A proposal to prevent wholesale financial failure

FT ^ | 01/29/09 | Lasse Pedersen and Nouriel Roubini

[TigerLikesRooster]

A proposal to prevent wholesale financial failure

By Lasse Pedersen and Nouriel Roubini

Published: January 29 2009 19:35 | Last updated: January 29 2009 19:35

The worst financial crisis since the Great Depression has highlighted the risks from the collapse of systemically important financial institutions. Huge bail-outs were undertaken based on a fear that the collapse of such institutions would cause havoc, with collateral damage to the real economy. Examples include Bear Stearns, Fannie, Freddie, AIG, Citi­group, the insurance of money market funds and new US Federal Reserve programmes for banks and broker-dealers. Allowing Lehman Brothers to collapse had such severe systemic effects that the global financial system went into cardiac arrest and is still dealing with the aftermath.

We propose a way to measure and limit this systemic risk and reduce the moral hazard and the cost of bail-outs. Our proposal is to impose a new systemic capital requirement and systemic insurance programme.

The current situation leaves the system vulnerable to financial contagion when big banks (or many small ones) go bust. The root of the problem is that banks have little incentive to take into account the costs they impose on the wider economy if their failure prompts a systemic liquidity spiral. This is akin to when a company pollutes as part of its production without incurring the full costs of this pollution. To prevent this, pollution is regulated and taxed.

[TigerLikesRooster]

Is banking industry to be treated like utility sector(water, electricity?)

[TigerLikesRooster]

Ping!

[Gaffer]

Is it any wonder that the world is cringing at the seeming onslaught of financial disaster? Presidente’-for-life Idi Obama preaches daily that it will take years (decades) to recover, if and only if, we commit all of other peoples money to his plan. He is planning a wholesale redistribution of the wealth in this country to consolidate his reign. He will rule over a country in shambles because he isn’t equipped to actually make things better - only complain, promise and blame.

[Woebama]

How does the Federal Reserve float through financial catastrophe after financial catastrophe, and the public focuses on the politicians and the businessmen as the root cause of the failure?

[JasonC]

The reason you can't treat banking externalities like pollution and discourage it through taxation and deliberately pettifogging regulation is you actually care how much capital is attracted to the banking industry. It is, indeed, the very figure you are allegedly attempting to increase. Pollution regulation is not designed to attract more capital to the heaviest polluting sectors.

Banks have massive positive externalities on the whole. As usual, the braintrust of finance haters wants to force them to pay for any negative one, even when heavily caused by other actors as well, while treating the capture of all of their positive externalities as the rest of the world's birthright. The US finance sector pays the government $400 billion a year in taxes, but if it every needs any help or services in return, this is presented as horrible and unjust.

Why? Envy, resentment, populist blame games, pretty much.

You want banks to be more adequately capitalized. Great. Now, ask what attracts capital to banking. Lower risk might, but higher costs and lower returns do not. It is not like the returns to banks are so awesome that you can require double the capital with lower gross returns spread over it. If you do, guess what? Capital will flee the banking sector, no one will lend to them at reasonable terms, above all no one will be willing to provide them their equity risk capital. So, guess what? You get to. The authorities, the taxpayers.

If the whole point of the exercise is that you want a functioning banking system *without* massive government capital being required to let it function, then the only way to get it, is to make the terms of return and risk for capital employed in finance *more* attractive, not less. You cannot fix a problem of no one wanting to risk a dime as a banker, by loading down bankers with brickbats and scorn and the heaviest requirements you can dream up.

This isn't hard to figure out, people. If a society *consumes* its banking capital in an orgy of deadbeat behavior, whether due to stupid risks run or any other way, then it either replaces that capital and restores all the losses it inflicted, or it goes straight to hell.

Worrying about incentives to behave more cautiously when the whole problem is that men are so shellshocked at 13 figure losses they won't take the slightest risk, is missing the point hopelessly. Don't worry. Epic losses have already provided all the incentive to scale back risk taking the market could possibly require. So much so, that the world economy is in reverse and final demand is in the toilet.

The only way to *economically* justify double the capital at major banks is to double the profits of major banks. Capital *is* the projection of future profits, discounted to the present. Anyone see the pols bending over backwards trying to accomplish that? The only other way is to reduce the rate of discount, but capital flows competitively to higher returns. If you try to deliberately peg the rate of return on banking capital well below what the market bears elsewhere, again, the capital allocated to banking will shrink, not grow.

The crisis doesn't end until bank stock goes *up*. Not to zero. Not, lower future profits divided over twice the invested capital. Nobody will invest that capital but you.

If you can also reduce the objective risk to banking business, then that can help attract capital to the business. Guess what that means about loan behavior or monetary regulation? It means it has to be rigorously *less* populist and tilted to favor lenders over borrowers. Anyone see *that* as the emphasis in e.g. loan work out programs and the like?

Socialists tried to solve famines by attacking the farmers as class enemies. It always fails and it destroys the service that is assaulted. Attacking bankers are class enemies because of a banking crisis is exactly the same mistake. In a famine, the rest of the society needs to support farmers, not blame them and attack them. In a financial crisis, the rest of the society needs to support financiers, not blame them and attack them.

If you don't, you go to hell.

Law of nature, people.

[JasonC]

Because there is nothing wrong with the Fed.

[JasonC]

Ding ding ding.

Then he just waits for things to get better on their own, and takes credit for the sun coming up in the morning.

[Woebama]

The Fed kept interest rates low throughout the housing bubble. Without that policy, the bubble wouldn’t have happened at all and the banks would not be at risk because of the collapse in the housing market.

[JasonC]

False. They raised rates about 20 times to over 5%, breaking the bubble. They held the growth of M1 to *zero* for 3 straight years, from the spring of 2005 to the spring of 2008. That is the only monetary measure the Fed directly controls by the size of its own balance sheet. Banks can freely extend broader money measures on their own, without any by-your-leave from the Fed.

And they did, while it was tightening and telling them not to and preventing any growth of narrow money. Their boneheaded action in fighting the Fed instead of following it, made the last 2 years of the bubbles and made the smash worse. But was quite entirely their own doing. They could have tightened up themselves in 2005 or 6.

The Fed perhaps left short rates too low for about one year, and it forecast its rate increases to an exceptional degree, to avoid catching the private sector off guard. That gave everyone plenty of time to adjust to coming higher rates. They used it to gamble recklessly instead.

The Fed is not omnipotent. It is not the only actor in the system. Fed haters always pretend that it can't do anything right and that everything that occurs is its doing. It is slander and nonsense, start to finish.

[Woebama]

Greenspan admitted some of the mistakes:

http://www.theaustralian.news.com.au/business/story/0,28124,24548000-643,00.html

I see blinkers on you — you claim the Fed is not the root cause of financial instability — even though they control the entire money supply.

[Texas Fossil]

A solution, a replacement U.S. (not international) currency tied to something tangible.

Many people have talked about the need for this for years, but no one was willing to conceive the pain of the transition. Now we have the pain, why no make the transition?

Problem, we do not have adult leadership, but a bunch of Commies committed to destruction of all but their power.

The battle is coming!

[Travis McGee]

Is banking industry to be treated like utility sector(water, electricity?)

That is also Nassim "Black Swan" Taleb's idea. Banks should just be uber-safe places to hold your money and lend under very controlled criteria. "Investing" firms should be completely separate, and operate knowing that they will never be bailed out of they place losing bets.

[Travis McGee]

Because there is nothing wrong with the Fed.

And their was nothing wrong with the Titanic's course and speed, right Captain Smith?

But we know where you're coming from.

"I'd like to see mainstreet try to live for 6 months without financiers directing their activities. They be reduced to shooting each other over the last can of campbells."

5 posted on Saturday, October 04, 2008 3:38:33 PM by JasonC

"The US economy is going to come back gangbusters. Might take as long as 2 years, more likely only 1, but it will happen. Baked in. The Fed already did enough, and the Bush treasury, and adjustments to prices in the free market (commodities, houses, stocks, corporate bonds, all of it). ... Buy a clue already. The US economy has buried every challenge thrown at it for over 200 years, and it will bury this challenge. Do the Dems deserve the credit for fixing it? No, but they'll take it anyway. And if all you do in the meantime is predict failure, then they will succeed in getting that credit from the American people, while you will stand revealed as an economically illiterate fool. Get some optimism, people! Conservatives without economic optimism are so useless. The place to watch Obama is foreign affairs, he isn't hawkish enough. The economy is going to be fine."

19 posted on Thursday, January 08, 2009 9:33:36 PM by JasonC

[listenhillary]

Our government as a whole gets my vote for the whole mess.

Bush aims to boost minority home ownership

From http://en.wikipedia.org/wiki/Community_Reinvestment_Act

In 1999 the Congress enacted and President Clinton signed into law the Gramm-Leach-Bliley Act, also known as the "Financial Services Modernization Act," which repealed the part of the Glass-Steagall Act, which prohibited a bank from offering a full range of investment, commercial banking, and insurance services.

The bill was killed in 1998 because Senator Phil Gramm wanted the bill to expand the number of banks which no longer would be covered by the CRA. He also demanded full disclosure of any financial deals which community groups had with banks, accusing such groups of "extortion." In 1999 Senators Christopher Dodd and Charles E. Schumer broke another deadlock by forcing a compromise between Gramm and the Clinton administration which wanted to prevent banks from expanding into insurance or securities unless they were compliant with the CRA.

In the final compromise, the CRA would cover bank expansions into new lines of business, community groups would have to disclose certain kinds of financial deals with banks, and smaller banks would be reviewed less frequently for CRA compliance. On signing the Gramm-Leach-Bliley Act, President Clinton said that it, "establishes the principles that, as we expand the powers of banks, we will expand the reach of the [Community Reinvestment] Act".

[listenhillary]

I like that idea.

It would help if our government also stopped penalizing citizens for saving money. That is a crime.

[EVO X]

It would help if our government also stopped penalizing citizens for saving money. That is a crime.

Ditto that

Taxes do have a dampening aspect to it. If we would have had a 5% to 10% capital gains tax on housing, the bubble might not have been as bad. Personally, I think we should have an across the board flat tax all investments. Why pick favorites?

[ikka]

There is EVERYTHING wrong with the Fed.

Once again, just like you shilled on FR for the moronic bailout #1, you are just flat wrong.

[GOPJ]

...each institution would be required to buy insurance against its systemic risk – that is, against its own losses in a scenario in which the whole financial sector is doing poorly. In the event of a pay-off on the insurance, the payment should not go to the company, but to the regulator in charge of stabilising the financial sector. This would provide incentives for a bank to limit systemic risk (to lower its insurance premium), provide a market-based estimate of the risk (the cost of insurance), and> reduce the fiscal costs and the moral hazard of government bail-outs (because the company does not get the insurance pay-off).

Flat out brilliant.

Regulating toxic incentive patterns will deal with this mess.

Every banking nightmare that happened was rewarded in subtle and not so subtle ways - - find those "rewards" and stop them...

[ex-Texan]

Bravo Travis ! One truth teller strikes again . . . LOL !

Video: What is Wrong With The Federal Reserve System

[Freedom_Is_Not_Free]

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