The End of Moral Hazard?

By Megan McArdle

The financial Twitterverse has been abuzz this morning with speculation as to what the administration was going to propose?  Yes, yes . . . they're going to sweat down Too Big to Fail banks.  But how?  Some commentators thought the gist would be HULK SMASH BANKS!!!  Others predicted it would be a minor tweak on the measures already proposed.

Now we know.  The administration's new proposal has two core pieces, both of which are at least somewhat novel.  First, banks that have access to the discount window will not be able to trade for their own account.  That means no prop trading desk.  No owning hedge funds or private equity funds.  No investments of any kind to make profits for your shareholders.  Financial institutions can make profits by servicing clients, or they can make profits by investing for their own book.  But they can't do both.

Senior administration officials I spoke to made it clear that this would not include market making activity, which the administration views as something you do for your clients.  But while that may partially reassure banks, that seems to mean that market makers--i.e. Goldman Sachs--are very definitely included.  That impression was reinforced by the way  Indeed, if they pass this thing, they should probably call it the Hey Goldman Sachs! You're Not Going to Be So Profitable Any More Act of 2010.

The second proposal is to extend something like the caps that already prohibit banks from holding more than 10% of federally insured deposits, to other kinds of liabilities.  I asked, but got no clarity, on what exactly this means.  Are regulators going to swoop in whenever a diversified financial institution has too big a share of the total liabilities in all US debt markets?  Or are they going to intervene when a bank becomes dangerous to one particular debt market, the way Lehman turned out to be in commercial paper?

One thing is clear, though:  the banks screwed up.  As I've been saying for months now, it was a simply gigantic mistake to seek huge profits and big bonus pools. Yes, I know that they were competing for talent with foreign banks.  Well, they kept the talent, and now it looks like they may well lose the profitable lines of business that they needed the talent for.  Last time I looked, Goldman's proprietary investments made up something like 90% of its profits.  Do they give up their profits, or their implied government guarantee?  Either move is going to hurt, which is why, despite reporting record profits today, Goldman's stock is down 4% at this writing.

Now, as to the merits of the policy:  is it a good idea?  On first pass, I'm going to say tenatively yes.  The government is recognizing that banks "paying back" the funds they were given is essentially meaningless, because they've still got a very, very valuable implied government guarantee.  One could argue that they've had it since 1991 when the Federal Reserve got the power to loan money to investment banks in extremis.  But since last fall, it's the next best thing to explicit.  That means the government needs to take steps to mitigate its own risk.

The way you do that is to decouple the key operation the government insures--the funneling of credit from those with money to those who want to borrow it--from making bets on market outcomes that can go badly wrong.  And to ensure that no institution has enough liabilities to take down the system if it fails.

That said, I'm not necessarily confident that this is going to work.  I'm not even sure that I understand how it will work at this point. I have only a hazy understanding of how the liability limits will be enforced, and after talking to administration officials, I'm not sure that they really know either; they seem to be waiting to see what the legislators and regulators say.  And while splitting off proprietary investment seems like it might mitigate systemic risk, it may be very hard to enforce.  Would "eating your own toxic waste" be prop trading, or client service, for example?  It's possible that this thing will end up with loopholes you could drive a truck through, and if so, it will probably be worse than nothing.

Too, I haven't talked to any prop traders or investment banking executives this morning.  They might be able to offer a convincing reason we shouldn't do this.

But even if it's not the best idea in the world, there are definitely many worse rules that we could think up.  And after a stunning defeat on health care, the administration needs to score big points against the bankers quickly.  If "Don't just stand there, do something!" is the order of the day, there are clearly worse somethings we can do.

If we do choose this "something", Americans should probably be clear that this is going to deal a major setback to New York as a world financial capital.  Many of the rules that were undone in the last two decades were got rid of because they were making it too hard for American banks to cope with foreign competition.  If we do this, America's financial sector will shrink, and our banks will lose a lot of business to foreign firms.  That means, among other things, that we are going to lose big chunks of tax revenue, because bankers are very disproportionate contributors to federal coffers.  It also means that New York's renaissance will probably slack off--and the people who complain about the bankers will discover how many city services those banker salaries paid for.

That doesn't mean we shouldn't do it.  I think finance has taken on an outsized role in our country, and as we've seen over the past year and a half, that hasn't been a healthy state of affairs.  But this means a substantial change to the American financial system, and as with all change, we won't like every single thing that follows.

This article available online at:

http://www.theatlantic.com/business/archive/2010/01/the-end-of-moral-hazard/33938/