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Thoughts and a response to Krugman's editorial on financial reform

By Michael Konczal

The new Paul Krugman editorial on financial reform is very important, and I want to discuss parts of it here. You should read all of it, but I want to focus on two parts:

Even among those who really do want reform, however, there’s a major debate about what’s really essential. One side — exemplified by Paul Volcker, the redoubtable former Federal Reserve chairman — sees limiting the size and scope of the biggest banks as the core issue in reform. The other side — a group that includes yours truly — disagrees, and argues that the important thing is to regulate what banks do, not how big they get.

[...] So why not update traditional regulation to encompass the shadow banks? We already have an implicit form of deposit insurance: It’s clear that creditors of shadow banks will be bailed out in time of crisis. What we need now are two things: (a) regulators need the authority to seize failing shadow banks, the way the Federal Deposit Insurance Corporation already has the authority to seize failing conventional banks, and (b) there have to be prudential limits on shadow banks, above all limits on their leverage.

For those who really do want to do reform, Krugman divides them into (a) those who want to break up the banks and call it a day, and (b) those who want to bring resolution authority and expand the scope of regulation into the shadow banking sector. There are a lot of people
who say all kinds of things in financial reform, so I don't want to table those who think breaking up the banks and calling it a day (which is very similar to the Republican opinion of just amending bankruptcy law and calling it a day) is a sufficient condition for financial reform. But I don't think this is an accurate way to characterize where the debate is for many people, and specifically in terms of the legislation on the table.

For me, it's not an either/or but a both/and question. I think we should do both (a) and (b), impose a hard size cap of $400 billion to $500 billion and then expand regulation over all the broken-up shadow banks. If you look at the conclusion of 13 Bankers, I think Simon Johnson and James Kwak are in a similar boat. And from the point of what to do with the Dodd bill in place, the question for progressive reformers is whether to push for something like Sen. Sherrod Brown's amendment on limiting bank size in addition to the resolution authority powers in Dodd's bill (Title II), not instead of those powers.

Why do I think this is important? A variety of reasons, but one is that we haven't dealt specifically with the issue of a scope of guarantees post-2008 crisis. I really think of this financial reform bill as something that should have been attached to TARP. "If you want a $800 billion loan, we are going to undo the '90s derivatives deregulation, make you follow consumer protection laws as if you were regular banks instead of shadow banks, and give ourselves the right to do FDIC-like resolution on you." Then we could begin to have a discussion on how to deal with the shadow banking sector as a Step 2. Instead, it is all being forced into Step 1.

What new deposits are insured?

Coming out of the New Deal, it was clear how depositors were insured for their deposits, and insurance was charged appropriately. What are the new scope of guarantees over the shadow banks? Let's do a specific example I've been thinking a lot about lately: Are the money
market mutual funds now guaranteed to be protected during a systemic crisis? The Federal Reserve jumped in through various mechanisms to protect the money market mutual fund from a massive run post-Lehman. Will it do it again? If so, that's insurance and the government should
be charging someone a premium and/or regulating things differently. The Roosevelt Institute has been thinking about this, the government is thinking about this, here's Paul Tucker discussing it (pdf), but there's not even a real debate going yet. And there's nothing in the bill about this.

On background, I've had enough people say that as long as resolution authority and the Dodd bill work really well, then we don't have to worry about a run on the money market mutual fund again. But this leads us in a loop back to what I first said about the Dodd bill: "since we don’t want to shrink the biggest banks, we are going to be putting a lot of stress on unproven and uncertain powers and institutions, particularly the Federal Reserve’s ability to discipline the largest financial firms, and resolution authority’s ability to take on firms whose business model is, in part, to warehouse gigantic derivatives portfolios."

With serious Gensler-style derivatives reform and firms that are smaller, there is much less pressure on these unproven and untested solutions. Without them, more pressure.

And practically, I think it is significantly easier to do these powers on a firm that is limited in both the size of its liabilities and in the cross-section of what its liabilities look like (how short-term funded it is). I'll illustrate that in a graph in another post, but practically since so much of the resolution authority is predicated on detection and regulators being able to discipline firms that will be significantly easier on smaller rather than larger firms.

-- Michael Konczal is a fellow with the Roosevelt Institute and the author of the Rortybomb blog.

By Multiplatform Editor  |  April 2, 2010; 12:20 PM ET
 
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Comments

Mike,

Have you read the Economists' Voice (with editors Joseph Stiglitz and Brad DeLong) 2008 article, "Investment Banking Regulation After Bear Stearns"? It's by Berkeley finance professor Dwight Jaffee and finance lawyer Mark Perlow, and it's available at:

http://www.bepress.com/ev/vol5/iss5/art1/

I think this article makes some important points. I like the way the authors use the phrase, "too interconnected to fail", not just "too big to fail", and I like their discussion of the value of separating, as well as regulating, banking activities, quoting:

Our proposal is to create a comparable separation of an investment bank’s counterparty operations from the risks and possible losses in its various investment activities. As mentioned above, U.S. investment banks currently operate (among others) two separate business lines: (i) running hedge-fund like trading operations that maintain a highly leveraged and maturity mismatched portfolio of risky investments, and (ii) operating as market-makers and primary counterparties in the OTC market for financial derivatives. Absent separation of the two activities, market discipline will not eliminate the incentive of an investment bank to use the Fed’s liquidity backstop as a means to take excessive risks in its trading operations.

Separating the risk-taking trading from the derivative counterparty operations thus seems to be the only way to implement Secretary Paulson’s prescription that market discipline play a role in future investment bank regulation. The counterparty subsidiary would be closely supervised and regulated to ensure it could operate safely and dependably on a stand-alone basis. The trading operations, in contrast, would continue to have limited regulation, but any losses would fall entirely on the debt and equity owners of the investment bank. These investors would thus have every incentive to enforce market discipline on the investment bank’s risk management activities. (page 4)

Posted by: RichardHSerlin | April 2, 2010 4:05 PM | Report abuse

I agree with RichardHSerlin.

For me, the best initial reform would be to simply reinstate the regulations that have been repealed, most notably the Glass Steagall Act, which kept deposit banking, investment banking, securities, and insurance separate.

Posted by: Patrick_M | April 2, 2010 4:46 PM | Report abuse

Agreed as well. Still want a derivatives tax directed at naked hedging (ie buying insurance on assets you have no stake in--speculating strictly for profit) and a financial transaction tax directed at hyper fast computer and day trading, not long term investing...
Having insurers with strict capital requirements to insure CDSs and CDOs would do alot to add some discipline to the market.

Posted by: srw3 | April 2, 2010 5:50 PM | Report abuse

So you dispute Krugman's entire thesis but it's still a very important column? Sounds like a waste of time to me.

Posted by: bmull | April 2, 2010 7:22 PM | Report abuse

What about a combination of reigning in too big too fail with regulations. Why not set a progressive scale to FDIC taxes on the bank where if they are leveraged at 10:1 they pay a certain amount towards FDIC insurance. If they are at 15:1 it doubles. If they are at 20:1, it doubles again. And so on. This would allow banks to still take risks but it would give them a disincentive towards taking more risk and it would also penalize banks that take more risk because those that do are more likely to need a bailout.

Posted by: timnlisa1 | April 3, 2010 3:01 AM | Report abuse

We need for many of the people that are currently making decisions to find their way to the wardrobe section of Attica or similar institutions of higher learning ....for the legally challenged

The World's Largest Ponzi scheme with both Wall Street and Washington participating needs to be addressed with vigor.

These entities should be put aside in any reform decisions and allow prudent,small, intelligent bankers with the necessary intelligent regulators propose a plan that has corrections to the entire financial system, with the closure to all loopholes. Something neither of the two criminal institutions listed have true interest in accomplishing.

No one cuts off the generous hand that feeds them......

With all the reading one can do on the MISHAP with the World Wide economy the easiest article to understand where guilt lies and their deceit is the Rolling Stone article pulling down the shades on the thieves......simple but pointed as only the RS can do....no frills

The perpetration and continuance of the cunning and practiced thievery needs to be stopped and no rewards to those with dirty fingers.....bonuses for stealing should be discouraged rather than rewarded as is currently taking place...

We have as a country digressed to actions by some being adversarial to the greater good of this society .....

Wall Street has given us all a potent potion of Hemlock as they walk away laughing........

Posted by: vistaviewpoint | April 3, 2010 11:13 AM | Report abuse

Me thinks all shadow banking activities will be difficult to monitor and regulate, as EU found out last year. So what's the remedy?
I've argued, since 2007, to outlaw all hedge funds subject to legislative scrutiny to decide whether to allow them to function - at all! - or to terminate this type of *cabal* operations - from global financial sector.
The problem lies with the rest of the socalled emerging markets - whether they will agree to end hedge funds in their domain.

Note: There is a heated argument going on right, here in EU, now on globalization/global governance in light of our inability to control shadow banking and other institutions.

Posted by: hariknaidu | April 5, 2010 9:54 AM | Report abuse

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