Financial Services Reform
When you enact economic policy legislation, setting the effective date is very important. Usually, you want to avoid a rush to market by the first to hear while you're in the middle of legislating, so you choose the date of the first public announcement. Often you set the date of enactment, when the president signs the bill into law because only then is it certain the law will be put in place. Retroactive effective dates are a no-no, because they trap people without warning, particularly tax increases on activities that have already occurred. Sometimes you set a future effective date to allow those affected time to comply. That was the thinking behind the Expedited CARD Reform for Consumers Act of 2009 that President Obama signed into law on May 22, 2009 with effective dates in February and August of next year. However, banks are using the interim to jack up credit card interest rates.
We will get more information today on whether the government is planning to institutionalize bailout in lieu of bankruptcy. At 9 o'clock, the House Committee on Financial services will hold a hearing on systemic risk and resolution issues. You can find the prepared testimonies and watch it here. The lineup includes Paul Volcker, Arthur Levitt, Jeff Miron, Mark Zandi, and John Cochrane.
I think most of the discussion of a "systemic risk regulator" has so far been misguided. I am very skeptical of how it would work in practice. How does that meeting between the regulators and an individual bank go? "So, in conclusion, while we find nothing wrong in your risk profile per se, we have observed systemwide too much leverage, so we are going to require your bank to restrict its lending at the margin?" Or how about, "While you haven't done anything wrong yet, we think that if you continue to compete so aggressively for loans, you will endanger your competitors. So back off." If the regulatory process could work well enough to do that, it certainly would have worked better up until now.
The White House couldn't let the one year anniversary of the fall of Lehman go by without it being "celebrated." At the very least the president had to say that things are much better now -- and they are -- than they were a year ago. He also had to say something to demonstrate to (please forgive me for using this phrase) "Main Street" that he knows it's still not happy.
But the real purpose of the speech was to refocus the financial services reform debate in Washington. The president may have been speaking to Wall Street executives, but the real audience was members of Congress, especially Democrats, some of who in the next few weeks will be marking up various pieces of financial services regulation legislation. He had to show that the general issue hasn't gotten lost in the health care debate and to say that the effort is still needed even if things seem to be better ("Normalcy cannot lead to complacency").
Immediately after the speech, the discussion on CNBC -- the financial channel that thinks it talks to and sometimes for Wall Street -- focused more on how what the president proposed could be implemented rather than whether it was needed.
This idea by Jeremy Bulow and Paul Klemperer is still the best one I've seen for how to reorganize the banking sector without massive infusions of taxpayer dollars. (See this earlier description). Here is the summary:
- We cannot efficiently value or transfer “toxic” assets - so a good plan cannot depend upon this.
- The UK’s Special Resolution Regime, or one similar to that of the US FDIC, can cleanly split off the key banking functions into a new "bridge" bank, leaving liabilities behind in an "old” bank, thus also removing creditors’ bargaining power.
- Creditors left behind in the old bank can be fairly compensated by giving them the equity in the new bank.
- We can pick and choose which creditors we wish to “top up” beyond this level, but should not indiscriminately make all creditors completely whole as in recent bailouts.
- Coordinating actions with other countries will reduce any risks.
The key point is the first one -- too much of the Obama Administration's plan is focused on so-called "toxic assets." Risky assets should be held by equity holders -- they should not be held by the government, nor should the government be subsidizing their purchase. These distressed institutions already have equity holders. What is needed is simply a mechanism to match the insured liabilities with the highest quality assets. This is such as mechanism.
Susan Woodward and Bob Hall illustrate nicely how a partitioning of an existing bank into a good bank and a bad bank could work. The key is that the good bank is a wholly owned subsidiary of the bad bank. The good bank holds the insured deposits of the current bank, along with all of the assets of sufficiently high quality. The bad bank holds the liabilities other than the deposits and owns the remaining assets and all of the equity in the good bank. Here is how they describe the rationale for making the partition:
