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The National Journal asks views on a recent proposal for financial reform:

The Dodd bill on financial regulatory reform embraces a supposed solution to the ‘Too Big To Fail’ conundrum: Contingent Convertible Bonds, or CoCos, which turn into equity once a bank’s capital falls below a certain level.

My response:

I do think that measures such as the Contingent Convertible Bonds would be a useful step. Some argue that it would be hard to know when to invoke the contingency clause. It strikes me that this argument largely vanishes when one realizes that the clause would of necessity be invoked by the time we got to the stage of a Bear Stearns or Lehman Brothers bankruptcy.

CoCos would not go very far in themselves toward comprehensive reform of the financial system, if that is the goal. But then no single policy measure would do that. I agree with Gillian Tett: “In theory, I think that CoCos certainly could be a useful additional to banks’ tool kits. However, in practice, the contagion risk suggests it would be dangerous to rely too heavily on an exclusive diet of CoCos for any policy ‘fix’.” (Financial Times, Nov. 12).

Two related issues are of much bigger import. First, is it a feasible goal to eliminate, credibly, the problem “too big to fail” or “too interconnected to fail,” thereby eliminating the critical moral hazard problem? My suspicion is that this is not an achievable goal, when push comes to shove, ex post, in a crisis; and if I am right, then it is very important that we don’t return to the rhetoric of claiming “no bank is automatically too big to fail” and so fail to regulate and collect insurance from the banks ex ante. This would just exacerbate the moral hazard problem. Commercial banks are like river banks in this respect.

Second, would the legislation that is offered by Senator Chris Dodd be a better approach to financial reform than alternative proposals, or even than the status quo? While the 1,000+ page Dodd bill undoubtedly has some good things in it (the CoCos and the principle of a Consumer Protection Agency in lending are probably at the top of the list), I believe it would be very damaging overall. The major reason is that it would seriously undermine the power of the Fed to set fully-informed monetary policy in normal times and to respond effectively in times of crisis. It seems that Barney Frank understands these things much better.

Source: The Dodd Bill: CoCos Are Fine, But Don't Hobble the Fed