The Fed and the Dirty Dozen

Dallas Federal Reserve President Richard Fisher in a recent speech called for an end of the “too big to fail doctrine.” He identified the dozen largest US banks (which represent almost 70% of all banking assets) as a continuing threat to the American public. He basically admitted that all the layers of bank regulation, including Dodd-Frank, are both overly complex and unlikely to succeed in preventing future bank bailouts. His plan calls the elimination of federal protection for all bank activity that is not explicitly apart of traditional commercial banking.

Our proposal is simple and easy to understand. It can be accomplished with minimal statutory modification and implemented with as little government intervention as possible. It calls first for rolling back the federal safety net to apply only to basic, traditional commercial banking. Second, it calls for clarifying, through simple, understandable disclosures, that the federal safety net applies only to the commercial bank and its customers and never ever to the customers of any other affiliated subsidiary or the holding company. The shadow banking activities of financial institutions must not receive taxpayer support.

Fisher’s plan does not directly reduce the size of the mega banks, it reduces taxpayer liability for the non-traditional “shadow” banking.

Comments

  1. Jonathan Weil of Bloomberg news also took note of Fisher’s speech (http://www.bloomberg.com/news/2013-01-17/richard-fisher-wants-a-warning-label-for-banks.html); in my reply to Weil’s column I offered this analysis of the role of the “shadow banking” sector:

    President Fisher offers an interesting proposal, but it doesn’t really address the reasons why failures of shadow banking firms posed such a threat to the entire financial system or the broader problem of how to maintain the solvency and liquidity of a fractional reserve banking system without imposing enormous costs on the rest of society.

    During the boom that led up to the Panic of 2008, the shadow banking sector was pooling and structuring risky investments that in theory transferred risk from one derivative to another and from derivatives to credit insurers (notably AIG), thus giving the safest tranches of debt a triple-A rating that was coveted both by commercial banks and by money market mutual funds.

    While that was a beautiful theory, the reality was that credit ratings agencies were being paid a lot to ignore the warnings of their experienced real estate specialists regarding the subprime mortgage pools they were evaluating, and instead blindly follow the models of their quantitative analysts who had no real understanding of the high correlation of defaults that can occur when a bank credit-fueled boom turns into a bust.

    As a consequence of this systematic over-rating of debt, commercial banks and money market funds were exposed to enormous cyclical risks as they accumulated triple-A rated mortgage-backed and asset-backed paper. It was really a regulatory bias in favor of S&P’s and Moody’s ratings, as much as the prospect of Federal Reserve or FDIC bailouts, that in part created a significant moral hazard that led to the infamous mortgage bubble (the laundering of lending risk by GSEs also playing a critical role). The Basel II regulations for banks and SEC’s rule 2a-7 for money market funds were the key culprits in incentivizing the shadow banking sector’s laundering of lending risk with the aid of credit ratings agencies on behalf of the commercial banks and money market funds.

    Even in the absence of such an overt moral hazard, however, cyclical risks are still an inherent feature of any bank credit expansion. Commercial bank loan portfolios will always be in danger even if regulators succeed in building a firewall between these portfolios and the questionable products of creative financial engineering.

    The deeper issues here are that credit quality is not something that can be precisely quantified in advance, nor is the quality of a given debt security independent of the overall expansion of credit associated with the creation of money out of thin air. There simply is no magic rule or formula that can tell us in advance what level of loan loss reserves will be needed to maintain the value of a given portfolio of debt securities. That is always a matter for subjective entrepreunerial judgement, not precise objective calculation (not even calculations by Nobel Prize-winning quants, as we should have learned from the 1998 LTCM fiasco).

    To the extent that money substitutes of any kind are not backed by money in the vaults of their issuers, they will always be hostage to unanticipated surges in credit delinquencies and defaults and to the cyclical deterioration of credit quality that accompanies fractional reserve credit expansions. President Fisher’s plan can’t eliminate or even seriously minimize the need for bailouts of commercial banks; only a 100% reserves requirement for all money substitutes can really prevent economic cycles and save us from having to pay for future bailouts to keep the financial system afloat.

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