Wednesday, February 23, 2011

Helping Thomas Hoenig and Regulators Deal With Too Big To Fail

The New York Time's Dealbook ran an article discussing the regulation of Too Big to Fail financial institutions.

As the author discusses, regulating TBTF under Dodd-Frank raises a number of important issues such as the mechanism by which regulators decide who is and who is not TBTF.  Perhaps more importantly, the focus of US regulators on TBTF does not mean that the next crisis will not come from the foreign TBTF institutions or other financial players who are not recognized as TBTF.

The Fed's Thomas Hoenig has a different take on TBTF.  He argues for breaking up TBTF firms. [emphasis added]
Large financial institutions continue to pose major risks to the U.S. economy, and must be broken up in order to avoid another meltdown, Kansas City Federal Reserve President Thomas Hoenig said on Wednesday. 
Citing a number of shortcomings in the recently enacted U.S. financial reform legislation, Hoenig argued that many of the firms whose size helped drive the financial system into crisis are now larger than ever. 
He also argued that regulators still lack sufficient powers to rein in financial giants, adding that the unfair advantages they glean from the implicit protection of government are self-reinforcing. 
"We must break up the largest banks, and could do so by expanding the Volcker Rule and significantly narrowing the scope of institutions that are now more powerful and more of a threat to our capitalistic system than prior to the crisis," Hoenig told a meeting of the Women in Housing and Finance. 
Hoenig called for "Glass Steagall-type" provisions that would no longer allow commercial banks to engage in the riskier activities normally confined to the investment sector. 
"We must make sure that large financial organizations are not in position to hold the U.S. economy hostage.
In the absence of Glass Steagall-type legislation or an expanded Volcker Rule, this blog has long advocated taking a different approach to handling the TBTF.

This approach has been to require under existing legislation that all financial institutions, like banks and hedge funds and insurance firms, disclose their current asset-level exposures on a global basis.

A key feature of this disclosure requirement is that, unlike the Basel III capital requirements, it directly addresses the issues of risk and solvency.  This disclosure requirement lets both the market and the regulators monitor and constrained risk taking and reduce the potential for contagion.

A key benefit of this disclosure requirement is that it naturally limits the risk any financial institution can take.  Any firm that invests in or relies on a financial institution for credit/interest rate/forex protection has an incentive to adjust their exposure to the financial institution based on the risk of solvency of the financial institution.  This direct feedback into the financial institution's profitability is known as market discipline.

A key benefit of current asset-level disclosure is that it will force the TBTF to shrink without the regulators having to figure out how to break up these firms.


There are many firms in the global financial markets who offer the same services as the large, global financial institutions but have the advantage that disclosure of their current asset-level data will allow market participants to readily assess their risk.  These firms will attract much more business, because no market participant is compensated for taking on risk from firms that are too complicated to assess.

Current asset-level disclosure gives each global financial institution an incentive to reduce their risk profile in order to maximize their profitability.  How the financial institutions elect to shrink will reflect where they think they can maximize their profitability for a given level of risk.

[emphasis added]
... United States regulators are puzzling through the issue of which financial companies are too big to fail and what kind of heightened regulation will be imposed on them. 
... The Dodd-Frank Act deliberately did not end the era of too-big-to-fail institutions.... Dodd-Frank instead set up a structure that would let the behemoths live, but they would be caged with a monitoring approach. Too-big-to-fail institutions are to be named and subject to extra regulation. 
... The rules are not a bright line and instead assess the label “too big to fail” based on factors including “size,” “leverage” and “interconnectedness.” This is a “you know it when you see it” test. 
... we still don’t know what exactly the regulators think is too big to fail. This is important because there are real consequences to being named to this select group. 
Too-big-to-fail banks may receive important competitive advantages from a lower cost of capital. Their cost to borrow money will be lower because they are perceived to receive an implicit government guarantee. They can also command greater access to regulators. 
... But there will be detriments. Among other things, these institutions will have to hold more capital, be subject to more regulation and, in certain circumstances, can be broken up by the government. 
Depending on whether the costs outweigh the benefits, too-big-to-fail institutions thus may be more or less competitive in the global marketplace. We just don’t know. But this is important, because finance is global. Eight of the 10 largest banks by assets are now outside the United States. 
And this is the biggest quandary about the too-big-to-fail concept. The worry is that the next financial crisis will be different than the last, whether it is a sovereign debt crisis or another currency crisis. Regulator focus on the biggest institutions may lead them to miss the next bubble or even an institution that is not on this list. 
Indeed, the next crisis may come from outside the United States, something Dodd-Frank does not address. 

No comments: