I'm attending the American Association of Law Schools conference in New Orleans, where cold winds are blowing but revelry of Mardi Gras has already begun. This morning Jeff Gordon presented his views on what it will take to deal with the systemic risk to the banking system to avoid crises like the one we have been through. He supports creating an explicit authority for innovative action to be taken by bank regulators.
The problem he says is that banks act as intermediaries between short-term depositors and long-term borrowers of funds. Their position is "fragile" in that there is a possible contagion effect from counterparty risk and "similarity risk". If one bank goes bad, depositors can reasonably assume that similar banks may go bad. But they are not sure how similar one bank is to another, so the risk is difficult to gauge. Also there is problem with uncertainty generally, that adds to the systemic risk.
The macroprudential means suggested to combat these problems aren't sufficient. Deposit insurance, limits on leverage and similiar approaches don't necessarily achieve liquidity to avoid credit crunches while ensuring protection for banks. Deposit insurance is only payable after a default. Limits on leverage are no guarantee. The shadow banking system of off balance sheet vehicles and money market funds as credit providers isn't a sufficient answer either--it relies on banking but is unwilling to pay the costs.
Gordon says that Bernanke and Paulson had to "scare" the country to get the power to do what was needed to deal with the crisis, but that "scare" also had the effect of pushing the country deeper into the crisis. Since systemic risk is inevitable, we should crate a TARP-like program to be waiting in the wings for the future.
Other mechanisms for dealing with systemic risk once it occurs, he claims, are inadequate. One mechanism is to have failing institutions merge with a healthier institution. But this is inadequate, as shown in the Lehman situation last fall. SHareholders want more than the bank is worth, and the government, prior to default, can't impose losses on creditors.
Another is for a federal agency, like the FDIC, to take over failing banks. But this is problematic, since it is a firm-by-firm proposition, whereas systemic risk involves widespread problems that cannot be sufficiently resolved on a case by case basis.
The only solution then is a "standby" emergency authority. He would have a "triple key" system to ensure the authority is not abused and thus will not represent a threat to democracy. His triple key proposal in the talk was a consensus among the Fed, Treasury and FDIC. Further, he'd require notice to Congress, and an ex post review to ensure accountability.
Does this proposal for a permanent "standby" authority to take hugely costly discretionary actions "as needed" to resolve a financial crisis make sense? I worry much more about the democracy deficit of such a proposal than Gordon apparently does. Even where Congress approves the power, as in the TARP bill, the lack of oversight and the establishment of a cozy relationship with the regulated entities, as in the case of Paulson, Bernanke, and Goldman and other banks, is worrisome. Notice to Congress would likely be perfunctory if Congressional approval weren't required, and ex post review is not often well done--look at our failure to conduct an open review of the many lapses of the Bush administration on torture, etc.
Shouldn't the fact that the authority was forthcoming when needed in this case show that we don't need the "standby" authority that would grant even more discretion to a few powerful hands on the pursestrings of the nation?