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The slow-motion train wreck in Europe is highlighting how financial risks haven’t disappeared from the economy. Several European sovereigns like Greece, Italy, Spain, and Portugal face a high likelihood of at least partial default. As e21 has repeatedly emphasized, the capital losses of such events will not only impact the European economy, but will also affect American financial institutions holding credit default swaps, as well as money market funds holding European debt.

It’s also clear that the reforms envisioned in Dodd-Frank do not go far enough in preventing financial losses from generating broader crises as in 2008. More needs to be done to effectively reform the financial sector.

Using market-based indicators and smarter capital would go a long way to fix problems in the financial sector. Instead of relying on simple estimates of credit ratings, market estimates provide real-time indications of financial distress. For instance, financial experts judging the odds of a European crisis look to the market price for insuring Italian and Greek debt in judging the riskiness of those sovereign debts – not the credit rating that those countries receive. Regulators need to do the same thing and force banks to adequately provision capital in light of market realities. Banking decisions to view sovereign debt as implicitly “safe” is the whole reason that European periphery debt has the potential to turn into broader financial problems in the first place.

Banks also need more capital – in particular “smart” capital that can convert to equity in times of crisis. If banks were required to hold convertible capital in addition to capital reserves, they would have an additional buffer that would serve as a firewall to absorb credit shortfalls before they turn into broader economy-wide problems.

The Financial Time’s Lex outlines another capital mechanism – requiring modern banks follow a partnership-style structure. The old system of partnerships among investment banks ensured mutual regulation and stability. While that system may be unsuited for modern capital needs, a modified system – such as the one operating in France – would finance the bank through a two-tiered capital structure. Senior partners would be personally liable for the failures of banks – while junior partners would provide additional financing without personal liability. This system offers the additional financing of a public offering, while ensuring monitoring and capital provision among a core group of dedicated insiders.

If firms lack flexibility to convert capital into equity or raise additional funds from senior partners, they need the legal ability to create flexibility among existing liabilities. Banks need the option of speed bankruptcy or some other rules-based mechanism (which should involve reforms to the current bankruptcy code). Most importantly, debtors and creditors must operate under clear rules and judicial review. New ideas, like setting a plan for how to convert subordinate debt into equity during the moment of a crisis should also be considered. This sort of action would leave depositors and senior creditors to banks unaffected – but would ensure that bondholders as well as equity holders bear some of the costs of bank failure (instead of being bailed out for every penny, as happened during the last financial crisis). Dodd-Frank instead envisions an ad hoc resolution authority that remains to be tested. Unlike the FDIC, which has a very particular mandate and method of operation, the new resolution authority leaves markets in the dark about which institutions will be bailed out, when, and for what reasons.

It’s astounding that, several years after the worst financial crisis since the Great Depression, we remain as vulnerable as ever to a severe financial shock. Dodd-Frank has done little in the past year to seriously address the questions of moral hazard, capital, and risk-taking that fueled the last crisis. As the prospect of another financial crisis grows – this one driven from Europe – it’s important to bring to the forefront serious domestic reforms that tackle the real and persistent problems in the financial system.

Source: Preparing for the Next Financial Crisis