Two Must Reads on Financial Reforms

Two things that have been very helpful, each in their own way.

1) Davis Polk has released “Side-by-Side Comparison Chart – Key Senate and House Bill Issues”, a 162 page monster document that, in easy to read chart form, walks through each feature of the financial reform bill and compares it to its counterparty. A great reference guide for those who want to check out specifics going into conference committee.

2) Wally Turbeville, a former Goldman Vice-President, has been tearing it up at New Deal 2.0 with his writing on financial reform. I really want to recommend his Jamie Dimon vs. Jimmy Stewart, which is all about the Collins amendment. The Collins amendment is going to be one of the huge fights in conference committee, and Wally walks through the topic:

Susan Collins offered an amendment to the financial reform legislation that has touched off a fight between the FDIC and an alliance between Treasury and the Federal Reserve. No doubt there is an interesting question of which side has the better argument. Floating above this inquiry is another question that should not be lost in the details of the bickering: why have the two bureaucracies taken their respective positions?….

The FDIC likes the Collins amendment. If there is more capital and less leverage at the holding company level, it can be used to fund subsidiary banks before they fail and the FDIC funds are tapped to bail out depositors. That makes sense. FDIC Chairman Sheila Bair makes the point that the Source of Strength doctrine implies that holding company capital structures should be just as sound depository bank structures. The reasoning is not perfect, but it has a persuasive symmetry.

The Fed and Treasury hate the idea. They may think that the Fed should be trusted to manage crises and flexibility enhances its prospects for success. They may think that the banks need to make more money to retain their health and higher leverage yields profits (which is true, unless there is a problem and there is no capital cushion to weather the storm).

The Collins amendment is essential for those worried about the shadow banking market. And here’s a great way to conceptualize the shadow banking market and the shadow banking market run:

Deposits are nothing more than loans by the customers to the banks. The funds are used to acquire assets, that is, loans to people and businesses. The problem is that the customer can withdraw deposited funds (demand repayment of the loan) and the bank has limited cash (net capital) to meet the need. Its assets (personal and business loans) cannot be converted to cash quickly enough. Mass withdrawals (a bank run) cause a liquidity crisis (and threatens Jimmy Stewart’s bank).

Things have not changed so much. Bank runs by depositors have become a thing of the past because of the FDIC. The problem is not that the deposits are callable loans. It is that the derivative-embedded credit between banks and industrial companies are actually complexes of callable loans. Bank customers withdraw deposited funds when they become insecure. With trading, counterparties demand collateralization of all out-of-the-money risk when insecurity sets in. That’s what happened to Lehman and AIG, and Enron before them, as well as some lesser known institutions.

A bank run now happens at the trading level. Chairman Bair was right. Depository banks need to be protected from the holding companies.

Jimmy Stewart will no longer have to plead with his bank’s depositors. It will be someone like Jamie Dimon pleading with fellow bankers and corporate CEO’s.

Financial reform is a long fight, but capitalizing the shadow banking system is something that must move sooner rather than later. Nothing in this bill makes derivative-embedded credit less callable, and thus less subject to a bank run. So getting banks seriously capitalized against this risk is something that must happen.

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One Response to Two Must Reads on Financial Reforms

  1. Ted K says:

    Great links and update on Collins Amendment Mike. With James Kwak busy with lawyering (and I mean “lawyering” in the best, most complimentary sense of the term) we’re counting on you to do double time and pick up James’ weight.

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