Are German naked short and CDS bans really that awful?

In response to the German bans on some naked short-selling and naked credit default swap (CDS) purchases Zero hedge declares:

If this pans out as expected, look for Bunds to collapse tomorrow, and wipe out a few billion from Pimco's NAV. We warned in February that the flight to safety in Bunds was both shortsighted, and too good to last.

I disagree.  Banning naked short selling and unmatched CDS purchases are fairly mundane regulatory changes.  Shorting is still allowed as long as the bonds or shares can be borrowed and default swaps are still available but only for hedging purposes.  Coming so soon after the bailout announcement, this is being linked to the "wolf pack" behavior mentioned by officials last week but these policies are in line with reform recommendations from before the Greek crisis made it to the front burner.

This may be the sort of news that can set off a panic given the view by many that the Europeans are flailing about but I expect the real money will take note of the limited scope and difficult enforcement of today's bans.  While I agree that Europe has not yet come to terms with Greece as a solvency problem rather than a liquidity problem, the current approach is still printing Euros to pay bond holders, so the downward pressure should stay focused firmly on the Euro.

With the lopsided view and large short positions in the Euro currently, I am not even sure the one way trip down there can continue through tomorrow.

Financial reform moves closer to passing

From the WSJ:

Democrats won the support of a senior Republican who voted in a Senate committee Wednesday for a sweeping overhaul of the market for derivatives, the complex financial instruments at the heart of the financial crisis.

With 41 Republican's in the Senate this is a critical achievement for the bill.  It will be interesting to see how bank shares react.  Tim Duy highlights positive developments making the economic recovery looks sustainable but stock prices and risk assets still appear to be on the high side.

This is particularly true of bank stocks given the public outrage over the pay structure and conflicts of interest.  Reducing systemic leverage is another likely regulatory theme.  Regulatory uncertainty along with lingering insolvency fears make it difficult to understand how owning bank shares makes sense to anyone here.  My personal view is that bank shares are in for a lost decade as deleveraging and capacity reduction work through the sector.  We shall see.

Are there scale economies in banking?

Mark Thoma concludes his summary on whether scale economies in banking justify the existence and benefit of large banks with the following:

I'd like to know the source of the scale economies. The paper linked above estimates returns to scale, but not their source. As noted in the introduction (and also noted by David):

Our results indicate that as recently as 2006 banks faced increasing returns to scale, suggesting that scale economies are a plausible (though not necessarily only) reason for the growth in bank size...

Without knowing the source of the changes in costs as banks increase in size, the (non-parametric) results -- results that differ from most previous work -- are hard to evaluate. I've been hoping for good estimates of the size and nature of the economies of scale for banks, but I'm not fully convinced by this evidence.

Mark is correct to try to figure out the specifics that are driving the returns in the study.  From my own experience - sales and trading in loans, bonds, and commodities - scale is found mostly through network effects.  The market players that have the most trading flow and transactional experience in a particular market have the accurate prices and up to date information.  This advantage leads to a higher return by being more likely to earn the bid / offer spread when making markets and being able to price services at a premium with clients wanting information access as well.  While this can be a stable and profitable advantage it was a small part of the profit in the banking areas I have worked in.

I would expect other economies of scale on the deposit taking side of the business as servicing a large number of depositors in a centralised fashion seems like a classic scale business.  The number of clients and transactions adds little marginal cost while the licensing, reputation, and infrastructure represent substantial fixed costs.  This advantage is hived off from the risk taking and higher margin bank  businesses with the internal treasury and risk department charging LIBOR plus a spread for use of funds.  These risky parts of the business still tend to grow fairly large despite the absence of scale economies.  I attribute this to the money politics of the industry as empires grow and shrink based on raw profit.  Growth is revenue rather than cost driven.   This fits well with the ease that hedge funds have found competing against banks in sales and trading functions though funds usually start with few people and no scale.

Another thought that I had from reading David's post, was that even if there are economies of scale that does not justify "too big to fail".  It shows that big can be a public benefit but if that is the case then a system needs to be created so that the naturally big entities created can be wound down effectively if necessary.  I believe this is now widely accepted following the difficult ad hoc responses that became necessary for troubled large institutions in 2008.

Particular banking businesses may need to be large to get the maximum public benefit but for the reasons above I doubt this applies to the financial industry as a whole.  Careful thought should be given so that if a safety net for large institution needs to be maintained it only applies to functions that can justify scale benefits.  If scale can be justified it still does not justify the lack of a mechanism to wind down large institutions when necessary.

Financial Risk Models

From the Mises Institute blog:

Although the mechanical philosophy is long dead and buried, our age is not without its own dogma regarding properly scientific explanations. Today, the prevailing belief is that any real science must be composed of mathematical models, models which yield quantitative predictions about some class of events based on particular, initial conditions, also specified numerically. Once again, the currently popular methodology has been imposed on diverse disciplines with little regard to whether it is suitable to their subject matter, but simply because it is thought to be the only respectable way to do science. The philosopher John Dupré calls this "scientific imperialism," meaning "the tendency for a successful scientific idea to be applied far beyond its original home, and generally with decreasing success the more its application is expanded" (2001, p. 16). Once again, we see a frantic effort to generate models fitting the accepted paradigm, with little regard for the realism of the assumptions and mechanisms from which they are constructed.

In my mind this relates prettly closely to this post from Brad Setser (be sure to read the comments which wade deeper into modelling and risk measurement). The basic problems in risk management seems to me that assets are assumed to have inherent properties like the physical bodies. Particles have mass, position and velocity while assets have price, varience, and correlation. I call it a basic problem because these aren't really the properties of the asset but are the properies of transactions.

Transactions necessarily have assets, counterparties, prices and times associated with them but assets need not be part of a transaction. A series of transactions in two identical assets need not have a realtionship at all if the counterparties have no contact. The existence of exchanges and the requirments of open-outcry and disclosure get around this basic problem, creating attachment between transactions but I am not sure this does much more than create the illusion that assets always have prices and those prices move in continuous fashion.

Inflation Targets and Asset Bubbles

From the Economist:

Some central bankers in Britain, continental Europe, Australia and New Zealand have said publicly that monetary policy needs to take more account of asset prices and that sometimes interest rates may need to rise by more than if the sole objective were to keep consumer-price inflation within target.

The author then gets a bit caustic with the Fed for reluctance to consider the overall liquidity picture and concludes with this.

During the past century, every monetary rule has eventually broken down: the gold standard, the Bretton Woods system of fixed exchange rates, and monetary targeting. Now it seems that strict inflation targeting may not be a panacea either. It would be foolish for the Fed to sign up for crude inflation targeting just as it goes out of fashion.

While centering on the need to include asset prices in inflation measures the article falls a bit short by suggesting central banks should consider asset prices in their policy decisions. A better solution is to remove asset prices from central bank control. Robert Shiller discusses the Chilean UF (unit of development) in his book The New Financial Order (Amazon) as an example of an alternative system to limit central bank influence over asset prices. The UF is an inflation indexed unit of account which is repriced daily such that everyone knows the correct price of a UF in Pesos. The UF was created in 1967 and has become widely used for pricing long-term contracts such as housing prices and mortgages while pesos are still used for day-to-day purchases and salaries.

I am getting a bit out of my area of expertise but I am pretty sure the Fed (and probably the world) is running into the problem the Economist describes with asset prices demonstrating large value swings while goods prices remain stable. These swings are making it impossible to effectively manage liquidity in the system. Rather than giving central banks the difficult task of adjust policy to correct asset prices I think it is better to create a mechanism for asset price stability outside of central bank control.