Saturday, February 26, 2011

Current Asset-Level Disclosure: The Solution to Too Big to Fail

To paraphrase Winston Churchill, American regulators always find the right solution, after they try everything else first.

This past week, Kansas City Fed President Thomas Hoenig ruled out higher capital requirements, bail-ins, resolution authority, and better supervision by regulators as solutions that fail to solve the problems of contagion and preventing the next financial crisis.

His proposed solution is to break-up the Too Big to Fail (TBTF) because this will reduce the interconnectedness in the financial system and risk of contagion should one of these institutions fail.   

As a practical matter, the US does not have the political will to break-up the US-based TBTF.  Tim Geithner summed up the Administration's position at the G20 by observing that the US financial system is stronger than it was before the credit crisis.  Without the US pushing to break-up the TBTFA, non-US based TBTF are also highly unlikely to be broken-up.  If any attempt is made to break them up, the non-US TBTF will threaten to leave the country and undermine the economic recovery by taking its lending and tax paying capacity with it.

Your humble blogger has long argued that there is a far better and more effective solution than breaking up the TBTF.  That solution is to require current asset-level disclosure.

The effectiveness of this solution is that it directly addresses the issue of interconnectedness and risk of contagion.  Current asset-level disclosure reveals both the interconnections and the risk of the TBTF to all market participants.  This in turn allows risk to be properly priced throughout the financial system.

Think of current asset-level disclosure as driving contagion in reverse.

Market participants have an incentive to not only avoid the high risk TBTF, but also smaller firms that are heavily exposed to the high risk TBTF.  This drives up the cost of funds and reduces the access to funds for everyone doing business with the TBTF and also the TBTF.  This puts substantial pressure on the TBTF to reduce its risk.

As reported in the Wall Street Journal,
Thomas Hoenig is still a rebel with a cause. 
Although the Federal Reserve Bank of Kansas City president no longer votes on interest-rate policy, and so can't continue his lone dissent to money printing, Mr. Hoenig still is going against the Fed grain. In a speech this week, he said breaking up big banks is the only way to end the threat posed by too-big-to-fail institutions. 
... Mr. Hoenig doesn't buy the idea that better supervision, higher capital levels and powers granted by the Dodd-Frank Act to wind down a tottering institution will take care of the too-big-to-fail problem. The biggest firms, he noted, can't be wound down because "there are too many connections that will bring down other institutions.
... the systemic risk from too-big-to-fail firms is, if anything, "even worse than before the crisis."

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