Streetwise Professor

September 14, 2009

Don’t Get Your Hopes Up

Filed under: Derivatives,Economics,Financial crisis,Politics — The Professor @ 10:04 pm

On the anniversary of the Lehman collapse, Obama gave a speech on reforming the financial system.  Color me underwhelmed.

One solid idea is to create an enhanced resolution authority that would permit the rapid containment of big, systemically important banks.  I think Obama oversells the idea by saying that it eliminates the “too big to fail problem.”  Indeed, this portion of his speech is maddeningly short of detail.  He says the resolution authority he proposes will differ from the existing FDIC approach, but doesn’t say just how.  He said that “So our plan would put the cost of a firm’s failures on those who own its stock and loaned it money.”  Well, in the crisis, the shareholders of Lehman, AIG, WaMu, etc., were wiped out, and for a time, the shareholders of Citi and BofA and other big banks were nearly so.  Lehman bondholders also lost a great deal, but those of other big institutions that did (unlike Lehman) receive government support were spared for the most part.  Therefore, Obama has to be proposing that those who bought bank debt would suffer losses before any government support would be offered.  That would be desirable, but without more detail I don’t know whether this promise is credible.  After all, during the bailouts, Treasury and the Fed could have crammed down bondholders, but explicitly decided not to do so in many instances because it feared the knock-on effects of bondholder losses (e.g., the effects on money market funds, which could have resulted in runs).  So, is the resolution authority Obama speaks of really credible?

Obama also throws some red meat when he says “And if taxpayers ever have to step in again to prevent a second Great Depression, the financial industry will have to pay the taxpayer back — every cent.”

This is at best meaningless, and arguably actually dangerous for it still means that risk is socialized.  “The Industry” doesn’t make risk-taking decisions.  Individual firms and their managers do.  Sharing the risk among industry market participants still creates a moral hazard.  Although this seemingly tough language has gulled the predictably gullible, it will in fact hardly encourage risk taking discipline.  (“[E]very bank, every banker, every hedge fund manager — . . . a mini-regulator, the eyes and ears of the systemic-risk regulator”?  Get real.)  Why should any individual firm incur an effort/cost to monitor the activities of other financial firms except insofar as it can profit from that information?  Free rider problems are rife here.  Given such free rider problems, no firm has an incentive to be its brother’s keeper.

The top concrete proposal in the speech–a Consumer Financial Protection Agency–doesn’t strike me as addressing a first order problem.

Obama emphasizes increasing capital requirements on banks to control risk taking.  This is the Conventional Wisdom approach to preventing the next crisis.  Unfortunately, it is based on a misdiagnosis of the last crisis, and could in fact have the effect of creating the same dynamic that got us in the current situation.

The 90s and 00s were actually a period in which there was considerable effort devoted to crafting an elaborate set of capital requirements–the Basel I and Basel II rules.  Sadly, these very rules were a major contributor to the financial crisis, as the specific rules, notably the risk weights applied to investments in “AAA” securities encouraged large depository institutions to keep massive amounts of mortgage backed debt (in the form of asset backed securities, CDOs, and the like) on their books, rather than to distribute these securities to non-depository investors.  When the mortgage/real estate bubble burst, in stark contrast to the bursting of the internet bubble in 2000, systemically important financial institutions took huge losses that destabilized the entire financial system.

Moral of the story.  Just saying that you will have higher capital requirements is not enough.  The details really matter.  Actions that were considered the epitome of prudence pre-2007/2008 turned out to be anything but.  Indeed, (a) faulty capital requirements can provide a false sense of security, and (b) higher capital requirements can intensify the efforts to engineer efforts to circumvent them.

Obama sells his plan by saying “[a]nd taken together, we’re proposing the most ambitious overhaul of the financial regulatory system since the Great Depression.”  As I’ve said many times before, the greatest lesson of the Great Depression is that people learned the wrong lessons from the Great Depression.  In particular, most of the regulatory structures put in place in the 1930s were based on a misdiagnosis of the actual causes of the Great Depression.  Methinks that history is about to repeat itself.

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