Responding to the Financial Crises: Lessons Learned

Vincent ReinhartResident Scholar

American Enterprise Institute

May 8, 2009

“The failure of a major policy…is, if nothing else, a marvelous lever with which to open a debate.”

David HalberstamThe Best and the Brightest (Twentieth-

Anniversary Edition)p. xiii

Bipartisan failures…

• In 2008, inconsistent policy making– Added uncertainty in an

uncertain environment,– Magnified the economic

shock,– Wasted government

resources, and – Damaged the reputations of

key government institutions

• In 2009, cynical policy making, recognizing the public’s distaste for bail-outs, has– Delayed the recognition of

bank losses– Designed a rescue package to

minimize the footprint on the budget, which will

– Extend and make more expensive the ultimate resolution

What are the lessons to learn from this experience?

Policy interventions (bail-outs) have significant costs

The source of policy makers’ fears is of their own making

Understanding this mechanism is important for framing new legislation and regulation

Four rules of bail-outs

Rule 1: Don’t do them

The possibility of government intervention has consequences for the private sector, the government, and the political process

The private sector Lessens pressure on management to raise capital and address

balance sheet problems Lessens counterparty discipline

The government Opens agencies to political pressure Confuses the public about policy intent Eliminates forever the possibility of serving as an “honest broker”

The political process Tilts the political playing field toward intervention generally Legitimizes increased supervision and regulation of a wide portion

of financial activity

Rule 2: If you break rule one, be consistent

Policy interventions by the Federal Reserve and the Treasury in 2008 were ambiguous as to the scale and scope of the

protection offered

This created incentives for creditors and short sellers to test the limits of intervention So, the fear of debt contagion led policymakers to act

in ways that encouraged speculative attacks

Rule 3: If you break rule two, be prepared to spend a lot

• The possibility of intervention leads investors to delay capital investments

• Given a capital hole, – If the private sector

does not fill it,– The government will

have to

Public debt three years after a crisis

Source: Reinhart and Rogoff (2009)

Rule 4: Whatever you do, don’t add to uncertainty and worsen confidence

Statements in the Fall (TARP/AIG) and the Spring (stimulus/market repair) Added to uncertainty Damaged confidence

This is a problem inherent in the brinksmanship of bail-outs Political salesmanship

does not always align with economic stewardship

Why are there bail-outs?Too complex to fail

Why do policy makers protect complicated firms?

Fear of spillovers The tyranny of event studies

Self interest of officials Krugman's ”capture by Wall Street”

Disguised subsidy to some forms of credit Housing is preferred beyond all else

Officials worry…

• About the effects on markets if a complex organization were to fail

• Those concerns become more elevated when markets are already stressed

Complexity and the probability of intervention

0

0.25

0.5

0.75

1

0 2 4 6 8 10 12

Complexity of the financial organization

Pro

babi

lity

of g

over

nmen

t ac

tion

, pe

rcen

t

Crisis Normal times

Complexity

• Is only imperfectly connected to the size of the firm

• Once a firm is too complex to fail, it has a market advantage– Funding costs are

lower for too-complex-to-fail firms

Complexity and asset size

0

2

4

6

8

10

12

14

0 200 400 600 800 1000 1200

Assets (billions)

Com

plex

ity

(ind

ex)

BoNY

BoA

Traditional costs of complexity

Complex sector Not complex sector

Cost of funds

Scale of activity

Cost of funds

Scale of activity

Protectionpremium

1

2

3

1 to 2: Risk takingis encouraged andthe scale of failurewill be larger

2 compared to 3: Resources are misallocated andincentives areskewed

Marginal opportunities

Marginal opportunities

The protection premium does not all go to owners

Rent seeking as firms spend resources to keep their special status by Going slow on industry initiatives that limit risk

Netting of swaps, central clearing houses Weaving systemically important activities into the firm's structure

Clearing banks Resisting regulation that would make closure easier

Uniform insured depositor list Making their balance sheets more intricate and their instruments

more complicated to take advantage of regulatory arbitrages

Shirking as owners find it more difficult to monitor employees, leading to Failures of suitability Compensation abuses

Note the irony

A firm’s effort to take advantage of government-induced distortions By becoming more complicated to gain a protection

premium By making its instruments more complex and its

balance sheet more opaque to take advantage of regulatory arbitrage

Lessens it owners’ ability to monitor management Eroding value and making the firm riskier

Note the circularity

Policy makers’ concern about complicated firms Puts money on the table (the protection premium) That induces firms to be more complicated And worsens the principal-agent problem between

owners and employees Making the financial system more vulnerable to

abuses and less resilient Raising the odds of strains That justifies policymakers’ concern about

complicated firms

The way forward

…is not to add another layer of supervision

As in some proposals to create a Financial stability supervisor “College of supervisors” Special resolution authority for too-complicated-to-

fail institutions

Those proposals Accept the inherent inefficiencies and gaps in the

current system and Leave the fundamental incentive for complexity (and

the resulting rent seeking and shirking) on the table

Ole Kirk Christiansen's modular solution

The whole of a financial holding company can be made of parts that can be disconnected and reassembled LEGO is formed from the Danish words "LEg GOdt"

meaning "play well" Any part of the firm that is systemically

important can be protected in bankruptcy With haircuts in the event and Infrastructure developed over time to limit the

perimeter of systemically important activities But the rest can be turned over to the market

Playing well also involves

• Reducing the number of corporate charters and agencies

• Enforcing consolidation of balance sheets

• Giving up some efficiencies of scale and scope to bend the curve relating size and complexity

Complexity and asset size

0

2

4

6

8

10

12

14

16

18

0 200 400 600 800 1000 1200

Assets (billions)

Com

plex

ity

(ind

ex)

Playing well

Facilitates international cooperation Because the module in a foreign country can be

supervised by the host (consider the Turner Report) Should have the goals of

Making pre-packaged bankruptcy a viable option for any large financial entity

Increasing discipline on management because hostile takeovers are more likely when entities can be carved up

Improving monitoring within a firm Works overall to improve economic efficiency

I have no illusions

• Playing well would– Be costly and take time

to implement– Be resisted by industry

because it • Takes money off the

table

• Put more pressure on management

– Lower the return on equity in finance

• But so will other, more burdensome and more likely regulatory alternatives

• Change is coming– We should at least get

some efficiency gains from it

Playing well is my aspiration

My prediction is that after heightened government intervention

• More and burdensome regulation is a certainty– which may make the job of attracting capital and restoring

confidence harder

• Capital once infused by the government will be slow to exit the private sector

• The Federal Reserve, in particular, will be overburdened and subject to political pressures that will – Change its current structure and powers– Call its inflation resolve into question