Banking on the Backroom Deal

While, GM’s bankruptcy and Chrysler’s emergence from bankruptcy grab front page headlines, yesterday’s banks withlogo-mr-monopoly issues are positioning themselves at the table to discuss future financial regulation. This comes as some of the premier researchers in financial economics look for systemic solutions. As you know, I’m a huge advocate for finding new regulations that promote transparency of process and recognize the importance of fiduciary responsibility when the financial industry takes on risk. Harvard’s Oliver Hart and University of Chicago’s Luigi Zingales, both NBER researchers, have just produced A New Capital Regulation For Large Financial Institutions. I want to review some of their findings and suggestions in conjunction with two more mundane articles.

The first of these articles is an astounding piece on Alternet that finds information suggesting Larry Summers has been taking kickbacks from big troubled banks. Another article is in today’s NY Times that shows how the banks have been spending a good year–even as they took TARP funds and cheap money from them FED–girding for a fight on forthcoming regulations.

I would think that the big lesson from the last few years is this is not time to go back to business as usual. However, the mindset of those making major decisions in the White House (Treasury Secretary Geithner and CEA head Summers) is this is just a glitch and there’s no chance anything like this could happen again. In other words, we don’t need to look for systemic problems, we just need to send the patients home with some aspirin and they can call back in the morning. This aspirin prescription has been particularly expensive. It is either utterly naive or completely disingenuous to think that pouring money into financial institutions and waiting this out is going to prevent any future occurrence of financial meltdowns. We need to be prepared to offset what may be an elaborate hoax to convince that nothing really needs to change systematically and a major congressional influence- and administration influence- buying spree by the big banks. Even as we see Dow de-list Citibank, we see evidence that Citibank possibly manipulated its stress tests results through Summers.

If the Alternet article is correct, Summers should be in trouble and the trustworthiness of the large institutions should be questioned by a congressional committee. This sure looks like pay-to-play to me. (HT to Dr. BB for the link.) The post by Mark Ames is a must read.

Last month, a little-known company where Summers served on the board of directors received a $42 million investment from a group of investors, including three banks that Summers, Obama’s effective “economy czar,” has been doling out billions in bailout money to: Goldman Sachs, Citigroup, and Morgan Stanley. The banks invested into the small startup company, Revolution Money, right at the time when Summers was administering the “stress test” to these same banks.

A month after they invested in Summers’ former company, all three banks came out of the stress test much better than anyone expected — thanks to the fact that the banks themselves were allowed to help decide how bad their problems were (Citigroup “negotiated” down its financial hole from $35 billion to $5.5 billion.)

The fact that the banks invested in the company just a few months after Summers resigned suggests the appearance of corruption, because it suggests to other firms that if you hire Larry Summers onto your board, large banks will want to invest as a favor to a politically-connected director.

Last month, it was revealed that Summers, whom President Obama appointed to essentially run the economy from his perch in the National Economic Council, earned nearly $8 million in 2008 from Wall Street banks, some of which, like Goldman Sachs and Citigroup, were now receiving tens of billions of taxpayer funds from the same Larry Summers. It turns out now that those two banks have continued paying into Summers-related businesses.

monopoly empty pocketsMeanwhile, the Grey Lady reports that even during the height of the meltdown, the banks were planning strategies daily on how to avoid future regulations. This sounds like collusion to me. I’d like to see the joint amount of market concentration held by these nine members in this consortium. If it’s any where the number I would guess it to be, my next question is why isn’t the Justice Department investigating this as collusion?

As the financial crisis entered one of its darkest phases in October, a handful of the nation’s largest banks began holding daily telephone sessions. Murmurs were already emanating from Washington about the need for a wide-ranging regulatory overhaul, and Wall Street executives girded for a fight.

The nine biggest participants in the derivatives market — including JPMorgan Chase, Goldman Sachs, Citigroup and Bank of America — created a lobbying organization, the CDS Dealers Consortium, on Nov. 13, a month after five of its members accepted federal bailout money.

To oversee the consortium’s push, lobbying records show, the banks hired a longtime Washington power broker who previously helped fend off derivatives regulation: Edward J. Rosen, a partner at the law firm Cleary Gottlieb Steen & Hamilton. A confidential memo Mr. Rosen drafted and shared with the Treasury Department and leaders on Capitol Hill has, politicians and market participants say, played a pivotal role in shaping the debate over derivatives regulation.

Today, just as the bankers anticipated, a battle over derivatives has been joined, in what promises to be a replay of a confrontation in Washington that Wall Street won a decade ago. Since then, derivatives trading has become one of the most profitable businesses for the nation’s big banks.

Meanwhile, back in academia, Hart & Zingales, really pose the germane question (emphasis mine). I’m just going to let you look at those two mundane articles above and then draw your own conclusions about the root of our problems.

If there is one lesson to be learned from the 2008 financial crisis, it is that large financial institutions (LFIs) are too big to fail. The too-big-to-fail doctrine has been around for a long time (Stern and Feldman, 2004), but its practical value has often been questioned (Meltzer, 2004). The backlash following the demise of Lehman Brothers, and the effort exerted to save major financial institutions at all costs, has established that the United States does not have the political will to let large financial institutions fail. Whether the too-big-to-fail doctrine is based on economic thinking (the cost of large LFI failure is too high) or political reality (the pressure to save LFIs is too strong), the conclusion is the same: we need to rethink how we regulate these institutions.

This is a paper that is amazing in its conclusion. (You may have to take my word for this.) It suggests that we don’t rely on credit rating agencies as trigger mechanisms but we rely on the Credit Default Swap (CDS) market. The authors suggest that the very market that created so many issues in the current global crisis meltdown might be the mechanism to prevent future meltdowns. How is this possible?

Bank regulation usually relies on capital requirements coupled with deposit insurance. Any market where insurance exists, reduces risk and makes capital cheaper. Since there deposit insurance seemingly reduces risk and makes capital cheaper, capital requirements are necessary to prevent banks from over-leveraging. The meaning of over-leveraging at its most simplest is over-borrowing. There’s a series of international banking regulations called the Basle Accords that provide a regulation structure primarily based on minimal capital requirements. If you’ve heard the terms Tier 1 capital or Tier 2 capital, that’s from the Basel Accords. Each of these tiers are defined by many things, among them the term or maturity of the capital.

Many of the problems that have occurred to date, have occurred because the Basel Accords and capital requirements cautionhave been applied to traditional financial institutions like Commercial Banks, but they did not apply to Investment Banks. This is because Investment banks are not depository institutions and they have no fiduciary responsibility as a result. This also infers no insured deposits. We’ve since learned that there is more involved with protecting people’s money than just examining institutions based on the the source of the funding (i.e. if they hold checking or savings accounts as liabilities or not). We’ve also taught the market itself that certain large financial institutions (LFI as the authors of the article designate them) as they approach bankruptcy can lead to systemic failures. But, the LFIs themselves won’t be subjected to the discipline and punishment of bankruptcy. Their status as LFI exempts them from that. The authors are looking for a way in their study to find a mechanism to replace the ‘threat’ of bankruptcy because the market now knows that threat doesn’t really exist. Without that threat, the market can’t correctly price bank risk because the assumption is the risk goes to the taxpayer and not to the private market. This is anathema to both taxpayers and market theoreticians. Bankers don’t want to change the game now, because by creating such havoc, they’ve actually set themselves up in an even better situation if the old rules still apply.

So the authors suggest the use of the CDS and show how it works as well as show a number stylized market statistics. The overall article is really interesting, but extremely wonky but at least go look at the graphs and consider this idea. It is a really out-of-the-box solution that I’m still digesting.

To solve this problem we rely on the credit default swap (CDS) market. A credit default swap on an LFI is an insurance claim that pays off if the LFI fails and creditors are not paid in full. Since the CDS is a “bet” on the institution’s strength, its price reflects the probability that the debt will not be repaid in full. In essence, the CDS indicates the risk that the LFI will fail. In our mechanism, when the CDS price rises above a critical threshold, the regulator forces the LFI to issue equity until the CDS price moves back below the threshold. If this does not happen within a predetermined period of time the regulator intervenes. (The role of the regulator represents the second difference from a standard margin call system.) The regulator first determines whether the LFI debt is at risk. If the debt is not at risk (i.e., the CDS prices were inaccurate), then the regulator declares the company adequately capitalized and to prove it injects some government money. If the debt is at risk, the regulator replaces the CEO with a receiver (or trustee),
who recapitalizes and sells the company, ensuring in the process that shareholders are wiped out and creditors receive a haircut. This regulatory takeover is similar to a milder form of bankruptcy, and it
achieves the goals of bankruptcy (discipline on the investors and management) without
imposing any of the costs (systemic effects).

Meanwhile, back at the Gray Lady, there’s a less ‘academic’ version of the same discussion.

Those who favor more regulation say it would offer early warning signals when companies take on too much risk and would help avert catastrophic surprises like the huge derivatives losses at the giant insurer the American International Group, which has so far received more than $170 billion in taxpayer commitments. The banks say too much regulation will stifle financial innovation and economic growth.

The debate about where derivatives will trade speaks to core concerns about the products: transparency and disclosure.

There are two distinct camps in this argument. One camp, which includes legislative leaders, is pushing for trading on an open exchange — much like stocks — where value and structure are visible and easily determined. Another camp, led by the banks, prefers that some of the products be traded in privately managed clearinghouses, with less disclosure.

The Obama administration agrees that more regulation is needed. A proposal unveiled recently by Treasury Secretary Timothy F. Geithner won plaudits for trying to make derivatives trading less freewheeling and more accountable — a plan that hinges in part on using clearinghouses for the trades.

Critics in both the financial world and Congress say relying on clearinghouses would be problematic. They also say Mr. Geithner’s plan contains a major loophole, because little disclosure would be required for more complicated derivatives, like the type of customized, credit-default swaps that helped bring down A.I.G. A.I.G. sold insurance related to mortgage securities, essentially making a big bet that those mortgages would not default.

Mr. Rosen and other bank lobbyists have pushed on Capitol Hill to keep so-called customized swaps from being traded more openly. These are contracts written for the specific needs of a customer, whose one-of-a-kind nature makes them very hard to value or trade. Mr. Rosen has also argued that dealers should be able to trade through venues closely affiliated with banks rather than through more independent platforms like exchanges.

Mr. Rosen’s confidential memo, dated Feb. 10 and obtained by The New York Times, recommended that the biggest participants in the derivatives market should continue to be overseen by the Federal Reserve Board. Critics say the Fed has been an overly friendly regulator, which is why big banks favor it.

So you can see the interplay here between politics and economic decisions. If we really wanted to solve this I still suggest we go back to the idea of trust busting. Again, there have been no studies that show that LFI’s have economies of scale or any benefits that outweigh the risk of their size. We should be applying the same rules to Citibank that were applied to AT&T. Bust them up into regional entities and then let the market deal with them as normal sized financial institutions. We should treat them like the illegal, colluding, oligopolies they really have become.

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