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Financial reform: It’s the politics—A Commentary by Jonathan Macey ’82

The following commentary was posted on on February 3, 2010.

Financial reform: It’s the politics
By Jonathan Macey ’82

The financial crises might be more easily understood if all the economic jargon were in plain English. For a start, here’s a translation of key points from Paul Volcker’s Sunday New York Times opinion piece about financial system reform and his testimony Tuesday before the Senate banking committee.

With gentlemanly understatement, Volcker notes that, while the government has been a whirling dervish in providing bailouts, “some central structural issues have not been addressed.”

What he means is that we haven’t addressed the central problem of financial regulation: what to do about institutions that are “too big to fail.” Until we solve this, the pattern of serial financial crises followed by massive taxpayer bailouts is sure to continue.

Volcker is saying that we’ve been spending a lot of money — trillions of taxpayer dollars — but we haven’t changed a thing. So when the machine that is our financial system starts up again, it will crash and burn, just like it did a few years ago.

This is what Volcker means by:

“A large concern is the residue of moral hazard from the extensive and successful efforts of central banks and governments to rescue large failing and potentially failing financial institutions. The long-established ‘safety net’ undergirding the stability of commercial banks — deposit insurance and lender of last resort facilities — has been both reinforced and extended in a series of ad hoc decisions to support investment banks, mortgage providers and the world’s largest insurance company. In the process, managements, creditors and, to some extent, stockholders of these nonbanks have been protected.”

Translation: We’ve bailed out hundreds of financial institutions (including all the big ones except Lehman Bros.) by throwing billions of taxpayer dollars at them. The regulatory system that is supposed to guarantee only insured bank depositors, and free-market discipline for other bank creditors and all nonbank creditors, has been thrown out with a “series of ad hoc decisions” (this last is pretty clear) by the government.

Volcker calls these decisions “extensive and successful.” Translation: The government threw money at the problem until all the big banks’ creditors were fully repaid. The government’s efforts were “successful” from the perspective of those creditors. But he doesn’t explain how the rest of us benefited from the largest bailout in human history.

As for “moral hazard,” what Volcker means is that the government has committed to bailing out anyone with a remote connection to a large financial institution. So the amount of moral hazard in the economic system has metastasized.

These businesses can now take huge risks without any fear of market discipline. The market doesn’t care, because, when the bets turn bad, Uncle Sam will be there to shovel money to any creditors who feel “unprotected.”

Volcker’s one substantive proposal is that financial institutions should have a “living will.” But this is just the latest rhetorical gimmick in the language of finance and law.

In finance, a living will is a document that lays out which creditors get paid, and in what order, should a financial institution fail. But this is not new. We already have commercial law, which has clear provisions for which creditors get paid and in what order.

Generally, under this law, stockholders and managers are not protected. Creditors, of course, also risk losing some or all of their anticipated interest and principal if a firm’s value falls short of its debts.

Cutting through the rhetorical fog, the “living will” is another empty threat by the government to refrain from giving handouts to those left standing in line after a financial institution’s money runs out.

The problem is that the government hasn’t been doing this. The scope of its safety net and the size of bailouts have been moving in only one direction: larger.

In his testimony, Volcker proposed limiting the safety net to “safe” institutions that avoid risk and empowering regulators to “appraise and contain” excesses. This, unfortunately, is far from the “structural change” that he wrote was essential to meaningful reform.

For only one structural change could work: We need to break up the banks into sufficiently small pieces that are no longer too big to fail, and instead are too small to rescue. Banks’ liabilities are easiest to deal with when limited to a reasonable size.

No financial institution should have liabilities greater than 5% of the value of the FDIC insurance fund so that a failure won’t roil too large a portion of the economy.

For the same reason, a financial institution’s debt should never be greater than 80% of its assets. If it gets larger, regulators need to put it into receivership. This insures that there will be plenty of stockholder’s equity available to creditors, so the government is not be left to pick up the tab.

Volcker is aware of all of these problems, of course. He has recommended breaking up the banks many, many times.

Jonathan Macey is a Yale Law School professor who specializes in banking and corporate finance and is a member of the Hoover Institution Task Force on Property Rights.