Cornell University Johnson at Cornell University


Vantage Point – Expediency is not a good guide for policy

MaureenOHara Maureen O'Hara is the Robert W. Purcell Professor of Management and professor of finance at the Johnson School at Cornell University. A former president of the American Finance Association, O'Hara is chairman of the board of directors of Investment Technology Group, Inc. (ITG) and a member of the board of NewStar Financial.

Alan Greenspan wrote an influential article early in his tenure as Fed chief. In this article, he identified the role of the central bank as two-fold: first, to provide liquidity to the banking system, and second, to make the level of liquidity consonant with stable prices.

In the discussions surrounding the Fed, the notion of the central bank as a money supply controller are often paramount, but events in September remind us anew how important the bank's first role really is. The collapse of the overnight markets following the problems at Lehman and AIG forced the Fed and Treasury's hand.

Above all, liquidity depends on confidence. Guaranteeing money market funds was absolutely necessary. It is very difficult to stop a run once it gets going, and had the run in the institutional money market funds spread to retail investors, the results would have been catastrophic. But, this is only a stop gap measure. The insurance safety net must be redesigned. Is the new $250,000 deposit insurance coverage level for bank deposits appropriate, or should we consider more expansive or restrictive levels? Should the government continue to guarantee money market deposits? Certainly, decisions made in haste need to be re-examined as the revamping of the financial system progresses. The banking system, and the financial markets more broadly, are widely viewed as having lost track of the risk of the financial assets they created and traded. Part of the blame surely rests with our regulatory system that allowed risk to be transferred to the markets and away from regulatory oversight. The largely unregulated $65 trillion credit default swap market is a prime example. However, our entire regulatory system was designed to regulate banks, not markets. And even there it failed, with Citibank writing off $55 billion with only the most optimistic thinking this is the final tally.

"Our current hodgepodge of banking regulation allows for all sorts of firms to sort-of be banks, and sort-of be regulated. This whole structure has to be revisited."

The Fed's decision to make Morgan Stanley and Goldman Sachs banks suggests that their solution is to make everything a commercial bank. This does not solve the problem. For one thing, both Morgan Stanley and Goldman already ran FDIC-insured, deposit-taking institutions in Utah without being bank-holding companies. Our current hodgepodge of banking regulation allows for all sorts of firms to sort-of be banks, and sort-of be regulated. This whole structure has to be revisited.

Some have suggested helping banks by changing various rules and regulations. A proposal floated in mid-September would allow banks to include intangible assets as capital. Consider JPMorgan Chase. At year end 2007, they had total capital of $132 billion. Allowing the company to include intangible assets would give it an instant boost of almost $50 billion. I am hard pressed to see how a bank can write off bad loans from goodwill. The U.S. made exactly the same mistake in the Garn-St. Germain Act when we allowed S&Ls to count net worth certificates as capital in 1982 — to disastrous effects. Fortunately, this proposal has not gained traction, but quick fixes are always attractive to Congress and regulators, and they are almost inevitably ill-fated. On September 23, the Fed announced that it will allow private equity investors to own up to 33 percent of a bank without triggering the rules on non-financial firms owning banks. Congress has considered and rejected proposals in the past to weaken the prohibition between banking and commerce. It is hard to see why, in a time of crisis, removing this prohibition is a good idea. But if Congress moves forward, why just limit it to private equity investors? Wal-Mart has been dying to own a bank and would likely be happy to invest.

We need to start anew and design a regulatory system that recognizes the realities of modern markets and risk bearing. Consolidating regulatory oversight would be a good start, but also expanding it to include market participants that play bank-like roles is critical. It will be paramount to design a system in which liquidity can arise from the market, and not the central bank.

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