More on Managing Systemic Risk

David Moss wrote a good article in Harvard Magazine about systemic risk and regulation; it’s based on an earlier working paper of his. The problem statement is not particularly original, but very clearly put: Depression-era regulation brought an end to recurring financial crises because deposit insurance was combined with strict prudential regulation to guard against moral hazard. Half a century of stability, however, was undermined by a philosophy that regulation was not only unnecessary but harmful in financial markets, at precisely the same time that financial institutions were becoming dramatically larger in proportion to the economy as a whole. For example, as Moss points out, “the assets of the nation’s security brokers and dealers increased from $45 billion (1.6 percent of gross domestic product) in 1980 to $262 billion (4.5 percent of GDP) in 1990 to more than $3 trillion (22 percent of GDP) in 2007.”

The problem today, in Moss’s words, is that “implicit guarantees are particularly dangerous because they are typically open-ended, not always tightly linked to careful risk monitoring (regulation), and almost impossible to eliminate once in place.” The solutions he outlines basically boil down to renewing that tradeoff, so that government guarantees are explicit and financial institutions pay for them through more stringent regulation and cash.

Continue reading “More on Managing Systemic Risk” →

Neal Wolin And The Bankers

Deputy Treasury Secretary Neal Wolin addressed the Financial Services Roundtable today.  His prepared remarks included the following key paragraphs,

“The days when being large and substantially interconnected could be cost-free – let alone carry implicit subsidies – should be over.  The largest, most interconnected firms should face significantly higher capital and liquidity requirements. 

“Those prudential requirements should be set with a view to offsetting any perception that size alone carries implicit benefits or subsidies.  And they should be set at levels that compel firms to internalize the cost of the risks they impose on the financial system.    Continue reading “Neal Wolin And The Bankers” →

The G20 Summit in Pittsburgh: Should You Care?

On Thursday evening and all day Friday, heads of government from countries belonging to the G20 will meet in Pittsburgh.  On paper, this looks important – 90 percent of world economic output and 67 percent of world population will be at the table: the G7 (US, Canada, Japan, UK, Germany, France, and Italy), plus the European Union, the largest emerging market countries (including China, India, Brazil, Mexico, and South Africa) and a few others.  And unlike the G7, which is really a club for rich industrialized countries, every continent and almost all income levels are represented in the G20. Continue reading “The G20 Summit in Pittsburgh: Should You Care?” →

Bank of America $4 Billion, Taxpayers $425 Million

I’m trying to figure out if I should be infuriated about the agreement allowing Bank of America to walk away from the asset guarantees it got as part of its January bailout in exchange for a payment of $425 million. I can piece together part of the story from The New York Times, Bloomberg, and NPR, but the complete story is a bit hazy.

The initial deal was that Treasury, the FDIC, and the Fed would guarantee losses on a $118 billion portfolio of assets; B of A would absorb the first $10 billion and 10% of any further losses, so the government’s maximum exposure would be about $97 billion. Part of that guarantee was a non-recourse loan commitment from the Fed, basically meaning that the Fed would loan money to B of A, take the assets as collateral, and agree to keep the assets in lieu of being paid back at B of A’s option. In exchange, the government would get:

(a) An annual fee of 20 basis points on the Fed’s loan commitment, even when undrawn (if B of A drew down the loan, which it didn’t, it would pay a real interest rate). The loan commitment could be interpreted to be only $97 billion, so this comes to $194 million per year.

(b) $4 billion of preferred stock with an 8% dividend. That’s a dividend of $320 million per year; B of A can buy back the preferred stock by paying $4 billion.

(c) Warrants on $400 million of B of A stock. B of A was at $7.18 the day the bailout was announced and yesterday it closed at $17.61, so if Treasury had gotten an exercise price of $7.18, those warrants would be worth about $580 million now.

Continue reading “Bank of America $4 Billion, Taxpayers $425 Million” →

The Good Part of the Baucus Bill

I’ve been generally critical of the Baucus Bill, primarily because of the reduced subsidies, which I see as an increased tax on the currently uninsured middle class. But luckily Ezra Klein has been providing detailed coverage of what’s good about it – notably, the proposed reforms to the health care delivery system. See his interview with Peter Orszag and his post about Chris Jennings and most of his other posts from yesterday. On my reading, the Baucus Bill will kick off a number of initiatives that will test different ways of reducing costs or improving quality, such as ways of linking payments to outcomes.

I think this is promising because, as I’ve said before, even though we have a general idea of what the problem is – economic incentives that are cut loose from outcomes – we’re not sure how to solve it. As a result, any master plan to reduce costs without sacrificing quality is easy to attack, and given the political dynamics people will be eager to attack it. The answer is that, in the medium term, we have to figure out what does work, and the way to do that is to try lots of different things. This is exactly what a smart business would do, so it’s good to see the government doing it.

By James Kwak

G20 Thinking: “In The Medium Run We Are All Retired”

It looks like the G20 on Friday will emphasize its new “framework” for curing macroeconomic imbalances, rather than any substantive measures to regulate banks, derivatives, or any other primary cause of the 2008-2009 financial crisis.

This is appealing to the G20 leaders because their call to “rebalance” global growth will involve no immediate action and no changes in policy – other than in the “medium run” (watch for this phrase in the communiqué).

When exactly is the medium run? Continue reading “G20 Thinking: “In The Medium Run We Are All Retired”” →

Health Care Reform and Fairness

Over at the Washington Post this week, it’s back to health care reform, and our topic is fairness. Specifically, somebody has to pay if we’re going to have near-universal coverage. Do you think it should be the people who benefit immediately (the uninsured middle class*) or do you think the payment mechanism should have nothing to do with the beneficiaries (like Medicare and, to an extent, Social Security)? I think this comes down to two concepts of what government programs are for. If the former, you probably want low (or zero) subsidies; if the latter, you probably want to tax the rich, tax gasoline, auction off emission permits, or something like that.

* This is a simplification, I know. But basically, the very poor have Medicaid and will still have Medicaid after reform; most of the insured middle class have employer-based coverage or Medicare, and that isn’t going anywhere in the short term. In the long term, as we’ve argued elsewhere, everyone benefits (except the super-rich) because of increased health care security.

By James Kwak

Financial Regulation, a Slightly Optimistic View

The big news on the regulatory front last week was the Wall Street Journal’s revelation that the Federal Reserve will give its regulators the ability to reject any pay package for any bank employee that encourages excessive risk-taking. The Fed is apparently claiming this authority on the grounds that as a safety-and-soundness regulator, it has the right to prohibit any bank practices that threaten the safety and soundness of the bank. Sounds good to me.

Now, there are certainly reasons to be skeptical, which Yves Smith abundantly outlines. This could be a ploy to gain some populist credentials and head off more Congressional oversight of the Fed. The Fed has been willing to trust banks to tell it what their risks are, so it is not equipped to identify compensation packages that create excessive risk. TheFed will be looking (according to the WSJ) for outliers among the group of the top 25 banks – so as long as all 25 banks are engaged in the same silly compensation practice, the Fed will let it go.

Continue reading “Financial Regulation, a Slightly Optimistic View” →

Financial Regulation, the Pessimistic View

Satyajit Das, who knows more about derivatives than I know about anything, has a guest post on naked capitalism about derivatives regulation. The quick summary? Don’t bet on it.

“‘Holy water’, ‘hosanna’s’ or other utterances (based on particular religious convictions) will be sprinkled or said in the form of initiatives to improve disclosure, increase capital and a new centralised counterparty (‘CCP’) to reduce the risk of a major dealer failing. Fundamental issues – the use for derivative for speculation, mis-selling of instruments to less sophisticated market participants, complexity, valuation problems – will not be substantively addressed.”

Continue reading “Financial Regulation, the Pessimistic View” →

The Fed, Regulation, And The Next Recession

This op ed appeared in the New York Times yesterday (9/20/2009).

SPEAKING at the Brookings Institution last week, the chairman of the Federal Reserve, Ben Bernanke, remarked that the recession in the United States is “very likely over.” He’s surely right that a recovery is under way; in fact, the short-term bounce back may actually turn out to be faster than he thinks — rapid growth is not uncommon right after a severe financial crisis.

Mr. Bernanke commands great respect because of his impressive efforts to head off financial collapse, but his speech was deeply worrisome on the bigger questions: what caused the financial crisis, and how can we prevent another such calamity? Continue reading “The Fed, Regulation, And The Next Recession” →

You Cannot Be Serious: US Strategy for the G20

According to the WSJ this morning (top of p.A1), the US is pushing hard for the G20 to adopt and implement a “Framework for Sustainable and Balanced Growth,” which would amount to the US saving more, China saving less, and Europe “making structural changes to boost business investment” (and presumably some homework for Japan and the oil exporters, although that is not stressed in the article).

This is pointless rhetoric, for three reasons. Continue reading “You Cannot Be Serious: US Strategy for the G20” →

Protect Consumers, Raise Capital, And Jam The Revolving Wall St-Washington Door

Ben Bernanke has a great opportunity to lead the reform of our financial system.  His standing in Washington and on Wall Street is at an all-time high, as a result of his bailout/rescue efforts.  He is about to be reappointed with acclaim for a second term as chairman of the Federal Reserve’s Board of Governors.  And he has a lot to answer for.

Look, for example, at his speech of May 17, 2007, which discusses some of the problems in the subprime market and contains the memorable line: “Importantly, we see no serious broader spillover to banks or thift institutions from problems in the subprime market; the troubled lenders, for the most part, have not been institutions with federally insured deposits” (full speech; marks in the margin are from an anonymous and careful correspondent.) Continue reading “Protect Consumers, Raise Capital, And Jam The Revolving Wall St-Washington Door” →

Regulatory Arbitrage 2.0

Gillian Tett has the latest perspective on a curious deal that Barclays did earlier this week (hat tip Brad DeLong). The deal goes something like this. Two former Barclays execs are starting a fund called Protium Finance. Protium has two equity investors who are putting in $450 million. Barclays is lending Protium $12.6 billion. Protium is using the cash to buy $12.3 billion in what we used to call toxic assets from Barclays. Protium’s 45 staff members get a management fee of $40 million per year (presumably from the equity investors, although that seems steep). Returns from the investments will be paid as follows, in this order (and this is important): (1) fund management fees; (2) a guaranteed 7% return to investors; (3) repayment of the Barclays loan; and (4) residual cash flows to the investors.

Barclays emphasized that it was not participating in regulatory arbitrage, because it is keeping the toxic assets on its balance sheet for regulatory purposes. That is, because it has a lot of exposure to those assets through its huge loan, it will continue to hold capital against those assets. So far so good.

Continue reading “Regulatory Arbitrage 2.0” →

Good for You, Barney

With the waves of criticism that come out of this website, I wanted to acknowledge someone for doing the right thing. Bloomberg reports that Barney Frank, chair of the House Financial Services Committee, barred Michael Paese, a former committee staff member and now Goldman Sachs lobbyist, from lobbying anyone on the Democratic side of the committee until the end of 2010. Paese was already barred from lobbying his old committee for one year after he left the staff in September 2008, so Frank is effectively extending the ban for another year and a bit.

The government-lobbyist revolving door has been around for a long time, and a one-year prohibition is just not long enough; it shifts the incentives too far to the side of using government service as a way to build friendly contacts in industry. Conceptually, I think the ban should be longer and pay for government employees should go up, in order to push the incentives the other way. But I’m not holding my breath.

By James Kwak