Streetwise Professor

I’m ambivalent, at best, about Obama’s just announced a proposal–and remember, now it is just that–to hive off prop trading and private equity from financial institutions that issue insured deposits or have access to the Fed discount window.  On the one hand, it is to be welcomed that efforts are being undertaken to grapple with the too big to fail (TBTF) problem.  Moreover, although some have vented on the unconscionability of mandating the forced separation of proprietary trading activities from other bank functions, the multi-tasking and influence cost literatures both show that information/measurement problems can make it efficient to preclude agents/entities from engaging in some types of activities.  This means that you can’t rule out a priori the efficiency of the types of restrictions contemplated in the Volcker-Obama plan.

That said, I am dubious about the prospects for this endeavor–in the unlikely event that it is implemented–because it does not strike at the root of the TBTF problem.  Obama is putting his finger in one hole of the dike, maybe, but the intense pressure generated by the underlying sources of TBTF makes it inevitable that new holes will appear in short order.

TBTF stems from two, quite different sources.  The first is the government’s very credible commitment to make whole insured depositors.  The second is the government’s inability to make credible commitments NOT to intervene to bail out the uninsured creditors of large, interconnected financial institutions.

Obama focused on the first source of TBTF in his remarks. He said that he wanted to insure that financial institutions don’t benefit from taxpayer-insured deposits while making speculative investments.”  He also decried “bank[s] backed by the American people” operating hedge funds.

In all honesty, I don’t think that deposit insurance is the main, current culprit in TBTF.  (I’d also note that deposit insurance needn’t lead to too big to fail institutions.  As the S&L crisis showed, deposit insurance can allow the proliferation of many small, high flying operations that individually are trivial in size, but which collectively can impose huge costs on the government.)

No, I think that the real source of TBTF that we face today is the second one: the widespread expectation that the government will intervene to protect uninsured creditors of huge financial institutions.  The government can’t tie itself to the mast, and say: we will not bail you out.  At least, no government has shown the ability to do so.  Knowing this, people are quite willing to lend money at low rates that do not reflect total risks to financial behemoths, because they are convinced that the taxpayers, not they, will bear the downside risk.  Note that during the crisis, a trivial fraction of bailout funds were devoted to protecting insured depositors.  Moreover, the institutions that received support directly or indirectly didn’t issue insured deposits, and weren’t eligible to borrow from the discount window.

I don’t think that the Volcker-Obama proposal does anything to address that big, looming problem.   TBTF exists because risk taking by large institutions is subsidized.  Yes, prop trading or running a hedge fund is one way to take on risk, but there are many other ways to do that too.  If there is a subsidy to take on risk if you are big enough, and one way to take on risk is foreclosed, there are myriad other ways to get your hands on the subsidy by taking on risky assets, using risky capital structures, etc.  Historically, banks have gotten into trouble the old fashioned way, by making highly risky loans.  It’s like trying to fight substance abuse by banning beer, but letting people buy scotch, or do meth.

Moreover, there are ways to restructure firms to escape the constraint that the V-O plan would impose.   Volcker is well-known to be nostalgic for Glass-Steagall, and this appears to be an attempt to implement a modified version of that.  Let’s say it works that way, and we’re in a back-to-the-future world with deposit-funded commercial banks that don’t do prop trading, and big investment banks that don’t issue insured deposits and don’t have access to the discount window, but can grow big funded by lenders confident that Uncle Sugar will save them in a pinch, and who do prop trading.   The fundamental problem would still exist.  As long as funders were convinced that the government would protect them if a big investment bank ran into trouble due to a prop trading blowup, the new IBs would have the incentive and ability to grow too big to take advantage of that subsidy.  Some firms would restructure to escape the limits, or new firms designed to avoid the constraint would form/grow.

Indeed, it’s quite possible that the restrictions could make things worse, by lulling Congress, regulators, and the public into the belief that the TBTF problem had been fixed.

In sum, the Volcker-Obama plan is fundamentally flawed, in my view, because it does not price the crucial risk at issue: the risks that TBTF institutions create would still be unpriced if the plan were implemented.  The plan, at best, just raises barriers to some ways of taking on risk, but there are so many close substitutes that that doesn’t help much at all.  The basic problem is the huge gravitational pull exerted by the government’s inability to commit credibly not to bail out the creditors of big, interconnected firms.  This means that the relevant risk is underpriced.

The Volcker-Obama plan is also odd, because it seems to pretend that the world ends at the borders of the US.  The likely result is to be a shifting around of activity among regulatory jurisdictions, with little overall impact on the total amount of risk in the system, or the composition of that risk.  Given the interconnectedness of the global financial system, this means that the effects of the change will be small, even on the US.

I am also somewhat skeptical of the plan because it is less of a policy proposal that could be seriously expected to address a major problem, than a transparent populist pivot rolled out precipitously in a desperate attempt to stem Obama’s political implosion post-Massachusetts.  The last thing we need right now is more economic and political uncertainty, and this proposal cranks up the uncertainty quite a bit.  Markets around the world fell pretty hard on the news, and the standard gauges of risk, like the VIX volatility index, spiked.  Given that the dismal employment news is attributable in part–and likely, in large part–to policy and economic uncertainty, this is unwelcome news.  Ironically, this means that a measure intended in part to secure a short-term political benefit actually undermines Obama politically over the longer term, because populist boob bait won’t do squat for his fortunes if the employment picture remains bleak.