This seems to be the era for dusting off old articles of mine. This one is one year old, I wrote it on April Fools’ Day — Federal Office for Oversight of Leverage [FOOL]. (Today I would simplify it to: Federal Office Overseeing Leverage.) I would recommend a re-read of that article, and encourage those at the Treasury to realize the enormity of what it is trying to do.
Well, now the Treasury ain’t foolin’ around. They think they can harness systemic risk. Check out the speech of Mr. Geithner, and his proposed policy outline. What are the main points of the policy outline?
1) A Single Independent Regulator With Responsibility Over Systemically Important Firms and Critical Payment and Settlement Systems
- Defining a Systemically Important Firm
- Focusing On What Companies Do, Not the Form They Take
- Clarifying Regulatory Authority Over Payment and Settlement Activities
2) Higher Standards on Capital and Risk Management for Systemically Important Firms
- Setting More Robust Capital Requirements
- Imposing Stricter Liquidity, Counterparty and Credit Risk Management Requirements
- Creating Prompt-Corrective Action Regime
3) Registration of All Hedge Fund Advisers With Assets Under Management Above a Moderate Threshold
- Requiring Registration of All Hedge Funds
- Mandating Investor and Counterparty Disclosure
- Providing Information Necessary to Assess Threats to Financial Stability
- Sharing Reports With Systemic Risk Regulator
4) A Comprehensive Framework of Oversight, Protections and Disclosure for the OTC Derivatives Market
- Regulating Credit Default Swaps and Over-the-Counter Derivatives for the First Time
- Instituting a Strong Regulatory and Supervisory Regime
- Clearing All Contracts Through Designated Central Counterparties
- Requiring Non-Standardized Derivatives to Be Subject to Robust Standards
- Making Aggregate Data on Trading Volumes and Positions Available
- Applying Robust Eligibility Requirements to All Market Participants
5) New Requirements for Money Market Funds to Reduce the Risk of Rapid Withdrawals
6) A Stronger Resolution Authority to Protect Against the Failure of Complex Institutions
- Covering Financial Institutions That May Pose Systemic Risks
- Options for Financial Assistance
- Options for Conservatorship/Receivership
- Requiring Covered Institutions to Fund the Resolution Authority
i. A Triggering Determination
ii. Choice Between Financial Assistance or Conservatorship/Receivership
iii. Taking Advantage of FDIC/FHFA Models:
(As an aside, did anyone else notice that point 6 didn’t make it into the introductory outline?)
The Great Omission
There’s a bias among Americans for action. That is one of our greatest strengths, and one of our greatest weaknesses, and I share in that weakness. Whenever a crisis strikes, or an egregious crime is committed, or a manifestly unfair scandal develops, the klaxon sounds, and “Something must be done! This must never, never, NEVER happen again!”
So, instead of merely having a broad-based law against theft/fraud, and allowing the judges discretion for aggravating/extenuating circumstances, we create lots of little theft/fraud laws to fit each situation, fighting the last war. Oddly, because of specificity of many statutory laws, it weakens the effect of the more general theft/fraud laws.
The Treasury will fight the last war, as they always do, but there is a great omission in their fight, even to fight the last war.
Why did they ignore the Fed? Why did they ignore that many of the existing laws and regulations were simply not enforced? For much but not all of this crisis, it was not a failure of laws but a failure of men to do their jobs faithfully.
Consider this opinion piece from the Wall Street Journal today. There is some disagreement, which helps to flesh out opinions. I think a majority of them concur with the idea that the greatest creator of systemic risk, particularly since 2001, was easy credit from the Federal Reserve. It’s been my opinion for a long time. For example, consider this old (somewhat prescient) CC post from RealMoney:
| ||David Merkel|
|The Fed Vs. GSEs: Which Is Most Threatening to the Economy?|
|2/24/04 1:35 PM ET|
|I found Dr. Greenspan’s comments about Fannie and Freddie this morning a little funny. I agree with him that the government-sponsored entities, or GSEs, have to be reined in; they are creating too much implied leverage on the Treasury’s balance sheet. They may prove to be a threat to capital market stability if they get into trouble; they are huge.|
Well, look to your own house, Dr. Greenspan. As it stands presently, the incremental liquidity that the Fed is producing is going into housing and financial assets. The increase in liquidity has led to low yields, high P/E ratios and subsidized issuance of debt. All of this has led to stimulus for the economy and the equity and bond markets, but at what eventual cost? The Fed has far more systemic risk to the economy than the GSEs.
No stocks mentioned
Since then, the GSEs have failed, and the Federal Reserve is trying to clean up the mess they created in creating the conditions that allowed for too much leverage to build up. Now they are fighting deleveraging by bringing certain preferred types of private leverage onto the balance sheet of the Fed/Treasury/FDIC.
The first commenter in the WSJ piece makes some comments about monetary aggregates, suggesting that the Fed had nothing to do with the housing bubble. Consider this graph, then:
Outpacing M2 (yellow) for two decades, MZM (green), the monetary base (orange) and my M3 proxy, the total liabilities of banks in the Federal Reserve really began to take off in the mid-90s, and accelerated further as monetary policy eased starting in 2001.
This brings up the other part of the omission: bank and S&L exams were once tougher, but became perfunctory. The standards did not shift, enforcement of the standards did. Together with increased use of securitization, and to some extent derivatives, this allowed the banks to lever up a lot more, creating the systemic risk that we face today.
There are other problems (and praises) that I have with (for) the Treasury’s proposals, and I will list them in the addendum below. But the most serious thing is what was not said. The government can create as many rules and regulations as it likes, but rules and regulations are only as good as how they are executed. The Government and the Fed did not use its existing powers well. Why should we expect things to be better this time?
- A single regulator for large complex firms is probably a good idea. Perhaps it would be better to limit the total assets of any single financial firm, such that any firm requiring more than a certain level risk based capital would be required to break up.
- Higher risk-based capital is a good idea, but be careful phasing it in, lest more problems be caused.
- With derivatives, most of the proposal is good, but the devil is in the details of dealing with nonstandard contracts.
- Risk based capital should higher for securitized assets versus unsecuritized assets in a given ratings class, because of potentially higher loss severities.
- You can’t tame the boom/bust cycle. You can’t eliminate or tame systemic risk. It is foolish to even try it, because it makes people complacent, leading to bigger bubbles and busts.
- Hedge funds are a sideshow to all of this. Regulating them is just wasted effort.
- With Money Market funds, my proposal is much simpler and more effective.
- Do you really know what it would take to create a macro-FDIC, big enough to deal with a systemic risk crisis like this? (The FDIC, much as it is pointed out be an example, is woefully small compared to the losses it faces, and it is not even taking on the large banks.) It would cost a ton to implement, and I think that large financial services firms would dig in their heels to fight that. Also, there would be moral hazard implications — insured behavior is almost always more risky than uninsured behavior.
- Very vague proposal with a lot of high-sounding themes. (late addition after the initial publishing, but that was my first thought when I read it.)