How would regulatory reform work, if it works?

Some examples

Looking at history and recent events is one way to try to assess what financial regulatory reform can accomplish. Yesterday’s posting took that approach. It is a comfortable approach because one can cite a few sources that support or clarify particular points. The readers are then free to read the citations and see if they reach the same conclusions or cite other sources they think are more relevant. Before abandoning that approach, there is one other citation worth making although readers who have followed events might skip it.

One of the benefits of a systemic risk regulator would be that theoretically those with oversight responsibility would be thinking about what to do if a systemic crisis occurs. If you think that such scenario analysis is a waste of time, read "On the Brink: Inside the Race to Stop the Collapse of the Global Financial System" by Henry M. Paulson, Jr. It is scary to recall how totally unprepared regulators were and realize how inefficient the absence of preparation made their response. However, making this citation reflects my bias toward scenario analysis as a risk management tool.
A second approach is to speculate about how regulatory reform would work. Be forewarned, my crystal ball is turned on. But before rolling out my crystal ball, here is a quote from someone else’s crystal ball gazing. Mark Zandi has published his assessment of how regulatory reform might work at http://www.economy.com/dismal/article_free.asp?cid=115952&src=economy-hp-dismal-article . While assessing a different set of regulatory reforms, these two points are very relevant to any regulatory reform that includes the two proposals he is addressing. I cite Mark as a professional crystal ball gazer and a recognized authority, I’m not.
• With authority to act as a systemic risk regulator, the Federal Reserve might have also worked to reduce leverage throughout the financial system. This is most likely with respect to Fannie Mae and Freddie Mac: the Fed had publicly expressed skepticism about risk-taking at these institutions. Yet it is not likely the Fed would have been willing to require broker-dealers to raise more capital and reduce leverage; regulators were actually allowing many of these institutions to take on more leverage, assuming they had the acumen to manage their risks. The Fed also displayed little appetite to require more disclosure or curb risk-taking by hedge funds.
• Perhaps most importantly, the proposed regulatory regime would allow a more orderly resolution of troubled institutions. Important financial players such as Fannie and Freddie, Bear Stearns, Lehman Brothers and AIG were not under the purview of the Fed or other banking regulators when they fell; they would be under the proposed system. Resolution of these institutions was botched in part because regulators lacked clear authority; this in turn caused the financial crisis to become a financial panic last September.
His analysis illustrates some important points. It isn’t realistic to expect anyone to get everything right. Some risks made the radar; some didn’t. It also illustrates the broader focus needed to address systemic risk.

Another approach is to take a current issue and see how regulatory reform fits. Let’s use Greece as an example. Greece experienced a near-default experience recently. Anyone with Greek bonds knows that’s not good. You’re thinking you don’t care. You don’t own them; don’t have any investments in Greece; maybe don’t even have any investments. But, under our current regulatory environment, are you insulated? Bad news; you are at risk. Greek bonds are insured, and the insurer is supposed to pay up if Greece defaults. Guess what; you’re the insurer. AIG insures the bonds, and you, as a citizen of the US, own 80% of AIG.

If you want, you can get mad later, but for now think about how we got into this mess. It says a lot about the appropriate regulatory reform. For starters, score one for regulating derivatives: if adequate collateral (an exchange’s or the trader’s) were available, that would have eliminated the issue. However, it does matter where the collateral is. It does not support the idea that just having better capitalized banks will fix a thing. It is important that the capital be collateral that is connected to the obligation. Otherwise, it is dead money as the capital just sits there doing nothing about risk. In this case, Greece, as the debtor, or AIG, as the insurer, is where the capital should be.

Score two for the need for better resolution authority. First, the government decided to throw a lot of money at AIG. It judged that throwing money at the issue was less unpleasant than a wind down. Second, the government is like Brair Rabbit stuck to the Tar Baby. Now that it owns AIG, it has no option except to wait and hope things work out. Things may work out. I don’t know about you, but some of us would rather not go for that ride. Selling naked puts, which is what default insurance really is, doesn’t seem like a good business for the government.

Score one for realizing that no organization is too big to fail. The US ought to be thinking about how to insure its debt. By guaranteeing AIG, they’re just adding off balance sheet liabilities to their books. It’s like the governments own not-so-little Structure Investment Vehicle (SIV). We know how those can turn out from Enron and the recent experience of the banks.

Glass-Steagall is irrelevant; AIG is not a bank nor is Greece. The relevance of a ban on
Prop Trading by banks seems questionable. In fact, a well-run bank might hold the bonds and have taken out insurance. That would be especially true if they underwrote or syndicated the bonds. They could have a residual exposure as well as reputational risk. In addition, they face the risk of push back from customers who bought the bonds. Hedging those risks might require a net position.

How does this relate to the proposed bank liability tax? Not much. There is a chance the tax would be on exactly the right liability on exactly the right balance sheet with exactly the right tax incidence. But, the chance that the tax would be borne by the potential source of risk just is not that likely. Trading fees would actually make a little more sense than taxing liabilities, although they also would not be borne by the source of the risk. But, by reducing liquidity, they might create an incentive for traders to be a little more cautious about assuming the risk. However, they are largely irrelevant, marginal at best.

Regarding systemic risk regulation, the Greek situation is very informative. As an event, it is “manageable.” Greece has been in default about half the time since 1800. The only reason it gets so much attention is because of the potential for contagion (i.e., cascade failure in risk management jargon). It also illustrates the limitation of US systemic risk regulation. The best that US systemic risk regulation could do is to protect our financial institutions from potential cascade failure. The US exists on the same planet as Greece; we will be affected no matter what. But, that’s different from systemic failure.

It is also relevant to the issue of who is in the best position to provide systemic risk oversight. The Fed is in the middle of US international capital flows. It would end up being the instrument of any action regardless of who initiated it. Further, its role gives it unique information about what impact Greece is having on the dollar and US capital markets. If the Greek situation isn’t financially manageable, the Fed is most likely to see it. So, regardless of who is the systemic oversight regulator, the Fed often has to focus on it.

Basically, the potential issue of Greek debt-related problems shows how irrelevant many of the proposals are. But, given that Greece is over there and we’re over here, that isn’t too surprising.