Woodward and Hall on Current Policy
Interesting throughout. They join the rest of what I call the peanut gallery (those of us, left and right, who cannot understand the bank bailouts).
The effect of the government’s current policy is to pay off all claimants on financial institutions at face value, including those which, when they were first issued, had no expectation of federal bailout and received substantial interest premiums on account of their willingness to accept the risk of default. This policy is hugely expensive and stands in stark contrast to the losses that the government has expected investors in the debt of automakers to recognize.
On future financial reform, they write,
Among economists, a consensus is forming that regulation of the financial instutitons that enjoy the government’s protection should compel those institutions to have a structure that eases the type of reorganization discussed above (see the statement of the Squam Lake Working Group, an alliance of leading financial economists). The simplest version is to require that banks hold fully subordinated debt and equity of, say, 40 percent of assets, in a holding company, in such a way that the bankruptcy of the holding company would not interfere even briefly with the immediate operations of the bank.
…The idea that banks should have large amounts of fully subordinated debt is hardly new.
Indeed. The group of economists calling itself the Shadow Financial Regulatory Committee has been calling for subordinated debt for years. For example, in May of 1998, they wrote,
the Committee believes that we should take this opportunity to require that all large banks have to raise a certain portion of their capital through the continued issuance of subordinated debentures. To count towards a bank’s capital requirements such debentures should have maturities of two years or longer. Subordinated debentures would more closely tie a bank’s cost of funds to its financial condition and activities, imposing greater market discipline on banks and mitigating the moral hazard problem associated with a “too-big-to-fail” policy.