Secretary Geithner was quoted by the Times as saying that from now on, “no one should assume that the government will step in to bail them out if their firm fails.”
Sorry, but that's just not credible. The Obama financial reorganization blueprint basically says that there are Tier 1 FHCs financial institutions that get special regulation) that are too-big-to-fail (TBTF). For these (today 19?) companies that the administration has decided are guaranteed a bailout. The blueprint refers to a guarantee of liabilities only passingly in its section on special resolution powers for Tier 1 FHCs, but given how we've handled the GSEs, AIG, Bear Stearns, etc., its hard to believe that we wouldn't guarantee the debts of a failed Tier 1 FHC–the whole nature of being a Tier 1 FHC is that there is systemic risk from its failure to honor debt obligations.
This means that for Tier 1 FHCs, their debt is as good as guaranteed by the U.S. government. The implications of this are far-ranging and serious; I haven't worked through all of them, but here's what jumps out at me:
(1) This implicit (or almost explicit) guarantee will give these financial institutions a huge advantage in the market–they will enjoy a cheaper cost of capital than any of their rivals (the same that the GSEs enjoyed). That means all smaller banks, broker-dealers, and insurance companies will get crushed. It also means that foreign financial institutions will be competing against the US government in essence. I hate to think of the trade law implications.
(2) This funding advantage for Tier 1 institutions will come at taxpayer expense–the result of guaranteeing the debt of large financial institutions is to balloon the federal balance sheet and raise the cost of Treasuries, which means raising the cost of borrowing for everybody (except maybe its offset by the cheaper cost of funds for borrowers from the TBTF institutions).
My intital thought is that this implicit guarantee would be very disruptive to the economy–possibly more so than the failure of any of these Tier 1 FHCs. If that's the case, it's a bad trade-off.
The blueprint's goal seems to be to regulate these TBTF institutions so carefully that they won't need a bailout (and maybe the regulation will be so onerous that companies will voluntarily shrink to avoid Tier 1 status or the regulatory costs will offset the funding advantage). Methinks there's a bit of Master-of-the-Universe-as-regulator hubris there. I don't trust the smartest guys in the room to get it 100% right, whether they're on Wall Street or Treasury. We should know better now. No regulatory scheme is failsafe, just as no investment scheme is guaranteed. Even if it works now, what works today will be dated in 5, 10 or 20 years. We shouldn't kid ourselves that a bailout will never be necessary with a revamped regulatory system and that we aren't therefore guarnateeing anything.
The Obama plan is an implicit guarantee of JPMorgan, Bank of America, Citi, Goldman, Amex, Morgan Stanley, CapOne, and the rest of the Stress Test 19 institutions. Do we really want the US government implicitly guaranteeing Goldman Sachs or CapOne's debt? Is that what this world has come to? Did we really cross the Rubicon in September 2008 without realizing it? I recognize that the alternative is trust-busting, and shrinking financial institutions until they are no longer systemic risks, and that isn't very palatable, but it strikes me as possibly the less bitter gall.
Comments
4 responses to “Too Big to Fail? Is Obama Proposing an Implicit Government Guarantee of Goldman Sachs’ Liabilities?”
As you point out, the TBTF concept has a whole set of unintended consequences. Experience will tell us that regulation wont solve the problem. Just have a look at the introduction of global financial standards and audit standards to name two. These interventions haven’t really helped.
One of the unintended consequences may well be the introduction of corporate strategies to grow to a stage where corporations are considered TBTF. Or as you point stay outside the definition of TBTF, by, perhaps, not fully disclosing the extent of assets or liabilities, perhaps questionable valuation practices?
How does Treasury intend to manage the possible financial exposure of taxpayer money on this.
Keep the system changing
Aren’t you making a mountain out of a molehill? The investment banks’ liabilities received a government guarantee on September 17 (the day the decision was made to keep AIG out of bankruptcy court at all costs). By formalizing the guarantee legally, you force the government to acknowledge the guarantee and you open the discussion of precisely what will and will not be guaranteed — and what price these institutions will pay for the guarantee. Surely that’s an improvement over the current system!
No, this isn’t a mountain out of a molehill. It’s one thing for the government to temporarily guarantee financial institutions liabilities in a crisis, it’s another thing to formalize that guarantee as part of an on-going regulatory system. What we’re talking about is formalizing an _implicit_ guarantee (formalized through regulatory structure, not by specific statutory promises about full faith and credit, yada yada yada), which means that there won’t be any discussion as to what will and will not be guaranteed. That said, the terms of the deal are clear: the price is heavier regulatory scrutiny and in exchange there is a guarantee of debts (but not equity, as financial institutions pose systemic risk primarily through their liabilities to counterparties, not shareholders), which means a reduced cost of capital (which could either help avoid disaster or encourage excessive risk-taking).
Great Banking Confusion
The (usually) transparent process of inter-bank lending works so well that most of the time we don’t even think about it. This process has largely weaned the public away from physical paper money. Note that most money (about 90%) now exists only as entries on bank ledgers, backed by loans (debt). Also, note that possessing physical paper dollars is like having equity in the economic output of the United States of America, and has no credit risk associated to it. Physical paper money is not anyone’s liability.
Bank deposit money, on the other hand, does have credit risk associated to it. That risk consists of the liability of the bank in which the deposit resides. Strangely enough, most of the time the credit risk of bank deposit money is lower than the theft and physical-loss risk of physical paper money. That is why we use bank deposit money more than physical money. Through this (normally) transparent process of inter-bank lending, the banking system acts like a huge clearinghouse (essentially a giant ledger) which clears payments between its customers without the physical transfer of cash, and keeps track of who has how much money. Most money in the world economy is not physical (paper cash or gold) but logical (ledger entries).
To summarize: physical paper money is equity. Bank deposit money is backed by debt (actually that’s not 100% true–reserves at the federal reserve system are also equity, essentially an electronic version of physical paper cash).
That difference — that physical paper money = equity in the nation’s economy, and that a bank deposit = debt (a bank obligation) causes great confusion.
We have become very comfortable with bank deposit money, without thinking much about the credit risk we are taking. Bank failures, when they happen, create confusion and chaos because the vast majority of businesses and individuals use checking accounts for convenience (they can write checks rather than handling physical paper cash) and they don’t really think much about the credit risk that is normally associated with keeping their money (their most liquid capital) in a bank in a checking account. In fact, in most cases users of checking accounts do not want to take a credit risk. But in the current banking system there are no alternatives.
Is There a Better Way?
Consider the banking industry’s contribution to society. The banking industry provides three major services to the public:
1. It provides a “safe” place to hold the public’s most liquid assets (cash).
2. It acts like a giant clearinghouse (settling checks without physical paper cash transfer).
3. It is a source of loan money (banks evaluate the credit worthiness of borrowers). Think of “credit worthiness evaluation” as a service to society. If bankers do a poor job at evaluating credit worthiness they will end up mis-allocating economic resources.
What I am asserting is that it is possible to have a banking system where a customer would get benefits 1 and 2 described above without taking a credit risk, if banks gave people a choice between a regular account and a special “100% reserve account.” These special accounts, which are not available to the public today, would have no credit risk. The money in such accounts would not be lendable. There would still be fraud risk, of course. A bank desperate for cash might be tempted to “dip” into the reserves allocated to their 100% reserve accounts. Of course we would make such “dipping” illegal. The 100% accounts would be the electronic equivalent of storing physical paper bills in a safe deposit box at the bank.
Such accounts would have no credit risk (like physical paper cash) but would have the benefit of being used in electronic transactions and be accessible by personal checks. Of course, a 100% reserve account would not earn interest but would most likely have monthly maintenance fees associated to it (similar to a safe deposit box; it would also be very much like the reserve accounts that banks have with the FED). Such accounts, if widely used, would lessen the impact of bank failures on the economy in terms of a contraction of the money supply, chaos and confusion–but would not completely eliminate them.
Lending involves business risks (credit risks). If a customer were to choose a non-100% reserve account then he would be subject to losing his money. This would force the public to do some homework before handing money over to a bank (in essence, customers would need to consider banks’ credit ratings, quality of management, etc.). Of course in this type of setup, a non-100% reserve account would probably have to pay a higher interest rate than the fractional reserve accounts do today. In fact if the public had a choice of 100% reserve accounts, there would be no need to impose legal reserve requirements on non-100% reserve accounts. There would be a clear separation between accounts that have a credit risk and accounts that don’t. The accounts with credit risk would need to set their interest rates high enough to attract depositors.
If our banking system were setup this way, we would avoid huge systemic risks in the future, since a major part of the money supply would likely be sitting in non-lendable accounts. Many enterprises probably should not take any credit risk with their liquid capital (utility companies, municipalities, states, hospitals, etc.). In any insolvency or bankruptcy the 100% reserve accounts would receive priority, and unless the bank was fraudulently “using” these reserves the deposit owners of such accounts would never lose their money. If an electronic deposit account with no credit risk were available, then any individual or business choosing not to use such an account would be subject to losing their at-risk deposit. If such an alternative were available, then the depositor who chose the lendable money account would be warned that he or she could lose money if the bank became insolvent.
Once this choice is given to the public the banks can then be allowed to fail without severely impacting the payment system which is needed to conduct day-to-day commerce. The only job of the FDIC would then be to insure smooth transfer of 100% reserve accounts to another bank.
I will go a step further and state that the availability of such accounts (non-lendable, 100% reserve accounts) should be mandated by Congress through force of law. Each business and individual should be able to choose whether they want to take a credit risk or not.
Mansoor H. Khan
http://aquinums-razor.blogspot.com/