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The Obama-Frank Systemic Risk Plan: Some Good and a Lot of Bad

Posted By David C. John On October 28, 2009 @ 5:32 pm In Economics | Comments Disabled

The Treasury Department and House Financial Services Committee Chairman Barney Frank have just released a highly complex 253 page draft bill that is supposed to deal with questions ranging from indentifying and dealing with systemic risk facing the financial services system, regulating and closing failing “too big to fail” financial services firms, and a wide variety of other potential problems. As expected with a bill that long and detailed, it will take a while to understand everything that it contains, but first impressions are that it contains many bad ideas with a few good ones sprinkled in.

The good news is that after a great deal of criticism, including ours [1], the Treasury Department has dropped its plan to make the Federal Reserve the regulator of systemic risk, and replaced it (as we urged [1]) with a council of regulators. The new draft bill also limits the ability of the Federal Reserve to bail out firms to its existing temporary liquidity assistance authority found in section 13(3) of the Federal Reserve Act, and only allows it to use that with the advance approval of the Treasury Secretary.

The council is a far more realistic approach to systemic risk in the financial system than Treasury’s earlier efforts. However, the likelihood that any systemic risk regulator — including such a council — will be able to adequately identify systemic risk and asset bubbles in advance remains low, and the possibility that it can actually deal with such a situation, even with unlimited powers, is virtually nonexistent. Congress and the administration feel the need to say something about the issue, but essentially what they are doing is to arrange for someone to take the blame if there is another crisis like the one that we saw last year.

The bad news is that they also decided to give both the council and the Fed virtually unlimited power to do what they want to a “too big to fail” financial institution including forcing it to break up completely, sell various subsidiaries, etc. This open-ended power is both dangerous, and very likely to cause even more damage to the financial system than that likely from large financial services companies’ potential failures. It would be far better to limit the potential risk of such a company by imposing higher capital requirements on it. That approach would both limit a firm’s incentive to grow unless it is efficiently managed, and provide a cushion of money that could be used to cover losses in bad economic times.

The new plan also gives the FDIC vast new powers to resolve failing “too big to fail” companies, a task that it is ill suited to handle. While the FDIC does a good job closing failed smaller banks, it has no real experience in dealing with vast multi-national giants. Instead, it would be far better and more efficient to create a special part of the bankruptcy code to deal with the special needs of large financial institutions.

Finally, the Obama-Frank plan virtually guarantees more federal bailouts of large financial firms. It creates a funding mechanism that might look good at the first glance, but ends up being so open-ended that it could be used to justify bailouts  in just about any situation. Most press reports focus on the requirement that any tax dollars advanced to a failing company be repaid by either the firm’s assets or by an assessment on other large companies. This misses the point. Tax dollars may be needed in the case of a dire emergency, but Congress needs to set clear priorities for when it is acceptable to use them. The new plan still gives Treasury and the regulators too much flexibility instead of requiring that they only be used in conjunction with the closure, breakup or sale of a failing financial institution and even then in only the direst of circumstances.


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[1] including ours : http://www.heritage.org/Research/Regulation/wm2471.cfm

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