Tuesday, October 27, 2009

Can FDIC solve "too big to fail" for non-banks? 

One of the stickiest points in debating how to regulate financial markets after the panic of 2008 has been what to do with investment banks and financial firms. There has been a desire for a "super-regulator" to deal with these non-banks as well as the banks, and most of the betting has been on the Federal Reserve taking on this role (at the request of the Obama Administration.) But most of Capitol Hill opposed this, and today Barney Frank has rolled out a trial balloon of giving that authority to FDIC.

Under this authority, jokingly referred to as "Death Panels for Banks," the Federal Deposit Insurance Corp. would oversee the dismantling of large financial firms much as it does now when it intervenes in commercial banks that are at risk of insolvency.

Decisions about which institutions are so large that they pose a system-wide risk and must be monitored would be made by a Council of Regulators, comprised of leaders from the Fed, the Treasury Department, the FDIC, and other bank-oversight agencies.

...Some independent analysts also have warned that handing the Fed new, expansive powers as the systemic risk regulator could distract it from its principal role of setting monetary policy to sustain growth and contain inflation.

"I didn't want the Fed to have that role because I think monetary policy is too important," said Vincent Reinhart, a former top Fed economist who's also wary of the emerging legislation. "If all you do is a college of regulators, that's just inviting a debating society."

I agree with this -- in fact, did last month -- but it has been clear for awhile that the Fed didn't want this role. In fact, the college of regulators is a Bernanke idea from a few weeks ago. You might argue Bernanke was just seeing the handwriting on the wall, but I doubt many in the Fed disagree with Vincent Reinhart's appraisal.

Reinhart and Fed governor Dan Tarullo have both argued in the last week that the problem is too-big-to-fail and that the issue is how to deal with non-bank financial giants like Lehman and AIG, for which regulators had to improvise. (See the McKinley and Gegenheimer timeline FMI.) If these companies are going to be placed under some government protection in a too-big-to-fail environment, I have to disagree with Ed that they don't get some kind of regulation. You may own a skyscraper as your private property, but when you tear it down you're responsible for any damage done to nearby buildings. If a private non-bank fails and in the process takes down healthy financial institutions that were counterparties, you may have a reason for using the law to limit collateral damage. (That doesn't mean you always get it right, as John Carney points out in the AIG case.)

So what can be done, if we're not going to use the Fed or FDIC? Before you say "we have to do something", consider the benefits of large banks, says Charles Calomiris. Diversification, economies of scope and extended reach to developing markets are some of these benefits. Are we at risk of losing those gains as we try to solve too big to fail?

UPDATE: John Taylor summarizes the testimony around Frank's FDIC proposal.

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