If you believe in Efficient Markets Hypothesis (I don’t in a strict sense) then the unworkability of a “credit insurer of last resort” is obvious on the face of it. It’s even hard for me to type “credit insurer of last resort” without cracking up in laughter. It’s nice to toss around the idea, but the only entity large enough to provide insurance for the behemoth known as banks could only be provided by Uncle Sam. Love it or hate it, that is a fact. Professor Mehrling deserves a tip of the hat for trying, but no chart, graph, or equation Professor Mehrling writes will change that.
Try making credit default swaps illegal, and go from there. I know that will never happen because it’s just to damned simple.

Ontario’s government introduced a mandatory pension insurance fund a few decades ago. In the 1990s they increased premiums to improve the fund’s finances, but after lobbying from a few large employers who would face significant premium hikes, they cut a side deal to exempt those employers in return for commitments to improve their respective pensions’ solvency. The companies, of course, didn’t hold up their end, assuming that the 90s economic boom would go on forever and their pension funds would be fine on their own. And, when some of them later ran into trouble and declared bankruptcy the insurance fund was far too small to cover the pension shortfalls. In (I believe) each case, the government ended up deciding to make large payments to help out anyway.

This was all before my time, but I’ve been told that predictions of that exact outcome were made when the exemptions were given. It’s the most basic example of the problems with politics and governance – the politicians in charge when the deal was made had something to gain, and were then long gone by the time the problems eventually arose and presumbly didn’t care much at that point. The lack of a meaningful chain of accountability will almost always lead to short-term compromises when powerful interests are involved.

1. ALL current bank loans would have to be called in, as they represent deposits that were created without full reserve backing.

2. The process of increasing the reserve requirement to 100% would mean a massive decrease in the money supply. The gov’t would have to counter this with a massive reflation of currency. But since currency, demand deposits, and time deposits do not turn over at the same velocity, how much new currency should be issued? There’s no way to know.

Insurer of last resort is a cute idea but it seems to be completely impractical.

An attmept by geekspeak (greenspan) to create a near 0% or 0% capital requirement banking system.

Does that help in creating UNLIMITED debt?

Are going off the gold standard; suppressing jobs and wages with outsourcing, legal immigration, and illegal immigration; a 0% reserve requirement; and a 0% capital requirement needed to produce unlimited debt on the lower and middle class?

Is the last thing needed no bankruptcy allowed?

Why not?

Would this be correct?

The shadow banking system represents a financial system that operated (operates?) totally outside regulation (national and international). In this system AAA-bond rated financial products were sold to mainly pension funds and mutual funds.

Thanks James for this timely post. All replies welcome.

Had mortgage default risk been properly priced, you would have had higher overall rates, no teaser interest rates or pick-a-payment, and you would have had geographically dependent rates – bubbly markets get higher rates due to collateral risk. We got the opposite. If you got a 90% loan in 2005, you could have turned it into a 80% loan in 2006, with a higher balance! Is that reducing risk?

Take out those mispriced risk variables in the prior paragraph and what happens to the housing bubble? What the risk-taker of last-resort will breed is more of this eyes closed mindless risk taking. Risk is mitigated through underwriting standards. How crappy were underwriting standards from 03-07? For so many of the loans, had the risk been acknowledged, the rate would have been high enough that the borrower said – not a good idea. Pick a payment, 2/28’s didn’t lower risk, they transferred it to the future. You had a continual shifting of risk time-wise until it could not continue to be rolled over. There is no way to eliminate risk, it just gets shifted either from one party to another (eventually to the govt) or it gets shifted temporally.

The whole irrational fear of risk is weird to me. Stupid people without adequate planning and research should not blindly walk into risk jungles. Companies spend millions developing risky project – but they put huge effort into making sure the projects work. They don’t always, but risks are acknowledged and effort is taken to understand the risks and change the design to reduce them. If banks don’t want risks – don’t lend money! Their whole function is offering no risk return on insured deposits and making semi-risky loans at rates greater than the no-risk return they offer. Why shoudl they get no-risk returns higher than an individual depositor?

Increasing risk increases returns, until it doesn’t.

Who will set the higher premium price? The feds, whose regulatory arm can at best be considered a failure in multiple areas? The “best and brightest” in the free market, whose narrow-minded focus on profit compromises their ability to set such a price?

The idea that the feds would operate in the long-term as the clean-up guy for the unregulated shadow banking system is a frightening concept – an “solution” that would further institutionalize the socialization of loss and privatization of profit.

We do need a “lender of last resort” (e.g., the Fed) because banking is inherently unstable due to the maturity mismatch involved in banking operations. If you’re going to have a fractional reserve banking system, deposit insurance and a lender of last resort are essential to keep it from blowing up. Doing away with fractional reserve banking is not, IMO, in any way a workable option. So we’re left with building firewalls around it to isolate it and prevent it from destabilizing the rest of the economy (which was the function of Glass-Steagall) and stabilizing it to the extent possible (deposit insurance, lender of last resort, strict regs on the amount of risk and leverage that can be taken).

The problem is that, somewhere along the line, we forgot about the inherent instability of banking and its ability to destabilize everything it touches. So we allowed a shadow banking system to arise. This system, which consisted largely of the money market mutual funds and the commercial paper market, operated like a bank, had all the inherent instability of a bank, yet had none of the failsafes and safeguards that, through experience, we learned had to be imposed on banks.

The answer is not a “credit insurer of last resort”. The answer is to recognize that the shadow banking system IS a banking system and must be regulated as such. It needs to be brought under the same umbrella as the primary banking system, with the same failsafes, safeguards, and restrictions. Of course, this would likely mean the end of the shadow banking system, since it’s entire purpose seems to be to offer slightly higher rates of return and dramatically increased risks by avoiding traditional banking regulations. So be it.

Look, the reason why the New Deal made sense to economists and politicians of the time was that a lot of people who had nothing to do with the risks that were taken on by the financial sector and their customers were suffering through no fault of their own. The TARP program and AIG bailout were sold on the basis that innocents would suffer just as they had during the Great Depression, if nothing were done. We know better now.

The fact that anybody is raising an “insurer of last resort” smacks of hubris on the part of the financial industry, who have gotten away with their blatant looting thus far.

This merry-go-round has to stop. Soon. Please make it stop.

Also regarding to Bond Girl’s comment – I don’t see that anybody really wants to see global banking (esp shadow banking) become boring. Policy makers may pay lip service to the notion of prudential macro regulation when a camera is pointed at them, but they know that jurisdictional arbitrage will keep the boffins in work
and if it’s not in New York or London, plenty of offshore havens will welcome them with open arms.

I read that property prices are booming in Monaco and parts of Switzerland.