Archive for the ‘financial reform’ Category

Suppose that a systemically important financial institution (the official designation, now in true DC style the acronym SIFI) actually fails.  Do we get a financial crisis?  Are owners/creditors punished for endangering the economic system or partly/largely bailed out by loans/transfers from taxpayers?  A few days ago here in Chicago, the acting chair of the FDIC, Martin Gruenberg, spoke to the Chicago Fed about how the FDIC would “systemic resolve” a failing SIFI without endangering the financial system while actually placing losses on those who own and are owned by the institution.  Speech here.


I am glad the work is proceeding.  If, . . oops I mean . . . when we end up in the next financial crisis, we will at least have a plan.  And an ex ante plan may help reduce the frequency of crises.  As  Gruenberg said, “developing a credible capacity to place a systemically important financial institution into an orderly resolution process is essential to subjecting these companies to meaningful market discipline. “

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The Journal of Consumer Affairs has some interesting reading on the regulation of the consumer market for financial products in a special isues here.  They also published a while back an article (speech) by Elizabeth Warren on applying what is known in product safety regulation to financial products, here. (These may be restricted or require a log in if you are not at an allowed IP address.)

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Just a quick post to flag, here, a candid and well-written overview of some of the policy failures leading up to the crisis and policy responses during the crisis by John Dugan, the outgoing head of the OCC (‘The what?’ you say. The OCC happens to have been a regulator of national banks.) And just so you don’t ignore the piece once you see it is a speech given to the “Exchequer Club,” which sounds like a group of guys that make one happy we rebelled against English rule, he contrasts this financial crisis with earlier financial disruptions, and notes how earlier policy responses were useful in this crisis:

“ . . .the systemic risk authority that Congress provided to the FDIC 19 years ago in FDICIA . . .  allowed the agency to guarantee obligations other than insured deposits in extraordinary circumstances . . .  Of course, this was the provision that we did use when the crisis hit, not only in individual cases involving several large institutions, but also more broadly to temporarily guarantee the obligations of a wide range of financial institutions, just as other governments were doing. As a result, this is the provision that has been widely criticized as the wellspring for the government’s “too-big-to-fail” actions, unfairly allowing bailouts of large firms about to fail, while smaller distressed banks have been forced to close their doors without government help.  . . . But here’s the thing of it: in the middle of the crisis, it worked. That is, in the absence of an orderly resolution mechanism for large financial firms, the provision worked phenomenally well to avoid runs and restore confidence, just as it was intended to do – and it will even end up making money for the taxpayer.”

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Here is the summary from the Senate Banking Committee. Lots and lots to digest here. . .

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Finally, the two parties have agreed on legislation that largely ends “too big to fail.”  The latest amendment to the financial reform legislation, sponsored by Senators Dodd and Shelby, is described by Dodd here.  My view is that this amendment does end too big to fail and dramatically reduces taxpayer exposure to large failing financial firms. The legislation allows large financial institutions to be taken over and run and liquidated in an orderly fashion by the government when they become insolvent. All shareholders and creditors will take losses in proportion to what they would have taken had the firm been allowed to fail.  It limits section 13(c) of the Federal Reserve Act so that the Fed can only use its emergency lending to lend to solvent institutions (My understanding was that this was pretty much the Federal Reserve’s interpretation of their authority during the initial phases of the crisis and that this interpretation is why Lehman was allowed to go under.  However, as the crisis evolved post-Lehman, the Fed relaxed its interpretation because the size of the “emergency” made the strict interpretation of “lending” as opposed to bailing out less relevant – see Maiden Lanes I through III.)

My two concerns? The legislation seems to be a field day for lawyers in the wake of any such failure.  I would prefer legislation that requires such institutions to have covenants in place ex ante that specify relative losses across debt classes when an institution fails. Second, I fear the complete stripping of an institution before it goes under, which would leave all creditors and equity with nothing but potentially leave the government either needing to cover some of those losses which “somehow” appear to be held in systemically important places or having to cover some commitments of the defunct firm to maintain faith in the financial system. This is related to my view that derivatives contracts allow firms to make new debt senior to existing debt and to pledge value out of firms ‘expropriating’ long-term debt holders and now potentially the taxpayer. Your thoughts are welcome . . .

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April showers bring May flowers, and maybe April preliminary reports will finally bring some developments on the financial reforms.  The first look at the thinking of the Financial Crisis Inquiry Commission is now available on the FCIC website. The five reports (available here) cover the roles of securitization, the Fed, the Community Reinvestment Act, the mortgage crisis, and the GSE’s in the financial crisis. Your chance to weigh in on these reports is now – the Commission is inviting comment until May 15.

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Robert Litan has written a forceful, balanced, and brave discussion of financial reform. Here is an excerpt:

I have written this essay primarily to call attention to the main impediments to meaningful reform: the private actors who now control the trading of derivatives and all key elements of the infrastructure of derivatives trading, the major dealer banks. The importance of this “Derivatives Dealers’ Club” cannot be overstated. All end-users who want derivatives products, CDS in particular, must transact with dealer banks …

I will argue that the major dealer banks have strong financial incentives and the ability to delay or impede changes from the status quo — even if the legislative reforms that are now being widely discussed are adopted — that would make the CDS and eventually other derivatives markets safer and more transparent for all concerned.

If you care about the prospects for meaningful financial reform, you should read Litan’s essay.

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