Richard Fisher of the Dallas Fed delivered a speech last week( h/t Zerohedge) on the topic of financial reform, which delivered some of the most brutally honest analysis of the problem at hand that I’ve seen from anyone at the Fed. It also made a few points that I felt deserved further analysis and elaboration.
The Dynamics of the TBTF Problem
In Fisher’s words: “Big banks that took on high risks and generated unsustainable losses received a public benefit: TBTF support. As a result, more conservative banks were denied the market share that would have been theirs if mismanaged big banks had been allowed to go out of business. In essence, conservative banks faced publicly backed competition…..It is my view that, by propping up deeply troubled big banks, authorities have eroded market discipline in the financial system.
The system has become slanted not only toward bigness but also high risk…..if the central bank and regulators view any losses to big bank creditors as systemically disruptive, big bank debt will effectively reign on high in the capital structure. Big banks would love leverage even more, making regulatory attempts to mandate lower leverage in boom times all the more difficult…..
It is not difficult to see where this dynamic leads—to more pronounced financial cycles and repeated crises.”
Fisher correctly notes that TBTF support damages system resilience not only by encouraging higher leverage amongst large banks, but by disadvantaging conservative banks that would otherwise have gained market share during the crisis. As I have noted many times on this blog, the dynamic, evolutionary view of moral hazard focuses not only on the protection provided to destabilising positive feedback forces, but on how stabilising negative feedback forces that might have flourished in the absence of the stabilising actions are selected against and progressively weeded out of the system.
Regulatory Discretion and the Time Consistency Problem
Fisher: “Language that includes a desire to minimize moral hazard—and directs the FDIC as receiver to consider “the potential for serious adverse effects”—provides wiggle room to perpetuate TBTF.” Fisher notes that it’s difficult to credibly commit ex-ante not to bail out TBTF creditors – as long as the regulator retains any amount of discretion with the purpose of maintaining systemic stability, they will be tempted to use it.
On the Ineffectiveness of Regulation Alone
Fisher: “While it is certainly true that ineffective regulation of systemically important institutions—like big commercial banking companies—contributed to the crisis, I find it highly unlikely that such institutions can be effectively regulated, even after reform…Simple regulatory changes in most cases represent a too-late attempt to catch up with the tricks of the regulated—the trickiest of whom tend to be large. In the U.S. financial system, what passed as “innovation” was in large part circumvention, as financial engineers invented ways to get around the rules of the road. There is little evidence that new regulations, involving capital and liquidity rules, could ever contain the circumvention instinct.”
This is a sentiment I don’t often hear expressed by a regulator – As I have opined before on this blog, regulations alone just don’t work. The history of banking is one of repeated circumvention of regulations by banks, a process that has only accelerated with the increased completeness of markets. The question is not whether deregulation accelerated the process of banks’ maximising the moral hazard subsidy – it almost certainly did and this was understood even by the Fed as early as 1983. As John Kareken noted, “Deregulation Is the Cart, Not the Horse”. The question is whether re-regulation has any chance of succeeding without fixing the incentives guiding the actors in the system – it does not.
Bailouts Come in Many Shapes and Sizes
Fisher: “Even if an effective resolution regime can be written down, chances are it might not be used. There are myriad ways for regulators to forbear. Accounting forbearance, for example, could artificially boost regulatory capital levels at troubled big banks. Special liquidity facilities could provide funding relief. In this and similar manners, crisis-related events that might trigger the need for resolution could be avoided, making resolution a moot issue.”
A watertight resolution regime may only encourage regulators to aggressively utilise other forbearance mechanisms. Fisher mentions accounting and liquidity relief but fails to mention the most important “alternative bailout mechanism” – the “Greenspan Put” variant of monetary policy.
Preventing Systemic Risk perpetuates the Too-Big-To-Fail Problem
Fisher: “Consider the idea of limiting any and all financial support strictly to the system as a whole, thus preventing any one firm from receiving individual assistance….If authorities wanted to support a big bank in trouble, they would need only institute a systemwide program. Big banks could then avail themselves of the program, even if nobody else needed it. Systemwide programs are unfortunately a perfect back door through which to channel big bank bailouts.”
“System-wide” programs by definition get activated only when big banks and non-banking financial institutions such as GE Capital are in trouble. Apart from perpetuating TBTF, they encourage smaller banks to mimic big banks and take on similar tail risk thus reducing system diversity.
Shrink the TBTF Banks?
Fisher clearly prefers that the big banks be shrunk as a “second-best” solution to the incentive problems that both regulators and banks face in our current system. Although I’m not convinced that shrinking the banks is a sufficient response, even a “free market” solution to the crisis will almost certainly imply a more dispersed banking sector, due to the removal of the TBTF subsidy. The gist of the problem is not size but insufficient diversity. Fisher argues “there is considerable diversity in strategy and performance among banks that are not TBTF.” This is the strongest and possibly even the only valid argument for breaking up the big banks. My concern is that even a more dispersed banking sector will evolve towards a tightly coupled and homogenous outcome due to the protection against systemic risk provided by the “alternative bailout mechanisms”, particularly the Greenspan Put.
The fact that Richard Fisher’s comments echo themes popular with both left-wing and right-wing commentators is not a coincidence. In the fitness landscape of our financial system, our current choice is not so much a local peak as a deep valley – tinkering will get us nowhere and a significant move either to the left or to the right is likely to be an improvement.