destabilised financial system to a more solid system with more modest systemic guarantees where even “too big to fail” firms are allowed to fail

From the FT:

"US crisis: the role of systemic risk guarantees

June 2, 2009 11:46am

by FT

By Carolyn Sissoko

US Federal Reserve

In recent years many large financial institutions have become used to the idea that governments stand ready to rescue the financial system when it gets into trouble. Swift regulatory intervention in the US whenever there was a systemic event encouraged this view. Over time, confidence in the government’s ability to act as the financial system’s executive manager resulted in a transfer of the responsibility for controlling systemic risk from the banks to the government.

In the early years of the 20th century, there was no central bank; systemic risk was resolved by the coordinated action of the banks through clearinghouses. While the founding of the Federal Reserve in 1913 might have transferred the responsibility for systemic risk away from the banks themselves, the Fed’s behaviour during the 1930s did not lend credence to this view. The systemic risks of the Great Depression were addressed by policymakers in Washington after Franklin D. Roosevelt became president, not by the central bank.

Experiences such as the Great Depression leave scars. For decades after, banks were managed with the understanding that, while the Federal Deposit Insurance Corporation would save their depositors, the banks themselves would in all likelihood be allowed to fail in the event of a systemic crisis.

In 1984, the implicit expansion of the federal safety net to include the creditors of “too big to fail” banks took place when the FDIC’s resolution of Continental Illinois protected the bondholders of the holding company. Continental Illinois was seized in 1984 in a move that was, at the time, the largest bank restructuring undertaken by the US.

Then in 1987 when the stock market crash left some of the investment banks with too little collateral to back their financing needs, the New York Federal Reserve Bank president intervened to protect them. In 1991 Congress condoned this expansion of the federal safety net by revising the Federal Reserve Act to enable the Fed to lend in an emergency against the collateral held by investment banks - or even hedge funds.

In a speech in February 1998, Alan Greenspan, then Fed chairman, made the new role of the central bank explicit by stating: “The management of systemic risk is properly the job of the central banks. Individual banks should not be required to hold capital against the possibility of overall financial breakdown. Indeed, central banks, by their existence, appropriately offer a form of catastrophe insurance to banks against such events.”

In short, over the past 25 years the US government has engaged in a large expansion of the protection offered to the financial system: the counterparties of a “too big to fail” bank could expect to be repaid even if the bank failed and the Fed chairman himself had taken responsibility for handling systemic risks. Every bank was encouraged to focus only on its own profits. Monitoring counterparties’ balance sheets was unnecessary, as long as they were large, and, as for the financial system as a whole, that was the regulators’ problem.

Unfortunately in a free market economy, the strongest bulwark against systemic risk is the fact that firms want to protect themselves from bankruptcy. So, the losses from trading with counterparties that go bankrupt are minimised by shunning counterparties that have weak balance sheets. Similarly, if the firm sees systemic instabilities building up, it has an interest in bolstering its own capital position to weather the coming storm. By encouraging financial firms to ignore these risks, the government stripped the financial system of its most stabilising forces.

Therefore, the first question we should ask when reviewing the consequences of the crisis is: how has the US government performed in its new role as guarantor of the financial system?

Under the circumstances, it would be hard to give the regulators a passing grade. While some officials at the Fed and the Commodity Futures Trading Commission recognised the dangers of “too big to fail” banks, of the outsized risks taken on by Fannie Mae and Freddie Mac, of over-the-counter derivative markets, and of predatory subprime loans, these individuals were unable to generate a sense of urgency commensurate with the seriousness of the problems. The regulatory agencies had, in almost every case, been forewarned of disaster looming somewhere on the horizon; in every case they chose not to act.

This abject failure on the part regulators is a red flag; the recent transfer of responsibility for financial stability from the private sector to the central bank was a bad idea. The free market principles that held sway through the 19th and much of 20th century left individual financial firms with most of the responsibility for protecting themselves in a systemic crisis and encouraged them either to be well-capitalised or to risk failure.

The evidence indicates that the wholesale transfer of responsibility for systemic risk to the central bank has resulted in a financial system that is seriously undercapitalised. In a genuine free market system risk does not naturally flow to where it is least monitored and where capital requirements are lowest, because each firm protects its own balance sheet by trading only with counterparties that are well capitalised and competent risk managers.

How do we address the crisis, then? First, avoid being misled by Orwellian claims that turn the concept of a free market on its head and portray the banks’ mismanagement of risk as natural economic behaviour. It is government intervention in the form an excessively broad safety net for financial institutions that creates this behaviour. Second, recognise that the stability of the financial system requires a lender of last resort with very narrow responsibilities: it lends only to banks that play a role in the money supply and that have recently been approved by examiners as sound. The reason a central bank lends generously to banks in a crisis is not to protect the banks from failure, but to minimize the likelihood of a sudden decline the money supply. Third, recognise that the only way to shrink the mandate of the Fed is to make it possible for all firms to fail.

Congress needs to enact a resolution authority so that bankrupt financial institutions can fail without causing an implosion in derivative markets. The Fed was forced to take extraordinary action in 2008 to protect the stability of the money supply. This move was the unfortunate consequence of mistakes made in the 1980s and 1990s that allowed bad decisions to snowball by 2006 into a situation where credit default swaps and subprime mortgages began to serve, in part, as the collateral backing our money
supply. The challenge is to lay out a path from our profoundly destabilised financial system to a more solid system with more modest systemic guarantees where even “too big to fail” firms are allowed to fail.

Carolyn Sissoko was an adjunct professor of economics at Occidental College in Los Angeles and is currently writing a book on the financial crisis"

Me:

In my mind, the system of Implicit Government Guarantees to intervene in a Financial Crisis is the main cause of this crisis. However, it formed the basis of banking and investment for the last 25 years. It has produced major financial crises by wedding deregulation and guarantees, an unholy union. But everyone knows that the government will intervene to stop a panic or debt-deflation, or other large financial crises. Hence, there's no point in pretending that the opposite would be the case. Given that, we are left with guaranteeing and regulating.

Now, we can either guarantee banking and investment, as Gorton is advising, or split the two up.

Firstly:

"Bagehot's Principles":

1) If the Fed exists, it will be the Lender Of Last resort, and that has to be taken in to account in real world Political Economy. It should lend freely in a crisis to solvent banks.

2) The rules for LOLR( from here on down this includes any government guarantee ) intervention should be clear, public, and followed, otherwise Moral Hazard is ineffective. All guarantees must be explicit.

3) The terms must be onerous.
4) The LOLR should get something valuable in return.

Here are a few others:

5) The taxpayer's interests should come first.

6) Moral Hazard needs to be constantly applied by quickly liquidating problem banks in normal times.

7) Any entity receiving a guarantee will have to be supervised or regulated effectively, and violations should be quickly and severely punished.

8) There is no doubt that any entity receiving a LOLR guarantee will need to be more conservative in its practices in order to limit the liability of the taxpayer.

9) There should be a class of financial concerns that can act more freely, but they should not receive LOLR guarantees. They will be strictly supervised, which is preferable, or regulated though, and are subject to laws against fraud, etc. They should be self-insured.

Or:

Narrow/Limited Banking on the one hand, and a version of 9 above on the other hand.

I would like a system that has a firm and sound base, and, having that, allows another part of the financial universe to experiment and innovate, which will happen in any case. But not acknowledging the reality of the guarantees is what we previously had, and what we cannot allow to continue. We are learning the price of fooling ourselves with overblown views of our ability to stand firm on principle or ideology. When that does happen, it's more than likely to be in defense of a lost cause.

Posted by: Don the libertarian Democrat