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Woodward and Hall on Current Policy

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Interesting throughout. They join the rest of what I call the peanut gallery (those of us, left and right, who cannot understand the bank bailouts).

The effect of the government's current policy is to pay off all claimants on financial institutions at face value, including those which, when they were first issued, had no expectation of federal bailout and received substantial interest premiums on account of their willingness to accept the risk of default. This policy is hugely expensive and stands in stark contrast to the losses that the government has expected investors in the debt of automakers to recognize.

On future financial reform, they write,

Among economists, a consensus is forming that regulation of the financial instutitons that enjoy the government's protection should compel those institutions to have a structure that eases the type of reorganization discussed above (see the statement of the Squam Lake Working Group, an alliance of leading financial economists). The simplest version is to require that banks hold fully subordinated debt and equity of, say, 40 percent of assets, in a holding company, in such a way that the bankruptcy of the holding company would not interfere even briefly with the immediate operations of the bank.

...The idea that banks should have large amounts of fully subordinated debt is hardly new.

Indeed. The group of economists calling itself the Shadow Financial Regulatory Committee has been calling for subordinated debt for years. For example, in May of 1998, they wrote,

the Committee believes that we should take this opportunity to require that all large banks have to raise a certain portion of their capital through the continued issuance of subordinated debentures. To count towards a bank's capital requirements such debentures should have maturities of two years or longer. Subordinated debentures would more closely tie a bank's cost of funds to its financial condition and activities, imposing greater market discipline on banks and mitigating the moral hazard problem associated with a "too-big-to-fail" policy.

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CATEGORIES: Finance: stocks, options, etc.

COMMENTS (5 to date)

Latest Comment

Kit writes:

At 40% of assets there wouldn't be a need for government protection in the first place.

Posted May 11, 2009 8:36 AM

tjames writes:

The 98 paper by the Shadow Financial Regulatory Group seems to be saying that the mega-merger under consideration - Citbank & Travelers - isn't bad, just as the Bank of America & Nationsbank merger isn't bad, becuase there really isn't a problem with "too big to fail" in these cases, and BTW, if there was a problem, you could solve it with subordinated debt. The suggestion regarding the debt is a side light to a work that seems to sweep under the rug the (now demonstrated) catastrophic consequnces of their policy analysis.

Can we trust this group?

Posted May 11, 2009 12:05 PM

q writes:

good idea.

on the same lines -- not nearly 40% but banks raised a lot of capital through convertible debt. this is not getting a govt guarantee and in many cases will not be paid back.

Posted May 11, 2009 12:07 PM

George Selgin writes:

Larry Wall at the Atlanta Fed deserves credit for having pushed the subordinated debt idea for a long time. See his Atlanta Fed page for many papers on the subject dating back to the late 90s.

Posted May 11, 2009 4:32 PM

Carl The EconGuy writes:

"Too big to fail" is just pol-speak. You have to dissect it, like Clinton's (in)famous "depends on what the meaning of is is." Read their actions, not their words. Too big to fail seems to mean big enough to be worth grabbing. They've used TARP to inflict various coercive settlements on financial institutions, and refuse to give up their grasp, even when the financial institutions want out from under. And that's the point. The pols under Obama are just grabbing an opportunity. The real cost of the bubble wasn't phantom gains and losses in the valuation of real assets; it's the political meddling that is now ensuing under the guise of rational regulation.
These people -- led by Obama -- can be trusted only to play politics, efficiency be damned. They don't believe in efficiency anyway. This is Chicago politics, that's all.

Posted May 12, 2009 10:39 AM

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