Financial Reform or a Commitment to Future Bailouts?
It is unsurprising given the melt down in the financial sector that politicians are looking at “reforming” financial regulations. To most people the general idea of regulatory reform should be to prevent conditions form coming about that lead to the meltdown and thereby prevent further bailouts. Problem is it is looking like the reform in question may implicitly promise more bailouts according to Phillip Swagel.
The debate over financial regulation is now focused squarely on the ability of the government to take over a failing financial institution such as a bank holding company or hedge fund—so-called non-bank resolution authority. This is the linchpin of reform because allowing the government to intervene in a crisis will affect investors’ risk-taking behavior from the start—for better or worse. A resolution regime that provides certainty against bailouts will reduce the riskiness of markets and thus help avoid a future crisis, while a reform that enshrines the possibility of bailouts will foster risky behavior and unwittingly make future bailouts more likely. The key choice is thus whether financial regulatory reform gives the government discretion to bail out creditors or instead ensures that these counterparties take losses.
It is the old moral hazard problem and also has a nice dash of time inconsistency as well. If the government does bailout institutions it takes over then investors will be more inclined to take on more risk than they otherwise would. And with a few large institutions the likelihood of a financial meltdown like we’ve seen increases. The time inconsistency aspect of this stems from the fact that unless there are clear rules stating that the government cannot bailout institutions or at the very least the conditions under which a bailout might take place, there will be an incentive to bail out the institutions if everyone acts as if there wont be any bailouts. Think of it this way, suppose the government enacts the Dodd plan and also says, “We will not bailout financial institutions with taxpayer dollars anymore.” Lets further suppose that people behave in accordence with this statement. Then a financial institution fails and is taken over, at that point the government will face a situation where if they bail out the institution it is welfare enhancing than if they don’t. Since investors are forward looking, they can foresee this type of outcome and thus wont take the initial statement about there being no bailouts as being credible.
So, does the Dodd plan have any rules on bailouts? Not that I can see, and Phillip Swagel agrees,
President Obama’s approach, as embodied in Democratic Senator Chris Dodd’s bill, is for discretion and thus for bailouts. Top administration officials state that they will impose losses on counterparties such as lenders to a failing firm. The reality, however, is that the Senate bill gives the government discretion, without a vote of Congress, to put money into a failing firm to pay off creditors. Shareholders will take losses but creditors can benefit from government-provided funds. Regardless of the administration’s intentions, markets participants will understand that the Senate financial regulation bill allows for bailouts, and this will give rise to riskier behavior that in turn makes future bailouts more likely.
I looked through the text of the bill and while it says that loses will be shared according to each participants role in creating the situation that led to any given institutions failure it isn’t clear how exactly this will be done. It will be left to the discretion of various bureaucrats, agencies, and such. In short, it is a discretionary policy vs. one that follows rules. Given this, the conclusion is that Dodd’s plan for financial reform is really nothing but a commitment to future bailouts.
In the fall of 2008, the Lehman Brothers bankruptcy was followed by severe negative effects as short-term credit markets shut down. This is sometimes taken as evidence that bankruptcy is not a tenable outcome for a large financial firm. This is wrong. The disruptions that followed Lehman’s collapse were greatly magnified by the idiosyncratic problem that a large money-market mutual fund broke the buck as a result of losses on Lehman debt. This sparked a panicked flight out of money-market mutual funds, which led commercial paper markets to seize up and in turn begat TARP. This situation would have been prevented only by guaranteeing Lehman debt—that is, by a bailout that the administration says would not be allowed to occur under its financial regulatory reform proposals.
This is the problem with discretionary policy, it is like running up stairs that are collapsing. If you stop, the stairs crumble and you fall. So you run further up the stairs. Problem is that you can’t keep running forever, and the higher you go the worse the fall. Once you bailout one institution (e.g. Long Term Capital Management (LTCM) back in 1998) it is noted by other market participants and it may very well alter their attitude towards taking on risk. The more bailouts, the more and more this shift towards riskier and riskier investments grows not unlike running up a collapsing stairway. At the time, it may have seemed wise to bailout LTCM, but now in 2010 after looking at a horrendous financial meltdown and one of the worst recessions of all times it looks like a very unwise decision. Yes, it may have meant a recession and financial crisis, but it may very well have been far less burdensome as the current one.
And enacting reform that could very well continue the process of running up the stairs is a very bad one. So of course it will probably pass and become law.