Preparing for Bear Stearns II?

Thanks to an alert reader for this heads up on Fed Chair Bernanke's recent speech posted to the FRB website. I found this portion of the speech particularly interesting:

In general, our system relies on market discipline to constrain leverage and risk-taking by financial firms, supplemented by prudential oversight when government guarantees (such as deposit insurance) or risks to general financial stability are involved. However, the enormous losses and writedowns taken at financial institutions around the world since August, as well as the run on Bear Stearns, show that, in this episode, neither market discipline nor regulatory oversight succeeded in limiting leverage and risk-taking sufficiently to preserve financial stability.

What this suggests is a likely consensus among the Fed, Treasury, and Congress that market discipline (i.e., free markets) is not enough to ensure financial stability, and the current level of regulation is not sufficient to ensure stability. It is not accidental that this speech was titled, "Financial Regulation and Financial Stability."

So what would this new, enhanced regulatory regime look like? The Chair continues:

As part of its review of how best to increase financial stability, and as has been suggested by Secretary Paulson, the Congress may wish to consider whether new tools are needed for ensuring an orderly liquidation of a systemically important securities firm that is on the verge of bankruptcy, together with a more formal process for deciding when to use those tools. Because the resolution of a failing securities firm might have fiscal implications, it would be appropriate for the Treasury to take a leading role in any such process, in consultation with the firm's regulator and other authorities. 

The details of any such tools and of the associated decisionmaking process require more study. As Chairman Bair recently pointed out, one possible model is the process currently in place under the Federal Deposit Insurance Corporation Improvement Act (FDICIA) for dealing with insolvent commercial banks. The FDICIA procedures give the Federal Deposit Insurance Corporation [FDIC] the authority to act as a receiver for an insolvent bank and to set up a bridge bank to facilitate an orderly liquidation of the firm. A bridge bank authority is an important mechanism for minimizing public losses from government intervention while imposing losses on shareholders and unsecured creditors, thereby limiting moral hazard and mitigating any adverse impact of government intervention on market discipline.

I suspect we'll see the government fulfilling multiple "bridge banking" functions before the current credit problems have run their course. The big question is whether that provides confidence and security to financial markets or fear and further risk-aversion. If I were one of the shareholders or unsecured creditors referenced above, I'm not sure I'd draw solace from the new regulatory regime. The emphasis is on keeping the system functioning, not bailing out those in trouble.

Comments

[MarvinMBA:]

It seems to me our banking and financial system is going to be socialized and supported now and in the future by Uncle Sam via the Fed. The only people that will be allowed to lose are the investors. Because of excesses in the Sub Prime Market, those that profited will still be around and they will think of other ways to take advantage of their position in the future. The public is going to pay a price now and in the future to support these players.

2008 Jul 08 02:09 PM

[Dan Walker:]

After almost 20 years, THAT is some news that could get me back in the bond business...

2008 Jul 08 02:10 PM

[Reinko:]

Bernanke speaks rosy words, but the utter lack of just normal oversight on the markets is one of the basic fundamentals of the present troubles.

It is mostly to blame on Alan Greenspan but why blame it on a mentally handicapped person? Alan was the one who brought oceans and oceans of liquidity to the markets, one of the big problems right now is that we have so much non productive money ramming around. Inside the financial institutions lots of that non productive money is already vaporized but there are still countless billions out there bringing nothing but trouble like high oil and commodity prices.

2008 Jul 08 02:58 PM

[mcadoo3312:]

Very well put by Reinko. However, that money is still in the system and there is no way to get it out for good.

The failure of certain institutions shows that the free markets are doing their jobs, just not to the behest of short minded individuals. Maybe Bernanke needs to clarify what he means by "Financial Stability". Expectations of "stability" in financial markets and trying to obtain said stability can sometimes end in the same, or even worse trouble. Greenspan fell in love with the idea of "stable" liquidity; look how that turned out.

2008 Jul 08 04:57 PM

[icandoitdon:]

"The failure of certain institutions shows that the free markets are doing their jobs..."

i beg to differ. had the "free market" done it's job bear stearns would have filed bankruptcy and the dominos related to it would have been permitted to fall. it didn't happen. the federal reserve...i.e. the taxpayers....absorbed the bad paper to protect all other dominos that should have fallen. it might well happen again.

this isn't capitalism. it's wall street socialism and no "free market capitalist" in his right mind should support such intervention. read any economics textbook and you will likely come across the words "freedom to fail." it's as important a principle to capitalism as private ownership of assets.

it is the job of the federal reserve to safeguard the stability of the financial system. it's in their charter. they failed to do so by permitting cheap and easy credit, and leverage in excess of any prudent standard, to overwhelm the system. and to bail out the bastards that caused the problem the fed is doing what? they're giving them more cheap and easy credit. that's why you're getting 2% or so on your money market funds in a 4-8% inflationary environment. (4% if clueless - 10% if clued in.)

the only people who shouldn't be pissed off as hell about what's happened and aren't pointing the finger of blame squarely at the federal reserve are those mortgaged to the hilt, without a pot to piss in.

2008 Jul 08 09:19 PM

[res ipsa lo...:]

icandoitdon: couldn't have said it better. Those applauding the bailout are doing so because it gives them comfort that they might be bailed out if they, also blinded by short-term greed-based myopia, fall on their swords over imprudent risks. They cheer OPM (other people's money) coming to their rescue--in this case the hapless middle class taxpayer who is already leveraged to the hilt via mortgages, credit cards, home equity loans, and government deficit spending. If the goal is the wipe out the middle class and turn the US into a third-world country with a 1% elite in a walled city with 99% impoverished peasant class, we are well on the way.

2008 Jul 09 12:11 AM

[notsosmart:]

this is a country that hums along just fine as long as greed is paying off for everybody. anybody who warns that things are out of control is labeled-unpatriotic,a fool, a socialist, a communist,a jerk,anti goldilocks etc. how many really believed a 1% mortgage,no down payment,no income check,on 125% of the value of the house could be sustained? after closing on this joke you now get a heloc.the dumb-dumber americans are greeting the chickens as they come home.

2008 Jul 09 10:10 AM

[vaduz:]

to liquidate an investment bank needs professionals, good professionals otherwise the other market participants would
be able to profit to much on it. who are these professionals?
the old management or some regulators?
the idea to reign in moral hazard is certainly a very good and necessary one. but not so easy to fulfill

2008 Jul 09 10:40 AM

[notsosmart:]

most organizations,business... & other entities will fire those whodont along with the bs. thats why thesebubbles happen. the i told you so are long gone when things fall apart. what kind of country has to have laws protecting a whistleblower?

2008 Jul 09 12:03 PM