Gulag Blog

Bubble-wrapping the China shop

Do you think we should establish a government-backed insurance fund for big banks’ risky trading activities? Probably not. But that’s precisely what the administration and Congress agree should be done. Today Sheila Bair proposed her own variation on the theme. At first glance her idea sounds better, but it’s just as bad as the others.

From Alison Vekshin at Bloomberg:

Federal Deposit Insurance Corp. Chairman Sheila Bair, breaking with the Obama administration, said U.S. financial companies should prepay into a fund the government would use to unwind large failed firms.

Congress should set up a Financial Company Resolution Fund and force institutions with more than $10 billion of assets to pay before a firm collapses, Bair said in testimony prepared for a House Financial Services Committee hearing today. Investors in failed companies also should take losses, she said.

As I noted in my column yesterday, Barney Frank’s legislation would have taxpayers front money for systemic bailouts while large financial firms would be on the hook to pay the money back.

Of course that would never happen. Banks would never pay. Look how hard it’s been to get banks to replenish the Deposit Insurance Fund. Anyway, Sheila agrees that ex-post funding is a bad idea.

But pre-funding is an equally terrible idea. If there’s a fund somewhere that’s supposed to protect the system, that will codify TBTF and reinforce moral hazard. Not only will investors know some firms are TBTF, they’ll see there’s a pile of cash to protect them. This would put TBTF firms at an advantage in the marketplace.

Now, some would argue that it would penalize the firms because they’d have to pay capital into the fund. Perhaps in the short-term. But soon enough everyone will be content that the system is “safe,” people will be making money and Congress will tell the regulators to lay off.

This is not just a hypothetical. Look at our experience with the Deposit Insurance Fund. From 1996-2006, FDIC was prevented by statute from collecting insurance premiums. Congress, in its infinite wisdom, had determined the DIF didn’t need any more money because the system was firing on all cylinders.

The S&L crisis–which cost $150 billion to resolve–taught us the moral hazards of government insurance funds for bank creditors. Because their money iss guaranteed, depositors don’t care what kind of risky activities their bank are engaged in. They just go to the bank that offers the highest interest rate.

We’re reminded of this fact by GMAC today, whose subsidiary Ally Bank is able to attract billions in deposits by offering high interest rates. And read the Puget Sound Biz Journal’s article on WaMu. They were so desperate for funding amid a bank run last fall that they started offering 1-yr CDs at 5%.

And think about what’s being insured here. Trading. In derivatives, stocks, bonds, forex, commodities …. all of it with leverage. Trading + leverage = high risk!

Despite the moral hazards of deposit insurance, we insure commercial banks because the functions they provide (managing the payment system, turning savings into loans) are important to society. In the fullness of time, I have my doubts that even this makes sense. But arguments supporting it are at least defensible.

This new scheme that Bair is proposing would insure investment banks, and all the risky trading activities they engage in.

Again, we’re acting to protect the needs of TBTF banks rather than protecting the needs of society. What we should be doing is getting trading activities out of the banks to begin with.

The repeal of Glass Steagall essentially put the Wall Street Bull inside the China Shop we call the commercial banking system. We’re surprised when he trashes the place every few years?

But instead of kicking him to the curb, we’re expending all this effort putting the China in bubble wrap…..which in the long-run is no match for the Bull….

Tags: Fed, pre-funding, sheila bair, too big to fail

No comments yet.

Leave a comment