Systemic risk, finacial contagion, and Jeff Gordon on avoiding ‘8 alarm fires’
by Linda Beale
I’m attending the American Association of Law Schools conference in New Orleans, where cold winds are blowing but revelry of Mardi Gras has already begun. This morning Jeff Gordon presented his views on what it will take to deal with the systemic risk to the banking system to avoid crises like the one we have been through. He supports creating an explicit authority for innovative action to be taken by bank regulators.
The problem he says is that banks act as intermediaries between short-term depositors and long-term borrowers of funds. Their position is “fragile” in that there is a possible contagion effect from counterparty risk and “similarity risk”. If one bank goes bad, depositors can reasonably assume that similar banks may go bad. But they are not sure how similar one bank is to another, so the risk is difficult to gauge. Also there is problem with uncertainty generally, that adds to the systemic risk.
The macroprudential means suggested to combat these problems aren’t sufficient. Deposit insurance, limits on leverage and similiar approaches don’t necessarily achieve liquidity to avoid credit crunches while ensuring protection for banks. Deposit insurance is only payable after a default. Limits on leverage are no guarantee. The shadow banking system of off balance sheet vehicles and money market funds as credit providers isn’t a sufficient answer either–it relies on banking but is unwilling to pay the costs.
Gordon says that Bernanke and Paulson had to “scare” the country to get the power to do what was needed to deal with the crisis, but that “scare” also had the effect of pushing the country deeper into the crisis. Since systemic risk is inevitable, we should crate a TARP-like program to be waiting in the wings for the future.
Other mechanisms for dealing with systemic risk once it occurs, he claims, are inadequate. One mechanism is to have failing institutions merge with a healthier institution. But this is inadequate, as shown in the Lehman situation last fall. SHareholders want more than the bank is worth, and the government, prior to default, can’t impose losses on creditors.
Another is for a federal agency, like the FDIC, to take over failing banks. But this is problematic, since it is a firm-by-firm proposition, whereas systemic risk involves widespread problems that cannot be sufficiently resolved on a case by case basis.
The only solution then is a “standby” emergency authority. He would have a “triple key” system to ensure the authority is not abused and thus will not represent a threat to democracy. His triple key proposal in the talk was a consensus among the Fed, Treasury and FDIC. Further, he’d require notice to Congress, and an ex post review to ensure accountability.
Does this proposal for a permanent “standby” authority to take hugely costly discretionary actions “as needed” to resolve a financial crisis make sense? I worry much more about the democracy deficit of such a proposal than Gordon apparently does. Even where Congress approves the power, as in the TARP bill, the lack of oversight and the establishment of a cozy relationship with the regulated entities, as in the case of Paulson, Bernanke, and Goldman and other banks, is worrisome. Notice to Congress would likely be perfunctory if Congressional approval weren’t required, and ex post review is not often well done–look at our failure to conduct an open review of the many lapses of the Bush administration on torture, etc.
Shouldn’t the fact that the authority was forthcoming when needed in this case show that we don’t need the “standby” authority that would grant even more discretion to a few powerful hands on the pursestrings of the nation?
crossposted with ataxingmatter
Not only does this fail the “sniff” test, it has allready failed in practice. Why are we expected to believe that the omnipotent commission would sagely use their non-democratic powers to divert disaster when the stupid bastards were unable to use their existing powers to prevent the disaster in the first place.
The citizens of this country had better be vigilant as the autocrats seek to use the crisis of their making to solidify their over throw of the USG.
To even suggest creating a standing TARP like program to help bailout failing financial institutions in the future be created is the heigth of contempt for the taxpayer. I have yet to see any of the banking CEOs lose their homes or retirement funds. When I see them on the unemployment lines with the rest of the country then I will have some sympathy. The TARP just allowed these financial institutions to continue their risk taking without any downside.
When all else fails, there is always nationalization!!
If the accounting standard disallow ‘off the book’ vehicles, the whole bubble would be a whole lot smaller. CDS should really be treated the same as gambling, and should never be considered an ‘asset’ on the balance sheet.
Here’s a step in the right direction except that the tax should be 80%, not 50%:
Of course the plutocrats who own America will probably defeat it. When you have a collective Hitler in control, you can’t do much the dictator doesn’t like.
Of course the big banks should all have been nationalized as Stiglitz and Krugmann wanted, but the plutocracy that Obama sucks up to wouldn’t hear of it.
First, just saving the banks is not enough. History indicates that it take the banks around two years to start lending again after a financial crisis. So far, we are on track for that. The money supply (credit) has shrunk by at least 50%. Not that all that borrowing was wise, but the banks aren’t the only ones needing a bailout. Small businessmen are being squeezed who would be good credit risks if there were more money out there. It is a Catch 22. If the banks won’t lend, the gov’t should, to cushion the blow. Simply bailing out the banks is not good enough.
In the U. S. the Federal gov’t should bail out the state gov’ts, who cannot print money on their own. They has been neglected this time around, with dire consequences.
Second, just providing for bailouts when there is a crisis or crash is not good enough. We have to rein in bubbles and potential bubbles. Expecting regulators to be supermen is crazy. We also have to risk bursting a bubble early instead of hoping that it will fizzle.
Third, these proposals do nothing to change the paradigm of privatization of profit, socialization of risk and cost. Therein lies not only moral hazard, but the undermining of democracy in favor of plutocracy. If we allow institutions that are “too big to fail” and bail them out, then they should pay for the bailouts, beforehand if possible, afterwards if necessary. (And it would probably be a good idea if an institution receives a bailout for its top management and board to be fired. Or, as with Lee Iacocca, to work for $1 per year for at least two years, or until unemployment falls below 5%, whichever comes last.) Oh, and repaying TARP funds and the like is insufficient payback.
There was this guy who believed very much in true love and decided to take his time to wait for his right girl to appear.
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You may painfully regret, only to realise that it is too late.
I think the socialization of losses/privitization of gains is, as you suggest, a key issue that we have to take into consideration in trying to develop ongoing financial regulation policies that will work. IN an earlier posting, I noted research that suggests that at least 9%–but probably closer to 49%– of Goldman’s 2009 profits are directly due to the cost of funds spread that Goldman has enjoyed because of the Federal guarantee–i.e., Goldman can borrow more cheaply than most of its competitors, and can leverage those borrowed funds, into profits that it is using to pay bonuses, by continuing the same “casino speculation” trading activities that it engaged in before the crash. Nothing, in other words, has yet changed except to the extent that the implicit Federal guarnatee has become more real.
I personally don’t see a solution working that doesn’t include reinstatement of Glass-Steagall boundaries, so that the Fed is not shoring up investment banks in their trading-for-own-interest activities. What dismays me is that academics like those at the conference may well serve as enablers of regimes that do nothing to address this issue at the heart of the problem.