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.

The Future Costs Of The Economic Bailout

It may be a generation before we know whether the government's massive spending was the right move, as the future costs of the debt remains uncertain. A new research paper by professors Carmen Reinhart and Kenneth Rogoff examines some of the potential effects to the future economy. See the following post from The Capital Spectator.

The monetary and fiscal stimulus dispensed by governments around the world was arguably effective in containing a recession and staving off depression. But if so, the question becomes: At what price?

Nothing is free in economics and so the world must grapple with the mountain of debt that now weighs on the global economy. In effect, policy makers have traded the acute for the chronic. Was it a worthwhile tradeoff? Perhaps, although the true answer won't be known for some time, perhaps as long as a generation.

Meanwhile, no one should underestimate the potential risks. A new research paper by professors Carmen Reinhart (University of Maryland) and Kenneth Rogoff (Harvard) bluntly lays out the stakes and the hazards that may be lurking. A working version of "Growth in a Time of Debt," forthcoming in American Economic Review, makes three key points. Quoting the paper, the authors advise:

• The relationship between government debt and real GDP growth is weak for debt/GDP ratios below a threshold of 90 percent of GDP. Above 90 percent, median growth rates fall by one percent, and average growth falls considerably more.

• Emerging markets face lower thresholds for external debt (public and private)—which is usually denominated in a foreign currency. When external debt reaches 60 percent of GDP, annual growth declines by about two percent; for higher levels, growth rates are roughly cut in half.

• There is no apparent contemporaneous link between inflation and public debt levels for the advanced countries as a group (some countries, such as the United States, have experienced higher inflation when debt/GDP is high.) The story is entirely different for emerging markets, where inflation rises sharply as debt increases.

Reinhart and Rogoff's recently published book—This Time Is Different: Eight Centuries of Financial Folly, which we reviewed here—made a timely statement with its arrival last year and this academic pair continues the tradition with their latest work. As their paper notes, the U.S. is among the nations with the biggest percentage increase in debt since 2007. A recent estimate of U.S. debt-to-GDP ratio is 84%, according to Reinhart and Rogoff--dangerously close to the 90% threshold, as illustrated in the following chart taken from the paper.

The bottom line: Bailouts are expensive, perhaps more expensive than generally realized. The worst of the financial crisis and Great Recession may be over, and perhaps that's due partly to the intervention of central banks and governments around the world. (The business cycle was a factor too.) But let's not celebrate just yet. The cleanup era has only just begun and it's not yet clear how much it's going to cost.

This post has been republished from James Picerno's blog, The Capital Spectator.

Bailout Nation: A Scathing Critique Of Greenspan's Fed

For a book that explores how we got into the current financial mess, check out Bailout Nation: How Greed and Easy Money Corrupted Wall Street and Shook the World Economy. Author Barry Ritholtz casts former Fed Chiarman Alan Greenspan as one of the villains for his flawed leadership and misguided policy. Tim Iacono from The Mess That Greenspan Made reviews the book:

For some time now, I've known that Barry Ritholtz's new book Bailout Nation was definitely not going to be kind to former Federal Reserve Chairman Alan Greenspan, but, had I known that it would offer the most damning critique of his term at the central bank, I certainly wouldn't have let the book sit on my desk for the last few weeks before finally picking it up the other day and polishing it off in record time.

With the subtitle How Greed and Easy Money Corrupted Wall Street and Shook the World Economy, it was natural to think the focus might be more on greed than easy money, but that's really not the case.

Greed is a constant on Wall Street and, for that matter, in most of the rest of the world, but financial systems don't implode unless generously lubricated with easy money, bailouts, and moral hazard - key elements of the Greenspan legacy.

Ironically, Fed economists and assorted hangers-on are meeting in Jackson Hole this week to deliberate on what's changed in the world of finance and monetary policy over the last year.

It was four years ago at that same gathering (i.e., before the housing and credit bubbles met their respective pins) that some were still lauding the former Fed chief as "the greatest central banker of all time" in something of a "going-away" party.

I wonder if his name will come up at this session...

Anyway, the book is not only fun-filled, thanks to the inimitable writing style of Mr. Ritholtz, but it's chock full of interesting little bits of information and perspective that, even to me, cast new light on what will surely be looked back upon as a disastrous period for central banking.

For example, it is common knowledge that Alan Greenspan was much more interested in asset prices than were his predecessors - they didn't coin the term "the Greenspan put" for nothing - but this passage gives the concept a bit more color.

History teaches us that the development of Bailout Nation, Wall Street edition, was not done in secret meetings. Rather, it occurred in the very public functions of the Federal Reserve, and the subsequent results of its policy actions.

The Greenspan Fed created an endemic culture of excessive risk taking. The U.S. central bank created moral hazard not by targeting inflation or the business cycle, but instead by focusing on asset prices. From the squishy focus on psychology, it was a short hop to asset prices. After all, when price go down, it negatively impacts sentiment, right? This was the Fed's fatal flaw under Greenspan's leadership.
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The Fed's previous rate cuts had only implied a concern over asset prices; now, the chief explicitly affirmed the fact. The Fed was not concerned just about inflation and employment; asset prices were an "integral part" of its calculus, too.

This was revolutionary. Fed chiefs didn't usually care so much about stock prices; they were more concerned with the bond market. After all, it was the fixed-income traders - known as bond ghouls for their morbid affection for bad economic news - who set interest rates. Worries about deficits, inflation, and trade balances all found a receptive audience among the bond traders.

Once Wall Street figured out Greenspan was concerned about equity prices, it wasn't too long before it learned how to play the Fed like the devil's fiddle. When rate cuts did not materialize, the Street would have itself a hissy fit. It is always ill advised to anthropomorphize markets, but observing the market kick and scream when cuts weren't forthcoming was akin to watching a two-year-old throw a tantrum. It may be illegal to manipulate the markets, but no trader will ever got thrown in jail for manipulating Greenspan.

Unfortunately, the current Fed chairman seems to share this same trait.

Well worth reading...

This post has been republished from Tim Iacono's blog, The Mess That Greenspan Made.