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Rogoff vs. Kling

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Tim Carney likes my financial reform ideas, but Ken Rogoff does not. Rogoff writes,

A surprising number of pundits seem to think that if one could only break up the big banks, governments would be far more resilient to bailouts, and the whole "moral hazard" problem would be muted.

That logic is dubious, given how many similar crises have hit widely differing systems over the centuries. A systemic crisis that simultaneously hits a large number of medium-sized banks would put just as much pressure on governments to bail out the system as would a crisis that hits a couple of large banks.

I agree. But the question is whether a large number of medium-sized banks could shape the contours of the regulatory system to their benefit (and to the taxpayers' detriment) as successfully as a few large Wall Street firms have. Even now, Wall Street is drooling over the prospect of a mortgage finance system in which Freddie and Fannie guarantee all mortgages but are not allowed to hold securities in portfolio, leaving Wall Street free to carve up and trade these securities in all sorts of ways, making yet more profits by exploiting their too-big-to-fail status and other regulatory anomalies.

Rogoff continues,

some finance specialists favor forcing banks to rely much more on "contingent" debt that can be forcibly converted to (possibly worthless) stock in the event of a system-wide meltdown. But how this form of "pre-packaged bankruptcy" could be implemented in a world of widely different legal, political, and banking systems is unclear. Financial history is littered with untested safety-net devices that failed in a crisis. Better to rein in the growth of the system.

Again, I agree. It is very hard for policy makers to credibly commit themselves to allowing an untried bankruptcy system to run its course. They will always be tempted to say, "Not on my watch," and to try to bail banks out instead.

I think that leverage is always dangerous. That is why proposals include changing all of the policies that produce biases in favor of debt finance, from the mortgage interest deduction to the corporate income tax.

The way I look at it, there is no perfect solution for financial reform. Rogoff favors an IMF idea, which is to tax bank size. My concern is that this would tighten the symbiosis between governments and large banks. It would give banks the ability to say, "Hey, we paid the tax. Now you owe us the bailout." It would give governments a reason to want to favor big banks--in order to collect more revenues.

I could see a tax on bank size opening up avenues for all sorts of mischief. How long would it take for Congress to enact a tax break for large banks that make lots of loans to favored political constituents, say...low-down-payment mortgages to low-income homebuyers?

(To be honest here, Rogoff is probably was not writing about my proposals. My guess is that he was taking on Simon Johnson and James Kwak on the "break up the banks" issue, and he is taking on Luigi Zingales on the "contingent debt" issue.)

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COMMENTS (10 to date)
M OLeary writes:

I am not sure your public choice justification holds up (it might). You feel many smaller banks will have less ability to capture the regulatory system than a few large banks. But many mid-size banks will likely have geographically dispersed headquarters and still subtantial financial heft for political donations. Those banks will be in more districts and impact more Senators, and their combined infuence could be more, not less.

Ted writes:

I find the political economy and legal arguments for breaking up the big banks the strongest.

I think the economic rationale is pretty weak for a variety of reasons. The first is the reasons that Rogoff stated, but also I think it would encourage herding. Let's say you set up a regulatory regime that resolves these medium size banks. If there is a recession that weakens only a few banks because of their balance sheet composition and they fail and are thus resolved. But, let's instead say that a lot of these banks that are medium size begin to fail in mass. Then you are in the situation of having to bail out everyone in order to prevent a severe disruption of credit allocation (Bernanke's "Non-Monetary Effects of the Financial Crisis in the Propagation of the Great Depression" is extremely relevant here). So, doesn't this encourage all these medium size banks to "herd" towards similar asset and investment strategies so in the event of a recession they know they will either be OK like the "other guy" or they will be bailed out because everybody is going under. I think you'll get a very similar problem of having a massive bail out of the financial system. I don't think we've seen this recently since commercial banks resolved by the FDIC have been pretty small, but I think this argument becomes very relevant once you are talking about dozens of multi-hundred billion dollar firms. Also, if you enforce bank size with a cap you basically eliminate the ability to use purchase and assumption agreements as a way of resolving banks near the cap which would be incredibly dumb. Prudent regulation and, above all, investor due diligence (which I think really broke down because of overconfidence in the rating agencies) must be the top priority from an economic perspective. The political economy arguments you put forth are far more appealing than the economic arguments which I think simply don't hold or are irrelevant for the reasons that I and Rogoff listed.

What I actually think is the biggest hurdle we'll have to jump over in the future of banking is how to deal with international institutions. Many of these banks are basically international companies (especially Citigroup). Assets stored at overseas divisions are subject to that respective nations bankruptcy and resolution proceedings. I'm thinking that resolution (rather than a bailout) of a very large firm would require a lot of coordination with every nations regulatory authority where a bank has a division that holds a substantial amount of assets. If not prepared for ahead of time (or even if it is it likely won't run too smoothly) it would still create chaos in the global market since it would be managed rather hazardously. In fact, I wouldn't even be surprised if banks intentionally tried to manipulate their asset holdings in foreign countries in order to create this massive legal coordination problem in order to facilitate a bailout rather than a resolution or semi-bankruptcy. The international legal issues seem tremendous here (and this is also why the argument for nationalizing Citigroup was purely theoretical since it would be practically impossible given the current international legal framework). To me this implies that we are going to need to set up international agreements in order to facilitate a "safe" resolution of firms with large deposits held internationally. But given how difficult it is to even get smooth free trade agreements, I can't imagine us getting a successful and robust international agreement regarding financial institutions any time soon. This makes me believe we should cut banks down to size so that internationally-held assets can be resolved easier. I can easily imagine it would be simpler to negotiate a quick deal when we are talking about a few billion dollars in assets as opposed to a quick management of hundreds of billions of foreign-held assets during a time of crisis.

To me the legal and political arguments is where cutting the banks down come from, not so much the economic arguments.

staticvars writes:

I think the S&L failures are a good case to examine.

Really, it is the institutions, or set of institutions, themselves that need to be more diversified. An asset revaluation in one sector could either be contained in institutions that focus on that sector, causing only those to fail, or contained in institutions that are sufficiently diversified. We need redundancy in the sector, but not institutions that are just trying to mimic each others behaviors. We need the longs and the shorts in sectors.

Easier hedging and more visibility into the derivatives used for shorting could pop bubbles sooner.

Mala Lex writes:

I think the added coordination difficulties for smaller banks is pretty minor. They can form lobbying organizations (ABA, etc).

It's true they get out-competed by larger bank lobbying today, but absent those banks I think they would simply inherit the field. I see no reason why they'd be less grabby than the big banks. Less love of lucre?

mark writes:

Without taking sides, good concise summary.

Personally I prefer lower leverage ratios as fin instns grow in size which is like Rogoff's idea but less politicized. I also very much like the convertible-by-regulator debt idea. If you worry that it isn't proven, I suggest considering adding the power of regulators to extend debt and derivative repayments for one to three years. I agree with you re eliminating policies in favor of debt creation. I'd extend it to compensation systems within fin instns that award fees and bonuses to employees based on,a nd at the time of, creation of debt, not collection of it.

Doc Merlin writes:

"But the question is whether a large number of medium-sized banks could shape the contours of the regulatory system to their benefit"

They did in the 1800's.

Colin K writes:

Financial innovation seems to rely either on scale or specialization. Large banks generate large piles of profit to work with while hedge funds and PE take a boutique approach with each firm doing a very specific type of finance.

Smaller financial institutions would arguably lead to less innovation on the bank side since they would not have the scale to develop and support multiple types of innovation.

Since "innovation" in finance is almost invariably about ways of creating and managing more leverage, less innovation would probably be less risky.

Andrew_M_Garland writes:

Government guarantees to any set of institutions provide a way to reduce risk, make the profits private, and the even larger losses public.

Financial crises will always occur when giant guarantees are offered by government.

Guarantees serve everyone but the public, which has to regularly pay for them under the delusion that these guarantees are making their investments safe.

End the guarantees. Make all investors assume all of the risks and make the investors look after the institutions which invest their money.

R. Pointer writes:

Wibbels (2004) looks at the 1830-40s state financial crises that hit a number of states. At that point only a minority of states had over-borrowed and they were unable to gain bailouts at the federal level. After that a number of states went bankrupt and then instituted balanced budget amendments.

Fast forward to today. If you have a nationwide bank with a large number of branches in many states versus numerous banks with limited regional reach. The evidence shows that while you will still have bank failures they will be limited to regions (not everyone will go hog wild; Arizona, Florida, California and Nevada did, but not everyone else). If those bubbles had been limited to regional banks and not national level ones, Congress and the President might have not been fearful that local branches of national banks would have rolled up and died. I think of small and many as the best bulwark against federal bailouts.

R Richard Schweitzer writes:

How does the "Pricing System" (as an information indicator) play into all this?

It is pretty well accepted that programs like the FDIC, etc. lower the costs of capital to some segments of the system (presumably - but not necessarily - flowing through in system onward lending). We can see an effect on pricing there; but, on some grander scope???

Then there is the nature of guarantor proposed for this so-called "fund," derived from taxes.

Those funds, taken out of the commercial system as taxes will go where? Invested in what productive objectives? Probably invested in none, only to become another internal accounting record of government receipts, possibly represented by theoretical U S obligations (does "Trust Fund" sound familiar?) and thus expended long before collected.

That's what U S obligations represent: expenditures made before collection.

Now, if members of the system were to be required to establish segregated reserves, similar to those of a life insurer (not like the pension plan provisions), and keep those reserve funds within in the commercial orbit, and outside political determinations - then, we might be on to something.

Right now the plans head for a future black hole. AND, that future may come sooner rather than later.

R. Richard Schweitzer

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