Malpass' positions. Especially as they accompany such a precipitous fall in net income.

How's that for empirical evidence of an economist's contentions?

Hillary Clinton's Call For Capital Flow Restrictions

The market, and America, got a good look at Hillary Clinton's misunderstanding of capital markets and economics, in an interview on CNBC this week, seen here.

The video clip is a discussion by members of CNBC's morning show, Squawkbox, of the interview, whose tape from the prior day is featured in the clip.

I would like to say that, having revealed herself to be a proponent of returning to an era of international capital flow controls, Clinton has severely damaged her presidential campaign and aspirations. Sadly, probably less than half of the American voting population will even understand what Hillary means by her statements, and how devastating her threats would be to the US and global economy.

Hillary expresses so many misunderstandings of economic reality that it is difficult to know where to begin critiquing her remarks.

First, of course, she is incorrect to suggest that we, the US, is at risk because we have debt outstanding held by foreigners. The debt is issued in our own currency. It is the debt of the world's leading economic growth engine, and only large, reliable and safe economy. The governments of China, and other nations, hold US debt because it affords them a competitive return on low-risk financial assets.

As Larry Kudlow pointed out, our allies hold approximately 80% of foreign-held debt. Further, Fed Chairman Ben Bernanke pointed out this week that our foreign-held debt is not a risk, in that they choose to hold these assets. Our debt is sought after for its relative return and low risk.

Next, Hillary indicated her lack of understanding of a growth economy. As one of the world's largest economies, the leading growth economy, and also a large, consuming nation, the US attracts capital from overseas to fund its growth. Foreigners buy US equities and debt, including that of our federal government, in order to participate in the growth in the American economy. We could not possibly fund all of our growth with domestic assets or savings anymore.

Further, when we spend money to import products, those dollars have to go somewhere. They return to the US via spending on exported US goods, and by investment in US enterprises or government debt. The mechanism of international investment requires US dollars to be used to pay for US investments. Thus, one way or another, US spending and growth leave claims on US assets in the hands of overseas individuals, companies, and other countries. This is simply a fact of global economics.

Hillary made a rather inane comment to the effect that the more we issue debt, the more the Asians buy it. Were that true! It's not that they buy because we issue. They buy our debt because it is offers a good return for the risk.

Finally, Hillary's hint at capital controls and somehow interfering with the issuance of debt or its purchase by foreigners runs the serious risk of triggering a global economic recession.

It was only with the dawn of the 1980s that better information and looser capital controls allowed private investors to discipline heretofore lax central bankers by punishing the currencies of profligate countries. International economics and finance have evolved to the point at which country finance ministers and central bankers must fear and respect the judgement of capital flows when managing their economies and currency issuance.

To retreat from this desired state, and return to the days of artificial controls on international capital movement, is to dismantle our relatively free and efficient global trading system, and harm global economic growth.

I'm very surprised Hillary's handlers even let her give this interview, let alone go afield with the absurd comments she made. It's on video, and will last through the entire election campaign.

Let's hope, first, that she doesn't get elected, and, second, that enough Americans understand what she meant to fear her appropriately.