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Saturday, April 23, 2011

Farmer: Don't Let Banks Gamble with Taxpayer Money

Roger Farmer:

Don’t let banks gamble with taxpayer money, by Roger E.A Farmer, Commentary, FT Forum: The US is in the process of implementing the Dodd-Frank Wall Street Reform and Consumer Protection Act. In the UK, the Vickers Commission has released interim recommendations to “ring-fence” the retail operations of banks from their investment banking activities. The Vickers report is a model of clarity and if the ring fence proposals are implemented, they will have bite. But there is already a push from Lloyds to weaken the proposals of the interim report and that is only the opening salvo. The pressure from financial institutions for lax regulation will be intense. That pressure should be resisted.
The proposed reforms of both the Dodd-Frank act and the Vickers report will increase the amount of capital held by financial institutions by reducing leverage. Increased capital requirements will reduce the probability that any given institution will fail but they will not eliminate the moral hazard problem created by implicit government support for large financial institutions. That requires a more radical reform of the kind I have argued for elsewhere. ...
Current opinion among financial regulators is that the problem of financial instability can be solved by imposing higher capital requirements on banks. But higher capital requirements cannot prevent banks from taking excessive risks. In the 2008 crisis, commercial banks speculated in the US housing market by buying low grade mortgage backed securities that were mistakenly rated as triple A by the US ratings agencies. Somebody was asleep at the wheel.
I am not opposed to financial institutions taking risk. Risk is an integral part of the engine of capitalist growth. But Barclays, and other deposit taking institutions, should not be allowed to gamble with private deposits that are insured by government guarantees. There is a strong case to be made that effective reform requires the complete separation of retail and investment banking. That separation should be accompanied by restrictions on the assets that can be held by any institution that relies on government guarantees. Restrictions of that kind were part of the Glass-Steagal act that led to 60 years of relative economic stability. Dodd-Frank and the Vickers report make significant steps towards restoring the protections of Depression-era legislation. In my view, they do not go far enough.

I am also of the view that higher capital requirements alone -- especially as proposed -- won't be enough to stop bank failures and threats of systemic meltdown. I also don't believe that resolution authority will fully close off one of the main channels through which systemic breakdown occurs, runs on the shadow banking system (Economics of Contempt disagrees, but I think that the uncertainty over whether resolution authority will stop a systemic breakdown will lead to runs on the shadow system at the fist sign of widespread trouble).

Higher capital requirements can reduce the degree of damage in a crash, e.g. by reducing leverage, but crashes can still happen. For that reason, the only way to effectively stop runs in the shadow system is to provide some sort of deposit insurance coupled with strict regulations on how much risk can be taken by these institutions (along the lines of how deposits are protected in the traditional system). We can separate retail and investment banking, impose higher capital requirements, and force firms to have explicit resolution plans in the event of failure, and this will help, but these measures can't always prevent bank runs and systemic failure in the investment banking sector (and hence does not eliminate the need for a bailout).

To stop runs in this sector, there are two main types of proposals, The first is to enhance the quality of the collateral held against deposits in the shadow/investment bank system -- the collateral plays the role of insurance and is intended to prevent runs. But since the value of these assets cannot be guaranteed a priori (even government bonds could be a problem in the right circumstances), full protection cannot be guaranteed and runs are still a problem. The second proposal is to provide explicit, government insurance on deposits in the shadow system along with strict limits on risk taking behavior. It worked in the traditional system, and it can work here too. The argument against this is that it will limit shadow bank activity so much that economic growth will be reduced. However, these fears are likely overblown and I'd like to see more discussion along these lines.

But the reality is that the government is not going to provide explicit deposit guarantees in the shadow system, and bank runs leading to systemic collapse will remain a possibility (despite claims that resolution authority will prevent this). Since crashes are still possible, we need to make them as mild as possible, and one way to do that is to impose leverage reducing capital requirements that are substantially higher than what is currently being proposed (unwinding levered positions is one of the big contributors to a downward spiral in the financial system). The requirements as currently constituted are too small, come online too slowly, and do not offer the protection we need. I doubt very much, however, that we will see any increases in these requirements. With the political power of banks we'll be lucky to maintain the increases that have been proposed. Thus, despite all the calls to shore up the financial system to prevent another crisis, critical vulnerabilities will remain.

    Posted by on Saturday, April 23, 2011 at 10:08 AM in Economics, Financial System, Regulation | Permalink  Comments (5)


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