The Agenda

Yves Smith and Charles Calomiris on Financial Reform

Yves Smith rips into Alan Greenspan for writing the following, among many other things:

The vexing question confronting regulators is whether this rising share of finance has been a necessary condition of growth in the past half century, or coincidence. In moving forward with regulatory repair, we may have to address the as yet unproved tie between the degree of financial complexity and higher standards of living.

Yves offers a counternarrative, drawn from her book Econned:

Advanced economies have become hooked on debt technology, which, like XCrop, is habit forming and hard to wean oneself off of due to its lower cost and the fact that other approaches have fallen into partial disuse (for instance, use of FICO-based credit scoring has displaced evaluations that include an assessment of the borrower’s character and knowledge of the community, such asstability of his employer). In fact, the current debt technology results in information loss, via disincentives to do a thorough job of borrower due diligence (why bother if you are reselling the paper?) and monitoring of the credit over the life of the loan. And the proposed fixes are not workable. The Obama proposal, that the originator retain 5% of the deal and take correspondingly lower fees, is not high enough to change behavior. And a level that would be high enough to make the originator feel the impact of a bad decision would undercut the cost efficiencies that made securitization popular in the first place. You’d have better decisions, but less lending, and higher interest rates. That’s ultimately a desirable outcome, but as in the XCrop situation, no one seems prepared to accept that a move to healthier practices will result in much more costly and less readily available debt. The authorities want to believe they can somehow have their cake and eat it too.

She concludes with the following:


We’ve been critical of the phony resolution authority as well as other features of Dodd Frank. But the reason is, as the critics Hirsh cites remind us, that the legislation failed to accomplish its stated aims and may be increasing big bank power.

Greenspan, by contrast, clearly object to the basic premise of Dodd Frank, that governments should have any meaningful say over the operation of financial financial firms. Einstein defined insanity as doing the same thing over and over again and expecting different results. But the true madness isn’t that Greenspan’s remarks border on deranged; he’s merely a useful and highly paid idiot. It’s that anything he says is still listened to after the huge cost his misguided policies have inflicted on all of us.

To her credit, Yves doesn’t try to characterize this as a left-right issue. What I find frustrating is that Yves seems to believe that Dodd-Frank “failed to accomplish its stated aims and may be increasing big bank power,” yet what we might call the cultural struggle against those who “clearly object to the basic premise of Dodd Frank” often seems to take precedence over making a sustained, serious case for fixing Dodd-Frank.

I imagine that Yves disagrees with Charles Calomiris about many things (actually, I know that she disagrees with him about many things), but I wonder what she’d make of “Beyond Basel and the Dodd-Frank Bill,” in which he offers a detailed roadmap for how to think about financial reform. Here are a few ideas from the report:

(1) The new Dodd-Frank resolution authority vested in the Federal Deposit Insurance Corporation (FDIC) awards it unlimited bailout authority, meaning it can now insure any debt on planet Earth against any loss. A better approach would have required unsecured creditors to bear significant but bounded losses, for example, requiring that creditors suffer the same losses as they would in bankruptcy up to some maximum proportion of loss. Bounded losses can prevent systemic problems of contagion but unbounded protection of creditors institutionalizes too-big-to-fail incentive problems.

(2) Use loan interest rates when measuring loan default risk. Loan interest rate spreads compensate banks for the risk of default on the loan. If U.S. regulators had followed the example of countries that use interest rate spreads to measure loan risk, they would have required substantial additional capital to be budgeted against high-interest subprime loans in 2004-2007, which would have discouraged the overinvesting in housing ex ante, and would have insulated the banking system from the losses on those loans ex post. 

(3) The SEC should reform the use of credit ratings to require NRSROs to estimate the probability of default, and provide that number as their rating for regulatory purposes, rather than give letter grades, and then hold NRSROs accountable for the accuracy of those estimates. Letter grades have no objective meaning, and thus, rating agencies cannot be held accountable for those letter grade ratings. If, instead, NRSROs were required to provide numbers, representing their estimates of the five-year probability of default on the debt, then regulators could construct (generous) confidence intervals for those estimates, and penalize rating agencies for grossly underestimating the probability of default.

(4) Establish a minimum uninsured debt requirement for large banks in the form of a specially designed class of subordinated debt known as “CoCos,” or contingent capital certificates. These CoCos would convert to equity based on observable market triggers (when the ratio of the market value of equity relative to the market value of assets falls below some pre-established threshold).

Is this a program around which we can build a consensus?

Reihan Salam is president of the Manhattan Institute and a contributing editor of National Review.

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