Arnold Kling  

My Ideal Financial Reform Bill

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A reader asked me for this.

1. Extricate the government from the mortgage market as soon as is practical. I foresee reducing the maximum mortgage amounts that of Freddie and Fannie to zero in stages over a period of three years, then selling off their portfolios two years after that. I would even get rid of FHA. I would also get rid of the mortgage interest deduction. My guess is that the market would evolve toward higher down payments, and probably toward mortgages like the Canadian five-year rollover.

2. Housing aid to poor people would take the form of vouchers. No other Federal involvement in housing.

3. I would support a law that says that lenders must not make loans with the intent of exploiting borrower ignorance. Allow case law to develop to define rules and norms in support of that principle, rather than try to come up with fool-proof regulations.

4. Break up the top 10 banks into 40 banks. I think that is the best solution to the "too big to fail" problem, although there is no perfect solution to Minsky-type financial cycles.

5. Replace capital requirements with systems that put senior creditors in line to lose money in a default. Let them discipline the risk-taking of financial institutions.

6. Define priorities for creditors in a bank bankruptcy. I think that the solution to the social value--or lack thereof--of derivatives and other exotic instruments can be handled by the priority assigned to them. I would assign them a low priority. That is, first ordinary depositors get paid off. Then holders of ordinary debt. Other contracts, such as swaps or derivatives, come after that. I think that this would provide all the incentives needed either to curb derivatives or lead them to be traded on an organized exchange. I don.t think that getting them onto an organized exchange should be sought after as an end in itself.

7. Get rid of the corporate income tax, which encourages excess leverage. If the private sector, including banks, had lower debt/equity ratios, the financial system would be sounder.

8. Develop emergency response teams and backup systems that can ensure that the basic components of the financial system, particularly transaction processing, can survive various disaster scenarios, both technological and financial.

The overarching principle I have is that we should try to make the financial system easy to fix. The more you try to make it harder to break, the more recklessly people will behave. By reducing the incentives for debt finance and for exotic finance, you help promote a financial system that breaks the way the Dotcom bubble broke, with much lesser secondary consequences.

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The author at in a related article titled A way to fix the financial system that might actually get implemented writes:
    Via Arnold Kling at the EconLog blog, is his plan to fix the US financial system. It applies with equal force to the UK, I think, apart from one or two specifics. It is not the sort of more radical measure that the likes of Kevin Dowd has favoured, but... [Tracked on April 27, 2010 7:04 AM]
COMMENTS (22 to date)

Excellent plan, Arnold.
Given your proximity to various Republicans on Capitol Hill, isn't it time you float this plan to them? Sure nothing may come of it. But if/when they retake congress, maybe some ideas will devolve thru?

Also, what do you think of the Pollock plan ?

Yancey Ward writes:

No handouts for voters. Check

No handouts for lobbyists. Check

No bailouts for losers. Check

Simple rules for liquidation. Check

Yes, this ideal bill has zero chance of ever being enacted. Arnold, you are letting the perfect be the enemy of the bad. Shame on you.

Philo writes:

If the failure of a really big bank is too awful for the government to allow, the simultaneous failure of a handful of smaller banks, with an aggregate size equivalent to that of a really big bank, would be equally awful. There is no economic reason for the government to bail out the failing big bank but not to bail out the handful of failing smaller banks. So the case for breaking up the big banks, not being economic, must be either political or preventive. Political, in that the political influence of a big bank is greater than the combined political influence of a group of smaller banks (so the government will bail out the big bank even when it really shouldn't). Or preventive, in that a failure of the magnitude required to trigger government bailouts is more likely if the banking industry is concentrated than if it is fragmented. Neither of these attempted justifications for breaking up the big banks seems convincing (to me).

You advocate "put[ting] senior creditors in line to lose money in a default." Fine, but how about putting depositors at risk? The system would be much more robust without governmental deposit insurance.

Carlsson writes:

Too-big-to-fail is a misnomer for political cronyism, and should have no place in a good policy platform. Trust-busting the banking system is not a good idea, because size matters, and bigger is better in terms of diversity and shock absorption capacity. I think we need to reduce the number of small banks, by busting the States' licensing systems and get a true federal banking system in place.

The gummint's role should be reduced to providing information about risk, not managing risk -- there's no evidence that they are any better at it than anyone else. I wouldn't mind a govt agency assessing bank behaviors and signaling risks, when they think they see them. We don't need any risk Nannies, but could use honest information brokers.

When loans are not backed by due diligence, I'd like to know before the bubble bursts. I'd like to know the percentage and value of mortgages with less than 20% down, and mortgages costing more than 35% of household incomes. Fix those things, and we'd have to worry a lot less about derivatives.

As for housing vouchers, I don't see any reason for them at all. If the poor are too poor for you, give them cash -- not Food Stamps or vouchers.

And get the special advantage for certain rating agents eliminated. Their ratings are pro-cyclical, so you can't trust them either.

SydB writes:

I concur with the plan by and large. Much better post than the Foucaultian power-class "studies" stuff.

But...I don't understand the pros/cons/analysis of #7. And I'm not sure about the impact of deprioritizing derivatives in bankruptcy proceedings.

Philo wrote "The system would be much more robust without governmental deposit insurance."

Probably not. Herding and bank runs would easily bring the system down. Not good. Better to have insurance and regulate the risks of low-earning income.

Carlson wrote: "As for housing vouchers, I don't see any reason for them at all. If the poor are too poor for you, give them cash -- not Food Stamps or vouchers."

Yeah, if you want that cash going into the local liquor store or crack dealer. Bad idea.

Mr. Econotarian writes:

Can someone explain how the corporate income tax leads encourages excess leverage?

Ben L. writes:

Not sure that I see anywhere in this plan a way to prevent or to balance the efforts of political ideologues manipulating the mortgage system. Barney Frank and Chris Dodd, with the cooperation of two presidents, forced banks to make bad housing loans in the name of race-based "fairness." When Barney and Chris do this again (as they or their intellectual inheritors certainly will) how do you propose to stop them?

Gary Rogers writes:

I am glad I was not the only one that got stuck on number seven. I was scratching my head for a few minutes then used the index to come up with "Banks and Modigliani-Miller". I remember reading that piece but I guess it didn't take the first time. Way to go Arnold!

Gary Rogers writes:

I would add another comment about the last paragraph. Systems that cannot fail, financial or otherwise, need redundnacy. Any system that cannot fail should be designed that way. Redundancy is a byproduct of free markets and experimentation but is destroyed by regulation that forces everyone to do the same thing.

I split a brake line on my truck last week and fortunately the brakes, as are all brake systems in modern cars, are set up so the front and rear use separate fluid reservoirs leaving me with some stopping ability. The parking brake adds additional redundancy because it is mechanical. all of that is done on purpose to minimize the chances of a total failure. Maybe the government should hire some of us engineers that no longer have manufacturing jobs to engineer redundancy into the regulations. If it were me, though, I could not improve on what Arnold just outlined.

Mr. Econotarian writes:

"I was scratching my head for a few minutes then used the index to come up with "Banks and Modigliani-Miller"

All I see there is that tax deductions for interest break Modigliani-Miller in favor of debt. Not that the corporate income tax itself does.

I'd certainly agree that the home mortgage interest tax deduction contributed to the bubble - at least for my house, because that was definitely on my mind when I decided to buy!

Mala Lex writes:

I'm not sure how the breakup helps; why don't you end up with 4 times as many bailouts, each 1/4 in size?

It seems to me the 'lender of last resort' concept is the single problem with 'too x to fail.'

Steve Roth writes:

Damn good lineup.

But you've said (and I certainly agree) that the financial system is too big, perhaps by a factor of x, and needs to be smaller. This may be the biggest issue.

None of the reforms here addresses that.

I personally admire Monsieur Pigou: if you want less of something, tax it.

Robert Bell writes:

I think you could easily do a more detailed piece on 5 and 6 alone, thinking about agency costs, information asymmetry etc and how depositors, counterparties and debtholders of financial institutions would gain access to the information needed to monitor their claims, and how they could meaningfully exert supervision over the managers of those institutions. As I understand it, one of the biggest chunks of the bailouts was AIG, which involved protecting counterparties in order to prevent a ripple effect throughout other seemingly independent parts of the financial system. So walking through a scenario where, under the seniority rules you propose, AIG *wouldn't have* built up huge concentrated risk exposures, would be interesting.

Also, to be clear, structuring the order of creditors *is* a technocratic regulation, so you are joining everybody else who is attempting to design regulation to mitigate financial crises. I'm ok with that in a nudge-y sort of way. Since there will be institutions and rules of property rights, especially in bankruptcy, we might as well design ones that are the most fail-safe we can envisage.

None of this should be construed as a criticism though - the only valid critiques are better designs, and I don't have one.

Les writes:

Mainly very good suggestions, but a few comments:

1."Housing aid to poor people would take the form of vouchers. No other Federal involvement in housing." Housing aid should be temporary, and limited to a few months to discourage dependency.

2."Too big to fail" makes no sense. If a huge bank fails, why not auction off the assets in small lots?

3. "Get rid of the corporate income tax" is certainly justified, but because it is double taxation, rather than any effect on leverage.

4. Repeal deposit insurance: it feeds the "too big to fail" syndrome.

Brian Clendinen writes:

Corporate Income tax do increase leverage, that is unless one changes the tax code and interest is no longer a tax deduction. To much of a slippery slop in my mind. Where do we stop if we start with interest payments as unallowable deductions. One starts to get into allowable verse unallowable compliance issues that you get into government contracting. Trust me you do not want to go there having dealt with it for a living. That is almost worse in my mind than the increased stability with a decrease in leverage . Removing corporate income taxes is the simplest method to reducing leverage by increasing the cost of debt.
The real long term benefit to getting rid of the corporate income tax is reducing the bootleg incentives. A lot of the corporate lobbying and why “Bootleggers and Baptists” is so prevalent resides in the power to change the corporate income tax code. The way politicians get industries to buy into regulations, most of the time, is tax breaks. If you remove the tax breaks, congresses arsenal is drastically reduced. Take the health bill, I do not think a lot of the medical industry groups would of bought in if they did not get special tax breaks. With cap and trade this is especially true.

That is the reason most Republicans and all Democrats do not even touch the subject and are most of the time very hostile to it. To much of their power and individual power over corporate America is in thier power to give special tax breaks.

Not sure why you recommend vouchers verse elimination of the program other than practicality. However, I think getting rid of corporate income tax is less politically practical than the department of housing with all their programs. So not sure why you would recommend a better solution to the one we have now verse the ideal solution.
I am convinced that is a primary if not the largest reason for urban decay and inner city higher crime rates. A free market would force people to move out of the inner city and go to places with cheaper cost of living. The standard of living would actually increase for people below the poverty line because of migration. Plus it reduces the power of a lot of corrupt urban political machines. Off course to much of the Democrats power base is in these regions so they would fight tooth and nail against the reduction of their constituents dependence on them.

mulp writes:

Replace capital requirements with systems that put senior creditors in line to lose money in a default. Let them discipline the risk-taking of financial institutions.

Ah, why not increase the capital requirements and force the creditors to buy stock in the firm instead of seeking to craft a way to make it easier for lenders to lose their money when the lenders have no say in the firm's operations?

If you buy 30 year bonds from a firm under capitalist management which is then replaced two decades later by plundering LBO management, you have no say in the change of management nor the management actions to plunder.

mulp writes:

Develop emergency response teams and backup systems that can ensure that the basic components of the financial system, particularly transaction processing, can survive various disaster scenarios, both technological and financial.

Is this like the FDIC taking over a FDIC deposit bank and making sure I can use the ATM to get my cash, my checks don't bounce, etc., while the bank would otherwise spend months in bankruptcy court with a judge approving all dispensing of cash?

In the case of the most recent crisis, this would mean the government would insure there are no delays in people with drawing from their IRAs to pay their monthly bills simply because the bond market has collapsed and money market fund depositors are withdrawing their cash as fast as they can, beyond the rate bonds can be liquidated to ensure they are stuck with paying for the bad mortgages created through the actions of Goldman Sacks and Bear and Lehman?

If you are merely saying the ATM and check processing system is kept working, but no one is sure they can use it to convert their deposits into cash or payments, what is the point?

mulp writes:

Extricate the government from the mortgage market as soon as is practical. I foresee reducing the maximum mortgage amounts that of Freddie and Fannie to zero in stages over a period of three years, then selling off their portfolios two years after that.

Here's an analysis which makes it clear this crisis wasn't caused by the GSEs:

Freddie and Fannie were created to get the government out of the business of securitizing debt. The Marriner Eccles government system doing that had been more successful that what preceded it; Freddie and Fannie were less successful in avoiding the perception of corruption and imprudent business practices even though they had stockholders who had real stakes in their success.

But I find it interesting that the very clear failure of the ABS issuer segment of the market has convinced you that Lehman, Bear, Goldman, Merrill, IndyMac, and most importantly AIG which is the best analog for the debt the GSEs insured, prove the private sector is much better at the job of providing liquidity and capital flows across the US than what Eccles, a conservative and successful banker, advocated and sold to the nation in the 30s.

Theory is nice and works in theory, but I go with Eccles who operated from real experience and was willing to discard ideology when it was clear it didn't work in practice.

But perhaps you think the golden years were when people regularly lost their life's work, either in bank deposits or their farms. If only the government hadn't stepped in to insure money market funds, and stepped in to buy bonds to keep the funds liquid, so we could have had the satisfaction of tens of millions seeing their money market savings vanish just like in the good old days before the evil Eccles made the US socialist.

Lord writes:

You do realize tilting the economy away from debt will leave monetary policy less effective? Ready for fiscal policy to take its place?

David writes:

The focus is too narrow. The "shadow" banking system was a major source of contagion. Reserve Fund the oldest institutional money market fund broke the buck. Treasury had to guarantee all money market funds to prevent a run on the financial system as a whole. The Fed had to enter the commercial paper market as it locked up threatening the operating liquidity of even the best managed large financial and non financial institutions.

Points 1 and 3 move in the right direction particularly point 3 as it relates to retail.

Point 5 begs the question as to why senior creditors would be more effective than subordinated creditors have been which is what the senior creditors would become. This rule simply eliminates senior credit investment pools from legally participating in funding for the financial system. It is the same as saying that financial institutions should be funded mostly with equity.

Point 6 is a truism. If any investment/derivative loses standing in bankruptcy then it will cease to exist. Whether it is on an exchange or not hardly makes a difference. Nearly all over-the-counter derivatives require collateral to be posted in the same fashion that exchanges through it's broker members require collateral to be posted. This proposal ends derivatives of any type. Far more thought is needed unless the that is the intent.

Point 4 is too simplistic. It would largely turn the problem from "too big to fail" to "too many to fail." Regulators globally are starting to come up with new liquidity standards to complement capital standards. A step in the right direction these new standards are still too weak to prevent contagion. Liquidity matches are more critical than "too big to fail" at this juncture.

steve writes:

#1 makes you feel better and is a good goal, but does little for financial reform per se.

#2 Again, I thought this was financial reform.

#3 and #4 good. Why didnt #5 work recently? Creditors have to know and understand what is going on. This would have done nothing to stop our recent crisis.

#6 Need a clearinghouse. The amount and kinds of derivatives in existence is unknown. Not good for markets.

#7 Good.

#8 This sure sounds like if all else fails, government has to come in and make it work.


Jomamma writes:

Loved every point except the one about a law about not exploiting borrowers' ignorance. Sorry, if you're too ignorant to understand what you're agreeing to, you deserve to be exploited. Maybe you should have legal representation available for contract review, but that's as far as it should go. This point is as stupid as "don't be evil".

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