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.

President Obama On Government Regulation

Since President Obama took office there has been a lot of discussion around how the governement should or shouldn't regulate certain aspects of the financial markets, among other things. Economist, Mark Thoma, takes a look at a recent article published by Obama, and offers his thoughts below:

President Obama on regulation:

Toward a 21st-Century Regulatory System, by Barak Obama: For two centuries, America's free market has ... been the greatest force for prosperity the world has ever known. ...

But throughout our history, one of the reasons the free market has worked is that we have sought the proper balance. We have preserved freedom of commerce while applying those rules and regulations necessary to protect the public against threats to our health and safety and to safeguard people and businesses from abuse.

From child labor laws to the Clean Air Act to our most recent strictures against hidden fees and penalties by credit card companies, we have, from time to time, embraced common sense rules of the road that strengthen our country without unduly interfering with the pursuit of progress and the growth of our economy.

Sometimes, those rules have gotten out of balance, placing unreasonable burdens on business... At other times, we have failed to meet our basic responsibility to protect the public interest, leading to disastrous consequences. Such was the case in the run-up to the financial crisis...

There, a lack of proper oversight and transparency nearly led to the collapse of the financial markets and a full-scale Depression.

Over the past two years, the goal of my administration has been to strike the right balance. And today, I am signing an executive order that makes clear that this is the operating principle of our government.

This order requires that federal agencies ensure that regulations protect our safety, health and environment while promoting economic growth. And it orders a government-wide review of the rules already on the books to remove outdated regulations that stifle job creation and make our economy less competitive. ...

Where necessary, we won't shy away from addressing obvious gaps: new safety rules for infant formula;... efforts to target chronic violators of workplace safety laws. But we are also making it our mission to root out regulations that conflict, that are not worth the cost, or that are just plain dumb. ...

And finally, today I am directing federal agencies to do more to account for—and reduce—the burdens regulations may place on small businesses. ...

Despite a lot of heated rhetoric, our efforts over the past two years to modernize our regulations have led to smarter—and in some cases tougher—rules to protect our health, safety and environment. Yet according to current estimates of their economic impact, the benefits of these regulations exceed their costs by billions of dollars. ...

Regulations do have costs; often, as a country, we have to make tough decisions about whether those costs are necessary. But what is clear is that we can strike the right balance. ...

There will now be a rush of lobbyists explaining to Congress and agency heads that the regulations the industries they represent face are excessive and need to be removed. There will be no shortage of effort in this direction. At the same time, a similar effort will be devoted to opposing any new regulation.

We need tougher, better regulation in many areas, and I'm sure there's a bad regulation to be found as well. But if the administration is going to move in this direction, it had better be prepared to match the effort it is up against. If it doesn't -- if special interests succeed in swaying the process in their direction -- we"ll end up as far from the "the right "balance" as ever. I hope the administration realizes that this is not an effort it can take lightly with a sweeping proclamation for action that attempts to straddle the political fence. To make this work, the administration will need to do the hard work needed to lead this process forward and guide it to a satisfactory end.

This article was republished with permission from The Economist's View Blog.

Why We Should Regulate Banks Immediately

Despite the banking sector's large role in crashing the economy there are still some who oppose increasing bank regulation. Harvard Economist Kenneth Rogoff, discusses why we need to regulate banks as soon as possible. Mark Thoma summarizes his commentary below.

Kenneth Rogoff warns us not to believe those who argue that the crisis was largely due to government failure, and hence that regulating the financial sector is counterproductive and unnecessary:

Why we need to regulate the banks sooner, not later, by Kenneth Rogoff, Commentary, Financial Times: When in doubt, bail it out,” is the policy mantra ... after the ... collapse of Lehman Brothers. With the global economy tentatively emerging from recession, and investors salivating over the remaining banks’ apparent return to significant profitability, some are beginning to ask: “Did we really need to suffer so much?”

Too many policymakers, investors and economists have concluded that US authorities could have engineered a smooth exit from the bubble economy if only Lehman had been bailed out. Too many now believe that any move towards greater financial regulation should be sharply circumscribed since it was the government that dropped the ball. Stifling financial innovation will only slow growth, with little benefit in terms of stemming future crises...

Certainly the US and global economy were already severely stressed at the time of Lehman’s fall, but better tactical operations by the Federal Reserve and Treasury, especially in backstopping Lehman’s derivative book, might have stemmed the panic. Indeed, with hindsight it is easy to say the authorities should have acted months earlier to force banks to raise more equity capital. The March 2008 collapse of the fifth largest investment bank, Bear Stearns, should have been an indication that urgent action was needed. Fed and Treasury officials argue that before Lehman, stronger measures were politically impossible. There had to be blood on the street to convince Congress. ...

[C]ommon sense dictates the need for stricter controls on short-term borrowing by systemically important institutions, as well as regularly monitored limits on oversized risk positions, taking into account that markets can be highly correlated in a downturn. ... There should also be more international co-ordination of financial supervision, to prevent countries using soft regulation to bid for business and to insulate regulators from political pressures.

...The view that everything would be fine if Hank Paulson, then US Treasury secretary, had simply underwritten a $50bn bail-out of Lehman is dangerously misguided. The financial system still needs fundamental reform...

I think that even if Lehman had been bailed out the economy would still have been bad, just not as bad, so either way there are substantial economic costs and a case for regulation.

This article has been republished from Mark Thoma's blog, Economist's View.