Streetwise Professor

May 3, 2010

Rules vs. Discretion

Filed under: Derivatives,Economics,Financial crisis,Politics — The Professor @ 6:36 pm

The debate over “rules vs. discretion” was a centerpiece of disputes over monetary policy during the 1960s-1980s.  One of the most important contributions to this debate was by John Taylor, who devised an eponymous rule for monetary policy.  A rule that Greenspan and Bernanke flouted, and in so doing, contributed mightily to the financial crisis.

Taylor has an article about rules vs. discretion in today’s WSJ.  It is not about monetary policy, but rules vs. discretion in the resolution of large financial institutions that have failed, or are teetering on the brink of failure.   Taylor comes down firmly on the side of rules:

You do not prevent bailouts by giving the government more power to intervene in a discretionary manner. You prevent bailouts by requiring adequate capital based on simple, enforceable rules and by making it possible for failing firms to go through bankruptcy without causing disruption to the financial system and the economy.

Taylor’s argument is that the capriciousness of a system that gives regulators tremendous discretion gives rise to destabilizing uncertainty.  A rule-based system is more predictable, and more stable.

I too have argued for limiting discretion, though on somewhat different grounds.  My concern is that discretion, especially when there is a possibility that that discretion can be used to commit government funds (or even funds eventually contributed by other financial firms) in order to bail out creditors creates moral hazard.  Political economy considerations will almost certainly favor bail outs; concentrated, politically connected creditors will exert greater influence than diffuse taxpayers.  The prospect for bailouts reduces the cost of credit, which encourages excessive leverage, excessive risk taking, and  insufficient monitoring.  Which, in turn, makes failure more likely.

Although Taylor’s argument and mine on discretion are different, they are complementary.  I have not seen an even mildly persuasive argument in favor of discretion.  Thus, whereas the Chapter 11F bankruptcy option that Taylor advocates (as does George Schultz, one of the only US Treasury Secretaries I wouldn’t swap for Kudrin) is languishing, the discretion-heavy Dodd bill advances apace.

Print Friendly, PDF & Email


  1. As the great Economics of Contempt ( ) said today on Twitter:

    “For the record, this mythical “Chapter 11F” bankruptcy that John Taylor talks about in his WSJ op-ed is beyond laughable – It’s entirely theoretical. There’s no legislative language, nor could there ever be, because the idea completely misunderstands how bankruptcy law works. The only substantive aspect that Taylor mentions is netting of repos and derivatives — which the bankruptcy code already includes, via the safe harbor! Bankruptcy courts are too slow because creditors have much greater rights under the bankruptcy code. FDIC resolution is fast because creditors have few rights there. Bankruptcy judges have to respect creditors’ rights under the code, which requires time-consuming processes. The FDIC can basically tell creditors: “This is what you’re getting. If you don’t like it, you can go f*** yourself. Dismissed.””

    Which is a very good point – what about the “destabilizing uncertainty” of time? Bankruptcy proceedings will invariably be longer than regulator-administered resolution. Taylor’s proposal would only serve to extend the process to uncertain lengths, and if we’re talking a run on the global financial system where time is of the essence it could very well be that a quick and dirty resolution is better than a protracted one.

    And, regarding your moral hazard argument, TED makes a great case against statutory specificity and in favor of regulatory discretion
    ( ) pointing out how your beloved certainty will only lead to gaming by the company’s lawyers before it fails.

    “I do not want legions of investors, lenders, and counterparties, much less financial institutions themselves, structuring their way around highly specific laws and procedures to evade the prophylactic and remedial powers of a resolution authority. And, whether she knows it or not, neither does Ms. Smith. The lawyers who work in and for my industry are just too good, and their job is to protect and advance the interests of their employers, the financial institutions, not the regulators, the government, or the taxpayers. For regulatory purposes, we must view them as the enemy. And if there is one universal rule of combat, Dear Readers, it’s that you don’t share your detailed battle plans with the enemy… Because markets evolve quickly, and because the nature of each financial crisis appears to be different enough from its predecessors to make detailed planning in advance fruitless, the legislation authorizing a resolution authority should not attempt to catalogue in exhaustive detail the tools, procedures, and conditions under which said authority should operate.”

    Comment by gcoaster — May 3, 2010 @ 9:46 pm

  2. The issue at hand isn’t necessarily whether the courts or the regulators handle the resolution of insolvent financial institutions. The primary goal must be the establishment of some set of rules that will allow lenders to establish a reasonable liquidation value of creditor assets in the case of insolvency. Absent an ability to reasonably estimate the recovery for lenders in the case of insolvency, there can be no risk – return calculation which would allow lenders to reasonable price the risk involved with the transaction. The inability to predict, with some degree of certainty, just how insolvent institutions will be treated will require investors to price that uncertainty into the price of capital and will needlessly burden the capital allocation system with inefficiencies.

    Allowing political institutions to make economic decisions inevitably leads to solutions based on political considerations, not solutions based on economic considerations. Allowing politicians to pick economic winners and losers, based upon discretion given to them under “reform” legislation, is inherently bad public policy. Before we even consider giving regulatory institutions a greater power, we need to first reform our regulatory institutions. The nature of the recent financial crisis certainly wasn’t different enough from its predecessors to make detailed planning in advance fruitless. A major problem during the recent train wreck on Wall Street wasn’t that regulators didn’t have enough discretionary and arbitrary powers. The problem was that the regulators weren’t doing their jobs effectively.

    Reform the regulatory structure first, then discuss what additional powers the regulators do or do not need.

    Comment by Charles — May 4, 2010 @ 1:04 pm

  3. Charles,

    In fact the major problem WAS whether the Fed/Treasury had the authority to resolve AIG and this open question was the impetus that caused these provisions to be drafted… it is much more important to prevent the catastrophic failure and subsequent knock-on effects of a systemically, too-big/interconnected-to-fail institution than making funding a bit cheaper for an institution already receiving a TBTF subsidy (implicit guarantee).

    And I must ask – When will a regulator ever be reformed enough to take on additional responsibility? What benchmark would you use to guide you on making that decision? And aren’t you putting the cart before the horse by reforming within the current framework and then expanding the framework rendering those reforms either inadequate or ill-suited?

    Comment by gcoaster — May 4, 2010 @ 2:22 pm

  4. “When will a regulator ever be reformed enough to take on additional responsibility? What benchmark would you use to guide you on making that decision? And aren’t you putting the cart before the horse by reforming within the current framework and then expanding the framework rendering those reforms either inadequate or ill-suited?”

    Giving incompetent regulators additional powers will do nothing to reform our financial system. Everywhere we look, regulatory failures were at the heart of the problem – With Madoff, he went 40 years reporting fictitious trades, sometimes with reported greater than actually traded and with reported prices outside the daily range, yet no auditor ever picked up on that. The IG report on Stanford demonstrated that the SEC enforcement system is set up to go for a body count by concentrating enforcement efforts on small, less wealthy individuals and allowing wealthy and powerful individuals to continue with their unlawful activities. With the recent financial crisis in generally, we showed we have no adequate method of measuring balance sheet risk or determining whether any financial institution actually has sufficient capital to support their balance sheet activities.

    We need to look at the failures of FINRA, the SEC, Dept of Treasury and other oversight/ regulatory bodies and how their failures allowed conditions that allowed the financial crisis to exist. I have yet to see any comprehensive report of failures of the SEC, FINRA, Dept of Treasury or the Federal Reserve to see how we can do what we are currently doing any better. If we don’t have the proper rules in place to measure and disclose risk, what good is giving incompetent regulators additional discretionary powers? What good is it going to do to give people like Maxine Waters additional influence with respect to funneling TARP money to cronies and to institutions such as Bank OneUnited? Why are we even considering giving political interests additional discretion to allow political considerations to influence economic matters? That answer is simple – because the goal here isn’t to protect the taxpayers. Rather, the goal here is to consolidate additional power in the hands of political appointees and to increase the power of political interests.

    In time, once political considerations pass into history, we will begin to understand the true facts behind the AIG bailout. Had the Government simply guaranteed AIG contracts, there would have arguably been much less disintermediation than there was by Timmy and the seven dwarfs pumping billions of taxpayer dollars to preserve the interests of various friends and, eventually, getting around to addressing the interests of the great unwashed masses (the taxpayers who had to foot the bill).

    The argument that the world financial system would unquestionably collapse if the individuals who largely caused the recent financial crisis were not kept in the exact positions they were in while creating the conditions that lead to the financial collapse is one I can’t believe the American people actually fell for. Bailing out the banks and then paying bonus payments to retain employees, in my mind, showed just how corrupt the system is. Most Wall Street employees are overpaid human potted plants (yes, I worked on Wall Street and yes, I still have many friends working on Wall Street). Assuming that new blood, new ethics and new leadership would cause irreparable harm to the global financial system is absurd. Bailing out failed institutions is one thing. Bailing out incompetent cronies you went to Princeton, Harvard, Yale or wherever with is another.

    So at the end of the day, failed regulators are still regulating. Failed executives are still in management positions. Failed policy officials are still comfortably protected. The thing these individuals want to do is protect their own interests, not protect the interests of the great unwashed masses (after all, the great unwashed masses have no choice in the matter – they have to pay regardless of whether “reform” efforts work or not). The solution of legislators is to place more powers in the hands of bureaucrats and to ensure that, when the next financial crisis hits, political considerations will decide the economic winners and losers. Now, does that solution REALLY make you sleep better at night?

    Chris Dodd has some cajones claiming to stand for financial reform when he fails to honestly disclose his ties to Countrywide. Blanche Lincoln fails do demonstrate any understanding of the history of financial markets. The “reforms” these two clowns are promoting will do nothing to address the root causes of the latest financial crisis. Again, will the passage of Dodd-Lincoln REALLY make you sleep better at night?

    Comment by Charles — May 4, 2010 @ 3:01 pm

  5. Charles – you haven’t answered my questions.

    When will you know if regulators are competent enough to have earned the extra discretion? What will you be looking at?

    You really, really dislike the regulators – I get it. Anyone would acknowledge there have been many lapses in regulators’ judgment. But you are not offering a solution, you’re only offering your complaints. We’ve got enough of those.

    PS – what makes you think that the Treasury/Fed had the discretion to guarantee AIG’s contracts?

    Comment by gcoaster — May 4, 2010 @ 4:02 pm

  6. “When will you know if regulators are competent enough to have earned the extra discretion? What will you be looking at?”

    We will never know with certainty that regulators in place are worthy of the responsibilities with which they are entrusted. My point is not to keep every commercial on the ground until we are certain it will not crash or to keep the police in the station house until we are certain they will arrest every individual committing an infraction of the law. My point is that we have evidence that a large part of the problem lies in the regulatory structure and, instead or addressing that weakness, we choose to “strengthen” the controls over of financial system by giving unquestionably incompetent individuals greater responsibilities. That, to me, borders on insanity.

    FINRA is a failed institution that not only didn’t detect that Madoff was reporting sham trades for 40 years, to this day FINRA has failed to hold any individual connected with eth Stanford debacle accountable. In fact, the Chief Compliance Office of two firms shut down by the SEC in connection with the Stanford affair is today not only still in the financial industry, he is teaching other compliance offices in eth industry his “tricks of the trade” used while he was at Stanford. This, with FINRA’s full knowledge and consent!

    Mary Schapiro, the individual who established the failed enforcement strcture at FINRA, is not establishing a similar structure at the SEC. This, in spite of the fact that the SEC enforcement mandate is to place a greater priority on enforcement actions against small players lacking the financial ability to actively defend themselves while leaving wealthy wrongdoers alone. What about THAT enforcement structure doesn’t scream for reform? Has Congress demand such reforms – of course not!

    Has Congress mandated ANY reforms with respect to the way the SEC or FINRA discharge their responsibilities? OF COURSE NOT! With respect to Lehman, there were CLEAR lapses in reporting of the true risk of their balance sheet, any I’m not simply referring to the Repo 105 transactions. If the aim of financial reform is to better control financial risks and protect those financial risks from endangering our financial system, shouldn’t Congress address the problem that, leading up to the recent financial crisis, we CLEARLY failed to measure and disclose risks on eth balance sheets of financial institutions. What in Dodd- Lincoln to you interpret to address this fundamental weakness in our system? Simply allowing regulators greater authority to oversee financial risks they are unable to measure in eth first place does NOTHING to reform our financial system.

    What are we doing to better train regulators? What are we doing to ensure continuing education for our financial regulators? Nothing and nothing. I have long said that the financial regulators need to adopt an attitude more like FAA regulators. When an aircraft crashes, a highly trained team of forensic investigators conducts a through investigation, determine causes, suggest reforms and then those reforms are largely enacted. Why can’t a similar system be created for the financial industry? When two pilots overflew the Minneapolis airport, it cost them their careers. No one was injured, no one was arguable placed in any real danger. Yet, regulators made sure those individuals were held accountable. In the entire financial debacle that we witnessed, for the most part, the regulators have failed to do anything to hold anyone accountable.

    And, as for the Fed/ Treasury and AIG, the Government unquestionably has the authority to guarantee the debt of any regulated financial institution should they deem such action necessary to maintain the stability of the financial system.

    Finally, for the record, I most certainly do not dislike financial regulators. Rather, I believe they badly need to be reformed and their incompetence has costs taxpayers and investors trillions.

    Comment by Charles — May 4, 2010 @ 5:02 pm

  7. @gcoaster. EOC is high variance. So is TED. The point about the relative skill and incentives of the financial institutions’ lawyers cuts the other way, IMO. They will be able to use their skills, and leverage political influence, when dealing with any regulator in a crisis situation. And likely with greater effect than when dealing with a judge, esp. an experienced one, in an adversarial situation when other affected parties with their own smart lawyers are arrayed against the failing/failed institution’s lawyers.

    Simple example. In December, 1988 when the FSLIC was forced to resolve several large failed thrifts, but Congress didn’t provide funding, it extemporized. And GS12s sat down across the table from dealmakers and lawyers working for Ronald Perlman and the Bass Brothers, etc. Guess who was taken to the cleaners?

    Again, you’re dreaming if you think that the FDIC will be Horatius at the Gate if a large institution goes down fending off the intense political pressure, much of it coming from Congress and executive branch departments with much more power (e.g., Treasury). The political pressure on it will be intense, and however good it might be at resolving the Backwoods Bank, that is completely irrelevant when dealing with the failure of a systemically important institution.

    And it is a red herring to state that a modified bankruptcy type mechanism will “catalogue in exhaustive detail the tools, procedures, and conditions under which said authority should operate.” There are rules of procedure, and principles (eg fraudulent conveyance, priority) that constrain the kinds of actions that can be taken, but there is not a detailed prescriptive cookbook. It is certainly not completely predictable–litigation never is–but it is more predictable than an ad hoc politicized process.

    At the end of the day, what is the issue? To reduce moral hazard in the system so that whatever resolution mechanism in place is less likely to have to be employed. Doing that requires reducing the likelihood that creditors will receive a bailout, whether that comes from taxpayers, or from other financial institutions. A bankruptcy-style process offers a much better chance–better, not absolute–of avoiding that outcome.

    I actually think, reading your comments, that we agree generally on the centrality of reducing moral hazard. We seem to differ mainly on what institutional mechanism is most likely to achieve that outcome. Given the political economy of the situation, in my view the more discretion, the less likely that is to happen.

    The ProfessorComment by The Professor — May 4, 2010 @ 7:14 pm

  8. Professor,

    Admittedly the FSLIC was before my time and is outside my knowledge base, but the FDIC very experienced with dealing with resolving financial institutions (especially these days), probably more so than any bankruptcy judge (who deals with all sorts of institutions), so I don’t know why you’re so down on the FDIC. Also, it would be a different situation under the Dodd-Lincoln frankenstein because you’d have the pre-paid resolution fund and not have to look to Congress to pony up some funds.

    Are the interests of creditors in a bankruptcy of a TBTF firm really so directly adversarial? We haven’t seen GM get together with Ford, Toyota, et al to bail out Mopar. But we have seen Wall Street get together to bail out LTCM and others. Finance seems different to me.

    If the next crises is serious enough that the FDIC could be manipulated into less optimal outcomes, its likely so could Congress, and legislation would be passed and we’d end up with another TARP. It is hard for me to think of a situation where the FDIC would no longer play Horatius at the Gate and Congress wouldn’t.

    Bankruptcy might be more predictable, but it is undoubtedly slower (and to what extent it is slower is in fact unpredictable). The ability of regulators to take prompt, corrective action was a major issue during the crisis and it strains credulity to say that if only AIG would’ve been put into bankruptcy like Lehman things would have been better.

    If you want to decrease the possibility of creditors receiving a bailout, why not avoid getting into a failing situation in the first place – make funding more expensive because of the regulatory uncertainty. Less leverage –> less risk –> lower chance of catastrophic failure. This seems like much more of a direct mechanism of discouraging a moral hazard. That’s my thinking anyway.

    So, yes, we do agree that moral hazard needs to be reduced. However, I just believe that if the political economy puts pressure on the FDIC we will see it other places as well (Congress). So as a preventative I would prefer to inject uncertainty before the fact, making funding more expensive, reducing risk taking overall. To my (less experienced, perhaps slightly idealistic) eyes, your mechanism doesn’t do that as well.

    Comment by gcoaster — May 5, 2010 @ 12:36 pm

  9. Thanks for making me feel old, gcoaster. I’ll get you for that 🙂 (I was a mere child when I was involved in the aftermath of the December ’88 deals:) If you’re interested, you can find in most university libraries the book that I and three colleagues, two passed away, sadly, wrote dissecting the FSLIC failure. It was an eye opening experience for me, and one that extinguished any idealism I had about regulators. I have not received any contradictory signals in the subsequent 21 years, despite extensive contact with, and thorough study of, regulators and regulatory agencies.

    You make it sound like the slowness of bankruptcy is a bug, not a feature. I think it’s a feature. A controlled, slower process is intended to preserve value, prevent fire sales, etc. It can work for financial firms too. And it has in some cases. I suggest you read a piece Jean Helwege wrote in Regulation last year where she talks about this issue.

    I can understand your concern about a judge picked by lot handling this. But it would be straightforward to create special masters, or designate particular judges to handle these kinds of cases. You could have the financial analog of FISA judges for intelligence/national security cases.

    I definitely do not think that, in the breach, Congress would play Horatius. Far from it. That’s why I want legal procedure in place that insulates to the greatest extent possible the resolution process from political influence by limiting regulatory discretion, Congressional discretion, and the ability of Congress to pressure regulators to exercise their discretion. I don’t want the FDIC making sh*t up as it goes. Nor do I want Congress or the Fed or the Treasury doing that. Discretionary political authority will be unduly susceptible to political pressure from creditors. An established, rule-based procedure overseen by the least politically responsive branch reduces the likelihood that a bailout will occur. In particular, such a mechanism would be walled off from any funding mechanism, whereas the Dodd bill gives FDIC the access to the Treasury, and gives the Treasury the power to make guarantees. There are measures in these bills intended to limit their use in bailouts, but they can be circumvented far more readily than a court process could.

    I can’t take you too seriously if you believe that regulatory uncertainty is going to be the best way to constrain leverage and the concommitant moral hazard; slightly idealistic doesn’t quite cover it. The main sources of uncertainty are the size and probability of a bailout. The best answer to prevent moral hazard is “0” and “0”. Any deviation from that will subsidize creditors. Regulatory discretion makes it highly likely that ex post there will be bailouts, and they will be of a significant amount. That is, the uncertainty is pretty one sided, and in a way that encourages moral hazard. Creditors are still long an option. It won’t be in the money 100 pct of the time (e.g., Lehman) but it won’t be out of the money 100 pct of the time either (e.g., pretty much everybody else). That option subsidizes credit. (I would argue that the fallout from Lehman, rightly or wrongly, will convince those in the future that a bailout is the way to go.)

    The ProfessorComment by The Professor — May 6, 2010 @ 6:47 pm

RSS feed for comments on this post. TrackBack URI

Leave a comment

Powered by WordPress