Monday, March 8, 2010

Banks Take Themselves Hostage

Yves Smith comments on the further weakening of banking regulation:
The notion that makes this guaranteed-to-continue-to-be-weak oversight OK is that the big banks will be permitted to fail. While that may be credible for some of the really big banks (Fifth Third, for instance, is large but not systemically important) any large capital markets player is an integral part of crucial debt market operations. Those large firms in turn are deeply enmeshed via counterparty relationships, most notably repos and credit default swaps. How, pray tell, do you shut down a trading firm in an orderly fashion? You can’t freeze positions, which is what you need to do in an unwind, and not create pain and inconvenience for the counterparties. Are we going to have a firm in default (presumably with emergency credit lines) continue trading? I haven’t heard a credible solution to this rather major conundrum from the officialdom.
There isn't a credible solution, and every time you hear a politician claim that the new regulations will allow for an orderly winding down of any of these institutions you should remember that. Unilateral regulations can never work in the age of globalization; it is essential that the G20 work together to come up with some method of dealing with cross-border resolution issues-as Simon Johnson has pointed out repeatedly, this just isn't going to happen anytime soon. And since it isn't, we need to break these big banks up, because if we don't we will have to bail them out in a couple years when they fail again, and it will only be worse next time.

Also, notice the perverse incentives created by this government guarantee. Fifth Third is not systemically important enough to get saved, therefore it probably won't. What does this tell the CEO of Fifth Third? If it's me, I'm going to get out there and try to make myself systemically important. I'm going to make my bank dangerous so that it won't be allowed to fail. I am essentially going to strap a bomb to my chest and walk around Wall Street daring taxpayers to let me fail.

These are not good incentives.

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