James Pethokoukis

Politics and policy from inside Washington

Why we shouldn’t break up the big banks

Apr 20, 2010 16:51 UTC

Tyler Cowen gives it his best shot and ends with this recommendation:

If you do wish to break or limit the power of the major banks, running a balanced budget is probably the most important step we could take. It would mean that our government no longer needs to worry so much about financing its activities. Of course such an outcome is distant these days, mostly because American voters love both high government spending and relatively low taxes.

3 TBTF loopholes in the Dodd bill

Apr 20, 2010 16:37 UTC

The wonderful Nicole Gelinas explains why she does not think the Dodd bill ends TBTF (as outlined by me):

1) Title II, which starts on p. 107, explains how “orderly liquidation authority” would work. When the Treasury and a panel of judges have determined that a financial firm is unsafe for bankruptcy, the FDIC would take over that firm. In “liquidating” the company, the FDIC would figure out who — of the firms’ lenders, other creditors, and shareholders — would get what. On the repayment list is “any amounts owed to the United States, unless the United States agrees or consents otherwise” (italics mine). That speaks for itself on whether taxpayers will be “exposed to a penny of risk of loss.”

2) More important, though, what does it mean to “liquidate” a company? … The bill does not ensure that lenders will take losses. Instead, it merely directs the FDIC to operate under a “strong presumption” (p. 131) that “creditors and shareholders will bear the losses of the financial company” (p. 132).

3) A hundred-odd pages later, the bill offers a big loophole for lenders in a crisis. It says that the FDIC, “with the approval of the [Treasury] Secretary, may make additional payments or credit additional amounts to or with respect for the account of any claimant or category of claimants of the covered financial company” — that is, to lenders — “if the [FDIC] determines that such payments or credits are necessary or appropriate to minimize losses” to the FDIC (p. 241). It wouldn’t be unreasonable for a lender to expect the government and the FDIC to use all of the discretion the bill affords them to guarantee financial firms’ debt in a future systemic financial crisis, just as happened this time around.

4) Finally, Geithner’s language — he wants to “dismember” failed financial firms “safely” — is interesting. Three months ago before Congress, Geithner had this to say about the AIG bailout: “We didn’t rescue AIG. We intervened so we could dismember it safely.” True, that was the government’s intent in the fall of 2008. But AIG is still with us; the stock trades at nearly $40.

Faith-based financial reform

Apr 19, 2010 18:46 UTC

The timing of the Securities and Exchange Commission’s suit against Goldman Sachs may sway a few doubters. But U.S. financial reform is still partly a matter of faith. That’s one reason for the partisan bickering. Preventing future government bank bailouts relies heavily on Wall Street believing new rules will be enforced and failures will be allowed. For skeptics, though, the current Senate bill leaves enough wiggle room to induce doubt.

On paper, Democrats have a case to support their convictions. Their bill gives regulators new authority to wind down non-bank financial institutions. Tougher new capital and leverage requirements, as well as limits on risky activities, are supposed to make failures much less likely. A $50 billion bank-financed pool would fund resolution costs — though this whole idea may yet be dropped.

The trouble is, teetering banks and their creditors might still assume that while not too big to sue — as Goldman can attest — Uncle Sam would still think them too big and interconnected to fail. And that’s the problem for many Republicans. The bill tends to favor discretion over hard and fast rules. While the feds would have the authority to shut down institutions, for instance, they wouldn’tbe required to do it. History hints that regulators and politicians will continue to be tempted to rescue banks in a crisis, a point made by several regional Federal Reserve Bank presidents who doubt the efficacy of the Dodd bill.

And those new rules on capital, leverage and risky activities will be spelled out only later by a new systemic risk council. The government would be able to guarantee financial firms’ debt without any automatic triggering of the resolution process. And it’s still fuzzy how the challenge of winding down cross-border obligations and operations would be met.

There’s an argument for leaving less to officials’ discretion. If the threat of liquidation isn’t credible, banks will operate — and investors will treat them — as if a government backstop still existed.

If the Democrats’ reform bill passes in its current form, believers might then look for signs that it’s working. One would be that big banks can no longer fund themselves so cheaply. Especially since the recent crisis, big banks — with, say, more than $100 billion in assets — have been paying less interest on deposits and debt than smaller brethren.

If that too-big-to-fail subsidy doesn’t narrow significantly, Republicans would be justified in calling for a reform revival.

COMMENT

Supply Siders had blind faith that self interest would preserve us, and their regulatory appointees considered themselves redundant, despite overwhelming historical evidence, and material incentives to the contrary.

Posted by loguealator | Report as abusive

Is McConnell right about TBTF?

Apr 14, 2010 12:26 UTC

Senate Republican leader Mitch McConnell charges that the Dodd financial reform bill supported by the WH fails to end Too Big To Fail. Is he correct. Well, this bit from Reuters highlights one problem area:

Seeking a middle ground between bailout and bankruptcy, the Senate bill sets up a new process for “orderly liquidation” of large firms that get into trouble. Authorities could seize distressed firms and dismantle them. The Senate bill creates a $50 billion fund to finance such actions. Large firms with assets above $50 billion would pay into the fund. Republicans object to a part of the bill that would let the fund borrow additional money from the Treasury — that means taxpayers — if the liquidation fund runs short. This provision smells like “backdoor bailouts,” say Republicans. … The House bill, like the Senate’s, sets up a new liquidation process, but it would be simpler to invoke and and it would come with a higher price-tag. The House proposes a $200-billion fund. Firms with assets over $50 billion would pay up to $150 billion into the fund, which could borrow another $50 billion from the Treasury.

Me: Then there is the issue of confidence in regulators and politicians to resist the temptation to bail/rescue in a crisis.

Imagining a new consumer finance regulator

Apr 13, 2010 17:38 UTC

Alex Pollock does, and the results are not pretty:

Consider a new, independent regulatory bureaucracy filled with ambitious officers and staffers who are interventionist by ideology, believers that people need to be guided for their own good according to the tenets of “behavioral economics,” social democratic by faith, and closely aligned to numerous “consumer advocates.” They will hardly be content with the project of “improving disclosure,” important as that is.

They will ineluctably embark instead on allocating credit in terms of “improved access” and “fairness.” In other words, they will promote expanding riskier loans, in spite of the fact that making people loans they can’t afford is the opposite of protecting them.

This is why, if such an organization is to be created, it is absolutely essential that it be truly part of, and subordinate to, a regulatory body also charged with financial prudence, safety and soundness, and balancing risks. Better would be not to create it at all, but rather to centralize the responsibility for clear, straightforward key information in a relevant existing regulator—the Federal Trade Commission, for example.

How to really end Too Big To Fail

Apr 13, 2010 17:22 UTC

Over at the must-read e21 site, Chris Papagianis provides an excellent counter to the Dodd-Obama financial reform plan. He prefers an approach devised by Oliver Hart and Luigi Zingales. Here are the key details via Papagianis:

1) Hart and Zingales would use credit default swap (CDS) spreads as a market-based default probability metric. The “spread” or premium on a CDS contract represents the market price of providing a financial guarantee against losses from a firm’s default.

2) In the Hart and Zingales framework, once the CDS spread rises above a pre-specified “critical threshold,” the regulator would force the institution in question to issue equity (offer new stock for sale) until the CDS spread moves back below the threshold.

3) While Hart and Zingales choose the right instrument for their trigger, their proposed remedial step should be strengthened. Instead of having the regulator demand that the institution issue new equity, the debt of the institution could automatically convert into equity. Say a large bank financed $150 billion of assets with $80 billion of deposits, $40 billion of senior debt, $20 billion of so-called junior debt, and $10 billion of equity. When the CDS on this bank surpassed the critical threshold, half of the bank’s junior debt would automatically convert to equity. Instead of having 6.7% equity (15-to-1 leverage), the bank’s assets would be financed with 13.3% equity (7.5-to-1 leverage). If that failed to bring the CDS below the critical threshold, the other half of the junior debt would also convert to equity.

4) The mandatory conversion would enhance systemic stability for two reasons. First, the risk that the debt would convert to equity would be priced into the debt, raising the systemic institution’s cost of capital and leveling the playing field with smaller banks. Secondly, the automatic conversion would eliminate the potential for regulatory forbearance caused by market conditions.

Me: I like this. It doesn’t depend on the omniscience of politically captured regulators, and it doesn’t involve bank bailouts by taxpayers. This would seem to be an antidote to Crony Capitalism.

7 keys to financial reform

Mar 30, 2010 16:53 UTC

Here is what you need to know about financial reform. If a bill in any way allows vast amounts taxpayer money to be poured into banks, then the bill does not end Too Big To Fail. Banks will assume this power will be used. Second, any bill that requires prescience by regulators and then the will to act on unpopular forecasts is doomed to fail. Keep that in mind as your read some key insights from the great Nicole Gelinas on fin reform:

1) The biggest financial crises arise from too much debt. Borrowers and lenders, ensconced in a bubble, fail to see the need for cash as a cushion against error. When the bubble bursts, it leaves behind so much debt that it bankrupts the financial industry.

2) Existing regulators should move toward consistency in their borrowing limits–requiring a financial institution to put a consistent level of cash down behind any debt security or derivative instrument, even if the government thinks the investment is perfectly safe, as it did with mortgage securities.

3) Further, existing regulators should wean financial companies off their reliance on the cheap overnight debt that they borrow from global markets to fund their investments.  … Regulators could require firms to put down greater cash cushions proportionate to this borrowing.

4) These rules would encourage the most important regulation of all: market discipline. Individual companies would still fail to meet their obligations, but they would not bring down the entire financial system in the process.

5) Instead of adding to Dodd’s 1,336-page bill, Washington should repeal the 2000 law that forbids existing regulators to set consistent rules for all derivatives instruments.

6) Then, Washington should tweak the bankruptcy code so that, for example, financial firms can go bankrupt without giving their creditors the right to pull their derivatives contracts, destabilizing the financial world.

7) We need politicians and regulators to implement simple rules that don’t require faith in omniscient, micro-managerial government planning.

Me: I would also add that there is a great need for financial transparency by Wall Street so markets can better judge their creditworthiness.

COMMENT

All this debate and no one really gets it. Stealing from one another has become an acceptable norm. How can I say this? The evidence is in how our society defines what it means to ‘steal’. Our lack of action to address the systemic thievery starting with the S&L crisis and moving through 3 decades is testimonial to our failure to punish white collar theft therefore we believe that white collar thievery is acceptable. Unless the perpetrator is armed with a deadly weapon our society cannot wrap its collective heads around what it means to steal from one another.

What is hilarious is by refusing to address these systemic white collar crimes we are in affect providing lunatic fringe radical groups to move away from theorizing about taking power into the realm of application demonstrated by arming themselves with deadly weapons.

Until we confront our inability to punish systemic white collar crime financial reform is meaningless.

It’s pathetic.

Posted by csodak | Report as abusive

Yup, America hates Big Anything

Mar 25, 2010 12:27 UTC

A new poll shows Americans hate Wall Street. Of course, bankers are never popular. But maybe never less so than right now. Yet polls also show Americans cynical about Big Anything — Big Money, Big Business, Big Government. As Sen. John McCain likes to say, the approval ratings of Congress are so low, its only supporters must be paid staffers and blood relatives.

That helps explains why the nation has not been flocking to government-created solutions such as the stimulus plan and healthcare reform. This isn’t a time when Americans are shifting from believing in markets to believing in government. It’s a time when the last remaining shred of faith in the country’s elite is quickly eroding.

COMMENT

I beg to differ, the US loves huge arsenals of weapons, nukes, oil, junk food, health care, extravaganza’s and last, but not least, its massive stock of flags.

Posted by Gandhiolfini | Report as abusive

Inside Dodd’s financial reform bill

Mar 15, 2010 16:35 UTC

A few thought on the Dodd bill:

1) The key to the consumer finance piece is how much influence regulators have in rule creation. Giving some final veto power to the systemic risk council with a two-third vote is a joke. Would never happen.

2) Does the bill end TBTF? Only if you believe regulators would actually wind down a big firm — or multiple firms. This is why some want to make banks smaller preemptively.

3) Do Democrats even want a bill? Senate Banking Chairman Chris Dodd does, though some Ds would love to use a stalemate as a way of portraying Rs as pro-Wall Street and campaign on it for the November midterms.

4) And what about Fannie & Freddie, housing policy, Fed policy — all keys aspects of true reform which the Dodd bill and the whole “financial reform” process ignore.

Liberals begin to drive financial reform agenda

Mar 12, 2010 15:50 UTC

This HuffPo piece backs up my analysis of how liberal activists are starting to drive the financial reform agenda:

“To be honest, a lot of us were surprised,” said one consumer advocate closely involved in financial reform efforts. “It seemed like a deal of some sort was imminent and on track.”

The advocate noted that Dodd’s decision was likely influenced by the outcry from progressives and other pro-reform groups who argued that Dodd, a Connecticut Democrat not seeking reelection this year, was giving Republicans and Wall Street-friendly Democrats too much sway over the legislation. Dodd’s original reform proposal in November had called for a strong, independent consumer-focused agency to protect borrowers from predatory lenders.

“At the end of the day, though, there is only so much that reform advocates were willing to give on this,” the advocate said. “And because of the context — what the banks did to the economy and the bailouts — reformers have a lot of high ground right now. Democrats just don’t benefit from teaming up with the banks and losing the interest groups.”

COMMENT

It says progressives, no liberals. They are not the same creature, duh.

Posted by Ken | Report as abusive
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