Tuesday, April 12, 2011

New Bank Regulation is Too Small to Succeed

The legislation in the Dodd-Frank financial reform bill allows regulators to avoid bailouts, but doesn't prevent the too-big-to-fail bank problem. Read more in this full blog post from Economist's View.

Would it surprise you to learn that if a bank like Lehman Brothers were to get into trouble today, we would have no choice but to bail it out? The Dodd-Frank financial reform bill includes resolution authority that supposedly allows regulators to avoid a bailout and dismantle large, systemically important banks that get into trouble without endangering the overall banking system. But this legislation does not end the problem of too big to fail banks.

If the banking system is threatened by the failure of a large bank, then resolution authority will not prevent the equivalent of a traditional bank run on the shadow banking system. Depositors can’t be certain that resolution authority will work as advertised, and as soon as they sense their funds are at risk, they will rush to withdraw them from endangered institutions. And as this fear spreads to counterparties worried about the ability of the troubled bank to meet its obligations, and in turn to the counterparties of counterparties, the overall system becomes threatened and the government has no choice but to step in to try to prevent collapse.

This is not the only problem with resolution authority. Most large, systemically important banks operate in many countries. For example, “When Lehman filed for bankruptcy protection in the United States, it had over 200 principal subsidiaries and participated in over 100 payment and settlement systems across the globe.” Since Dodd-Frank only applies to domestic operations, an international agreement would be needed to coordinate the response and prevent the trouble from spreading to additional banks and additional countries.

One solution to the too big to fail problem that is often proposed is to break large banks into smaller pieces. I’ve yet to hear a convincing argument why we can’t break large banks into smaller pieces – there do not appear to be any efficiency gains associated with mega-sized banks. However, this won’t solve the bank bailout problem. A large, widespread shock to the financial system could still create problems for smaller banks and require a bailout. Banks were relatively small at the time of the Great Depression, but that didn’t stop problems from developing in the banking sector. However, reducing bank size does reduce the political power of the large banks, an important consideration.

If breaking banks up isn’t the answer, then what can we do?

We should do our best to prevent financial breakdowns, but I don’t think we will ever be able to completely prevent bank crises. A system-wide collapse will always be a possibility, and we need to take steps limit the damage that occurs when a crisis hits despite our efforts to prevent it.

On the preventative side, regulators need to limit the ability of banks to take advantage of their too big to fail status. Too big to fail banks can take large risks, and if those risks pay off the banks win big. If they don’t, there’s a bailout and someone else takes the loss. With health, auto, and other insurance this problem is reduced through the use of deductibles that force the individual to share in the loss.

The same requirements can be placed on banks. If banks are forced to post substantial amounts of capital, and that capital is subject to “first loss” provisions, then they will be much more careful about the risks they take. So substantial capital requirements, even higher than required under Basel III, are needed. In addition, better transparency so that investors can monitor what the bank is up to, improved rating of assets, fees to establish a bailout fund and offset potential gains from exploiting too big to fail status, better consumer education, and prosecuting fraud would help as well. Beyond this, regulators also need to develop better early warning systems that tell us when risk is accumulating to dangerous levels.

If prevention fails, then it’s important to limit damages. One important way to reduce the severity of a financial collapse is to reduce the interconnectedness of financial institutions. This makes it more difficult for problems to spread. In addition, reducing leverage also helps to limit the damages in a financial crash. Basel III does impose leverage limits, but they are not strict enough and don’t become fully effective until 2018.

If the banking system gets into trouble, we will bail it out – no politician or regulator wants to be responsible for the next Great Depression. The resolution authority in the Dodd-Frank bill attempts to hide this reality. It avoids the need for strict regulation associated with the promise of a bailout, something that pleases banks, but leaves the system vulnerable to collapse. We should accept that bailouts cannot be avoided, impose the regulatory structure needed to limit problems, and do our best to reduce the damages associated with the inevitable crashes of the financial system.

This blog was republished with permission from Economist's View.

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