Crisis Policy is Redrawing the Boundaries of our Financial System – and not Necessarily in Productive Ways

Somewhere along the path of this crisis policymakers have lost touch with the basics of financial system design. This is a topic that every development economist and financial institutions specialist knows, well but one which is lost on post-modern financial scholars and macroeconomists.

The idea is that there exists an array of financial markets and institutions across the financial system. Each particular market or institutions performs a crucial task. While it doesn’t matter so much what any particular economy calls each institution, i.e., its legal name, the task, itself, is crucial to a well-functioning financial system.

Take, for instance, commercial banks. Depository institutions take deposits and make loans. As such, they make investments in things (consumer, small business, and commercial loans, among other things) that are very hard to value from the outside. At the same time, perform a crucial economic function of aggregating small short-term deposits to fund large, long-term loans. But those short-term deposits are brought to depository institutions by unsophisticated investors who spook easily. Hence, we regulate depository institutions to limit their risk and provide deposit insurance to keep depositors (and their money) in the financial system.

On the other end of the scale, we have financial markets. You can invest in anything in financial markets. The Securities Exchange Commission regulates markets and their primary participants (investment banks and broker-dealers) only for purposes of transparency. That is, you can engage in as much risk as you wish, as long as it is accurately and credibly reported. We assume there are sophisticated investors who can face the risk of loss and that investment banks and broker-dealers will pay the price for misdealing with their reputations and possible bankruptcy.

Between those two extremes are many other types of institutions. In the US, we have insurance companies, mutual funds, and finance companies, to name a few. Each faces intermediate degrees of regulation. Each poses varying degrees of market discipline. Each is an important part of the continuum of financial institutions, gradually spanning the space between safe depository institutions and risky markets.

Hence, contrary to many recent assertions, the SEC plays virtually no role in mitigating risk in the investment banking world, nor should it. Instead, the SEC relies on accounting rules and sometimes bond ratings to report various types of risk to investors. Depository institutions regulators, on the other hand, play a crucial role in restraining risk among depository institutions. Insurance regulators are in the middle, restraining risk using firewalls to safeguard some standard consumer products (like life insurance) while allowing the market to reign free in others (like, in many cases, GICs and SPDAs).

This view has important ramifications for policy today. Lehman and Bear can play all they want, but should be constrained not by depository institution-style functional regulation – telling them specifically what they can and cannot do – but by accounting rules and bond rating measures of risk. When they fail, they fail. On the other hand, Countrywide, IndyMac and WAMU – being functionally regulated – should never have been allowed to get as far as they did.

Assuming, however, that Countrywide, IndyMac and WAMU really did manage to actively fool their regulators, there exists a safety net for depository institutions in order to insulate the unsophisticated investors and borrowers from undue loss. The discount window and deposit insurance provide a backstop in case the hard-to-value depository institution assets run into trouble. Investment banks and markets have no such backstop, because transparent reporting is supposed to give sophisticated investors all the information they need to make rational decisions.

Perhaps we are temporarily bailing out investment banks and insurance companies because the information was not as transparent as we had hoped. That may be fine, but without improved accounting rules and bond ratings we have little hope of ending the crisis. Perhaps we are bailing them out because regulators permanently want more “turf” in their bid for power. That is not okay, because risk will just migrate to a new, unregulated, platform to blow up on us once again.

The problem is that we really don’t know why we are bailing out all these institutions. In fact, this week we chose to bail out some but not bail out others that are nearly identical. While bailouts might engender moral hazard, and the lack thereof a widespread retreat from risk, random bailouts confuse markets so that investors have no idea what to do. Such policy will certainly draw out the economic effects of the crisis for far longer than would otherwise be the case.

One can’t help but wonder what the IMF and World Bank, who deal with these types of financial market structure problems all the time, would think of US developments. They seem uncharacteristically quiet. For an idea, I recently asked an ex-IMF economist, who reminded me that “the way the IMF would [help the US financial system redesign] is though the Financial Sector Assessment Program (FSAP), which began around 2000 after the Asian crises. Most major countries have had one and many others too. The country can choose to have the resulting report published in full or just summarized. THE US HAS REFUSED TO HAVE ONE. Bush finally agreed, but only if the results are released after he has left office!”

I fear that we can expect bad financial markets policy to constrain economic growth for some time to come.

9 Responses to "Crisis Policy is Redrawing the Boundaries of our Financial System – and not Necessarily in Productive Ways"

  1. villager   September 18, 2008 at 9:42 am

    This article is educational. It provides a holistic view which some commentators say is missing from the government’s actions in responding to the financial situation. The conclusion that I take is that without taking the whole financial system into account, more power and authority should not be heaped onto the Federal Reserve.”When they fail, they fail.” I had been thinking for some time that the proper response by government to the circumstance of the financial sector is that a “fire wall” be placed around the deposit-taking institutions leaving the rest to “burn”, should that be the case. This article may or may not be saying something similar.Instead of a “fire wall”, the US government has built a “bridge” (Statute 23A) to allow the fire engines (liquidity) to cross over. Now we have to wait and see how strong and in what direction the wind is blowing.

  2. Alex   September 18, 2008 at 4:31 pm

    Lol the US government has built a bridge so the fire can spread more quickly and destroy what’s left of the US financial system. This is moral hazard on an unprecedented scale.If the US government actually succeeds this could be an even bigger disaster than a failure. Now companies can produce subprime,stated income loans at their leisure confident that there will be the US will be the buyer/sucker of last resort.The real issue here is who bears the risk. Traditionally its always been the lender who bore the risk, with the advent of securitization it was the bond holder, now its the US taxpayer. Notice a trend here?What makes this so dangerous is that if this proposal succeeds lenders and bond holders have no incentive for due dilligence, because Uncle Sam has said he’s going to bail them out.Something stinks in Denmark.

    • Andres   September 19, 2008 at 3:16 am

      Could not have put it better myself.

  3. PhilT   September 18, 2008 at 7:54 pm

    Thank you for articulating what is on the minds of many and I hope that this article is widely read.I also hope that you might consider publishing a follow-up with more detail on solutions from appropriately experienced institutions/individuals that could have realistically been entertained in real time (armchair quarterbacking) even as recently as 18-months ago.

  4. PhilT   September 18, 2008 at 7:57 pm

    Apologies the parenthesis were to include the words… NOT armchair quarterbacking

  5. Benedict@Large   September 19, 2008 at 1:15 am

    And so what WOULD the FSAP have done? Would it have helped if performed few or more years back? Assuming that the assessment folks weren’t just another group of deregulating utopians and that they actually did find a number of the problems that have led us here, where would the will have come from to implement their recommendations? What interest group could have arisen that would have been capable of overcoming the inertia of this myopic “no government” fantasy cult that has highjacked this country?No. We had to fail. There was no other way to route out the demons.

  6. Anonymous   September 19, 2008 at 6:03 am

    In our high school history books we can find reviews of the last depression by flipping a few pages – or chapters at best. In fact it was a process that lasted almost 10 years after the Wall Street crash of Oct ’29 and really didn’t take hold on the general population until large insurance companies and pension funds failed. Looks like history is repeating itself (?)

    • Guest   September 19, 2008 at 12:05 pm

      someone justified the view that “this is not as bad as the great depression” by saying that the effects on the main street were not bad yet. Perhaps what you are saying would explain why: we just are not there yet.

  7. Anonymous   September 19, 2008 at 8:23 pm

    History is repeating itselfThey should had a recession to flush out all the bad corrupt bankinginstead of an depression of this magnitude