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					Responding to the Financial
 Crises: Lessons Learned

          Vincent Reinhart
          Resident Scholar
     American Enterprise Institute

             May 8, 2009
“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
           Bipartisan failures…
• In 2008, inconsistent            • In 2009, cynical policy
  policy making                      making, recognizing the
   – Added uncertainty in an         public’s distaste for bail-outs,
     uncertain environment,          has
   – Magnified the economic           – Delayed the recognition of
     shock,                             bank losses
   – Wasted government                – Designed a rescue package to
     resources, and                     minimize the footprint on the
   – Damaged the reputations of         budget, which will
     key government institutions      – Extend and make more
                                        expensive the ultimate
    What are the lessons to learn
      from this experience?
   Policy interventions (bail-outs) have significant
   The source of policy makers’ fears is of their own
   Understanding this mechanism is important for
    framing new legislation and regulation
Four rules of bail-outs
           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
Rule 2: If you break rule one, be
   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
 Rule 3: If you break rule two, be
     prepared to spend a lot
• The possibility of        Public debt three years after a crisis
  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)
Rule 4: Whatever you do, don’t add to
 uncertainty and worsen confidence

    Statements in the Fall
     (TARP/AIG) and the
     Spring (stimulus/market
         Added to uncertainty
         Damaged confidence
    This is a problem inherent
     in the brinksmanship of
         Political salesmanship does
          not always align with
          economic stewardship
Why are there bail-outs?
  Too complex to fail
    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
            Officials worry…
                      Complexity and the probability of intervention
• About the effects
  on markets if a                                            1


                       Probability of government action,
  organization were                                                        Crisis                            Normal times
  to fail

• Those concerns
  become more                                              0.25

  elevated when
  markets are                                                0
                                                                  0   2          4           6           8           10   12
  already stressed                                                        Complexity of the financial organization
• Is only imperfectly                   Complexity and asset size
  connected to the                           14
  size of the firm                           12

• Once a firm is too                         10

                        Complexity (index)
  complex to fail, it                         8

  has a market                                6

  advantage                                   4

  – Funding costs are                         2

    lower for too-                            0
                                                  0    200   400         600           800   1000   1200
    complex-to-fail                                                Assets (billions)
     Traditional costs of complexity
                                                              1 to 2: Risk taking
                                                              is encouraged and
  Cost of funds                        Cost of funds          the scale of failure
                                                              will be larger
                Marginal                        Marginal
                opportunities                   opportunities 2 compared to 3:
                                                              Resources are
                      1                                       misallocated and
                                                              incentives are
                            2                                 skewed

                   Scale of activity               Scale of activity

             Complex sector                    Not complex sector
    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
      Failures of suitability
      Compensation abuses
                  Note the irony
   A firm’s effort to take advantage of government-
    induced distortions
       By becoming more complicated to gain a protection
       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
           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
The way forward
…is not to add another layer of
   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
Ole Kirk Christiansen's modular
   The whole of a financial holding company can be
    made of parts that can be disconnected and
       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
      Playing well also involves
• Reducing the number                         Complexity and asset size
  of corporate charters
  and agencies
• Enforcing                                        14

  consolidation of

                              Complexity (index)

  balance sheets                                   10
• Giving up some                                    6
  efficiencies of scale and                         4

  scope to bend the curve                           2

  relating size and                                     0   200   400         600           800   1000   1200
  complexity                                                            Assets (billions)
                    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
            I have no illusions

• Playing well would        • But so will other, more
  – Be costly and take time   burdensome and more
    to implement              likely regulatory
  – Be resisted by industry   alternatives
    because it              • Change is coming
     • Takes money off the
       table                  – We should at least get
     • Put more pressure on     some efficiency gains
       management               from it
  – Lower the return on
    equity in finance
Playing well is my aspiration
     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

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