I take it all back: Bengt Holmström says securitization wasn’t the problem, but Glass-Steagall repeal might have been

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I’ve done a lot of bashing here of those who think the 1999 repeal of the Glass-Steagall Act separating banking from the investment business is to blame for all our troubles. I’ve also argued that securitization—at least fancy-pants securitization—has been partly at fault. So it was interesting to hear an economist I admire make the opposite arguments Thursday. The occasion was a Columbia Business School symposium on on Preventing the Next Financial Crisis, and the economist was MIT’s Bengt Holmström.

Holmström is a theorist, and he has charming habit of reminding people that his theories are just, you know, theories. But at the same time he has ample experience with real-world economic  phenomena. He’s been on Nokia’s board of directors for a decade, and he once briefly served on the board of a Finnish investment bank. (“Never go on the board of a bank, because you will never know what goes on there.”) Most important, he was back home in Finland (at the Helsinki School of Economics) during the Scandinavian financial crisis of the early 1990s.

That Scandinavian financial crisis–a favorite topic of this blog–was similar in so many ways to today’s crisis: There were lots of real estate loans gone bad, sharp drops in house prices, bankrupt banks, and government takeovers of the various national financial systems. “But there was zero securitization,” Holmström said.

Holmström’s theoretical contributions mainly have to do with the economics of information, and that’s where he located the problem in both Scandinavia in the early 1990s and the U.S. now. There are low-information assets–cash, bank deposits, money-market securities–where, most of the time, nobody really needs to know anything about their underlying value. Then there are high-information assets–stocks are the best example–where the value is highly uncertain, and every investor assesses it differently.

“The key is who should hold what,” Holmström said. Complex, high-information assets don’t pose big financial-system risks in and of themselves. Earlier this decade, “the Nasdaq fell 90% and nothing happened.” The problem is when leveraged liquidity providers (a.k.a. banks) end up with lots of high-information assets on their books. “When you’re in the liquidity providing market and rolling over 25% every night, you don’t have the luxury of wondering whether you can trust somebody.”

A financial crisis happens when market participants suddenly realize that what they thought were reliable low-information assets are really risky high-information assets. And that usually happens after an extended period during which market participants become willing to accept almost anything as a low-information, liquid asset. Holmström: “If you come to the phase of the cycle where everybody thinks everything’s liquid, you’re going to have a problem.”

Holmström said he doubted government could ever regulate away that occasional tendency. “How do you prevent people from considering equity to be the same as Treasuries? You can’t legislate that.” But he did think was something to the idea of treating liquidity providers differently from other financial players.

During the Q&A, an audience member who said he was at Salomon Brothers when Citicorp and Salomon’s parent Travelers merged in 1998 (“I watched those nice stodgy Citi bankers try to boogie like the Salomon Brothers investment bankers”) wondered if Glass-Steagall repeal wasn’t part of the problem.

Replied Holmström: “I’m for going back to some separation between liquidity providers and the rest of the market. I don’t think it’s coincidental that this happened after Glass-Steagall repeal.”

A couple of other people on Holmström’s panel then chimed in with the argument I’ve made–that the issue was letting investment banks and other market players (it all began with money market mutual funds) grow into a liquidity-providing shadow banking system, an evolution that began long before Glass-Steagall repeal.

“Investment banks led the way, but commercial banks decided they liked it too,” retorted the ex-Salomon guy in the audience. “The abolition of Glass-Steagall put this kind of behavior in the hands of people with much bigger balance sheets.”

Holmström’s summation: “I’m a theorist. I’m allowed to speculate. I think we’re in a bad state of the world when we rely on theorists.”

Update One more nice Holmström quote from my notes, on nationalizing banks:

One of the things governments can do very easily is take over banks, because they’re very bureaucratic. It’s much harder to take over institutions where imagination is required.