TARP for Regulators

By James Kwak

We’ve had TARP for banks, TARP for auto companies, and now, with the Obama Administration’s plan for financial regulatory reform, we have TARP for regulators. After AIG, Citigroup (C), Bank of America (BAC), and General Motors (GMGMQ.PK), the administration has decided that all the existing regulators are Too Big to Fail – except for the Office of Thrift Supervision, which must play the role of poor Lehman Brothers in this saga. (Actually, they are more like Merrill Lynch, since they are getting merged into the new National Bank Supervisor, so most of them will probably keep their jobs.)

There is actually a serious issue here, and one with no obvious solution. One question that has gotten a lot of ink, both before and after the unveiling of the plan, has been the identity of the systemic risk regulator: new agency? council of agencies? the Fed? What this really shows is that it’s easier for the media, the administration, and Congress to focus on how the agency acronyms will be reshuffled, which is a bit like covering a sporting event, than on the underlying issues, like how to make those agencies more effective.

(Warning: I’m about to argue three sides of an issue.)

(1) So, for example, it’s a little ridiculous that the Federal Reserve is being given the role of systemic risk regulator, since the Fed (under Greenspan, but with no dissent from Bernanke) completely missed the housing bubble, the risks of a massive derivatives market, and the systemic implications of toxic mortgages that it was actually supposed to be regulating – and, in fact, contributed to the financial crisis by keeping interest rates low for the first half of this decade, and then helped aggravate it by letting Lehman fail. Yes, I know, most economists didn’t predict the crisis, either, but no one is nominating them for systemic risk regulator.

(2) But what’s the alternative? You could posit a new regulatory agency focused on systemic risk; let’s call it Bill. But you have no right to simply assert that Bill will do any better than the Fed. In fact, since Bill will start out with no building, no computers, and no staff, you could argue that the Fed, after being given an appropriate pep talk, would do better than Bill. It’s likely that many of the people working for Bill would be people who used to work for the Fed. Planet Money had a story a while back (I think it’s in this episode) about how when the Federal Home Loan Bank Board was abolished in the wake of the savings and loan crisis, its employees just kept on working and eventually the sign on the building was changed to Office of Thrift Supervision.

So given those alternatives, it’s easy for someone as smart as Larry Summers to argue that the Fed is a better choice than a new agency, or a committee, as he did on All Things Considered today. Basically he is positing an ideal Fed – one with the technical skills it has today (according to Summers) but not the huge blind spots it had in the past. I can posit an ideal Bill, but it won’t be any better than his ideal Fed.

(3) The real issue behind this reshuffling of agencies and responsibilities is how you can get better regulators – people with the skills, motivation, and stomach to stand up to both banks and politicians who are screaming at them to get out of the way of progress and prosperity. And here I don’t think the administration’s plan gives us anything.

What could it have done? Here’s one idea: it could have spun the regulatory agencies off into semi-independent bodies, so their heads aren’t replaceable at will by political figures (as is currently true of the Fed); established a long prohibition (5 years?) on making any money from the financial sector after leaving the agency; and then doubled the salaries of every single regulator. (I know there are some transition issues you would have to deal with, like getting rid of a lot of the people who were asleep at the wheel.)

That would be a step toward increasing the status of regulators and reducing the threat of regulatory capture. I’m sure there are problems with these proposals, but at least they address the real problem.

Comments

[Sovestor:]

It is now time for Americans to remake and revamp themselves so that in the future, Americans won't need any bailouts. Lessons must be learned the hard way.

Jun 19 11:03 AM

[Clive Corcoran:]

Alas there can be no systemic guarantor of last resort - it would be a self-referential paradox.
The dis-illusionment will be complete once it is accepted that no-one can control the financial system. To think otherwise is to subscribe to the mythology of credentialism and asymmetric entitlements.

Jun 19 11:55 AM

[stillafewleft:]

The Fed can't watch the financial hen house because it has been proven unable and has a gross conflict of interest to say the least. Well, let's have civil servants do it. Oops, the revolving door, not to mention influence by politicians who either have their own gross conflict of interest (need to get re-elected) or are influenced by those who do. OK, academics then. Oops, no real-world experience needed in that club, and getting that next promotion is a disincentive to cross those (wealthy donors) being regulated. Thank goodness for the watch dog media. Hmmm, "green shoots" and all those "less bad things presaging recovery" anyone?

Policing those with ultimate wealth and power requires (a) smart, well informed, nonconforming idealists with public credibility and an effective podium (a very small group) AND (b) an assertive, educated public which has long been among the missing. Intellectually it is a non-starter because beyond window dressing it simply will not be permitted by those with power and influence. Can anything other than changing the monikers and acronyms of ineffective institutions be accomplished?

Jun 20 09:30 AM

[TinyTim:]

"increasing the status of regulators and reducing the threat of regulatory capture"

can't be done.
If these people could foresee hazardous events, they wouldn't be civil servants.

The best way to minimize systemic risk is to eliminate TBTF and keep things simple and transparent, including derivatives.

Jun 20 02:36 PM

[dcb:]

Please pay attention to how a professor a professor documents how the snow job will be pulled over on the taxpayer. I have stated that what is going on is the biggest criminal ripoff of the tax payer ever. It just continues. Obama is all smoke and mirrors. And my stipulation that he was installed y the elites as the anti bush to represent change but actually do nothing becomes more a reality each and every day.

If you want to know why I have been openly advocating a non violent popular revolution this is just another reason.


Fair Game
Too Big to Fail, or Too Big to Handle?

By GRETCHEN MORGENSON
Published: June 20, 2009

“No one should assume that the government will step in to bail them out if their firm fails.”
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That’s Timothy F. Geithner, the Treasury secretary, talking tough with lawmakers last week as he promoted the government’s remake of the financial regulatory framework.

Talk is cheap, however. And the notion that the plan shows a new aversion to bailouts is not at all supported by its chapter and verse. In fact, there’s precious little in the 88-page document about how the government will eliminate systemic risks posed by financial firms that aren’t allowed to fail because they’re simply too big or to interconnected to other important economic players here and abroad.

Rather than propose ways to shrink these companies and the risks they pose, the Geithner plan argues instead for enhanced regulatory oversight of the behemoths. This suggests the taxpayer safety net will be larger after our national financial train wreck, not smaller.

More than two years after the crisis began, “too big to fail” remains “too problematic to address” with anything other than more souped-up regulation. Given that earlier efforts at policing these entities failed so miserably, why should anyone think that a new-and-improved regulatory approach will fare better?

“The sudden failures of large U.S.-based investment banks and of American International Group were among the most destabilizing events of the financial crisis,” the Geithner proposal said. “These companies were large, highly leveraged, and had significant financial connections to the other major players in our financial system, yet they were ineffectively supervised and regulated.”

All true, of course, with Citigroup — a bank that Mr. Geithner himself regulated — being Exhibit A. But the solution the document proposed is “a new, more robust supervisory regime for any firm whose combination of size, leverage, and interconnectedness could pose a threat to financial stability if it failed.”

Hmmm. Sort of an enhanced status quo, just with a bigger safety net.

That this taxpayer-supported net will be larger and more encompassing when this mess finally ends comes as no surprise to some people. Last August, Edward J. Kane, a finance professor at Boston College, wrote about just this likelihood in a paper titled “Ethical Failures in Regulating and Supervising the Pursuit of Safety-Net Subsidies.”

In the paper, Professor Kane described why the policy responses to financial crises historically had involved expanding the universe of companies eligible for taxpayer support if another mess arose.

“When a substantial portion of the financial sector appears to be at risk, it is far easier to patch up the weaknesses in the system with ad hoc loans and guarantees than to negotiate genuine reform,” he wrote.

PROFESSOR KANE’S paper certainly is prescient. For top regulators to be able to push through larger bailouts, he argued, two conditions must hold. “First they must be able to control the flow of information,” he wrote, “so as to keep taxpayers and the press from convincingly assessing either the magnitude of the implicit capital transfer or the anti-egalitarian character of the subsidization scheme.”

Sound familiar? Recall the months of secrecy surrounding the bailout of A.I.G.’s counterparties and the refusal of the Federal Reserve Board to disclose how it chose BlackRock to oversee three of its rescue programs and what it was paying the firm to do so?

Then there is Professor Kane’s second condition: Regulators’ commitment to these bailout policies “must be continually nourished by praise and other forms of tribute from the bankers, borrowers and investors whose losses are being shifted to less-influential parties.”

We’ve heard a lot of this, of course, in recent weeks. Here is Timothy Ryan, president of the securities industry lobbying group, responding to the Treasury plan on the group’s Web site. “This is an important step forward,” he said. “We have a once-in-a-generation opportunity to rebuild our regulatory structure so that our financial system is more stable, more resilient and better underpins a dynamic U.S. economy.”

To be sure, the Treasury proposal does hope to curb the growth of large, systemically scary companies by raising their costs of doing business. But entrusting greater responsibilities to the same supervisors who missed the risks at the institutions they oversaw during the mania doesn’t inspire confidence.

And with the exception of merging the Office of Thrift Supervision into the Office of the Comptroller of the Currency, the plan doesn’t suggest how the regulators who failed will be held accountable for their mistakes.

According to some experts who study systemic risks posed by huge and complex companies, installing a “more robust supervisory regime” isn’t enough.

I do not think that intensification of traditional supervision and regulation of large financial firms will effectively address the too-big-to-fail problem,” Gary H. Stern, president of the Federal Reserve Bank of Minneapolis and an authority on resolving big and troubled institutions, said last month in Congressional testimony.
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Mr. Stern declined to comment last week on the Treasury proposal, citing Fed rules against its officials speaking publicly in the days surrounding meetings of its Federal Open Market Committee. But he told Congress that the key to tackling problems posed by financial behemoths is to convince uninsured creditors of these companies that they will not be bailed out by the government. (Rescuing uninsured creditors is exactly what the government did a great deal of in 2008; think Bear Stearns and A.I.G.)

To protect other companies from also becoming unnecessary casualties when a troubled institution founders, regulators must have a quick-response plan in hand, Mr. Stern advised. Reforms that do not materially reduce spillover effects, he warned in his testimony, shouldn’t be relied upon.

There isn’t much in the Treasury plan about such spillovers. Nevertheless, it is candid about the failings of regulatory efforts during the recent credit boom. “It is clear now that the government could have done more to prevent many of these problems from growing out of control and threatening the stability of our financial system,” it says.

It’s beyond disappointing that the Treasury plan offers no way to measure regulators’ effectiveness or hold them accountable for their failures. Neither is there a discussion of mechanisms that could be used to signal regulatory failings well before they put the entire system at peril.

True financial reform should reward efficient regulation and supervision, Professor Kane said in his paper. “Regulators should be made accountable not just for producing a stable financial economy, but for providing this stability fairly and at minimum long-run cost to society,” he wrote. This means creating incentives that encourage regulators to perform in the taxpayers’ interests.

“The public policy problem,” Professor Kane concluded, “is to design employment contracts that would make it in supervisors’ self-interest to invoke ‘market mimicking’ disciplines when and as a country’s important institutions weaken.”

It may be naïve to expect the nation’s top regulators to devise ways to ensure that their dismal performance of late will not occur again. But it’s certainly worth hoping for.

Jun 21 09:27 AM

[dcb:]

Let me tell you something. there is very little difference between Iran and the US. they are smart enough to riot.

In Iran they elect different people, but the government ensures the people do not change and their voice is not reflected in the ballot booth. In the US we elect different people but the government ensures nothing changes. they net effect is the exact same. The people are not represented. Nothing changes in both systems, and those in power maintain their power and wealth. we are given the illusion of choice/control to pacify us. There is in fact little difference, the governments us different systems of control, but the outcome is the same.

Jun 21 10:36 AM