responding to the financial crises: lessons learned vincent reinhart resident scholar american...
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Responding to the Financial Crises: Lessons Learned
Vincent ReinhartResident Scholar
American Enterprise Institute
May 8, 2009
“The failure of a major policy…is, if nothing else, a marvelous lever with which to open a debate.”
David HalberstamThe Best and the Brightest (Twentieth-
Anniversary Edition)p. xiii
Bipartisan failures…
• In 2008, inconsistent policy making– Added uncertainty in an
uncertain environment,– Magnified the economic
shock,– Wasted government
resources, and – Damaged the reputations of
key government institutions
• In 2009, cynical policy making, recognizing the public’s distaste for bail-outs, has– Delayed the recognition of
bank losses– Designed a rescue package to
minimize the footprint on the budget, which will
– Extend and make more expensive the ultimate resolution
What are the lessons to learn from this experience?
Policy interventions (bail-outs) have significant costs
The source of policy makers’ fears is of their own making
Understanding this mechanism is important for framing new legislation and regulation
Four rules of bail-outs
Rule 1: Don’t do them
The possibility of government intervention has consequences for the private sector, the government, and the political process
The private sector Lessens pressure on management to raise capital and address
balance sheet problems Lessens counterparty discipline
The government Opens agencies to political pressure Confuses the public about policy intent Eliminates forever the possibility of serving as an “honest broker”
The political process Tilts the political playing field toward intervention generally Legitimizes increased supervision and regulation of a wide portion
of financial activity
Rule 2: If you break rule one, be consistent
Policy interventions by the Federal Reserve and the Treasury in 2008 were ambiguous as to the scale and scope of the
protection offered
This created incentives for creditors and short sellers to test the limits of intervention So, the fear of debt contagion led policymakers to act
in ways that encouraged speculative attacks
Rule 3: If you break rule two, be prepared to spend a lot
• The possibility of intervention leads investors to delay capital investments
• Given a capital hole, – If the private sector
does not fill it,– The government will
have to
Public debt three years after a crisis
Source: Reinhart and Rogoff (2009)
Rule 4: Whatever you do, don’t add to uncertainty and worsen confidence
Statements in the Fall (TARP/AIG) and the Spring (stimulus/market repair) Added to uncertainty Damaged confidence
This is a problem inherent in the brinksmanship of bail-outs Political salesmanship
does not always align with economic stewardship
Why are there bail-outs?Too complex to fail
Why do policy makers protect complicated firms?
Fear of spillovers The tyranny of event studies
Self interest of officials Krugman's ”capture by Wall Street”
Disguised subsidy to some forms of credit Housing is preferred beyond all else
Officials worry…
• About the effects on markets if a complex organization were to fail
• Those concerns become more elevated when markets are already stressed
Complexity and the probability of intervention
0
0.25
0.5
0.75
1
0 2 4 6 8 10 12
Complexity of the financial organization
Pro
babi
lity
of g
over
nmen
t ac
tion
, pe
rcen
t
Crisis Normal times
Complexity
• Is only imperfectly connected to the size of the firm
• Once a firm is too complex to fail, it has a market advantage– Funding costs are
lower for too-complex-to-fail firms
Complexity and asset size
0
2
4
6
8
10
12
14
0 200 400 600 800 1000 1200
Assets (billions)
Com
plex
ity
(ind
ex)
BoNY
BoA
Traditional costs of complexity
Complex sector Not complex sector
Cost of funds
Scale of activity
Cost of funds
Scale of activity
Protectionpremium
1
2
3
1 to 2: Risk takingis encouraged andthe scale of failurewill be larger
2 compared to 3: Resources are misallocated andincentives areskewed
Marginal opportunities
Marginal opportunities
The protection premium does not all go to owners
Rent seeking as firms spend resources to keep their special status by Going slow on industry initiatives that limit risk
Netting of swaps, central clearing houses Weaving systemically important activities into the firm's structure
Clearing banks Resisting regulation that would make closure easier
Uniform insured depositor list Making their balance sheets more intricate and their instruments
more complicated to take advantage of regulatory arbitrages
Shirking as owners find it more difficult to monitor employees, leading to Failures of suitability Compensation abuses
Note the irony
A firm’s effort to take advantage of government-induced distortions By becoming more complicated to gain a protection
premium By making its instruments more complex and its
balance sheet more opaque to take advantage of regulatory arbitrage
Lessens it owners’ ability to monitor management Eroding value and making the firm riskier
Note the circularity
Policy makers’ concern about complicated firms Puts money on the table (the protection premium) That induces firms to be more complicated And worsens the principal-agent problem between
owners and employees Making the financial system more vulnerable to
abuses and less resilient Raising the odds of strains That justifies policymakers’ concern about
complicated firms
The way forward
…is not to add another layer of supervision
As in some proposals to create a Financial stability supervisor “College of supervisors” Special resolution authority for too-complicated-to-
fail institutions
Those proposals Accept the inherent inefficiencies and gaps in the
current system and Leave the fundamental incentive for complexity (and
the resulting rent seeking and shirking) on the table
Ole Kirk Christiansen's modular solution
The whole of a financial holding company can be made of parts that can be disconnected and reassembled LEGO is formed from the Danish words "LEg GOdt"
meaning "play well" Any part of the firm that is systemically
important can be protected in bankruptcy With haircuts in the event and Infrastructure developed over time to limit the
perimeter of systemically important activities But the rest can be turned over to the market
Playing well also involves
• Reducing the number of corporate charters and agencies
• Enforcing consolidation of balance sheets
• Giving up some efficiencies of scale and scope to bend the curve relating size and complexity
Complexity and asset size
0
2
4
6
8
10
12
14
16
18
0 200 400 600 800 1000 1200
Assets (billions)
Com
plex
ity
(ind
ex)
Playing well
Facilitates international cooperation Because the module in a foreign country can be
supervised by the host (consider the Turner Report) Should have the goals of
Making pre-packaged bankruptcy a viable option for any large financial entity
Increasing discipline on management because hostile takeovers are more likely when entities can be carved up
Improving monitoring within a firm Works overall to improve economic efficiency
I have no illusions
• Playing well would– Be costly and take time
to implement– Be resisted by industry
because it • Takes money off the
table
• Put more pressure on management
– Lower the return on equity in finance
• But so will other, more burdensome and more likely regulatory alternatives
• Change is coming– We should at least get
some efficiency gains from it
Playing well is my aspiration
My prediction is that after heightened government intervention
• More and burdensome regulation is a certainty– which may make the job of attracting capital and restoring
confidence harder
• Capital once infused by the government will be slow to exit the private sector
• The Federal Reserve, in particular, will be overburdened and subject to political pressures that will – Change its current structure and powers– Call its inflation resolve into question