Michael Mussa on the Liquidity Tsunami
Short-Term Costs of Long-Run Fiscal Stupidity

Morris Goldstein's Ten Planks for Financial Sector Reform in the Wake of the Subprime Credit Crisis

Morris Goldstein (2008), "The Subprime and Credit Crisis" http://www.petersoninstitute.org/publications/papers/goldstein0408.pdf writes:

Reform 1. We need a prompt corrective action and orderly closure rule for large investment banks along the lines of what we have for banks in FIDICIA, the Federal Deposit Insurance Corporation Improvement Act of 1991. The assumption used to be that failure of a large bank would be much more costly for the economy than failure of a large nonbank, but that assumption has become less and less defensible. Nonbanks now provide a larger share of financial intermediation in the United States than banks. Large nonbanks are big players in derivative markets. Like large banks, large and entangled nonbanks are now special, even if they don’t have deposit insurance. They still benefit from the official safety net and hence face a lower cost of funding than those with no such access. The US authorities have also shown that they will almost certainly not put a troubled large and entangled investment bank into corporate bankruptcy. Without a FIDICIA-like framework for large investment banks, US authorities will find themselves in a tough situation. They will intervene only very late in the day when collapse is imminent, and then they will have two unpleasant options. Option A: Put the investment bank into Chapter 11bankruptcy and accept the potential chaos and contagion that is likely to go with it. Or B: Provide large-scale public assistance to take over the bank on terms unlikely to be most favorable to US taxpayers. Think of what would have happened in the Bear Stearns case if JP Morgan Chase was unable or unwilling to step in and do essentially a purchase and assumption. Recall that under FIDICIA there are capital-based triggers for corrective action; the bank is closed when it still has positive net worth; the shareholders are wiped out; management is changed, and when the FDIC becomes the receiver, they have the option to set up a temporary bridge bank to pay off depositors and creditors and sell the assets in an orderly manner. So as long as they resolve the bank at least cost to the deposit insurance fund, the regulators have quite wide latitude in how they manage the process to maintain financial stability. This is not the case with regular corporate bankruptcy, as the United Kingdom found out in the Northern Rock case. The US Treasury apparently plans to treat the Bear Stearns case as a one-off event and doesn’t offer an orderly closure rule for nonbanks. Large investment banks need to be under supervision of the “prudential regulator” in the Treasury’s blueprint, not under the business conduct and consumer protection regulator.

Reform 2. We need an international agreement on liquidity standards for banks and large investment banks. Much of this crisis has been about liquidity. If you look over the past several decades, you see that large banks in some G-7 countries have reduced significantly the share of narrow liquid assets, like treasuries, in their total assets. This trend has been exacerbated recently by off–balance sheet vehicles; they get their liquidity on the liability side by very short-term borrowing. And brokers and dealers in the United States have long relied much more heavily than banks on repos and short-term borrowing for their funding. So what we increasingly have is “just-in-time” borrowed liquidity for major players instead of an adequate reserve of owned liquidity. This is okay in normal times. It’s not good in a crisis when credit lines dry up, when even collateralized borrowing may be in short supply, and when market prices nosedive for what were formerly regarded as liquid assets. This problem will not be solved by calls for more stress tests and scenarios or by new principles of liquidity management. You need a definition of (narrow) regulatory liquidity and a quantitative benchmark for it. I have some ideas on how such a liquidity standard could be designed so that commercial banks and investment banks have adequate owned liquidity, don’t hoard that liquidity, and don’t draw unduly on the Fed for liquidity support. We should seek an international agreement on liquidity standards, but until we get it, we should impose our own national standard.

Reform 3. Basel II will need to be reworked thoroughly, not just tweaked at the margin. Two of the key features of Basel II are that banks can use their own internal models to calculate capital requirements under Pillar 1, and that credit ratings also serve as risk weights in regulatory capital calculations. These internal models typically generate lower capital requirement for (large) US banks. Suffice it to say that all these elements have had their credibility severely damaged by the events of the past eight months. Were UBS and Citigroup using these internal models to guide their asset allocation decisions, including subprime exposure, and were banks using the credit ratings on collateralized debt obligations (CDOs) to make such portfolio decisions? If anything, the crisis shows we need higher capital requirements, not lower ones (as well as capital requirements that are countercyclical—not procyclical). One of the reasons why proposals for higher liquidity and higher capital are not popular in the financial services industry is that they would limit leverage and asset growth and probably reduce the average profit rate. But they would also reduce the risk of financial crises and what you and I pay for them.

Reform 4. Reduce conflict of interest at credit rating agencies by separating the rating and consulting business like we did with the accounting industry after Enron.

Reform 5. Improve coordinated action between monetary authorities and regulators during the buildup of asset price bubbles so that both of them don’t simultaneously say, “identifying and pricking asset price bubbles is not my job.” If one doesn’t act, the other must.

Reform 6. Make Wall Street compensation an integral part of risk management by imposing a capital charge on firms that don’t implement sensible, deferred compensation plans.

Reform 7. Tilt the growth of derivative markets toward organized exchanges where systemic safeguards (the creditworthiness of the clearinghouse, standardization, and marking to market) are stronger and away from the over-the-counter (OTC) market (this too could be done by appropriate use of capital charges or by putting settlement of OTC contracts lower down on the priority list relative to organized exchanges during an insolvency under a FDICIA or FDICIA-like framework). In the wake of the CDO and CDO-squared debacles, why the US Treasury would want to make it easier to issue complex securities escapes me.

Reform 8. Improve incentives in the originate-and-distribute model by requiring originators to have skin in the game and by eliminating any capital bias in favor of off–balance sheet structures.

Reform 9. Rationalize the US regulatory structure using the objective-based model (that is, a market stability regulator, a prudential regulator, and a business conduct and consumer protection regulator) in the recent US Treasury plan.

Reform 10. Use some version, probably a smaller one, of the Dodd-Frank bill and a “recovery lease program,” to reduce US home foreclosures.

In closing, the US subprime and credit crisis has multiple causes. But large-scale regulatory failure is surely one of them. It requires a comprehensive response. Light touch financial regulation does not increase US competitiveness or US leadership when it contributes to a costly financial crisis like the ongoing one.