VIEWPOINT: Obama Restructuring Plan Fails Economics

Article excerpt

Byline: Joseph R. Mason

Recent regulatory proposals advance many changes to the structure of the financial services industry. The chief economic problem with those proposals, however, is that many of them go against the grain of decades of economic research on financial system design and incentive conflicts.

Voluminous academic literature on bankruptcy costs, deposit insurance, banking and regulatory policy provides templates for reform. Virtually none of the lessons from that literature are acknowledged in the proposals.

Take, for instance, bankruptcy costs. While it is fine to advocate a resolution regime for nonbanks, the fact is that deeply insolvent firms are costlier and more difficult to resolve (see, for instance, Weiss 1990, Journal of Financial Economics). We saw this most recently in the thrift crisis, where regulatory forbearance left managers to "bet the bank," leaving entanglements that were costly to sort out after managers had carted off most of the cash.

After the crisis, the FDICIA's prompt corrective action provisions were put in place to prevent such forbearance and the recurrence of unnecessary losses. The idea was to shut banks down when they had remaining tangible capital so that the excess value could cover resolution costs. The positive capital would also make resolution easier when going-concern value was preserved. Regardless of how well Tier 1 financial holding companies plan their own funerals, the proposed policies do nothing to alleviate Tier 1 FHCs' systemic (and political) importance that will prevent them from being closed well in advance of insolvency, in contrast to the proper economic intent of PCA.

Such influences further undermine the rules-based approach of FDICIA's PCA provisions, which were obviated again in the present crisis when regulators refused to downgrade bank Camels ratings to levels at which FDIC resolution authority takes hold. Despite a substantial body of economic literature on the inefficiency of discretionary regulatory principles relative to well-designed and well-articulated rules (see, for instance, Kydland and Prescott, 1977, Journal of Political Economy), the Obama administration seeks not to enforce and build upon existing rules but to ignore them altogether.

That's OK, says the administration. We will assess the Tier 1 FHCs to cover the additional costs. The problem with the approach, however, is that only a subset of institutions is assessed and members of that subset influence their inclusion in the assessed class - whether by virtue of size, "systemic importance," or other factors. Well-managed and solvent institutions will be able to use their influence or control to stay outside the penalized subset of institutions. Hence, the only institutions assessed at the higher rate will be those that lack the wherewithal to wield such influence or control, and are therefore doomed to fail.

Again, this is nothing new. Deposit insurance experiments in the U.S. in the 1800s and early 1900s also allowed voluntary participation. Time and again, those deposit insurance schemes failed when the only banks that chose membership were those about to fail (see, for instance, Calomiris 1989, Federal Reserve Bank of Chicago "Economic Perspectives"). …