James Pethokoukis

Cato’s Mark Calabria thinks the problem is not people but policy:

MIT Professor Simon Johnson recently argued that Bill Daley’s appointment as Obama’s Chief of Staff signals that “too big to fail”, as it relates to our largest financial institutions, is here to stay. Personally I never thought it was in doubt. With Geithner at Treasury and Dodd-Frank further codifiying “too big to fail”, its been clear for sometime that the bailout net is larger than its ever been, and is not being pulled back.

That said, Professor Johnson’s focus on Daley distracts from the real issue, which is changing our bank regulatory structure to end bailouts. The focus on Daley has the potential to lead us down that path of “if we just had the right people in government.” We shouldn’t be designing our regulatory structures with the “right” people in mind, but rather with the rule of law in mind. In fact one of the benefits of the Obama Administration is that it serves as a great test of the “right people” hypothesis of government. One is unlikely to see a more left-leaning White House than this one, so if this one gets captured by special interests, including Wall Street, than its a safe bet that any future Administration will as well.

Since I believe most of us actually want to end “too big to fail”, the real question is over how. It strikes me that we have three options: regulate the largest institutions to death (or competitive disadvantage), break them up, or credibly impose losses on their creditors. Ultimately I think the regulation approach is bound to fail, if for no other reason than regulatory capture. (Even Elizabeth Warren seems to get this: “Regulations, over time, fail. I want to see Congress focus more on a credible system for liquidating the banks that are considered too big to fail.”) The breaking them up might sound attractive in theory, but I have a hard time seeing how it truly works in practice. After all few in Washington viewed Bear Stearns as “too big to fail”. Accordingly I believe the best approach would be to force creditors to take losses, or be converted into equity. To make this credible, we must bind the hands of the regulators. As long as the Fed. Treasury or the FDIC can inject money, then bailouts are always on the table.

Sadly what the Daley appointment reminds us is that any attempt to end “too big to fail” will likely have to wait until the next Administration. Not only is this one wed to bailouts, the President would likely veto any bill that really tied the hands of the Fed.

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.

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.