Washington, D.C. -An independent panel of academics Monday cautioned Washington against rushing into an innovation-stifling regulation of investment banking, but urged that structures be put in place to ensure the industry itself bears the cost of any future federal bailouts.
The Shadow Financial Regulatory Committee also took a stand against new restrictions on short-selling and recommended that the government liquidate Fannie Mae and Freddie Mac once the market for mortgage financing has stabilized. The federal government took over the two quasi-private mortgage giants earlier this month.
...The committee noted approvingly that the Federal Reserve Bank of New York has been pushing industry players to create a central clearinghouse for credit default swaps and other derivatives. In a clearinghouse model, Calomiris said, investment banks would share the costs of a member's default, thus creating an incentive to enforce capital standards and to demand more transparency from other participants.
The committee also recommended that the federal government levy a special assessment on investment banks to pay for any future industry bailouts, thus giving the bankers an incentive to support federal intervention only when a failure would present a true risk to the financial system.
The model for this, the committee noted, was established when Congress passed the Federal Deposit Insurance Corporation Improvement Act of 1991.
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The $70 billion liquidity fund that 10 financial institutions, including Citigroup, Credit Suisse and Deutsche Bank, agreed to set up over the weekend was an acknowledgment by these institutions that it's appropriate for them to share losses to contain systemic risk, the committee noted.
In his post, White adds:
If the Fed and Treasury are now giving a de facto guarantees to the creditors of investment banks (as in the Bear Stearns intervention), why not require the Fed or Treasury to recoup the cost through an assessment on all investment banks? That would insulate ordinary taxpayers, and it would give healthy investment banks an incentive to oppose unnecessary bailouts. Ditto for guarantees to the creditors of insurance companies (as in the AIG nationalization).
It is a bad idea to extend federal guarantees to the creditors of investment banks and insurance companies. First-best is to let those industries organize their own cross-supports (on the model of pre-Fed bank clearinghouses) if they think it worthwhile. But extending federal guarantees to an industry at a zero price, subsidized by ordinary taxpayers, is the worst idea of all.
I could certainly get behind such a proposal going forward. The liquidity fund setup over the weekend is definitely a step in the right direction. To the extent that the Fed and Treasury used moral suasion to make it happen, they deserve some credit. Providing government guarantees to insurance companies is not something that I like to see either, but I'm willing to give the benefit of the doubt to the front line troops in the heat of battle. I would agree that for the next firm in this position, the Fed and Treasury need to lean on them really hard to use the private liquidity fund. I mean really hard.
Another good comparison that may be more familiar to people would be the way that we fund unemployment insurance. Unemployment insurance is funded by a tax on employers that is experience rated. That is, firms that have more layoffs are taxed more heavily. Likewise, the government could set up an assessment (i.e. tax) on investment banks, perhaps even make it dependent on an audit of their financial position and transparency. I think that idea deserves some attention.
There is a way forward. And it is definitely appropriate to start thinking creatively about ways to prevent the moral hazard which could lead to another crisis. The door is broken and the cows are out of the barn. Our first priority is rounding up the cows, but it doesn't hurt to put a few smart minds to work on the problem of fixing the door--it may even keep in some of the cows that have not yet escaped.
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