Monday, February 13, 2012

Wallison on financial regulation

Peter Wallison has an important Op-Ed in the Wall Street Journal last week (AEI link) titled "Dodd-Frank and the Myth of Interconnectedness"

The chain of bankruptcies is one of the central myths of the financial crisis. A owes money to B,  B owes money to C, C owes money to D. If A fails, it wil result in a chain of bankruptcies where B, C,  and D fail too.

As Peter points out, it simply did not happen. We had a run, not a chain of bankruptcies.
A (L actually!) failed, investors noticed that B, C and D were invested in many of the same things, and stopped lending to B, C and D; B, C  and D also stopped lending to each other. Everyone tried to buy Treasuries. Since the banks were funding themselves by overnight debt, they were supremely exposed to such a run.  

Getting it wrong matters. To produce a sensible regulation of the financial system, it helps to have a vaguely coherent idea of what happened -- and what did not happen. The Dodd-Frank/Fed approach seems to be "we don't know what happened, really, so we'll just regulate everything that moves."

On the chain of bankruptcies theory, and as directed by Dodd-Frank, the Fed is getting ready to monitor and regulate all links between "systemically important" institutions, and implement regulatory limits on their cross-exposures. I reviewed  this in an earlier WSJ oped, and pointed out how fairly hopeless the effort is.

The central idea of Dodd Frank, which the Fed is now endorsing and implementing, comes down to this:  no "large," "systemically important," "interconnected," or whatever (nobody knows what these words mean) will be allowed to fail. The Fed will be looking over their shoulders the whole time.

That approach will necessarily mean protecting them from competition. How else do you make sure they're "strong," and will never get in trouble? And it's only a matter of time that "policy goals" get enmeshed with "regulation." See last week's agreement whereby banks agreed to lower principal amounts on one group of homeowners, as "settlement" against their paperwork problems with another completely unrelated group. The Fed is pushing hard for banks to "do more" for housing... you can see where this will go fast. 

If, instead, we had a run, as I and Peter believe, that sends you thinking in a completely opposite direction. In my view, it means we need to get rid of the institutional focus -- protecting specific "systemically important" institutions -- and instead focus on the run-prone assets. Peter seems to lean more to the "common shock" problem. But either line of thought is a long way from what's going on in the dungeons of the Fed.


  1. What would you think the chances are that inter-connectedness of such large banks, even if it didn't lead to the near-collapses in 2008, would still lead to some sort of collusive behavior that limiting their exposure to each other could possibly reduce?

  2. You point to a potential weakness in my, and Wallison's article -- Ok, that's not what happened last time, but maybe it could happen next time?

    While logically true, though, basing a thoroguh and very intrusive regulation on stories of what might go wrong seems pretty dangerous. Anvils could fall from the sky. If you watch enough cartoons you start to worry.

    If you want to go this route, we should first see strong evidence that there is a danger, that banks and SIFIs are not doing enough to address the danger, that this is intentional not an oversight -- that they have strong incentives not to do enough to address the danger -- and the only solution is that they must be extensively and bluntly regulated. Nobody has done that at all with the "chain of dominoes" theory.

  3. Didn't the Reserve Primary Fund break the buck because of exposure to Lehman? It then faced a run, but a run based on the fact of exposure to A (or rather L). The run was caused by losses at Lehman.

    The connection from A to B to C to D was also certainly on the minds of CEOs on Sunday of the Lehman weekend. For just one piece of evidence see Ross Sorkin's Too Big To Fail quoting Jamie Dimon, page 3. This scenario then was averted through government intervention, an entirely appropriate response. Why should this make it less of a concern for designing future government intervention?

  4. If I recall correctly, there was a major counterparty problem -- specifically AIG. Wasn't that why Goldman was buying insurance against AIG's collapse?

    And I was also under the impression that's why Goldman and AIG's other counterparties are alleged to have received a much bigger bailout than they officially got; AIG was going broke because it had huge debts, and the Fed made sure those debts got paid, an effective bailout for AIG counterparties who would otherwise have taken haircuts or gotten nothing.

  5. The obvious counter will be that, Well, since the government got involved with bailouts and stimulus, then that is why we did not see a cascade of failures. (I don't buy it, but that will be the argument)

  6. "Instead focus on the run-prone assets". Isn't a run-prone asset any illiquid asset funded with liquid liabilities with some information asymmetry between the originator and the funder? Doesn’t this describe banking in general?

  7. If Dodd Frank is flawed there are two groups of people responsible: (1) the Republicans in Congress and K street lobbyists for the Banks who did everything possible to obstruct passing any legislation, because they did not want to give Obama a victory; and (2) commentators like you who put out every sentence you could to confuse and obfuscate the issues (my favorite: the bill doesn't deal with Fannie Mae and Freddie Mac).

    Those who create "the fog of war" have no right to complain when their obstruction results in "collateral damage."

    Now, the banks are big boys and they could have walked into the Senate and said, we had a run, because we were bad, and this is what you should do. But they didn't. They spent millions in campaign contributions, donations to Cato, and lobbying contracts, all with the message that it was all caused by the Community Reinvestment Act.

    If Dobbs Frank is bad, it is the price of duplicity, misinformation, and misdirection. It is not the fault of the people who passed the bill.

    1. Are you out of your mind? Dodd and Frank were up to their eyeballs in encouraging the behavior that lead to the crash. It was anything goes so long as more people got home loans, regardless of their ability to pay. Without that government involvement there would simply have not been enough mortgages to build the MBS market into such a behemoth. The MBS market in turn created an ever growing demand for more mortgages. The estimates are that MBS creation was limited to 10-12 $Billion without relaxing of lending standards, which Dodd and Frank defended every time it was even suggested this could lead to problems.

      It isn't so much foxes minding the henhouse as foxes minding other foxes.

    2. This comment has been removed by the author.

    3. Whatever Dodd and Frank were up to, the idea that relaxation of government lending standards was responsible for the housing bubble is just a myth (and one that Wallison fervently subscribes to). All you have to do to confirm this is look at the default rates of Fannie/Freddie - backed loans vs private loans to confirm that.

      MBS originators on wall street needed no encouragement from government to make a killing packaging mortgages (or carbon-copying them into CDOs). And private lenders needed no encouragement from government to further relax their lending standards when they knew they could sell it to wall street no matter how crappy the terms of the loan and the creditworthiness of the borrower. I'm not sure where you get your $10-$12 billion figure, but it is genuinely laugable. Do you have a source for that?

  8. I agree with the thesis that Dodd Frank will likely be ineffective and lead to market distortions. Increasing shareholder liability (as Tyler Cowen suggests) would be an interesting market-based alternative.

    Having said that, I think Dodd Frank is an improvement on the status quo: large institutions already dominate and have paid no real penalty for their recklessness. Dodd Frank will at least reduce the likelihood of future runs by reducing interconnectedness, and will fund potential bailouts by taxing "systemic" institutions. I've yet to see a conservative alternative to Dodd Frank proposed on capital hill that would actually address any of these issues. Doing nothing at all would be the worst course of action.

  9. The banking system was saved because the government flooded the system with money.

    We know that the Banking system has created enormous systemic risks by creating hundreds of trillions of dollars in naked derivatives (naked in the sense that there is no real underlying commercial interest).

    The argument put forward by the anti-regulation folks sounds like a teenager talking:

    Boy "I'm going to a party with drugs and alcohol and fast cars."
    Father "That's a really bad idea. The last party you went to one of your friends, Lehman, died."
    Boy "That was Lehman, that was not me, I did not die the last time, so its not dangerous for me to go to the next party."

    1. Well it is clear what should happen: the government should hire someone to go to the parties to monitor our children. Stop the risk of inter-connected-ness at the know as opposed to sensibly regulating and controlling drugs and alcohol....

    2. LAL

      I think the government should deal with the banking risk at source by simply outlawing naked derivatives - so you could buy a guarantee on a bond only if you owned the underlying bond and then only to the amount of the bond that you held.

  10. Financial regulation is a form of regulation or supervision, which subjects financial institutions to certain requirements, restrictions and guidelines, aiming to maintain the integrity of the financial system. This may be handled by either a government or non-government organization.
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