Do We Really Need a Systemic Regulator? By Hal S Scott
Based on what we now know about AIG, it's unclear 'too big to fail' institutions are in fact too big to fail.
WSJ, Dec 11, 2009
The principal assumption underlying the financial regulatory reform legislation working its way through Congress is that certain financial institutions are "too big to fail" because of the severe consequences of "interconnectedness"—a word that entered our lexicon during the financial crisis.
The problem is presented as follows: There are major financial institutions that are systemically important because their failure can, due to interconnectedness, bring down other large financial institutions. A chain reaction of such failures is unacceptable since it would disrupt our economic system. The chain reaction must be stopped after the fact by the use of taxpayer-funded bailouts that avoid the kinds of losses for investors or counterparties that would normally occur in bankruptcy. Finally, taxpayers need to be protected by new regulations designed to protect against the failure of these major institutions.
But how severe is the threat from interconnectedness? Last month's report by the Special Inspector General for the Troubled Asset Relief Program (Sigtarp) on AIG is illuminating. While the report's focus is on whether Goldman Sachs unduly profited from the Fed's rescue of AIG, more significant is its discussion of why AIG even received an $85 billion rescue. It does not appear to be because counterparties would have failed as a result. According to the report, Goldman had adequate collateral to protect itself against an AIG default. Indeed, the collateral was cash whose value would not have been decreased by a "rush to the exits." There is no reason to assume other counterparties did not follow similar collateral practices.
Viewed in this light, FDIC Chair Sheila Bair's proposal to increase the losses secured counterparties must bear in case of a financial institution's failure seems misguided. Counterparties whose exposure to credit losses is fully backed by collateral are after all "secured." Treating them as if they were unsecured—forcing them to take a "haircut"—in the case of a financial institution's failure would only increase the risks of chain reactions.
An amendment to the House bill ("The Wall Street Reform and Consumer Protection Act") very likely to be adopted today fortunately exempts most derivative contracts from haircuts. But it fails to exempt all short-term repurchase agreements ("repos"). Short-term repos are normally fully secured; if lenders know they will have to take a haircut they will be less likely to extend credit to financial institutions most in need.
Sigtarp further reports that the Fed and the U.S. Treasury were actually more concerned with $88 billion of AIG investor and debt-holder losses: $10 billion on loans by state and local governments; $40 billion for workers in 401(k) plans; and $38 billion for retirement plans. Certainly, these losses would be "connected" to an AIG default. But they did not involve the threat of a chain reaction of financial institution failures. The auto company bailouts also had little to do with the fear of devastation to the financial system.
If large losses by institutional investors and other stakeholders are the real reason why we are concerned with interconnectedness and "systemic risk," then we would have to regulate all large global corporations, not just financial ones, whose failures could trigger similar losses—an impossible task.
The Sigtarp report does mention concern with losses to money market funds, principal holders of $20 billion in AIG commercial paper. It is certainly possible that an AIG default right on top of the Lehman bankruptcy could have led to more money-market funds falling below $1 per share and have intensified the irrational run on funds generally. The answer to the run problem was not to rescue AIG but rather for the government to use, as it did, its lender of last resort powers to stem the runs.
Clearly we need to know far more about the facts of interconnectedness. As a starting point, Congress should require Fed Chairman Ben Bernanke and Treasury Secretary Tim Geithner to give the American people a complete account, with supporting documentation, of why the Fed and Treasury thought it was important to rescue AIG. This account should include a detailed analysis of counterparty exposure to the extent this is claimed to have played a significant role in their decision.
If it turns out that there are no severe consequences to the financial system from interconnectedness, then do we really need to control the risk of large financial institutions by imposing heightened capital or new liquidity requirements? Indeed, why would we need a systemic-risk regulator at all? Congress, as part of its reform legislation, should mandate the creation of a new expert commission designed to fully investigate the extent and consequences of interconnectedness before any new regulation of systemically important institutions is actually adopted.
Without real adverse consequences from interconnectedness, the too-big-to-fail problem becomes much more manageable. Public money might still have to be injected into a failed institution to avoid a sudden economic disruption, but this would only be after losses were fully imposed on the private sector without fear of a chain reaction. Thus, we could avoid the untenable situation of private gains and public losses that we have persuaded ourselves we are faced with today.
Mr. Scott is professor of international financial systems at Harvard Law School and the director of the Committee on Capital Markets Regulation.
Friday, December 11, 2009
The Disarmament President - Obama's Oslo speech versus the real nuclear world
The Disarmament President. WSJ Editorial
Obama's boffo Oslo speech versus the real nuclear world.
The Wall Street Journal, Dec 11, 2009, page 12
President Obama gave a gracious speech yesterday accepting his Nobel Peace Prize, starting with the humble note that he has yet to earn it. If his Oslo hosts expected a woolly-headed address about peace in our time, they also didn't get it. He stated clearly that sometimes war is necessary to defend the peaceable and to serve justice and liberty. He even hit the George W. Bush note that "evil does exist in the world."
Congratulations, Mr. President.
On the other hand, Mr. Obama also didn't disappoint the Norwegians, who in giving the award had cited his "work for a world without nuclear weapons." He repeated his commitment to that cause, starting with his effort to rework the Strategic Arms Reduction Treaty of 1991 that expired December 5. So it's worth checking in to see how his disarmament vision is faring in the rougher world of rogues and national interest. The answer is not so well.
The Administration decided that rather than negotiate an extension of the existing Start treaty, a whole new arrangement to limit warheads and delivery systems should be crafted. In July, the U.S. and Russia signed a "framework agreement" to reduce stockpiles by as much as a third. Alas, the Administration was so focused on the numbers that it neglected the stickier details—such as verification, and whether the current Start regime would stay in place if negotiations dragged on.
Though the far weaker party, the Russians have figured out their leverage over an Administration eager to show any progress. Pushing that advantage, Russia has already secured lower ceilings on nuclear weapons and delivery vehicles, scaled back verification, and pocketed other strategic concessions.
Let's take those in order. The U.S. looks likely to agree to cut the number of permitted delivery vehicles, such as missiles, long-range bombers and submarines, by half, to 800 or less. This is to Russia's advantage, which as of last spring had 814—and not all of them in working condition. Many of America's 1,198 nuclear delivery vehicles—from B-2 bombers to ICBMs—are being fitted with conventional weapons. The ceilings in a new Start would likely make no distinction between bomb types. If the goal is to move away from nukes, why limit the military's capacity to deploy conventional weapons?
As for verification, with fewer allowable warheads, Ronald Reagan's "trust but verify" maxim applies more than ever. Yet Russia wants to reduce oversight, and it specifically told the U.S. that continuous monitoring at the Votkinsk Machine Building Plant would end once Start expired. The Russians are building new RS-24 mobile nuclear missiles at Votkinsk. According to one Russian general, the RS-24 will by 2016 constitute four-fifths of its ICBM forces. Without monitoring, the U.S. won't know for sure how many of these missiles the Russians make and where they are deployed.
While Russia invests in new warheads and missiles, the Obama Administration has yet to lay out its own plans for updating the U.S. nuclear arsenal. Even staunch proponents of arms control concede that to be able to reduce the quantity of U.S. arms, we have to improve the quality. The Senate should ask why the White House isn't.
The Russians also refused to discuss their huge advantage in tactical weapons, and the Administration said OK. After the July "framework agreement," Russia signalled that U.S. plans to deploy missile defenses in Poland and the Czech Republic stood in the way of a final deal. Mr. Obama obliged, informing the Poles and Czechs of his reduced defenses late on the day before the sixth round of Start talks in Geneva. The announcement pleased the Russians, though it still hasn't got Washington a deal. Stay tuned for more concessions as U.S. negotiators try to get it before the year's end.
Meanwhile, the world's rogues continue to pursue nuclear weapons, and Mr. Obama said yesterday that "it is incumbent upon all of us to insist that nations like Iran and North Korea do not game the system." He added that "we must develop alternatives to violence that are tough enough to change behavior." But all the President has to show for a year of courting these regimes is their refusal even to consider giving up either their weapons (North Korea) or their growing capacity to make them (Iran).
The French, for one, see this danger plainly and want the U.S. to press harder on Tehran. But on these hard cases, the Administration can't muster the same sense of urgency it is bringing to the cause of an unnecessary arms control pact with Russia. Mr. Obama is right that he still has to earn that Nobel.
Obama's boffo Oslo speech versus the real nuclear world.
The Wall Street Journal, Dec 11, 2009, page 12
President Obama gave a gracious speech yesterday accepting his Nobel Peace Prize, starting with the humble note that he has yet to earn it. If his Oslo hosts expected a woolly-headed address about peace in our time, they also didn't get it. He stated clearly that sometimes war is necessary to defend the peaceable and to serve justice and liberty. He even hit the George W. Bush note that "evil does exist in the world."
Congratulations, Mr. President.
On the other hand, Mr. Obama also didn't disappoint the Norwegians, who in giving the award had cited his "work for a world without nuclear weapons." He repeated his commitment to that cause, starting with his effort to rework the Strategic Arms Reduction Treaty of 1991 that expired December 5. So it's worth checking in to see how his disarmament vision is faring in the rougher world of rogues and national interest. The answer is not so well.
The Administration decided that rather than negotiate an extension of the existing Start treaty, a whole new arrangement to limit warheads and delivery systems should be crafted. In July, the U.S. and Russia signed a "framework agreement" to reduce stockpiles by as much as a third. Alas, the Administration was so focused on the numbers that it neglected the stickier details—such as verification, and whether the current Start regime would stay in place if negotiations dragged on.
Though the far weaker party, the Russians have figured out their leverage over an Administration eager to show any progress. Pushing that advantage, Russia has already secured lower ceilings on nuclear weapons and delivery vehicles, scaled back verification, and pocketed other strategic concessions.
Let's take those in order. The U.S. looks likely to agree to cut the number of permitted delivery vehicles, such as missiles, long-range bombers and submarines, by half, to 800 or less. This is to Russia's advantage, which as of last spring had 814—and not all of them in working condition. Many of America's 1,198 nuclear delivery vehicles—from B-2 bombers to ICBMs—are being fitted with conventional weapons. The ceilings in a new Start would likely make no distinction between bomb types. If the goal is to move away from nukes, why limit the military's capacity to deploy conventional weapons?
As for verification, with fewer allowable warheads, Ronald Reagan's "trust but verify" maxim applies more than ever. Yet Russia wants to reduce oversight, and it specifically told the U.S. that continuous monitoring at the Votkinsk Machine Building Plant would end once Start expired. The Russians are building new RS-24 mobile nuclear missiles at Votkinsk. According to one Russian general, the RS-24 will by 2016 constitute four-fifths of its ICBM forces. Without monitoring, the U.S. won't know for sure how many of these missiles the Russians make and where they are deployed.
While Russia invests in new warheads and missiles, the Obama Administration has yet to lay out its own plans for updating the U.S. nuclear arsenal. Even staunch proponents of arms control concede that to be able to reduce the quantity of U.S. arms, we have to improve the quality. The Senate should ask why the White House isn't.
The Russians also refused to discuss their huge advantage in tactical weapons, and the Administration said OK. After the July "framework agreement," Russia signalled that U.S. plans to deploy missile defenses in Poland and the Czech Republic stood in the way of a final deal. Mr. Obama obliged, informing the Poles and Czechs of his reduced defenses late on the day before the sixth round of Start talks in Geneva. The announcement pleased the Russians, though it still hasn't got Washington a deal. Stay tuned for more concessions as U.S. negotiators try to get it before the year's end.
Meanwhile, the world's rogues continue to pursue nuclear weapons, and Mr. Obama said yesterday that "it is incumbent upon all of us to insist that nations like Iran and North Korea do not game the system." He added that "we must develop alternatives to violence that are tough enough to change behavior." But all the President has to show for a year of courting these regimes is their refusal even to consider giving up either their weapons (North Korea) or their growing capacity to make them (Iran).
The French, for one, see this danger plainly and want the U.S. to press harder on Tehran. But on these hard cases, the Administration can't muster the same sense of urgency it is bringing to the cause of an unnecessary arms control pact with Russia. Mr. Obama is right that he still has to earn that Nobel.
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