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At one level, it is good to see the Republican Senate leadership finally express clear positions on the financial industry and what we need in order to make it safer. At another level, what they are proposing is downright scary.
In a Senate floor speech Tuesday, Senator Mitch McConnell (Senate Republican leader) said:
"The way to solve this problem is to let the people who make the mistakes pay for them. We won't solve this problem until the biggest banks are allowed to fail."
Do not be misled by this statement. Senator McConnell's preferred approach is not to break up big banks; it's to change nothing now and simply promise to let them fail in the future.
This proposal is dangerous, irresponsible, and makes no sense. The bankruptcy process simply cannot handle the failure of large complex global financial institutions without causing the kind of worldwide panic that followed the collapse of Lehman and the rescue/resolution of AIG. This is exactly the lesson of September 2008.
If a huge financial institution were to reach the brink of bankruptcy, the choice again would be: collapse (for the world economy) or rescue (of the very bankers and creditors who are responsible for the mess). The point of the reforms now before us is to remove that choice, as far as possible, from the immediate future.
There is only one plausible way to ensure banks that are currently "too big to fail" can actually fail: Make them substantially smaller. This is necessary but not sufficient for financial stability—a point we make most forcefully in 13 Bankers, where we support a whole range of complementary measures (including more capital, very tight regulation of derivatives, and tough consumer protection), as well as a broader approach to breaking the political power of these banks.
And, at some level, the size point has already been taken on board by the administration. The second Volcker Rule, as announced in January, reads:
"Limit the Size—The President also announced a new proposal to limit the consolidation of our financial sector. The President's proposal will place broader limits on the excessive growth of the market share of liabilities at the largest financial firms, to supplement existing caps on the market share of deposits."
The hard size cap proposed—although somewhat vaguely specified—in this part of the Volcker Rule should be applied and tightened considerably in the Dodd bill now approaching the Senate floor.
You can do this with the Brown amendment, a version of which we should expect to see on the Senate floor. Or you may prefer the approach of the Kanjorski amendment, which is already included in the House legislation. Our position is that the Democrats should propose—and the White House should support—the strongest versions possible, with low and hard size caps on banks. Force the Republicans to defend explicitly our biggest banks and how they operate—as Senator McConnell now appears willing to do. Take that to the polls in November.
You cannot responsibly propose what Senator McConnell is now putting forward: Do nothing and later on we will be tough—despite the fact that, at the key moment of decision, the consequences of being tough on a failed global megabank (and its creditors) would be catastrophic. This is the true road to disaster.
Also posted on Simon Johnson's blog, Baseline Scenario. The following were previously posted.
Greek Bailout, Lehman Shenanigans, and Tim Geithner
April 14, 2010
We live in an age of unprecedented bailouts. The Greek package of support from the eurozone this weekend marks a high tide for the principle that complete, unconditional, and fundamentally dangerous protection must be extended to creditors whenever something "big" gets into trouble.
The Greek bailout appears on the scene just as the US Treasury is busy attempting to trumpet the success of the Troubled Asset Relief Program (TARP)—and, by implication, the idea that massive banks should be saved through capital injections and other emergency measures. Officials come close to echoing what the Lex column of the Financial Times already argued, with some arrogance, in fall 2009: The financial crisis wasn't so bad—no depression resulted and bonuses stayed high, so why do we need to change anything at all?
But think more closely about the Greek situation and draw some comparisons with what we continue to learn about how Lehman Brothers operated (e.g., in today's New York Times).
The sharp decline in market confidence last week—marked by the jump in Greek yields—scared the main European banks, and also showed there could be a real run on Greek banks; other Europeans are trying to stop it all from getting out of hand. But there is no new program that would bring order to Greece's troubled public finances.
It's money for nothing—with no change in the incentive and belief system that brought Greece to this point, very much like the way big banks were saved in the United States last year.
If anything, incentives are worse after these bailouts—Greece and other weaker European countries on the one hand and big US banks on the other hand, know now for sure that in their respective contexts they are too big to fail.
This is "moral hazard"—put simply, it is clear a country/big bank can get a package of support if needed, and this gives less incentive to be careful. Fiscal management for countries will not improve; and risk management for banks will remain prone to weakening when asset prices rise.
If a country hits a problem, the incentive is to wait and see if things get better—perhaps the world economy will improve and Greece can grow out of its difficulties. If such delay means that the problems actually worsen, Greece can just ask Germany for a bigger bailout.
Similarly, if a too big to fail bank hits trouble, the incentive is to hide problems, hoping that financial conditions will improve. Essentially the management finds ways to "prop up" the bank; on modern Wall Street this is done with undisclosed accounting manipulation (in some other countries, it is done with cash) . If this means the ultimate collapse is that much more damaging, it's not the bank executives' problem anyway—their downside is limited, if it exists at all.
The Greeks will now:
- Lobby for a large multiyear program from the IMF. They'll want a path for fiscal policy that is easy in the first year and then gets tougher.
- When they reach the tough stage, can't deliver on the budget, and are about to default, the Greek government will call for another rapid agreement under pressure—with future promises of reform. The eurozone will again accept because it feels the spillovers otherwise would be too negative.
- The Greek hope is that the global economy recovers enough to get out, but more realistically, they will start revealing a set of negative "surprises" that mean they miss targets. If the surprises add to the feeling of crisis and further potential bad consequences, that just helps to get a bailout.
- The Greek authorities will add a ground game against the European Central Bank (ECB), saying things like: "the ECB is too tight, so we need more funds." We'll see how that divides the eurozone.
In their space, big US banks will continue to load up on risk as the cycle turns—while hiding that fact. Serious problems will never be revealed in good time—and the authorities will again have good reason (from their perspective) to agree to the hiding of issues until they get out of control, just as the Federal Reserve did for Lehman Brothers. Moral hazard not only ruins incentives, it also massively distorts the available and disclosed information.
As for Mr. Geithner, head of the New York Fed in 2008 and Secretary of the Treasury in 2009: Those who cannot remember the bailout are condemned to repeat it.
Greece Saved for Now—Is Portugal Next?
with Peter Boone
April 11, 2010
The Europeans announced Sunday they would provide 30 billion euros of assistance to Greece, amid informed rumors that the IMF will offer another 10 billion to 15 billion. With a total of say 40 billion to 45 billion euros in the bag—more than the market was expecting—the Greeks have time to make changes.
The Greek government, helped by the market threat of a near term collapse, appear to have strong armed the other eurozone countries into a generous package without making efforts to change seriously their (Greek) fiscal policy. This is good for near-term calm, but it does not solve any of the inherent problems now manifest in the eurozone.
Often assistance packages of this nature just help "smart money" to get out ahead of a default. This could be the case here; 40 billion to 45 billion euros total money could last roughly one year. Both Russia and Argentina got large packages in the late 1990s but never regained access to private markets, so eventually everything fell apart.
Sunday's package should make it possible for Greece to borrow short term but it takes courage to lend for 5 or 10 years to the Greeks unless there is much more fundamental change.
There are two key things to watch for:
- 1. Is the global recovery so strong that Greek's economy picks up fast and their budget deficit comes down sharply?
- 2. Will the IMF and Greeks now come up with a real austerity program that sharply cuts the deficit so that a year from now, when the official bailout money could run out, the market is receptive to Greek debt?
The danger for private debt holders is clear: Sovereign loans are invariably treated better in a restructuring than private debt. So the European aid in some sense squeezes private debt holders. They will be pleased there is no near-term default, but it means their recovery value has gone down if things get bad again. Greek long-term yields will probably stay high. The key market reaction to watch over the next 6–12 months is long-term yields, and whether these come down to levels that imply low risk of default.
And there is still definite risk of contagion. The actions of the European Union show they are willing to intervene when yields get up to 7 to 8 percent on long-term debt and markets close off to a nation.
What does this really mean for Portugal or Ireland? People holding Greek debt lost a lot of money in the last few months. That will not come back soon as markets will, for a long time, be wary of buying their debt—especially when Fitch just took the Greek rating to BBB minus, i.e., at the floor where the ECB now lets banks borrow against ("repo") government debt.
The Portuguese therefore are not at all out of the woods. If they do not start making serious moves toward cutting their deficit, they are next for a test.
Surely the eurozone will bail Portugal out also—but where would it stop after that? The stronger Europeans, by coming to Greece's rescue at this time with little conditionality, are effectively showing all the weaker nations that they too can get a package. This will undoubtedly reduce the resolve for needed fiscal reforms across the European periphery.
We are still lurching from crisis to crisis in Europe.
Fix the Dodd Bill—Use the Kanjorski Amendment
April 10, 2010
At the heart of the currently proposed legislation on financial reform (e.g., the Dodd bill and what we are expecting on derivatives from the Senate Agriculture committee), there is a simple premise: Key decisions about exact rules going forward must be made by regulators, not Congress. This is obviously the approach being pushed for capital requirements, but it is also the White House's strong preference for any implementation of the Volcker Rule—first it must be studied by the systemic risk council (or similar body) and only then (potentially) applied.
Treasury insists that Congress is not capable of writing the detailed rules necessary for a complex financial system—only the regulators can do this. This is either a mistake of breathtaking proportions, or an indication that the ideology of unfettered finance continues to reign supreme.
The regulators who got us into our current mess include Ben Bernanke (from the Greenspan tradition of financial regulation), John Dugan (who makes Bernanke look progressive), and of course Alan Greenspan himself.
If legislation can only empower regulators then, given regulators are only as strong as a newly elected president wants them to be, the approach in the Dodd bill simply will not work.
There is still a feasible alternative, based on a different approach proposed by Representative Paul Kanjorski (chairman of the Capital Market Subcommittee of the House Financial Services Committee) and adopted as an amendment in the House bill .
This amendment will allow federal regulators to preemptively break up large financial institutions that—for any reason—pose a threat to financial or economic stability in the United States. (Yes, there is a weak version of this idea currently in the Dodd draft, but it is very weak—allowing regulators to act "only as a last resort"; see page 3 of the official bill summary .)
Representative Kanjorski has exactly the right idea, but we need to go a step further because we cannot at this point reasonably expect regulators to implement it properly. Remember, in the catch-22 type nature of these issues, the regulators can easily say: Implicit in Congress's decision not to mandate a breakup, we will infer a congressional intent that no institutions currently meet the criteria.
The reality is this. As documented in 13 Bankers (see chapter 7), six banks currently fit the Kanjorski criteria—they are, by any definition, "too big to fail." Congress should mandate their breakup rather than leaving this to the judgment of regulators.
We can discuss the best language and exact terms but the broader point is that we need change by statute, not "after further study."
Even if you trust and believe in the newfound regulatory zeal of our current regulators, Senator Dodd and all other Democrats should be concerned that the next president may be a free market adherent who will appoint regulators captured by Wall Street.
The Dodd legacy should be to break the doom loop for future generations. It would be unwise to let that legacy depend on the judgment of regulators to be named later.
Standing at Thermopylae
with Peter Boone
April 8, 2010
No one in official Washington is seriously worried about Greece. It's far away, relatively small, and—anyway—"we already sent the IMF." Under current circumstances, this is very much like saying 2,500 years ago: We sent 300 Spartans to stand against a horde of Persians, so what's the problem?
The Greek economic situation is worsening fast—with government bond yields rising rapidly today (currently the 10-year rate is around 7.5 percent). Unless there is rapid action by the international community, this has the potential to get out of control.
There are three scenarios to consider: the nightmare, the "savior," and the decision.
Nightmare scenario: No one makes a quick decision, and bond spreads for other relatively weak eurozone countries take off. "Core Europe," such as Belgium and France, are also hit by higher bond yields. At that point, the European Union does something small for Greece, but that does not really address the worsening problems elsewhere. Real interest rates remain differentiated across Europe, with Germany very low and the periphery very high. This causes very different growth rates, feeds into strikes, and budget deficits worsen. European banks take capital losses so they (again) need to recapitalize. The periphery banks need their recapitalization to be funded by the state, which increases national debt. At some point soon a European country defaults. Then there is a wave of defaults.
"Savior" scenario: Phone Larry Summers and he will help arrange another round of unconditional bailouts for all creditors everywhere—perhaps on scale that makes the 13 bankers episode look small. The strategy will be to welcome all the moral hazard back into the system so people feel the risk of state (and private) bankruptcy is zero. Each day we delay now, Mr. Summers and his colleagues will have to provide more largesse—and more distortion—when they finally come in. For example, they could do a new round of "stress tests" and decide that each European nation has a good enough plan to reduce its budget deficit. Perhaps the eurozone nations agree to a common tax or fiscal mechanism to help each other through transfers. They then open the European Central Bank (ECB) lending windows to all those countries. Investors realize they are safe because the ECB shows it has no backbone—maybe Mr. Trichet resigns but probably not, so the spreads come in, etc. The moral hazard issues are mind boggling, and it would be very hard to get any teeth into the system after that. The financial markets would, of course, in the short term stand up and applaud—until they thought through and began to understand all the consequences for government balance sheets.
Decision scenario: As we laid out at length, Greece faces only hard decisions involving some combination of: much more fiscal austerity than is currently in the cards, debt restructuring (also known as default), and leaving the eurozone. Given all the players involved on the European side, it is hard to see how they take any of these decisions soon. This is why "prompt correction action" is never prompt and rarely truly corrective—politicians in this situation (and regulators more generally) have an incentive to delay taking hard decisions that will encounter serious pushback; they would rather wait for events—either they will get lucky or, more likely, they will be forced in a particular direction. But this is exactly how you get forced to a decision point where the only options really are "global collapse or overly generous rescue that creates major problems down the road."
The United States needs to step forward with some clear leadership on these issues. The situation would still be difficult, given the attitudes and fractious nature of Europe. But Washington will not even try—the White House still doesn't understand what it has helped create and the dangers that this poses.
