First, it may not be effective if the same approach is not followed by other countries. For example, it would be possible to imagine the acquisition of these scaled-down, overspecialized financial firms by Sovereign Wealth Funds, government-owned banks, and/or large international financial firms – I know that there are complications, and such deals could be blocked on many grounds. In effect, the end result of your plan could be further consolidation and concentration, but now at the global level;

Second, I’m not sure if reducing the size of financial firms and limiting the scope of their activities to certain niches would be effective in eliminating systemic risk. Although smaller, financial firms would still be highly interconnected, and some “systemically-important firms” in specific markets would still have the capacity of knocking-out markets and initiating a chain reaction – with the difference that now we would not be talking about one big financial firm or bank but maybe a handful of smaller firms systemically important in their respective markets;

Third, decreasing the size of a financial firms does not necessarily eliminate the influence they may have on regulators – although, of course, it helps. However, on of the problems is that people can shift very easily from positions in the industry to positions in the regulators. This symbiosis may or may not be desirable – I do think that it is problematic and may give rise to serious conflicts of interest – but it will continue even if financial institutions become smaller. It is thus also important to think about ways to limit the appointment of individuals with ties to the financial industry to official positions;

Finally, limiting the size and scope of financial firms may have some impact on international liquidity – although there is nothing preventing smaller financial institutions occupying the space left by the bigger ones. Here the problem may be one of exposure – and smaller sizes may mean less appetite for risk and less exposure to potentially good but generally riskier assets such as those issued by emerging market companies and states.

Any thoughts?

get a good risk manager at the regulator not guys like Ben bernanke who felt that the housing crisis has been contained even in 2008, who can’t access the extent of risks in the system, who cannot ask the right question before the event and so on..

Markets tend to resemble underdamped control systems. They respond quickly to news and other inputs, overshoot and ring. Viewed from this perspective recent events make sense.

In the search for bigger profits, especially in the short term, the leverage in the system was increased. This is analogous to turning up the gain. At the same time regulation (damping) was in many areas reduced either through deregulation or regulatory neglect. The stability of the system was thus compromised and a downside input sent it out of control.

One can argue that markets will be most efficient if allowed to behave in this way. By running them at the edge of stability they will respond faster than if they are damped by regulation and leverage is reduced. The downside is periodic crashes. It would be an easy decision if the crashes didn’t hurt people. Since they do, we must find a balance that provides acceptable risks while not giving up too much of the benefits of markets.

In my view gain has been turned up too high and too little damping has been applied in recent decades. Your mileage may vary.

The response of the banking industry to the rise of these huge clients was scale up, first by consolidating heavily, and then by making huge investments in information technology that would allow them to essentially bet against their institutional investing counterparties using complicated mathematics backed by the latest computing technology. The need for more and more capital, both to invest in infrastructure and to use in betting against counterparties, also explains why all the now-consolidated investment banks eventually went public.

If you were to break down Wall Street into a bunch of small and medium sized firms, the institutional investors would have them over a barrel again, shifting the center of financial policymaking gravity from the banks back to the institutional investors. Whether you think that would be a good thing or not is another matter; your mileage may vary.

What, ultimately, was the nature of the AIG debacle? Entities which either owned mortgages, or wished merely to short them, “sold” or “shorted” them to AIG. They did this this through so called credit default swaps. In a securities based world, the standard way to sell is to sell outright for cash, or more often, to sell by financing the sale through the repo market. The typical “repo” requires a “haircut”, or a partial cash down payment; has a maintenance provision, which means more cash must be posted if prices go down; and is immediately callable, which means the seller can simply unwind the trade at any time for any reason.

There is certainly no reason CDS trades cannot operate in a similar manner. In fact, CDS trades among “dealers” and between dealers and other entities, are structured, for all practical purposes, in a comparable way. However, this is not how the AIG deals were structured.

They were really 100% financed (no haircut); they had no maintenance provision as long as AIG remained AAA; and they were term contracts which could not be unwound by the “sellers” accept under certain conditions. Why did the street do this? Sellers either were looking to hedge their longs, or were looking for capital relief, or were looking to short the market. When the final tally was made, AIG “owned” about $600 billion of mortgage related credit instruments through this method. When their credit rating declined, and market prices declined, then certain “maintenance” or “cash calls” were triggered in massive amounts. Of course, by then they could not come up with the cash.

Those are approximately the details. What does this mean system wide, and what does it mean to the concept of interconnectedness? I will stipulate it as obvious that a dollar of investment can only be lost once. If these CDS represented, for example, mortgages on defaulting houses in California, then the decline in the value of those houses is the true loss the financial system experiences. The financial world believed it had “resold”, or shorted, these mortgages to AIG. What is the systemic impact of AIG’s inability to post collateral?

The bottom line, of course, is that other institutions never really did sell these mortgages. They thought they did, but did not. For all intents and purposes the losses from the decline in mortgage values now reverted back to the original sellers. Of the two types of “sales”, “reselling” and “shorting”, naked shorting is the least disruptive to the financial system. The trade effectively disappears as if nothing happened. They thought they made a bet with a guy who could pay it, but did not. Of course, believing you made money probably effected your behavior in other ways, but that is what happens some times. Still, no money was lost—money was just not made.

Firms who thought they were hedging discovered they did not. Would they have gone “long” mortgages had they not been able to resell them? No. Many used AIG to free up regulatory capital–so by definition they could not have bought as much without someone like them to lower the capital requirement. This, of course, is not an “interconnectedness” problem, but a judgment problem based on their belief in AIG’s ability to pay if there were a problem. Other hedgers were likely hedging inventory so they would not have held as much, presumably.

This is speculation of course. They may have viewed AIG’s guarantees as so cheap that they entered into those trades opportunistically. They might have bought just as much as they would have otherwise. Still, all the losses, which the sellers thought would be AIG’s are now reverting back to the sellers.

When AIG failed, what should the regulators have done? First, they should have taken their damn time and thought about it. AIG’s failure was like a giant “long squeeze”. To replace the now failed company, there was likely enormous short selling in the CDS market—creating widening spreads and declining mortgage values. The sizes were large enough to have caused the rapid decline in mortgage values we saw. The Lucy study (UVA professor William Lucy) demonstrates this decline in values was not based on fundamentals, but panic long covering. Does this remind anyone of something similar? Long Term Capital of course.

What happened with LTCM? Greenspan, in a famous move which was criticized as encouraging moral hazard–how innocent that view seems today—met with LTCM’s counterparties and basically said “it is in your interest not to force these guys to post collateral”. Why? Because that would have set in motion an even larger wave of unwinding thus driving down prices further. One might call this “collateral posting forbearance”.

Paulson and Bernanke should have called a big “timeout” and required the sellers to look at the true underlying value of these instruments What is true? Pontius Pilate once asked a similar question. What is true is one’s judgment as to what is true. That may not have been mark to market values. If the underlying instruments were still paying, an orderly process of unwinding could have occurred—without cash being put up by the government—and without forcing a long squeeze.

Some losses would have been taken just like 1998, and more so. AIG should have been broken up, resold, and gradually the rest of the financial system would have had to assume their positions—not the Government. But Paulson is a creature of Wall Street and is a “hopelessly talented” individual. Talented, because he can see the trees—hopeless because he cannot see the forest. In 1998, Greenspan lead. In 2008, Lloyd Blankfein lead. Goldman had money owed to it and it wanted it now. So Paulson gave it to them

That’s why the idea that paying eg. judges a lot of money and giving them job security in the hope of making them incorruptible is never going to be wholly successful. The threat of social isolation remains, and is more than most people can stand. And the threat of isolation extends also to family – can their wives stand it? Can their children?

There is room for a more in-depth study of how pressure is actually exerted on policy-makers, and their vulnerabilities. I think there’s a lot to be learned.