How to downsize the US financial sector

I was heartened to hear that Alan Greenspan has repudiated the Too Big to Fail doctrine (as practiced in the Bush and Obama Administrations) in such unequivocal terms. He almost sounded like a Teddy Roosevelt trust buster.

Nevertheless, President Obama clearly believes the line fed to him by Wall Street. He is no Teddy Roosevelt. The question you should be asking is, will the tentative reforms proposed by the Obama Administration have any kind of positive effect?  The answer is probably in a very temporary fashion, but that is more a function of the impairment of the capital markets themselves.  However, if you don’t deal with a cancer fully, it comes back and spreads – even if you conduct surgery to take out some of the tumour.

Reform of the current US financial sector is neither possible nor would it ever be sufficient. It’s a bit like Lincoln saying, "Well, this slavery thing has a few problems, but we can ‘reform’ it and make it better.”  As any student of horror films knows, you cannot reform zombies. Zombie banks must be killed. In other words, the financial system must be downsized.

Downsizing can begin with the following set of actions:

• All bank assets and liabilities must be brought onto balance sheets, and made subject to reserve and capital requirements and—more importantly—to normal oversight by appropriate regulatory agencies. Any assets and liabilities that are left off balance sheet will be declared null and void, unenforceable by US courts.
• All CDSs must be bought and sold on regulated exchanges; otherwise they will be declared unenforceable by US courts.
• Unless specifically approved by Congress, securitization of financial products such as life insurance policies will be prohibited and thus unenforceable by US courts.
• The FDIC will be directed to examine the books of the largest 25 insured banks to uncover all CDS contracts held. These will then be netted among these 25 banks, canceling CDS contracts held on one another. CDS contracts with foreign banks will be unwound. The FDIC will also examine derivative positions with a view to determine whether unwinding these would be in the public interest.
• In its examination, the FDIC will determine which of these banks is insolvent based on current market values—after netting positions. Those that are insolvent will be resolved. Resolution will be accomplished with a goal of i) minimizing cost to FDIC and ii) minimizing impacts on the rest of the banking system. It will be necessary to cover some uninsured losses to other financial institutions as well as to equity holders (such as pension funds) arising due to the resolution.

These actions should substantially reduce the size of the financial sector, and would eliminate some of the riskiest assets, including assets that serve no useful public purpose. The financial system would emerge with healthier institutions and with much less market concentration.

Failing that, we should at least have the government get into the insurance business as credit insurer of last resort. Private firms can’t do it, as they do not have the financial resources to meet the potential claims (see AIG).  And private firms have a tendency to mis-price credit risk (again, see AIG), which creates further incentives to bad behaviour. 

As "Credit Insurer of Last Resort" (see Professor Perry Mehrling’s paper inventing this term – pdf), the government can charge proper premiums for it, which will have the additional impact of mitigating the worst behaviour of Wall Street. The government can put a floor on the value of the best collateral in the system. As Mehrling says (in a variation of the Bagehot rule – i.e. "lend freely but at a high rate during a crisis"): “Insure freely but at a high premium.”

Source

Shadow Banking: What It Is, How it Broke, and How to Fix It – Atlantic Magazine