Monday, March 1, 2010

Does the Volker Plan confuse insolvency with illiquidity?

Volker Plan and Taxes on Liabilities

There is a well known quote from Bagehot’s rules for how central banks should handle financial crises: “lend freely against good collateral at a penalty rate – you will make money.” It worked for 100’s of years, yet past wisdom seems to have become a deflated currency now days.

In Bagehot’s terms, two policy mistakes were made during this crisis, and only one involved banks. In TARP they didn’t insist on good collateral (at AIG, the auto industry). We should admit the mistake and move on. The second, the one relevant to banks, didn’t involve TARP. It involved and still involves the Temporary Liquidity Guarantee Program, TLGP. Governments under-priced the Government Guarantee. They also don’t seem to have thought out the differences between short-run and long-run effects of Government guarantees.

(I’ve ignored mortgage modification because I view it more as a social program than a bailout of the financial system. It, like Fannie and Freddie, involve a totally different set of issues. They overlap and are rather central to financial and economic stability, but involve much more).

Liability taxes are part of the proposal to tax the large financial institutions. But we should all be very skeptical of that idea. Regulators have historically tried to pick the “safe” things for banks to do (e.g., higher capital requirements for certain types of loans, differential Tiers for assets, setting reserve requirements, etc). But, the results are mixed at best (i.e., off balance sheet SIVs, foreign based special purpose vehicles, over exposure to specific types of loans, shifts to fees based services such as securitization, rotating between different funding sources, and convoluted capital structures). There is no evidence governments are particularly good at assessing the risks associated with various types of liabilities other than in hindsight.

If a liability tax is to be taken seriously as anything other than a political sop, one thing that has to be considered is the size of the TLGP exposure. The government should care about the liabilities only if they have a contingent liability. If it is anywhere near the Fannie/Freddie exposure, then the issue should be revisited. But, even if the government’s exposure is large, an analysis of history would probably argue for an insurance premium for TLGP (like FDIC premiums on deposits), not a tax. Then, unlike the closest proposal floating around, the reasonable approach would be to apply the tax to (or better yet require the insurance of) every holder of the liability in question, not just unpopular institutions.

It would be far better if we just stopped giving government guarantees. Just give them on a few forms of bank liabilities (basically, deposits up to a limit a la FDIC) and then only as reinsurance after a first line insurance pool like FDIC. Once the government gets out of the business of guaranteeing liabilities, both retrospectively and prospectively, the liability tax issue becomes moot.

That’s not Monday morning quarterbacking. The argument for avoiding government guarantees is more focused on the long-run verses short-run issue. In the short-run, guaranteeing bank liabilities in any form may have been what was required to end the collapse in liquidity that was occurring in every market. The NY Fed has real time information on market liquidity and, more importantly, knows how to interpret it. We will never have that info and can’t. The only reason the institutions will share it with the Fed is because they know it won’t be disclosed. Unlike of those who see a Fed / Wall Street conspiracy, I recognize my ignorance. Besides the facts that were known publicly -- TED spreads, LIBOR rates, commercial paper market flows, default swap prices, the lock down in the auction market for munibonds – all supported the Fed’s and Treasury’s interpretation of conditions on the ground at the time. If anything, Cramer’s rant was right. The Fed was late.

But being right at the time is different from being permanently right. We know from Freddie and Fannie and a multitude of historical examples that government guarantees lead to excesses (bad financial management, excessive risk-taking, and misallocation of capital).

There is an amusing contradiction in the Volcker Plan; the government is going to tax the same liabilities their guaranteeing. Perhaps they should just tax TLGP liabilities. It would be a way to unwind the program. Since many of the banks have been able to raise capital with stock issues, the program, like many government programs, has outlived the need.

Rather than supporting an effort to manage risk by regulating the liability side of financial firms’ balance sheets, this cycle should be viewed as a case study in the futility of that approach. Each of the failed institutions experienced a run. Their liquidity was drawn down and sources of replacements were gone. But each firm used different liabilities. The mortgage banks depended on bank loans and short term bonds. WAMU and Wachovia were classic bank runs as large depositors pulled down account balances. Freddie and Fannie didn’t even have deposits. Lehman and Bear Sterns used different liabilities than Fannie/Freddie or the banks/thrifts. AIG used even different forms of liabilities. GE is the clearest case of commercial paper as a source that choked.

The entire idea of a liability tax is just a way to avoid the problem. In the 21st century, problems in the banking system originate with their assets, not their liabilities. Banks become bad loans because they made bad loans. That’s how they become insolvent. Problems originating on the liability side are always and inherently a risk. But, they are a liquidity risk. The essence of banking is a maturity miss-match. Banks lend long term using short-run liabilities. Thus, a run is always a possibility. Adding liquidity is the appropriate regulatory response. But, if the loans aren’t going to earn more than they cost, it doesn’t matter where the funding came from.

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