Responding to the Financial Crises: Lessons Learned

1. Vincent Reinhart Resident Scholar American Enterprise Institute May 8, 2009 Responding to the Financial Crises: Lessons Learned

2. “The failure of a major policy…is, if nothing else, a marvelous lever with which to open a debate.” David Halberstam The Best and the Brightest (Twentieth-Anniversary Edition) p. xiii

3. 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 Bipartisan failures…

4. 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

5. Four rules of bail-outs

6. 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

7. 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

8. Rule 3: If you break rule two, be prepared to spend a lot Public debt three years after a crisis • 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 Source: Reinhart and Rogoff (2009)

9. 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

10. Why are there bail-outs?Too complex to fail

11. 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

12. Officials worry… • About the effects on markets if a complex organization were to fail • Those concerns become more elevated when markets are already stressed Crisis Normal times

13. 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 BoNY BoA

14. Traditional costs of complexity 1 to 2: Risk taking is encouraged and the scale of failure will be larger 2 compared to 3: Resources are misallocated and incentives are skewed Cost of funds Cost of funds Marginal opportunities Marginal opportunities 1 3 2 Protection premium Scale of activity Scale of activity Not complex sector Complex sector

15. 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

16. 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

17. 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

18. The way forward

19. …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

20. 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

21. 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

22. 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

23. 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 I have no illusions

24. Playing well is my aspiration

25. 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