Thursday, February 7, 2013

Neil Barofsky: Geithner doctrine lives on in Libor scandal

In his Financial Times editorial, Neil Barofsky looks at the results of the policy of financial failure containment championed by Tim Geithner.  His conclusion:  the policy is a disaster and needs to be abandoned.

Regular readers know that there is an alternative to the policy of financial failure containment and that is the policy championed by your humble blogger and built into our financial system:  financial failure prevention.

Our financial system is based on the FDR Framework.  Under this framework, the government is responsible for ensuring that market participants have access to all the useful, relevant information in an appropriate timely manner so the market participants can independently assess this information and make a fully informed decision.

Under this framework, market participants have the incentive to use this information as they are responsible for all losses on their exposures under the principle of caveat emptor (buyer beware).

By design, the FDR Framework is focused on preventing a systemic financial crisis.  It achieves this because each market participant has an incentive to limit their exposures to what they can afford to lose.

The reason we had the financial crisis that began on August 9, 2007 is that global financial regulators, led by the US Treasury adopted the policy of financial failure containment.  By adopting this policy they effectively abandoned the government's responsibility to ensure access to all the useful, relevant information (no reason to butt heads with Wall Street over what to disclose if you plan on mopping up after the crisis hits).

If you look at the financial system, what you see is that adoption of the policy of failure containment coincided with a dramatic increase in the size of the opaque parts of the financial system (think banks and structured finance securities).

Bottom line:  we are not having a financial crisis in the parts of the financial system where the legacy of the policy of failure prevention still prevails and we have transparency and market discipline.  We are having a financial crisis in the parts of the financial system where the policy of failure containment was adopted.

In his editorial, Mr. Barofsky shreds the policy of financial containment.
Now that Tim Geithner has resigned as US Treasury secretary, it is time to survey the damage wrought from four years of his approach to the financial crisis. 
The “Geithner doctrine” made the preservation of the largest banks, no matter the consequences, a top priority of the US government. 
Aside from moral hazard, it has also meant the perversion of the US criminal justice system. The US faces a two-tiered system of justice that, if left unchecked by the incoming Treasury and regulatory teams, all but assures more excessive risk-taking, more crime and more crises.
Please re-read the highlighted text as Mr. Barofsky nicely summarizes the policy of financial containment (his term is the "Geithner doctrine", but this gives too much credit to Mr. Geithner as the policy was adopted under Robert Rubin's leadership) and the practical fallout from pursuing it.
The recent parade of banking scandals, such as the manipulation of Libor rates by Barclays, Royal Bank of Scotland and other major banks, can be traced back to the lax system of regulation before the financial crisis – and the weak response once disaster struck.
One result of the adopting the policy of financial containment is that banks were not required to provide ultra transparency and disclose their current global asset, liability and off-balance sheet exposure details.

Had they been required to provide ultra transparency, the Libor scandal would not have occurred as Libor would have been based off of actual trades that market participants could see and confirm.
Take the response of the New York Federal Reserve to Barclays’ admission in 2008 that it was submitting false Libor rates and was not alone in doing so. Mr Geithner’s response was to in effect bury the tip. 
He sent a memo to the Bank of England suggesting some changes to the rate-setting process and then convened a meeting of regulators where he reportedly described only the risk but not the actual manipulation of the rate. He then put the government imprimatur on the rate via bailout programmes. His inaction helped permit a global crime to continue for another year.
The changes that Mr. Geithner suggested and that are being belated adopted would in fact not have prevented Libor from being manipulated.  The NY Fed got the proposed changes from the very banks that were manipulating Libor.

The only way to prevent the manipulation of Libor is by requiring that banks provide ultra transparency  and base the rate on actual transactions.  With ultra transparency, banks with deposits to lend can assess the risk and solvency of banks looking to borrow.  This keeps the unsecured interbank market unfrozen.  Once the trades have occurred and been reported, it is easy for market participants to select the trades on which to base Libor and similar benchmark interest rates.
When it was UBS’s turn to settle its Libor charges, even though a significant amount of the illegal activity took place at the parent company level, only a Japanese subsidiary was required to take a plea
Eric Holder, US attorney-general, demonstrated his embrace of the Geithner doctrine (a phrase coined by blogger Yves Smithin explaining the UBS decision. He said that a more aggressive stance against the parent company could have a negative “impact on the stability of the financial markets around the world”. 
This week we saw the latest instalment of the saga. In fining RBS £390m, the DoJ only indicted one of the bank’s Asian subsidiaries, avoiding the more damaging result that would have stemmed from charging the parent company. 
Instead of seeking deterrence and justice, the US government increasingly appears to have fully absorbed the Geithner doctrine into its charging decisions by seeking a result that has a minimal impact on the target bank but will generate the best-looking press release. Some banks today are still too big to fail – and they are still too big to jail. 
The lack of robust enforcement is of course not limited to the Libor scandal. 
It was seen in the recent settlement talks with HSBC, when Treasury officials reportedly pressed the DoJ to consider the broad economic consequences that would follow an indictment. After hearing these arguments the DoJ chose not to criminally charge HSBC. 
And, of course, it is seen in the stunning dearth of criminal prosecutions arising out of the crisis. 
This was all but preordained given who the government turned to when the crisis struck: the same captured regulators who had blindly advanced bankers’ self-serving calls for a “light touch” before the crisis and who unsurprisingly embraced the Geithner doctrine afterwards. 
Having done so, of course, there would be no criminal prosecutions while the banks still teetered on the brink of collapse. The risk of causing them to fail, and thereby undoing all of the bailout efforts, was too high.
Please re-read the highlighted text as Mr. Barofsky makes the critical point that so long as banks are perceived by policymakers to be fragile, they will escape any form of discipline either from the market or the judiciary.
But that these arguments continue to resonate with officials in 2013 shows that the Geithner doctrine, perhaps justified by the conditions in 2008-09, has planted deep roots in our system of government. 
Again, what Mr. Barofsky and Yves Smith refer to as the Geithner doctrine has its roots in the policy of financial failure containment established during Mr. Rubin's years heading the US Treasury.

The policy of financial failure containment is the Treasury's default policy.

Unfortunately, it is also the Federal Reserve's default policy.  This policy is a legacy of the Volcker Era and can be seen in the attempt to handle behind closed doors the failure of Continental Illinois and the savings and loans.

Of course, Alan Greenspan took this policy to new heights with his explicit statement about how it was hard to identify a bubble and the role of monetary policy was to clean up afterwards.
This forbearance will have potentially devastating long-term effects, as each settlement on favourable terms reinforces the perception that, for a select group of executives and institutions, crime pays. 
It is only rational. They know that they will get to keep all of the ill-gotten profits if they go undetected, and on the small chance that they’re caught, most probably only the shareholders will pay – and only a relatively minor fine at that. 
The lack of meaningful consequences for those committing these frauds encourages future fraudulent conduct. Ultimately, the financial crisis was a game of incentives gone wild, and the lack of accountability in the aftermath of the crisis has only reinforced those bad incentives. 
The financial crisis was about opacity and the use of opacity by bankers whose incentives had gone wild.

It is only by restoring transparency to all the opaque corners of the global financial system that we are going to restore accountability and create proper incentives (after all, sunshine is the best disinfectant).
Breaking those incentives requires ditching the Geithner doctrine, which has led to the banks becoming even larger and more systemically significant than they were before the crisis. 
It means ditching the whole policy across the government of financial failure containment and returning to the policy of financial failure prevention that worked for 7+ decades.

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