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.
April 2, 2010; 12:20 PM ET
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