Too Big to Fail: Now It Gets Interesting 32 comments
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By Simon Johnson
On Wednesday, Dan Tarullo, a governor of the Federal Reserve and distinguished law school professor, dismissed breaking up big banks as “more a provocative idea than a proposal” and instead put almost all his eggs in the “creation by Congress of a special resolution procedure for systemically important financial firms”. He stressed: “We are hopeful that Congress will, in its legislative response to the crisis, include a resolution mechanism and an extension of regulation to all systemically important financial institutions” (full speech).
This put him strikingly at odds with Mervyn King, governor of the Bank of England, who said Tuesday night, quite bluntly,
“There are those who claim that such proposals [involving breaking up the largest banks] are impractical. It is hard to see why. Existing prudential regulation makes distinctions between different types of banking activities when determining capital requirements. What does seem impractical, however, are the current arrangements. Anyone who proposed giving government guarantees to retail depositors and other creditors, and then suggested that such funding could be used to finance highly risky and speculative activities, would be thought rather unworldly. But that is where we now are.”
Tarullo’s speech actually framed today’s problem just right: “I would suggest … that the reform process cannot be judged a success unless it substantially reduces systemic risk generally and, in particular, the too-big-to-fail problem.” This is consistent with the tone of King’s remarks (even if less pointed than what Neal Barofsky said).
Tarullo also made some astute comments on how “too big to fail” emerged in its current specific form in the US and threatens us in a general form always.
“First, no matter what its general economic policy principles, a government faced with the possibility of a cascading financial crisis that could bring down its national economy tends to err on the side of intervention. Second, once a government has obviously extended the reach of its safety net, moral hazard problems are compounded, as market actors may expect similarly situated firms to be rescued in the future.” ….
“The fact that the largest financial firms will account for a significantly larger share of total industry assets after the crisis than they did before can only add to the uneasiness of those worried about the too-big-to-fail phenomenon. It is notable that current law provides very little in the way of structural means to limit systemic risk and the too-big-to-fail problem.”….
“I only urge that we all keep the too-big-to-fail problem front and center as the regulatory reform effort moves forward.”
But the “resolution authority” idea the Obama administration is pushing (and Tarullo endorsed) is a theoretical construct that would have no discernible practical effect. Charles Calomiris hit that particular nail on the head Tuesday in the WSJ – in his second paragraph, he explains that bank failures are hard to handle because “there is no orderly means for transferring control of assets and operations, including the completion of complex transactions with many counterparties perhaps in scores of countries via thousands of affiliates” (emphasis added).
The Bank of England will tell you, for example, that their experience with BCCI – a bank that was closed nearly two decades ago – pointed clearly to the need for cross-border agreement between regulators on exactly how to handle bank failure.
But talk to any dozen or so central bank officials, and they will confirm that we do not have and are not close to having such cross-border agreements. And there is no sign that the G20 has this issue in its sights.
Still, the Tarullo-King gap – which loomed so large on Wednesday – finds potential closure in the Fed’s proposed “guidance” (read: orders) on executive compensation, announced Thursday. (WSJ; FT versions).
The proposal is obviously flawed, particularly in the quaint notion that there are only 28 financial institutions that can damage the system through excessive risk-taking (has the Fed really forgotten LTCM?) And the stock market yawned deeply on the announcement – presumably believing that the Fed cannot currently organize a regulatory tightening along any dimensions.
But the proposal is actually quite brilliant and – given the logic of our politics, including Mr. Bernanke’s impending re-confirmation hearing – is likely to have real impact.
For the first time, the appropriate regulators have recognized that excessive risk-taking generates a large negative externality, i.e., a spillover that has pernicious effects on the rest of the economy, and that this can be dealt with in a reasonable manner.
Attacking compensation is not the only way (nor ultimately the likely best way) to address this externality, but it does get everyone thinking along the right lines.
And the bottom line is clear: if your financial institution is big relative to the system, you will be at a systematic disadvantage relative to the smaller firms due to the way pay is regulated; “talent” (or, if you prefer, excessive risk-takers) will move from large firms to small.
My read of the Fed’s current intentions is that they do not intend the differential tax on size to be too great, so dangerously big firms could still survive. But once Capitol Hill understands the opportunity created by these compensation rules, all things are possible – think about the transparency and accountability implications for the Fed and the banks in question.
And remember two things: the midterm elections at the end of next year still lack an obvious and appealing theme, and the big banks are completely unable to cut back voluntarily on their compensation practices, their lobbying, or their egregious public behavior and obnoxious remarks (e.g., the latest AIG example).
The Fed’s press release quotes Dan Tarullo as saying, “In customizing the implementation of our compensation principles to the specific activities and risks of banking organizations, we advance our goal of an effective, efficient regulatory system.”
My translation: Now it gets interesting.
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This article has 32 comments:
If you read the preserved newspapers from that long ago time, you'll find that John D. Rockefeller and the other robber barons said the EXACT same thing at the time that Goldman, Citi, Morgan, B of A and AIG are saying today. "If you break us up, millions of jobs will be lost." "America will now lose its competitive position in the world." "We must keep our mega-giants so as to compete with other giants from across the sea." And "You are destroying the very strength of America, replacing capitalism with socialism."
To which I say, hooey, balderdash, horsefeathers and moose poo. These "too big to allow to fail" oligarchies were split up and it ushered in a new era of competitiveness in American industry that allowed us to label the 20th century "The American Century."
The choice we face now is remarkably similar. We have allowed a few institutions to enjoy a revolving door relationship with Washington DC, providing favors, campaign contributions and employment to politicians in exchange for "Most-Favored Corporation" status. Whenever they do something stupid that would destroy another company, these once and future employees rush to transfer OUR savings (via taxation) to the Most-Favored Corporations.
David can beat Goliath and often does. It's part of the creative destruction that allows hope, change, and growth. But when David has his arms and spirit broken by a government that then stands firmly behind Goliath, propping him up whenever he is felled, usually by his own mis-deeds, it makes the job a lot tougher.
Too big to fail? Tell it to Teddy Roosevelt. Or to today's Exxon, Chevron, and a host of newer names allowed to grow and prosper because we refused to believe the hooey, balderdash, horsefeathers and moose poo put out by a bunch of cowards Too Big to Be Willing to Compete.
"The choice we face now is remarkably similar. We have allowed a few institutions to enjoy a revolving door relationship with Washington DC, providing favors, campaign contributions and employment to politicians in exchange for "Most-Favored Corporation" status. Whenever they do something stupid that would destroy another company, these once and future employees rush to transfer OUR savings (via taxation) to the Most-Favored Corporations.
David can beat Goliath and often does. It's part of the creative destruction that allows hope, change, and growth. But when David has his arms and spirit broken by a government that then stands firmly behind Goliath, propping him up whenever he is felled, usually by his own mis-deeds, it makes the job a lot tougher."
Exactly.
If you are big enough to create a wave in the pond; you have more freedom to speculate and use higher leverage. If you succeed you make money, if you fail your make money. The risk is passed to the taxpayer.
The real hazard is that this signal has not been lost on the average person and small business owner. They will be running up their credit cards and debt spending just like the government and banks and insurance companies. This is the tsunami wave coming that is ignored. The only entity too big to fail is the entirety of individual households and small businesses which have been given the shaft. For every action there is an equal and opposite reaction. The shaft is coming back towards the banks and government but I don't think they see it coming.
You left out one step in the "if you fail scenario."
1. You fail
2. You pay huge bribes to politicians
3. the taxpayer bails you out.
You forgot the number 2, which I believe has to be behind the 9.7 trillion and counting the US is on the hook for bailouts.
"Too-big-to-fail" bailouts dilute the concept of capitalism. PERIOD.
Letting an institution fail will create a vortex of growth in competitors and the market eventually takes care of itself.
Keeping the weak organization on life support weakens the total market because then the next organization that starts falling has no incentive to correct itself, they will just wait for their bailout.
CORPORATE AMERICA HAS BANKRUPTED THIS COUNTRY BY SELLING OUR JOBS TO SLAVE LABOR IN OTHER COUNTRIES, FORCING US TO COMPETE WITH THEM, LOWERING OUR BUYING POWER, OUR TAX BASE AND OUR STANDARD OF LIVING. THIS COUNTRY BUYS MOST OF WHAT THE WORLD PRODUCES... UNLESS OUR GOOD PAYING MANUFACTURING JOBS ARE BROUGHT BACK THERE WILL NOT BE BUYING POWER, NO TAX BASE, NO MAIN STREET AND WITH OUT MAIN STREET THERE WILL BE NO WALL STREET.
If we agree that this may be the case, then I suggest an idea that could solve both problems, and save the American taxpayer billions of dollars and probably save the free market system as well.
Have the Feds pay off the counterparties (like was done for AIG), but ONLY if the bank or entity that caused the panic was closed, This way the counterparties get their deserved money, the risk doesn't ripple through the system, and the only entity to be hurt or shuttered would be the entity that caused the panic in the first place.
What the Feds did in this latest crisis was exactly the opposite. THey stiffed (for the most part--not counting Goldman) the counterparties for a large percentage of their due, but they gave billions to "save" the banks. "Saved" them for what?
1. Getting free money at the discount window.
2. Paying interest to the banks on money they get from the Feds that they do not want to lend and keep in reserve.
3. The banks are making money, not by lending to individuals and businesses (the stated reason for bailing out the banks), but by putting on big, hedged trading programs which add zero to capital formation for business.
During the crisis, Paulson/Bernanke told Congress that unless the $700 Billion was given to the big money center banks, people would not be able to use their ATM machines. Then why didn't they just backstop the ATM system? You don't need the prop trading desk to fund the deposit business. And it certainly would not have cost $700 Billion .
It's like eating the whole baked potato. You cannot afford the calories, you don't really even like potatoes, but you eat it to get to the sour cream. We are eating that fattening potato/saving zombie banks even though we only really want the sour cream/sound contracts and reliable deposit banking.
Sooner or later the politicians will be voted out or hung from street lamps.
This is the revolt they (the politicians and bankers) don't see coming.
It will start with people voting with their money by not buying into the market, buying gold, paying down debt, doing what the politicians, bankers, and insurance companies won't do (being responsible).
It will end with blood in the streets, the innocent along with the guilty.
What a tragedy.
However; it has happened over and over throughout history.
Those who fail to learn from history are doomed to repeat it.
We have failed to learn.
We are reflating the housing and debt bubble with privatized gains and socialized losses.
The example has been set by government and industry and will be followed by the average person.
It will give "moral hazard" a new meaning.
Sad yes, true...yes.
On Oct 23 01:24 PM talld wrote:
> ebworthen,
>
> You left out one step in the "if you fail scenario."
> 1. You fail
> 2. You pay huge bribes to politicians
> 3. the taxpayer bails you out.
>
> You forgot the number 2, which I believe has to be behind the 9.7
> trillion and counting the US is on the hook for bailouts.
You either allow market mechanisms to work (no bailouts and let them fail) or you break them up and remove the systemic risk.
Stop privatizing profits and socializing losses.
Right now, the real unemployment rate in LA is high and climbing. I expect to see a mass exodus from LA after the jobs leave.
The banks collapsed, I guess we are lucky to have things as good as we do, but I do not agree with Bush's decision to lie to people and call the collapse a "bailout."
On Oct 23 10:53 AM Joseph L. Shaefer wrote:
> The last President with the guts to go trust-busting was Teddy Roosevelt.
> Couldn't we, just once a century, enjoy a similar courage from our
> leadership?
>
> If you read the preserved newspapers from that long ago time, you'll
> find that John D. Rockefeller and the other robber barons said the
> EXACT same thing at the time that Goldman, Citi, Morgan, B of A and
> AIG are saying today. "If you break us up, millions of jobs will
> be lost." "America will now lose its competitive position in the
> world." "We must keep our mega-giants so as to compete with other
> giants from across the sea." And "You are destroying the very strength
> of America, replacing capitalism with socialism."
>
> To which I say, hooey, balderdash, horsefeathers and moose poo.
> These "too big to allow to fail" oligarchies were split up and it
> ushered in a new era of competitiveness in American industry that
> allowed us to label the 20th century "The American Century."
>
> The choice we face now is remarkably similar. We have allowed a
> few institutions to enjoy a revolving door relationship with Washington
> DC, providing favors, campaign contributions and employment to politicians
> in exchange for "Most-Favored Corporation" status. Whenever they
> do something stupid that would destroy another company, these once
> and future employees rush to transfer OUR savings (via taxation)
> to the Most-Favored Corporations.
>
> David can beat Goliath and often does. It's part of the creative
> destruction that allows hope, change, and growth. But when David
> has his arms and spirit broken by a government that then stands firmly
> behind Goliath, propping him up whenever he is felled, usually by
> his own mis-deeds, it makes the job a lot tougher.
>
> Too big to fail? Tell it to Teddy Roosevelt. Or to today's Exxon,
> Chevron, and a host of newer names allowed to grow and prosper because
> we refused to believe the hooey, balderdash, horsefeathers and moose
> poo put out by a bunch of cowards Too Big to Be Willing to Compete.
What should happen with any bank that needs government support is that it should be taken over 100% by the tax payer for a holding period. No delay, no temporary support, no questions. As soon as a bank has difficulty meeting regulatory capital requirements, the stock and bond holders should be wiped out. They lose everything. Either a bank stands on its own feet, finds additional capital in the market, or the owners and lenders are wiped out in favor of the tax payer. After appropriate management changes etc. the bank can be IPO'd at an appropriate time (probably not the bottom of the market). If appropriate, the bank can also be split before being floated. There are 3 main benefits of this approach:
1. The bank continues to operate, so there is no systemic impact.
2. Instead of being defrauded, the tax payer turns a profit.
3. Stock and bond holders suddenly become a lot more interested in the risks being run by the bank. Risk capital will start to have an appropriate market price and banks will have to report on how it's being used. This means that the market will reward good banks and punish bad ones. Bad ones will ultimately be taken over and/or reorganized out of existence.
The downside is that, despite the greater market scrutiny, some banks will still fail and, when that happens, the government or some regulatory body, has to be involved while the bank is owned by the tax payer. But there is no perfect solution to this in today's world, and I think this is the least bad.
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A better question would be where is Attorney General Eric Holder who promised a break with past policy of cronyism and promised to hold Wall Street accountable.
On Oct 24 11:21 AM a fat panda wrote:
> Where is Teddy Roosevelt? Decomposing I suppose.
>
> A better question would be where is Attorney General Eric Holder
> who promised a break with past policy of cronyism and promised to
> hold Wall Street accountable.
>
>
Markets are complex systems. If there is complexity, there is uncertainty. In “We’re All Screwed (reference below), I argue against governance policies that conflate “risk” and “uncertainty.” The inability to move away from the risk-uncertainty conflation affects not only capital market governance but the environment, homeland security, education, and healthcare. The gravamen of this problem stems from our policymakers being almost exclusively deterministically trained—law, accounting, and economics. They therefore have difficulty identifying, analyzing, and solving issues that are increasingly becoming more indeterminate.
What we need now is capital market governance of randomness—a blueprint for fundamental change to the legacy, one-size-fits-all deterministic governance regime. Trying to have a one-size-fits-all governance, is analogous to writing one driving manual for the US and UK. In “We’re All Screwed,” I describe how to segment the market into predictable, probabilistic, and indeterminate regimes to do the right things for governance effectiveness and how to do things right for governance efficiency.
The legacy governance system for the US capital market is in disrepair. To achieve real regulatory reform, policymakers have to move beyond form to substantive issues. Unless experimentations to the legacy, one-size-fits-all deterministic regime take place, our capital market will be caught in a recursive loop of errors of commission (boom-bust bubble inefficiencies) and errors of omission (externality market inefficiencies). Such inefficiencies will eventually render our source of economic wealth ineffective.
If this happens, we’re all screwed.
Stephen A. Boyko
n2keco@bellsouth.net
Author of “We’re All Screwed: How Toxic Regulation Will Crush the Free Market System”
w-apublishing.com (www.w-apublishing.com/...)
Book Review: Brenda Jubin, Ph.D Thursday, October 8, 2009
readingthemarkets.blog...
Boyko, We’re All Screwed!
I'll tell why it's harder than it was a year ago. The BoE intervened, saved the failed banks and has recently injected £175bn into the banks via its failed quantitative easing program. If the BoE wanted to break them up, it should have done it a year ago.
On Oct 23 01:07 PM notevipr wrote:
I suggest that a special tax be put on
> people who have profited to the extreme, such as the 100 million
> to a trader at AIG.
When Vince Cable the Liberal Democrats Shadow Chancellor of the Exchequer first proposed this it reject out of hand by many City Bankers, but now I think it would very difficult for Conservatives to maintain creditability by opposing this now the Governor of the Bank of England has made this speech.
Real reform has not happened and until the US realizes that 20 % of the worlds material consumption is in the USA and that if that consumption drops,the rest of the world is in serious trouble Again. The chance of this consumption dropping is very real when robber barons are being supported by the government instead of being closely watched. VERY CLOSELY watched i might add!
The financial firms should not be banks, or put in another way BANKS should not be in the business other than banks.
BRING BACK THE GLASS STEAGAL ACT, that some politicians caused to be closed; the system worked before but it was the Federal government trying to break the STATES' power over the insurance and financial institutions that cause the greed which they knew about when Congress inadvertedly reverse the Act that caused all of this mess.
We need the banks to start getting back to being banks and doing what they are supposed to do instead of using the taxpayer dollars and also bank money for speculative projects.
www.pbs.org/wgbh/pages...
www.pbs.org/wgbh/pages...
"In The Warning from PBS, veteran FRONTLINE producer Michael Kirk unearths the hidden history of the nation's worst financial crisis since the Great Depression. At the center of it all he finds Brooksley Born, who speaks for the first time on television about her failed campaign to regulate the secretive, multitrillion-dollar derivatives market whose crash helped trigger the financial collapse in the fall of 2008."
The Frontline links include (the second one) a serial commentary section which include top economists and core thinkers on the issues.
In effect this has become privitized "central planning" and the financials are telling us all Le Marche' ;C'est Moi... as sovereign entities onto themselves.
Why would any "unbiased student or professor" of financial markets want to give the powers to Congress for oversight.
They are for the most part an extension of BIg Business and can easily become so if they are not; bribery (voter influence) has a long and successful history and these poor congressional fellows up for re-election are easy targets as long as private money is allowed to fund campaigns. I would also say much the same of many academicians in that they are easily influence by big business; happens all the time in medicine where the pharm-mafia funds studies aligned to their for profit agendas. Does anyone realize that there are about 30+ lobbyists per senator and congressman in DC ?
Add to that the $8,000 first time homeowners credit offered by the Feds and I am sure it will draw only the finest of those soon to be unemployed. Good God, what are we doing to ourselves and these people?
On Oct 25 04:00 PM No Sympathy wrote:
> Size is irrelevant. So to mitigate risk you cut the pie into ever
> smaller less efficient, less professional, less diversified little
> pieces in hope that the risk might some how disappear. Wrong, you
> have not reduced the collective risk you just broke it up into more
> pieces that now requires more less efficient oversight. One reason
> that these banks got so large is that the government pushed the failures
> into the larger banks so that they (seekingalpha.com/symbo...)
> didn't have to pay off the depositors and manage the assets (ie.
> bad mortgages). The basic fundamental reason for the risk is Government
> meddling in the credit markets to fund mortgages and home sales to
> people who could not afford them. Of course the government did this
> due to pressure from voters (not necessarily tax payers). Tax payers
> ultimately pay for what voters want, we call this the tyranny of
> the majority.
Mervyn King apparently doesn't believe this, but he's tired, and in addition he wants to be popular. Going after fat-cats is one way of increasing your popularity. and it might also help to relieve some of the stress associated with that job, although I prefer the method employed by an earlier Governor of the bank of England, which if I remember correctly involved one of his female employees..
THRU MANUFACTURING AS WE USED TO DO. WE NEED TO DO
MORE EXPORTING THAN INPORTING. GIVE MANUFACTURERS
TAX BREAKS. WE NEED TO KEEP PEOPLE WORKING HERE NOT OVERSEAS. AS WE KNOW "CHARITY BEGINS AT HOME".
HELP THE PEOPLE ,NOT THE BANKS, OR COUNTRIES THAT
HATE THE U.S. WE CANT AFFORD TO KEEP PEOPLE ON WELFARE. IF THEY ARE STRONG THEY CAN DO MANUAL LABOR FOR THE COMMUNITY THEY LIVE IN. THIS NEW GOVT. IS MASCHUGANAH, LOCO. WE NO LONGER CAN AFFORD TO GIVE HANDOUTS TO ALIANS OR OUR OWN . WE ARE HELP[ING OTHER COUNTRIES WHEN WE CANT HELP OURSEVES.
ALL BECAUSE OF IMAGE?