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Tuesday, January 19, 2010

Simon Johnson says the Obama Financial Tax is only part of the solution

The Obama Financial Tax Is A Start, Not The End
Peter Boone and Simon Johnson
Baseline Scenaria
January 11, 2009

The flurry of interest this week around ways to tax Big Banks is important, because officials in the US are – for the first time – recognizing that reckless risk-taking in our banking system is dangerous and undesirable.

But the possibility of a tax on bonuses or on “excess profits” that are large relative to the financial system should not distract us from the more fundamental issues.

Mr. Bernanke and Mr. Geithner need to admit that the Federal Reserve and New York Fed played a key role in creating this problem through misguided policies. They were part of the regulatory failure, not independent of it. When you keep interest rates very low and let balance sheets explode under your watch, we’ve seen how things fall apart.

As long as Bernanke and Geithner do not concede this point, they send a clear message to banks throughout the US and around the world that they can load up on risk again, and hope to profit – personally and professionally – from Mr. Bernanke’s next great credit cycle.

Yes, a new tax on these profits will raise money. But it will not prevent a major collapse in the future. There is no use discussing tough regulation when the previous regulators are still in charge, and they refuse to admit they were part of a system which egregiously failed. Mr. Bernanke’s speech at the American Economic Association 10 days ago was a big step backwards for those – such as Tom Hoenig, head of the Kansas City Fed – who want to send a message that there is a new regime in place to stop future crises.

One view of regulation is that you can adjust the rules and make it better – with each crisis we learn more, so eventually we can make it perfect. This appears to be the current White House position – there is even mention of the US becoming “more like Canada”, in the (mythical) sense that we’ll just have four large banks and a quite life.

Another view is that the current complicated rules obfuscate and make it easier for the financial sector (sometimes with collusion of regulators) to game and hide risk. Successive failures of regulators at large cost over the last three decades make it clear that fine tuning the system is not likely to work; every time you hear the “Basel Committee [of bank standard setters] is meeting today to discuss the details”, you should wince.

The ingredients for regulatory reform need to be simple and harsh.

Capital requirements at banks need to be tripled from the current levels so that core capital is 15-25% of assets.
Simple rules need to be in place to restrict leverage – the amount that banks, firms, and individuals can borrow (including in the form of mortgages).
Complex derivatives where risk is hard to measure need to have very high capital requirements behind them. It is not the regulators’ job to work out the complex implications of derivatives, and we can’t rely on banks or ratings agencies to do the job, so just keep it simple (and less profitable than today).
And, as the ultimate fail-safe, we need a hard size cap on major banks. All financial institutions have to be small enough so they can fail without causing major damage to the economy.
By all means, implement a sensible tax system that creates a punitive disincentive to size in the banking system – if you can figure out how to make this work. Most likely, the big banks will game this, like they have gamed everything else over the past 30 years.

But don’t think taxes are the answer. We need to go back to simple, transparent regulation, and much smaller banks.

5 comments:

  1. The biggest problem with any reform is that it requires you to have regulators who actually do their job. Geithner denied he was ever a regulator. Greenspan denied it was part of his job. So any future system has to have simple rules that the banks cannot get around, and ones that regulators can actually understand, and can be expected to enforce.

    Define tier one capital as only cash, deposits with the Fed, and liquid government bonds. MBS assets or other corporate debt are off-limits.

    The simplest way to reform the banks is to have simple leverage rules. None of the 33 times capital shenanigans. Commercial banks should have a maximum leverage of 12 times capital, investment banks a maximum leverage of 4 times capital. Insurance companies are to have little or no leverage. Any business that is in any of these businesses has to operate at the leverage of the lowest entity. That way the universal banks will be forced to hive off insurance arms as they wouldn't be able to support any leverage of the business. If they had an investment bank or trading desk then they again would be forced to meet the leverage level of an investment bank. Again this would force the banks to hive of one arm or another. If Citicorp opted to become an investment bank they would have to sell the commercial banking operations.

    Investment banks directors are to have unlimited liability for any losses. That way if they trade and make profits no one will object to these. If they make losses then the directors risk bankruptcy. It reimposes moral risk at investment banks. Then if a commercial bank collapsed owning an investment bank it will be treated as an investment bank and you wipe out the directors before the FDIC comes in and saves depositors.

    Also banning investment banks access to Fed funds would also force them to be more responsible. Knowing that the cavalry will not be able to ride into their rescue will have its own impact.

    Another option should be a lifetime ban on working for a bank of any kind if you take up a regulatory job or government job. That will stop the revolving door between banks and the government. The only problem is that the banks own Congress and will never allow sensible reforms to take place.

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  2. Very good comment. Thank you.

    These are precisely the rules that would have prevented the previous mess and should be instituted to prevent future messes.

    I'm not clear on the word "hive," is that "live off" or a term I am just not familiar with?

    But whatever the case there, the way forward bears very little resemblance to the way we got here, so as good as these rules are, and hopefully the breakup of the banks and the limitation on their derivatives exposure, it is necessary to find a scheme that produces investment that does not rely on these private banking institutions.

    Right now the banking function is being underwritten explicitly by the Fed... Will pick this up later.

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  3. Hive off is a British term for selling. If you hive off a division you sell it or give it away. Either way it is no longer a part of the original company.

    I left derivative reform as it is a complex issue, though standardised contracts, traded through an exchange would help considerably in reducing risks. It would show exposure to all concerned.

    Of major concern to me is that the credit rating agencies have not been looked at closely. The fact that banks could slice and dice mortgages into a variety of products that all had AAA ratings is the heart of the problem. Without this, the banks would not have been able to securitise their low quality loan books and been able to inflate a bubble of epic proportions.

    Like you I read Calculated Risk, and expect huge losses in the banks prime mortgage market. The sub prime problem is practically over it is the prime market that is to suffer next. With huge numbers underwater and major recasts not due until later this year and next I expect further problems at the big banks. I fear unfortunately this crisis has been wasted and we have to wait for the next one to institute major reforms.

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  4. Very good.

    My concerns with the next crisis are (1) that we didn't even learn this time that the predatory markets don't work, that they need to be structured, and (2) the private credit economy that has been the framework for thinking about capitalism to date has failed so completely that the rubble it has left behind cannot be reconstructed into anything like it was before and we need to retrain it or form some kind of public-credit economy to get any kind of investment going.

    Thanks for your comments.

    With regard to the ratings agencies, I don't see their function. They seem to be there to replace due diligence, but how can they pass on anything better than their own rating, which cannot be the highest after their disastrous calls?

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  5. One huge problem of all is that so many are still enamoured by the whole concept of monetarism. The free marketers do not understand that markets can be rigged and failure to regulate has been the real source of the crisis. Without proper regulation of mortgages banks ran amok. The Fed failed to raise bank rates to stop a bubble being created. Until that is recognised the US will repeat the mistake.

    So the majority of political efforts will be for further tax cuts and low rates to stimulate the economy. Businesses and consumers will be de-leveraging as fast as possible. Which is completely rational for them to do so. Only once people feel comfortable with the level of debt will they resume spending or recruiting.

    As such the paradox of thrift will mean that the impact of such efforts will only damage government finances further. That combined with Republican vetoes of tax increase and Democrat vetoes of spending cuts. Nothing will improve until someone gives and with the Republicans seemingly intransigent, that means that it will be spending cuts will be the outcome. That will deepen the recession and increase unemployment further. Then further collapses in the housing market.

    The existence of the GSE's gave banks a false sense of security. If the banks had to hold on to their mortgages rather than being allow to bundle them into MBS then banks with poor risk management would have collapsed earlier, when borrowers defaulted. It would have eliminated contagion as well.

    For small investors the ratings agencies are vital. Individuals cannot afford to do their own research to determine the outcome. Though they need to be seriously reformed. So far they have come out of the crisis unscathed.

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