Monday, April 19, 2010

Why We Can't, and Shouldn't, Eliminate Bailout Guarantees

. Monday, April 19, 2010

Remember when I said the proposed $50bn wind-up fund for failing financial institutions was a bad idea? Well, apparently the Obama administration agrees. Kind of.

In a move aimed at jump-starting bipartisan negotiations on Wall Street reform, Obama administration officials have signaled that they want Democratic Sen. Christopher Dodd to remove a $50 billion bank liquidation fund from his financial regulation bill.

Republicans have pounced on the $50 billion provision, saying the legislation will lead to more government bailouts of large banks, effectively stalling progress on the bill.

"The ex-ante fund was not in our original proposal we announced almost a year ago, and we don't feel it is an essential part of final legislation," said one administration official late Friday. "The president will only sign a bill if it passes the test of putting an end to bailouts."

Democratic officials suggested the move is really an attempt to challenge Republicans on whether they will still oppose the reform bill even after the controversial provision is removed. That would play into the White House's efforts to portray the GOP as defenders of the status quo on Wall Street.

To me this move makes little sense if the plan is to force the GOP into a corner. At this point I think it's clear that they'll oppose anything that Obama supports as a matter of principal. In fact, it may be the GOP's only organizing principal right now. And despite denials from Democrats, the GOP actually is right that this rainy-day fund amounts to a bailout guarantee for TBTF institutions.

So dropping the fund makes sense as a matter of policy, and maybe politics too (although I can't imagine how an obscure provision of an arcane bill could possibly effect the midterms). But it also signals that the Obama administration doesn't have the stomach to enact the type of strict regulatory reform that many have called for. The cynical take on this is that the Obama administration, as well as legislators in Congress, have been effectively lobbied by industry groups. This may be true, since Democrats receive more contributions from the financial sector than Republicans (although that might be changing). A more charitable take is that it isn't clear what regulatory changes would have prevented the last financial crisis, and it's even less clear what is needed to prevent the next one. Exchange-traded derivatives? Higher capital requirements? Stricter leverage ratios? None of those on their own would have done much to stop the last crisis. Not only that, but I have not yet seen a convincing discussion describing what combination of those in what doses would actually improve system stability, and if enacted unilaterally they could actually destabilize the U.S. financial system by making it uncompetitive in globalized markets.

The Obama administration seems focused on eliminating bailout guarantees above all else. This is not only impossible, it is also unwise. At some point in the future some financial institutions will become illiquid. If the government makes a credible commitment to not provide funds to those distressed institutions, then the first sign of trouble will touch off a run on those firms. Bank runs are contagious, so even if only a single firm is affected initially, the trouble could sink the whole system. It's much better for the government to instill confidence in the system by guaranteeing that they will support illiquid firms than to guarantee that they won't.

Of course, the government also needs to be able to close insolvent firms in an orderly fashion, but the FDIC has done a pretty good job of that in this crisis, except for the botched liquidation of Lehman. Giving the FDIC more resources and broader authority is a good idea.

It's been a recurring theme of mine for nearly two years now that major financial regulatory reform is unlikely, and that this may even be a good thing: overhauling the system could possibly do more harm than good, especially when it's carried about by legislators with torches and pitchforks. I see no reason to change that tune now.

At the same time, there clearly needs to be more transparency in the system. If I were an advisor to the Obama administration I'd focus on shining light on the "shadow banking system", making the ratings agencies and internal risk assessments of financial firms more open, and forcing liabilities from SIVs onto balance sheets (and vigorously prosecuting firms that violate this rule). That sort of thing. This type of reform isn't likely to make headlines, but I think it can have the biggest effect on making the system more stable.


Anonymous said...

i'm confused: if you think that it is inevitable that a big bank will fail in the future and that the government will have to bail it out, then why do you think its a bad policy idea to pass a bill with a $5 wind-up fund?

Kindred Winecoff said...

Click through the link at the top. The argument is that since the funds will be used to make counterparties whole, TBTF institutions that pay the tax to create the fund have de facto insurance on their obligations. This, then, will lower their borrowing costs and actually increase the moral hazard trade.

Thomas Oatley said...

I'm with anonymous on this one. You have me thoroughly confused.

I have a hard time understanding why you think the moral hazard generated by the insurance fund is greater than the moral hazard that exists in a world in which you know the government will bail you out.

I also don't understand how this proposal differs from the FDIC which is insurance for one counterparty of one particular financial institution paid for by private rather than public sector. So, do you argue we ought get rid of that too?

Kindred Winecoff said...

I didn't say the hazard was bigger than without the fund. But the one thing the fund does not do is minimize or eliminate hazard. If anything, it exacerbates it: WaMu, Lehman, Bear Stearns, Merrill Lynch, etc. didn't get bailouts before. They'd be guaranteed to the next time.

But that's not really my problem with it. My problem with it is that only firms who pay into the fund get the protection, and only firms that are super-large pay into the fund. In other words, it's the opposite of how the FDIC works. If you're concerned at all about a "moral hazard trade" that encourages big firms to get bigger by taking on more risk, then this is the wrong way to go about fixing it.

No, of course we shouldn't get rid of the FDIC. We should expand it, as I've said more than once. But the insurance fund isn't like the FDIC: it only covers the counterparties of TBTF firms, not all firms. That gives TBTF firms an advantage over their competitors and an incentive to get even bigger.

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Why We Can't, and Shouldn't, Eliminate Bailout Guarantees
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