The New York Times reports that Congress and the administration might soon reach some kind of view on legislation for addressing “too big to fail” institutions. Off the table is Paul Volker’s proposal to re-establish some line between commercial banking and proprietary trading – some updated Glass-Steagall demarcation. On the table is the Treasury’s proposal to designate various institutions as “too big to fail” in various degrees and subject them to greater capital requirements, limits on risk-taking, and in addition require a so-called “living will” that would make clear how to disentangle these institutions from others in a crisis. I think the “living will” idea is not a bad one on its own, as long as we all understand the limits of what it gets you.
Much, much more puzzling to me is this description in the Times, quoting Michael S. Barr, assistant Treasury secretary for financial institutions (italics added to show the quote):
The White House plan as outlined so far would already make it much more costly to be a large financial company whose failure would put the financial system and the economy at risk. It would force such institutions to hold more money in reserve and make it harder for them to borrow too heavily against their assets.
Setting up the equivalent of living wills for corporations, that plan would require that they come up with their own procedure to be disentangled in the event of a crisis, a plan that administration officials say ought to be made public in advance.
“These changes will impose market discipline on the largest and most interconnected companies,” said Michael S. Barr, assistant Treasury secretary for financial institutions. One of the biggest changes the plan would make, he said, is that instead of being controlled by creditors, the process is controlled by the government.
Some regulators and economists in recent weeks have suggested that the administration’s plan does not go far enough. They say that the government should consider breaking up the biggest banks and investment firms long before they fail, or at least impose strict limits on their trading activities — steps that the administration continues to reject.
The changes will “impose market discipline”? How? They all seem designed to make for better prudential regulation by government regulators – not a bad idea necessarily, in fact not a bad idea at all – but hardly market discipline. As the Times says Barr says, if there is a big problem, instead of “being controlled by creditors,” the process will be “controlled by the government.”
Which, again, might conceivably make sense, if one trusts that prudential regulation by the government will be superior to using private ordering via the creditors to eliminate moral hazard and re-impose the risks on market participants. Everything about the Treasury’s arrangement, however, seems instead to contemplate allowing key financial firms to take whatever risks they can affirmatively take, knowing that they are going to get bailed out – the regulatory scheme contemplates it – and depending upon front line regulation to stop them by management or perhaps micr0-management.
I understand the argument that the firms have to be left as unified financial firms across ordinary banking and proprietary trading, because there is no real way anymore to establish, let alone police, the line. I get that, although simply drawing a bright line even if it is somewhat arbitrary and somewhat inefficient is not necessarily a crazy way to address it.
What I do not understand is the idea that we have to allow these firms to commingle these activities in order that … what exactly? So that they can earn a better rate of return along with higher risks? But not such high risk and leverage that, day by day, the regulators won’t be able to stop them from getting in a big mess, while also managing to spot – and stop – the emergence of a new credit bubble? That’s a mighty big job – big and delicate at the same time.
Why shouldn’t we instead conclude the following?: The only levels of risk that regulators can really police are the ones that limit these institutions to the staid, limited return-limited risk models of ordinary commercial banking. Which is to say, regulation not by undertaking risk and leverage management on the front line, in the first instance, but first of all by activity and line of business. If the risks are harder to spot than that, then the regulators will have no methodological grounds for saying in specific cases where to draw lines on risk and leverage as the firms chase higher returns.
You can tell me (a) that regulators have a way to calibrate these risks with such Goldilocks certitude, not too hot but not too cold – okay, but haven’t we been down that road recently and not happily? Or you can tell me (b) that there is no way to establish the line Volker wants between these activities. I can understand those responses. Although I think (a) is flat-out wrong; regulators can’t calibrate a middle ground of risk and leverage, and it is therefore better to regulate by drawing activity lines. As to (b) – well, as I said, I think Volker’s line can be somewhat arbitrary and still work. If the argument, however, is that the financial institutions need these higher returns on higher risk to thrive and survive – well, that sounds awfully like we’re once again storing up tail-risk to the public at compounded rates. It will all go swimmingly well – until it doesn’t in a big way, and the public will pay massively once again.
Put another way, I don’t see a justification for creating a conglomerate firm – one which combines a government-guaranteed banking firm with a proprietary risk taking firm – unless the idea is that the higher risk trading profits will benefit the lower risk part of the firm, while the lower risk part of the firm will anchor the higher risk trading … how? What value does the lower risk part contribute – oh, I remember, a government guarantee. Why in principle couldn’t investors get the true economic value of each by buying shares of each? Isn’t the only real point of bundling these two firms together in a single holding company in order to tap the government guarantee for the entity as a conglomerate, implicitly in ordinary times and explicitly when the the tail-risk event occurs? If someone wants to explain to me what the additional value-added of creating this conglomerate is apart from the public subsidy, I am happy to be persuaded, but at this moment I can’t see what it is.
This Treasury proposal also assumes that shifting from creditors in bankruptcy to the government as regulator, but also bail-out party, will not have unintended consequences for the future of credit, when creditors realize that they are no longer controlling the process. Here’s one possibility that, I grant, I haven’t thought through and might be false: the government looks more attractive as a borrower as a consequence, because creditors at least know where they stand on that issue. I understand that the USG might want to shine as a borrower; is that good for the economy as a whole?
Again, I see a role for firm and rigorous prudential regulation and bank supervision, although I would prefer that it be a final step after having re-imposed the market discipline of failure, and then using regulatory ordering to deal with market failure that is left-over – something like Volker’s proposals or, for that matter, Sheila Bair’s views at FDIC that we need to get away from a too-big-to-fail concept in the first place. Neither of them is in the least bit opposed to strong bank regulation.
What I don’t see is how the policies described above are “market discipline” at all. It sounds to me like the words were just tossed in because that’s what you’re supposed to say.
LarryA says:
Right. The same government that’s a kazillion dollars in the hole. The same government that wrote the rules that financial institutions followed into the hole. The same government who mismanaged government “companies” so that they were the first ones to fold.
Why am I reminded of the circus clown car gag?.
October 26, 2009, 4:58 pmShelbyC says:
Well, the thing I don’t understand is, don’t politicians (and therefore regulators have more of an incentive to take risks for short term gains than managers? Isn’t that why bubbles pop in the last years of presidencies?
October 26, 2009, 5:03 pmTheBadness says:
The Treasury plan is throwing sand into the wrong gears, in my opinion.
Glass-Steagal was crude, in its way, but effective. Especially when combined with FDIC guarantees on deposits, and enforced transparency in the securities and commodities markets.
Instead, they’re just proposing to substitute Treasury for derivatives/lending counterparties as the primary rein on conglomerate banks. Because market transparency is so 20th century.
October 26, 2009, 5:32 pmtvk says:
Correct me if I am wrong, but my impression of the “market discipline” comment went like this: If we regulate the heck out of firms deemed “too big to fail,” then that is like taxing those firms at a higher rate or collecting insurance premiums from them in return for the government guarantee. If we make it costly enough (if government can somehow get the regulatory burden just right), then firms will calibrate their own size in order to balance out the cost of additional regulation. This is a bastardization of the word “market discipline,” but you can see where the idea comes from.
October 26, 2009, 5:44 pmPersonFromPorlock says:
“When I use a word,” Humpty Dumpty said, in rather a scornful tone, “it means just what I choose it to mean — neither more nor less.”
October 26, 2009, 6:00 pmMark N. says:
Somewhat more accurate phrasing might be something like: very large institutions, confident that they’re too big to fail, lack any market discipline, since they (correctly) feel that market pressures don’t apply to them. This proposal will substitute some other kind of discipline in the place of that missing market discipline.
October 26, 2009, 6:23 pmRelic says:
What “market forces” are large institutions immune from? Supply? Demand? Certainly not bankruptcy.
October 26, 2009, 6:55 pmSplunge says:
Ah yes, because we know that “regulators” are drawn from a species of superintelligent beings that sleep at the Earth’s core, in suspended animation, until Congress calls them forth from the vasty deep.
They are therefore, of course, not subject to the limitations of ordinary human intelligence that afflict people who merely have their pensions and salaries at stake, like the officers and shareholders of the corporation itself. So we can trust that those “regulators” will make far better decisions out of pure altruistic wisdom, and for no more reward than their GS-10 salary and a hearty well done! handshake from the Deputy Assistant Under Secretary of Commerce at the annual Christmas dinner, as opposed to the people whose livelihood and childrens’ college tuition is at stake, who from sheer blind piggish overreaching will knowingly destroy themselves, the corporation, and the entire national financial system if not otherwise prevented.
Right. Nothing like a little touch of magical thinking when faced with sticky problems. If we all clap our hands, Tinkerbell will live. It’s that simple! Believe!
October 26, 2009, 7:36 pmdrunkdriver says:
So government bureaucrats conclude that the problems were caused by private actors, not government; and that the solution is more government power.
October 26, 2009, 7:37 pmMark N. says:
Bankruptcy’s the one that quite a few large financial institutions seem to have been rendered immune from.
October 26, 2009, 7:59 pmAllan Walstad says:
LarryA, ShelbyC, PFP, Splunge–how cynical of you.
How appropriately, sanely, advisedly cynical.
October 26, 2009, 7:59 pmRelic says:
Mark N.: Like AIG? It doesn’t seem so much like they are “immune”. They go under just like everyone else. The only difference is that everyone else is allowed to go through bankruptcy proceedings, and the large firms get bailed out. That don’t sit right with me. Seems to me like the large firms should go through the bankruptcy proceedings. That’s just me, though.
October 26, 2009, 8:52 pmBenP says:
Bankruptcy certainly would be it. That’s the very concept of too big to fail.
The problem isn’t really that some banks by themselves are too big to fail, it’s that they’re so tightly interlinked that if one falls, it causes massive problems with all the others and the potential to create a cascade. If we had let AIG fall like Lehman, it would have taken Goldman Sachs with it, if Goldman had gone down a couple more trading houses would have had massive holes on their balance sheets, and in the space of a few days you’d see the potential for hundreds of billions if not trillions of deposits to more or less vanish, and all the attending financial chaos.
That’s the point of deeming something “too big to fail.”
I think it pushes the point a bit far to say that banks explicitly acted with this in mind, but they definitely acted in such a way that shows that bankruptcy simply wasn’t a concern. Massive leveraging and a focus on short term profits took precedence over having a solid foundation. d
You can always chase these behaviors back down a rabbit hole of unintended consequences of regulation if that’s what you want to do, but at some point you hit a proximate cause problem. There’s always some causation in responding to incentives, but some of the fault also lies with banks overleveraging and risk taking. (Like Lehman’s 30:1 leverage ratio).
That’s why Glass-Steagal really wasn’t all that bad as far as things go. It hit this problem pretty directly by forcing banks to choose between banks being commercial banks and trading banks, and thereby keeping any single entity from getting so far into each side that it collapsing could bring down both.
October 26, 2009, 8:56 pmvic says:
the one problem with free market capitalism is that the capitalist is not always a free marketer. The captalists innate desire is to become a monopoly capitalist.
therefore
the only truly legitimate role of the govt. in the markets is enforcement of antitrust. one of the consequence of which should be – that no entity should be too big to fail. The very fact that they were too big to fail is a failure of either antitrust laws or their enforcement.
therefore the only legitimate role of the govt. is to break up these finacial monopolies
October 26, 2009, 9:09 pmCareless says:
I don’t see how that follows. When you invest in AAA, you don’t expect it to be junk. They were stupid for thinking it was anything like AAA and the ratings agencies should have fired everyone involved with rating mortgage backed securities. They didn’t act like they were taking big risks because they didn’t think they were taking big risks.
edit: of course, a few of them did go bankrupt.
October 26, 2009, 9:25 pmAllan Walstad says:
Not necessary. Counterproductive. True monopolies are extremely rare on a free market. The largest and worst monopolies historically have been fostered, sponsored, or owned and operated by governments.
…is not a fact.
October 26, 2009, 9:33 pmSoronel Haetir says:
There is plenty of evidence that the rating agencies were under enormous pressure to label the junk as gold.
October 26, 2009, 10:16 pmI am amazed at how unscathed they have remained for the most part despite how susceptible to pressure they have demonstrated themselves. I’ve seen a few proposals that would shift the fees but I really don’t know that it would help.
vic says:
The largest and worst monopolies historically have been fostered, sponsored, or owned and operated by governments.
absolutely correct
October 26, 2009, 10:25 pmthe capitalist desirous of becoming a monopolist has necessariliy to co-opt the govt. in his quest by getting the govt. to change rules to allow the monopoly to occur– precisely why the govt.’s role should be restricted to preventing monopolies not aiding them.
BenP says:
That’s the investor side.
The trading house side is borrowing money to buy D, slicing it up so you can sell 1/3d of it as AAA, 1/3d as AA, and 1/3d as A, then selling bonds on the AAA and using the funds to rinse and repeat.
October 26, 2009, 10:30 pmAnon21 says:
Do these business types actually have these incentives, though? The whole point of the “socialize the risk, privatize the profits, and ignore the fact that it was the gamblers on Wall Street who got us into this mess” paradigm seems to be removing any incentive for these supposedly responsible officers and shareholders (I assume we’re talking major shareholders here, since small shareholders probably have little to no influence on firm governance) to get things right next time.
October 26, 2009, 10:49 pmCareless says:
I’ve never seen a proposal to shift fees that would really work. Branding (literally, on the forehead) the people who gave the crap AAA ratings and then firing them would be something I’d support, since the ratings agencies are “too insulated to fail”
October 26, 2009, 11:31 pmCareless says:
How the hell am I the only person Google has ever writing “too insulated to fail”? The people who run Moody’s should be hated at least as much as the random AIG executives!
October 26, 2009, 11:35 pmMatthew Bilinsky says:
Completely agreed on the ratings agencies. Moody’s lack of accountability in this crisis is obscene.
Can’t one of their executives get caught in a lurid sex scandal so that some righteous populist anger gets re-directed to them? Is that too much to ask for?
October 27, 2009, 3:17 amJames says:
Why don’t the simply reenable the Glass-Steagall barrier between Investment Banks and Traditional ones. (Give the existing banks 6mos – 1 years to separate them into 2 entities. Let the companies have the option to issue shares to the apropriate Spinoff’s to all of their share holders, etc)
October 27, 2009, 3:55 amKevin says:
How did Moody and other rating agencies avoid civil liability for their egregious errors? Similarly? the credit rating agencies?
October 27, 2009, 7:07 amZeno of Citium says:
I know it is like asking water not to be wet, but if the real underlying problem is the government subsidies and guarantees, then shouldn’t those be addressed? After all those are most certainly with the government’s control.
October 27, 2009, 8:22 amBenP says:
This may sound overly cynical and conspiratorial, but I suspect this is part and parcel of wall street’s influence.
the repeal of glass steagal allowed a lot of money to be made on both sides of the Aisle, and I suspect many of the big players would rather there be increased oversight and control of a few (and which they can assert influence in the rulemaking of) than the return of legislation that would hamstring everyone in the market.
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February 15, 2010, 1:00 am