Thursday, January 17, 2013

Richard Fisher's two step for breaking up the Too Big to Fail

In an excellent speech, Dallas Fed President Richard Fisher presents his two step approach for breaking up the Too Big to Fail banks.

Our proposal is simple and easy to understand. It can be accomplished with minimal statutory modification and implemented with as little government intervention as possible. 
It calls first for rolling back the federal safety net to apply only to basic, traditional commercial banking. 
Second, it calls for clarifying, through simple, understandable disclosures, that the federal safety net applies only to the commercial bank and its customers and never ever to the customers of any other affiliated subsidiary or the holding company. The shadow banking activities of financial institutions must not receive taxpayer support.

Mr. Fisher asserts that what makes this approach attractive and effective is it combines simplicity and a reliance on market discipline.

Please note that at the heart of Mr. Fisher's approach is disclosure.

As your humble blogger has been saying since the beginning of the financial crisis, the solution to ending the Too Big to Fail problem is based on disclosure.

In my case, I prefer banks be required to provide ultra transparency and disclose on an ongoing basis their current global asset, liability and off-balance sheet exposure details.  This is the disclosure that is necessary so that market participants have all the useful, relevant information in an appropriate, timely manner on each banks so the market participant can independently assess and make a fully informed decision.

This independent assessment by market participants is important, because it re-establishes that the market participants are responsible for all gains and losses on their exposures.  When market participants know they can lose money, they have an incentive to use the disclosed information and exert discipline on the banks to reduce their risk taking.

Mr. Fisher's two-step does nothing to help market participants assess the risk of the banks.  This leaves market participants still dependent on what the financial regulators claim is the risk of the banks.  Think bank stress tests.

As regular readers know, it is this reliance on the financial regulators to properly assess and communicate the real risk of each bank that creates the moral hazard associate with the Too Big to Fail. It is hard to make an investor that relies on the financial regulators' statements about a bank's solvency take a loss.

Mr. Fisher lays out the criteria to measure any solution for handling the Too Big to Fail bank problem.  The criteria the solution must meet is it combines simplicity and market discipline.

Requiring ultra transparent meets this criteria.  It is simple and it is the only way to truly subject the banks to market discipline.

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