Market Discipline? What Market Discipline?

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.