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The Public Policy
Failing Successfully
Speed bankruptcy expert Garett Jones on how to cure “too big to fail.”
Last week I had a chance to interview Garett Jones, a professor of economics at George Mason University and the BB&T Professor for the Study of Capitalism at the Mercatus Center, on the pending financial regulation reform bills and the recent financial crisis.
Earlier this year Jones wrote a paper, published by Mercatus, that proposed an alternative to bailouts and the financial regulation bills for dealing with troubled banks: speed bankruptcy. The simplified idea behind speed bankruptcies is that failing banks would be subjected to procedures very similar to Chapter 11 bankruptcies, with shareholders getting wiped out and bondholders becoming the new shareholders. What would make these bankruptcies “speedy” is that the terms for this procedure would be written into the banks’ bonds, meaning that during a crisis the bonds would automatically convert to equity stakes in the bank once regulators decided that the bank had failed. The goal of such convertible bonds would be to remove uncertainty about regulators’ decision-making and prevent discretionary bailouts, and also to recapitalize endangered banks.
I asked Dr. Jones about the fallout from the bailouts of 2008, how to prevent bailouts in future financial crises, and the possibility of speed bankruptcies as an alternative to the current regulatory reform legislation’s “resolution authority” that would give federal regulators the ability to take over and wind down financial institutions in crises.
We now have financial regulation reform bills from the House and Senate. What are your general thoughts on the reform legislation?
I have to say, the resolution authority in the bill is not the worst thing I can imagine. I’m so used to politicians doing the worst thing I can imagine that this is a pleasant surprise. They’re getting about a third of what I think would make up a sound anti-bailout policy. They certainly have taken some steps in the right direction.
How well does this bill address the problem of banks being regarded as too big to fail?
I think the bill moderately reduces the problem of too big to fail. It doesn’t totally reduce the problem. Let me start off with what I think is the best part first.
The best part is the “funeral planning” provision that they’ve required in the bill — every few months, every big financial institution in the country is going to have to show the government its plans for how to dismantle it in the event of a financial crisis. So it’s a little bit like the bomb maker saying “here’s how to diffuse my bomb.” It’s a little bit like BP saying, “If we build this platform, and there’s a catastrophic collapse, here’s how we’ll cap the well.” Because banks are going to have to make these plans, and present them during nice calm economic times, I think that the government regulators will actually probably be willing to really say no to the banks, and say, “No, this isn’t a good enough plan. We’ll give you six months or a year to fix it, but if you haven’t given us a real plan for how to dismantle you if you go bankrupt, then we’re going to force you to shrink. We’re going to force you to sell off the weirdest, most difficult to bankrupt parts of your firm.”
During a crisis, everyone’s in favor of a bailout. No matter what they say verbally, they’re still going to walk down to the floor of the Senate or the House and vote for a bailout. But during periods of calm we might be able to structure the big financial institutions so that we’ll have a better shot at preventing them from becoming un-bankruptable. So I think that’s a key strength of the plan.
Right now firms don’t have to do this at all. They can just do whatever they want to and they can create a web of financial networks that are so complicated that voters, regulators, and politicians are all terrified of the prospect of sending these firms to a bankruptcy judge, or the FDIC. I think that making plans during a period of calm is a little bit like making the plans for a house — planning the fire sprinklers or the fire escapes during a nice calm time rather than deciding in the middle of the fire, “OK, here’s how we’re going to get people out of the building.”
If banks make funeral plans in advance, does that make regulators at the Fed or one of the proposed new agencies redundant? Or do they still have discretion over whether banks get bailed out?
That’s a huge problem. The question is, they can spend a lot of time creating these plans, but when the crisis hits will they cave, will they get weak in the knees like Paulson and Bush did?
That’s really the big question. That’s why I think there have to be five or six different ways built into our political system to make sure we don’t dive back into bailouts. The funeral planning is one. I think the rest is a lot weaker… much, much weaker.
There is this resolution authority in the bill, which basically says that the government will have the authority to take over a big financial institution just as the FDIC does now, and in a way just as a bankruptcy judge takes over a firm when it goes bankrupt. So they’ll have that authority — the question is will they use it or will they get scared again like they did last time?
Personally, I think there’s nothing in that resolution authority that couldn’t have been hammered out in the two weeks it took to write the TARP. I don’t think it was outdated bank regulations that was keeping us from letting Citigroup fail. The absence of a resolution authority was not the big deal.
About the Author
Joseph Lawler, former managing editor of The American Spectator, is editor of Real Clear Policy. Follow him on twitter: @josephlawler.
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Bill Hussein O'Stalin| 6.15.10 @ 6:23AM
Whenever you make plans in advance that automatically wipe out shareholder equity, you won't have any shareholders. No one with any brainpower will invest in a deal that could south behind closed doors wiping out their investment. If anything that idea will lead to less investment in banks.
The other concept of allowing debt to be turned into shares is weak. It would lead to high risk investing and probably wouldn't work anyway. Badly run banks don't turn positive overnight or realistically ever.
What's missed here is the fact that the government caused this financial crisis through central economic planning, which always fails.
Central economic planning has never worked, however it can't be done away with because politicians, promises and imprudent plans are always afoot.
As long as there is a taxpayer's dollar to be confiscated more bubbles are to come. In fact, we are headed to a health care bubble with disastrous effects, but that's another story.
ncatty| 6.15.10 @ 9:21AM
Bankruptcy is Constitutional and has been since ratification! (Article I, Section 8). Let's fashion remedies that are actually based on our Constitution, unlike TARP, EPA regulatory legislating, bailouts, etc. Keep up the good work Professor Jones!
Clinton nee Publius| 6.15.10 @ 11:49AM
The reality is that we are doing things that cannot work. Many (on the left) have opined that, like all democracies in history, America is doomed and is failing. Indeed it is on the brink of its final failure due to its own inherent corruptions that allow politicians to vote themselves the public purse.
Believe it or not, these people are right, but the die need not already be cast.
This is an "educational moment" and I would hate to deprive you of the opportunity to become participants in the ultimate free-market economy so please bear with me as I explain it.
The problem we face today is that government spending exceeds our revenues. Fiscal spending is - by definition - an unlimited activity because the people who make the decisions on spending are not made to suffer the consequences of their decisions (it doesn't come out of their pockets) so they have no reason to reduce spending.
Revenues are quite different. There are only three ways to obtain revenues: (i) gifts - and you can't think government will be financed that way; and (ii) stealing - government calls it "taxation"; and (iii) you earn it by your own labor and investments. There are no other ways. Currently, government uses taxation and taxation is a LIMITED RESOURCE. You can only tax so much before the economy grinds to a halt.
This is the heart of the problem that liberals don't realize in their words, but know in their actions - our system of fiscal finance MUST FAIL because we are using a limited resource (taxation) to address an unlimited activity (fiscal spending). Your own common sense tells you this must fail and that's how we got $13 trillion in national debt.
But the story goes a little further and we have to take a small sojourn in order to explain it all because the solution comes in how we create money for our economy and we have to understand some basic accounting to understand how currency (money) comes into existence in our economy.
Money is an asset and in the Western system of accounting, the value of assets are determined by the sum of their liabilities and equities (liabilities plus equities equals total assets). To create money, our government increases our collective liabilities (called "liability expansion") so every dollar that exists in our economy comes into existence only by virtue of being a loan that is owed to the banking industry, so there is no real wealth in our economy and this creates most of the problems we have in our economy today. Think of it like credit card debt for your family - the more credit card debt you have, the higher your credit card payments get until you can't pay anything but credit card bills and you go broke. Our economy works the same way for fiscal spending and the creation of currency.
The solution ("The Fix - Capitalism Version 2.0") is equity expansion. Now the same government that has been running up all these debts becomes our "white knight" and enters the private-sector economy to make equity investments in businesses (under controlled conditions) using new currency to buy these securities (that's how the money gets into the economy). The outcome is that our nation's "balance sheet" gets stronger each time, our currency is attached to something of real value (these equity securities) and now we create the conditions that allow us to have unlimited funding for government. The problem was a limited resource was being used to address an unlimited activity and we now have an unlimited resource addressing an unlimited activity to solve the problem.
This means that now all government spending is a "gift" to our economy and can only help it while our national debt is retired automatically without anyone suffering and government can no longer corrupt the economy or businesses, throw its weight around, take advantage of us or be taken advantage of.
In the end, this is the only solution as there are only three (3) ways to get money. You know you can't do it with gifts. You know that stealing (taxation) is a limited deal and won't work (or we'd have all $13 trillion in debt paid off). There is only one way.
Did I mention the result of this was that investment income (the money the government receives for its investment activities in the future) is what pays these bills and not a single dime of taxes. That's right - "The Fix" - ends taxation along with all the other things we don't like about government and that beats bankruptcy any day if you ask me.
dcd| 6.15.10 @ 12:37PM
You need more nuance on the taxation=stealing. Military, police, courts, roads, etc provide services that are generally considered necessary even by the more idealogical libertarians.
Charles Stevens| 6.15.10 @ 2:45PM
Your proposals deserve thoughtful consideration, and of course will raise some questions along the way, for example:
What do you suggest as "proper" (as in useful, wise, etc.) investment for government? Doesn't this get into the issue of government making decisions based solely on politics, with the effect being a crowding-out of otherwise useful investment, and subsequent market distortions?
Could one example of a "useful" government investment be the solution to 'the problem of the commons', e.g., ownership paper is issued for each specific area now designated as public land, with the intent being to make money off of capital investments, and associated protection of whatever pristine qualities made it desirable in the first place?
Clinton nee Publius | 6.16.10 @ 2:22PM
In this new system government cannot crowd-out the private-sector, cannot be defrauded and cannot distort the economy - that was the "magic" of The Fix. I call it the "Goldilocks Solution" because it allows the government to invest enough, but not too much, provide stability without distortion, prevent fraud from happening, but also prevent corruption from entering the system.
Based upon that the useful government solution for public lands is to make them private. Government ownership - with control - always results in corruption.
Dixie Pixie| 6.15.10 @ 12:57PM
Let me get this straight.
The shareholders get nothing, the bondholders get the banking company and the trigger gets pulled on the whims of the banking regulator. So a regulator can wipe out a bank for what reason?
What fool would want to buy a bank stock then.
Jerome Brick| 6.15.10 @ 2:00PM
I have a better idea. Let's go back to the Glass-Steagall days (pre 1999) when the full faith and credit of the USA stood behind the deposits of Federally insured commercial banks and nothing more. In all liklihood no shadow banking system would have evolved and the Wall Street purveyors of financial weapons of mass destruction, otherwise known as credit derivatives, would not have infected our financial system to the extent that it did.
axbucxdu| 6.15.10 @ 4:02PM
I have an even better idea: Eliminate the Fed, return to the era of Free Banking in the U.S., and force ALL consumption to synchronize with production.
For more info, consult a paper that reviewed the wildcat era by Rolnick and Weber, formerly of the Minnesota Fed.
Louis Jenkins| 6.15.10 @ 4:03PM
With all the catawallering about the banks being too big to fail- well- they will fail. There's too much debt out there for the banks to handle, and not enough (stealing) taxes being paid even if we paid every penny we made. Regardless of which side of the fence you're on you'd best get ready for a bad ride. Of course the Fed could always monitize the market, but then a bushel of money would buy you a bushel potatoes. Bad times are a coming and they're not for the faint hearted.
aware| 6.15.10 @ 7:19PM
It is not failure that government is preventing, the crappy businesses DID fail obviously! It is the consequences of failure that the State can not allow its "favored" to suffer. Who's the "robber baron" now?
No amount of "regulations" can change a rotten, money created by debt, smoke and mirrors, Wizard of Oz banking system controlled by a cartel owned central bank. To even believe that can be "reformed" is pure crack-induced fantasy.
Yosemeti Sam| 6.16.10 @ 2:54AM
" ... government ...."
Can. We. Get. Rid. Of. That. Metonymous word?
The gubberment is a SET of people!
People on medications.
People subject to venality.
People who are Leftoids.
People who border on senility.
People, some of whom are psychotic - statistically speaking.
People who are apparatchiks - closet or otherwise.
People who are general dummkopfs.
People who are bent.
Offering SOP - set of people - as a useful acronym versus the metonym 'government'.
I think SOP connotes better!
SOPs dish out - sop by the trillions, self-evidently, to preserve their capitalizing tenures in 'government'.
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