Answering Sheila Bair's 5 questions on financial reform

In a Fortune article, Sheila Bair proposed 5 questions on financial reform that she felt were critical to preventing another financial crisis.

Your humble blogger though Ms. Bair deserves a response to her questions.

[N]either candidate's campaign script acknowledges the connection between our current economic woes and the financial crisis which caused them..... The reality is, without a stable financial system, neither of you will achieve the sustainable economic growth you promise. 

Here are five questions I would like you to answer. 

WILL YOU BREAK UP TOO BIG TO FAIL BANKS? Dodd-Frank, the financial reform law enacted in 2010, bans future bailouts of failing financial behemoths and requires instead that they be put into either bankruptcy or a government-run liquidation process. Dodd-Frank also requires big financial institutions to demonstrate that they can fail in bankruptcy without causing widespread damage to our financial system. If they cannot make this demonstration, the law authorizes, indeed requires the regulators and Secretary of the Treasury, to restructure them or break them up....

Yes, but rather than use regulators as proposed under Dodd-Frank to break up these banks I will use market discipline.

All banks will be required to provide ultra transparency and disclose on an ongoing basis their current global asset, liability and off-balance sheet exposure details.

With this information, market participants can independently assess the risk of the banks.  With this assessment, market participants can adjust the amount and price of their exposure to the banks to reflect each bank's risk.

As the cost of funds to each big bank increases to reflect their risk, the banks will come under significant pressure to make themselves less risky.

The first part of the TBTF bank to go will be the 'casino'.  This will disappear because traders know if they have to report their positions to the market every day this allows market participants to engage in activities that will reduce the profitability of the traders' proprietary bets.

The second part of the TBTF bank to go will be all those subsidiaries that are not engaged in supporting the real economy, but rather exist to arbitrage some rule or regulation.

WILL YOU CAP THE ABILITY OF LARGE FINANCIAL INSTITUTIONS TO TAKE RISKS WITH BORROWED MONEY? Prior to the crisis, regulators let many large financial firms fund their operations increasingly with borrowed money. When the housing market turned and mortgage-related losses mounted, these institutions were unable to make good on their massive debt obligations. Indeed, leading up to the crisis, many large banks borrowed over $30 for very $1 put up by their shareholders. In contrast, banks which borrowed $12 or less to every $1 of shareholder equity generally remained healthy....

Yes, but rather than use complex regulations like capping leverage I will use market discipline to cap the risk taking by large financial institutions.

As discussed above, the banks will be required to provide ultra transparency.  As a result, their cost of funds will reflect their risk.

Higher risk banks will face a higher cost of funds than lower risk banks.  This acts as a restraint on bank risk taking.

To put teeth into this restraint, I would let investors know up front that under the FDR Framework, the government has fulfilled all of its responsibility by ensuring that they have access to all the useful, relevant information in an appropriate, timely manner so they can independently assess each bank and make a fully informed investment decision.

As a result, the investors is responsible under the principle of caveat emptor for all gains and losses.

Knowing that the government will not bail the banks out, investors will keep bank management on a short leash or at least make sure that they can afford to lose their exposure to the bank.

WILL YOU REQUIRE WALL STREET FIRMS AND OTHERS WHO "SECURITIZE" LOANS TO RETAIN PART OF THE RISK IF THOSE LOANS DEFAULT?  Securitization, or selling bonds to investors which are backed by pools of mortgages, played a key role in the run-up to the crisis. Mortgage brokers and lenders originated millions of toxic mortgages which Wall Street firms blindly snapped up and sold off to unsuspecting investors. Paid up front, without having to retain any of the risk if those mortgages went bad, the mortgage securitization industry had all the wrong incentives to produce as many toxic loans as possible. Indeed, they had a saying - IBG/YBG -- for I'll be gone, you'll be gone - leaving investors, homeowners, and the public suffering the repercussions when those loans started to default....

No, as risk retention violates both the disclosure and caveat emptor principles of the FDR Framework.

First, risk retention is substituting complex regulation for transparency.  Investors should be provided with observable event based information so that all activities like a payment or default that occur with the underlying collateral are reported before the beginning of the next business day.  With this information, investors can know what they own.

Second, risk retention is substituting the idea that the securities are safe because the issuer would not want to lose their money for investors doing their own independent assessment of the securities.  Investors at all times are responsible for all gains and losses.

Finally, the investors' ability to enforce their rights under representations and warranties needs to be enhanced.  One way to do this is by providing observable event based reporting.  With observable event based reporting, the collateral can constantly be monitored for rep and warranty violations.

WILL YOU END SPECULATION IN THE CREDIT DERIVATIVES MARKETS? Many people rightfully point to bad mortgage lending as a key driver of the crisis.  Yet, hundreds of billions of mortgage losses by themselves would not have caused the crisis. The problem was the trillions of dollars of additional losses that were incurred world-wide by financial institutions who had made wrong-way bets on the performance of mortgage-backed bonds (and trillions of gains for the speculators who bet against them). Credit default swaps or "CDS" were the weapons of this mass destruction. Those who want to buy insurance protection against losses on bonds should be required to actually own those bonds, just as those who buy fire protection on a house need to actually own it. Will you require such an "insurable interest" for those buying CDS protection? Such a requirement would limit the size of this radioactive market and remove perverse economic incentives for speculators to benefit when bonds default. 

Yes, but rather than using complex regulations to ban trading in CDS I will use market discipline to ensure that when it comes to the banks they actually have the offsetting exposure.

This is easy to do because the banks will be providing ultra transparency.  A program like IBM's Watson can be trained to look across all the bank's exposures to see if the bank is blindly betting in the CDS market or has an offsetting exposure.

WILL YOU END THE REVOLVING DOOR? The spectacle of senior regulators moving into and out of industry has undermined public confidence in our regulatory system. Will you commit to appointing individuals at the Treasury Department and regulatory agencies who will be independent and promise never to work for the industry they regulate? People who want to use regulatory positions as stepping stones to more lucrative employment in the private sector have no place in government.

No.  While I strongly agree with what you have said, I would lose out on being able to attract people like yourself.

The only requirement I make of political appointees is that they adhere to making sure the FDR Framework is implemented in all the opaque corners of the financial system.  By definition this means that they will not substitute complex rules and regulatory oversight for transparency and market discipline.

Finally, one of the reasons that I am pushing that banks be required to provide ultra transparency is that it allows market participants to also monitor the bank regulators and their performance.  Ultra transparency not only brings market discipline to the banks, but also to their regulators.