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Jul 07
2010

The financial crisis is only "on pause"

Posted by Ron F in Volcker RuleRiskRegulationObama Administrationfinancial market reformfinancial crisisCongresscomplianceBanksbanking reformBankingbailouts

Ron F

There's some additional recent work out there that's worth citing in connection with Karen's post on Tuesday.

In particular, I would point readers to the piece posted Monday on voxeu.org by Enrico Perotti, a finance professor at the Amsterdam Business School. Essentially, Perotti's piece explains why Kotlikoff's prescription is necessary. As it did the US Congress, the banking industry has fought off international attempts to get the so-called Basel Committee to force the industry to de-leverage its business model. And Kotlikoff's idea does exactly that, simply because mutual funds are financed entirely by equity.

They do suffer from one flaw, though, at least those that hold themselves out as money-market funds, and that's where Perotti's column is insightful. Like banks, money funds suffer from an acute funding mismatch when they promise to hold their value at $1 a share and allow unlimited withdrawals.

The problem with banks, is that after all is said and done, they still depend on hot money for their own financing, and that can subject them to the sort of runs that took down Lehman Brothers and Bear Stearns. And Perotti, like Kotlikoff, would address this by changing the asset/liability structure, though Perotti would do it with a tax instead of a wholesale change in their financing. But both end up in the same place.

Both also would require a complete change of heart among the powers that be. Instead of focusing on the psychology of investor confidence in such institutions, as Congress, the Obama administration and the G20 seem intent on doing, Perotti, for his part, says regulators must deal with the fundamentals on which such confidence may be based.

More specifically, he says, that requires so-called "liquidity buffers," essentially taxes on their use of uninsured sources short-term cash instead of insured deposits. We're talking about repurchase agreements or repos, which despite their lack of formal taxpayer backing still have an implicit guarantee from the government.

In other words, the "living wills" and resolution authority for complex financial institutions that Congress is about to send to the president for signing do little or nothing  to prevent another huge bailout if investors once again lose confidence in such institutions, especially if, as they would be under financial reform efforts so far, they're still allowed to do just about anything they want with no limit on their size.

As Perotti put it: "Future financial stability requires more than a ‘pause in panic'. We need to reverse the dramatic slide of the financial system towards unstable funding - a trend which holds a gun to the heads of governments and central banks."

 

 

 

 

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