Bair and Bernanke Back Size Disincentives For Banks

In an about-face, the Administration seems to be getting serous about trying to Do Something about the too-big-to-fail syndrome.

Or is it? The proposal comes from Shiela Bair, and does not have the support of the Treasury Department. Curiously, Bloomberg reports that Bernanke has endorsed the Bair plan, which unusually puts him in opposition with Geithner.

Is this move to bolster the Fed’s bona fides as a systemic risk regulator? Probably not, since Bloomberg gives the impression that Bernanke is on board with Bair’s proposal, when in fact the evidence is thin indeed. If you read the Bloomberg piece, its current headline, “Bair, Bernanke Push to Toughen Plan to Curb Biggest U.S. Banks ” suggest that Bernanke and Bair are allied on this measure, while Bernanke has simply said restricting size is a “legitimate option.”

The problem with the concept, however, is that it does not attack size and complexity per se, but goes back to trying to separate traditional banking from investment banking by slapping charges on depositaries who do more than traditional lending.

While this is better than nothing, Glass Steagall v. 2,0 would have a large impact on Citi, JP Morgan, and Bank of America. I’m not opposed to that, but this move has the effect of singling them out without doing anything to Morgan Stanley or the great (from a reregulation standpoint) untouchable. Goldman.

It would presumably lead these firms to separate their traditional banking businesses from their investment banking operations. That is not a bad move, but the benefits are probably overstated. The safety net has clearly been extended to what were investment banks. “No more Lehmans” is now official policy. So reducing complexity is a step in the right direction, but we still have the boys with the big trading operations with a de facto government guarantee, no charge for it (like FDIC insurance) and insufficient supervision given the guarantee.

I’m also leery of piecemeal approaches, It’s easier for the industry to mobilize against initiatives launched separately, and single measures create the impression that the problem is being tackled, when any one measure will have limited effect.

A second problem is that trying to separate the two types of enterprise does not cut the links. Traditional bank lay off risks in the credit default swaps. market. And as we have learned, the investment banks have hedged their CDS risks for the most part by entering into offsetting contracts. That means the ultimate risk-taker sits elsewhere. So if the investment bank has done an adequate job of judging that the third party can absorb the risk, great, but if not, the IBank is exposed, and the obligor for the banking system risk. And as we saw with AIG and insurance-type guarantee like monoline guarantees, the investment banks didn’t seem to do much due diligence on claims-paying ability of these guarantors (while CDS writers do post collateral, the CDS are subject to “jump to default” meaning a sharp rise in CDS price, and colletaral required at the time of default. An adequately collateralized positron can quickly change into something not well supported).

From Bloomberg:

Federal Deposit Insurance Corp. Chairman Sheila Bair, with support from Federal Reserve officials, is pushing for tougher measures to curb the size and risk-taking of the nation’s largest financial firms.

The FDIC will propose slapping fees on the biggest bank holding companies to the extent that they carry on activities, such as proprietary trading, outside of traditional lending. The idea goes beyond the Obama administration’s regulation-overhaul plan, which would have the Fed adjust capital and liquidity standards for the biggest firms, without any pre-set fees.

“What we have suggested is financial disincentives for size and complexity,” Bair said in a July 9 interview. Fed Chairman Ben S. Bernanke told lawmakers last month that restricting size is a “legitimate” option.

Size limits would overturn decades of regulatory tradition that promoted the view that large, diversified institutions were more immune to risks when specific industries or regions slumped.

Bair’s proposal is another chapter in the clashes she’s had with Treasury Secretary Timothy Geithner and his department over dealing with banks and the financial crisis…

The fees would go to a reserve fund for rescues of bank holding companies, modeled on the FDIC’s deposit-insurance fund. They would target risky assets, such as structured products, over-the-counter derivatives and assets kept off of balance sheets….

Minneapolis Fed President Gary Stern has also favored expanded FDIC powers to levy premiums on large, complex financial firms and tougher merger reviews where risks posed to the banking system are an “explicit consideration.”

The Treasury’s plan would tax financial firms only after bailouts occurred, reflecting concern that a pre-funded bailout reserve would worsen moral hazard, making the firms confident of a rescue in case their bets go wrong…..

House Financial Services Committee Chairman Barney Frank plans a hearing on the so-called too-big-to-fail issue later this month…

“There is nothing in the Treasury proposal designed to put creditors of large, systemically important financial institutions at risk of loss,” Stern said in a July 9 speech in Helena, Montana. Bair also favors making explicit the losses for shareholders and creditors of firms that seek federal aid.

“A financial system characterized by a handful of giant institutions with global reach and a single regulator is making a huge bet that those few banks and their regulator over a long period of time will always make the right decisions,” Bair told the Senate Banking Committee in May.