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Saturday, April 04, 2009

"Why Creditors should Suffer Too"

Tyler Cowen:

Why Creditors Should Suffer, Too, by Tyler Cowen, Economic View, NY Times: The Obama administration’s proposals to reform financial regulation sound ambitious enough as they aim to bring companies like A.I.G. under a broader umbrella of government rule-making and scrutiny.

But there is a big hole in these proposals,... the new proposals immunize the creditors and counterparties of such firms by protecting them from their own lending and trading mistakes.

This pattern has been evident for months, with the government aiding creditors and counterparties every step of the way. Yet this has not been explained openly to the American public.

In truth, it’s not the shareholders of the American International Group who benefited most from its bailout; they were mostly wiped out. The great beneficiaries have been the creditors and counterparties at the other end of A.I.G.’s derivatives deals — firms like Goldman Sachs, Merrill Lynch, Deutsche Bank, Société Générale, Barclays and UBS.

These firms engaged in deals that A.I.G. could not make good on. The bailout, and the regulatory regime outlined by Timothy F. Geithner..., would give firms like these every incentive to make similar deals down the road. ...

What the banking system needs is creditors who monitor risk and cut their exposure when that risk is too high. Unlike regulators, creditors and counterparties know the details of a deal and have their own money on the line. ...

A simple but unworkable alternative is to let major creditors make their claims in the bankruptcy courts, as was done with Lehman Brothers. But that is costly for the economy and, after the fallout from the Lehman failure, politically impossible now. Instead, the key to effective regulatory reform is to find a credible means of imposing some pain on creditors.

Here is one possibility. The government has restricted executive pay at A.I.G. and banks receiving government funds, but this move fails to recognize that the richest bailout benefits go to creditors. Restricting compensation at these creditor firms would have more force — if it is done transparently, in advance and in accordance with the rule of law. A simple rule would be that some percentage of bailout funds should be extracted from the bonuses of executives on the credit or counterparty side of transactions.

Such a rule would make lenders more conservative, which would generally be a good thing. ...

Here is another option..., credit agreements should provide for the possibility of a future, prepackaged bankruptcy. Those agreements should require that the creditors themselves would suffer some of the damage — even if the government stepped in to bail out the afflicted firm.

There is a risk that these sacrifices will not be extracted when the time comes, but the prospect might still check the worst excesses of leverage. ...

This poses a very difficult public relations problem for the government, because the Federal Reserve and the Treasury do not want to discuss the importance of the creditors too publicly right now. ... The challenge isn’t easy, and we can’t start on it today, but one way or another a new regulatory plan has to move some risk back to creditors.

These seem like good ideas, but I'm not so sure that these options pose a threat that is credible enough to "check the worst excesses of leverage" as much as is needed. Given the propensity for bank runs in both the traditional and non-traditional banking sectors when depositors/creditors are threatened - they will want to get their money out of institutions that look to be headed for trouble, i.e. to stop being creditors, before the firm is declared insolvent and these restrictions cause them to incur losses that they would be protected from otherwise - would the government step in with guarantees that keep them whole even if, a priori, they had declared they wouldn't in order to avoid the negative fallout from such runs?

The possibility that the government would keep its word and enforce the losses, along with the possibility of being unable to get money out in time and then coming under the regulatory restrictions, ought to check behavior to some degree. But to get substantial effects we need to have a substantial probability that the government will keep its word about imposing losses. However, I'm not so sure that the belief that the government will keep its word is as widely held as is needed, particularly if too large to fail, politically powerful institutions are allowed to persist.

    Posted by on Saturday, April 4, 2009 at 02:34 PM in Economics, Financial System, Policy, Regulation | Permalink  TrackBack (0)  Comments (29)


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