Calomiris and Meltzer on Financial Reform

Charles Calomiris and Alan Meltzer have a very nice Op-Ed on financial reform in the Feb 13 Wall Street Journal

At a Senate hearing in January, Elizabeth Warren asked a bipartisan panel of four economists (including Allan Meltzer ) whether the Dodd-Frank Act would end the problem of too-big-to-fail banks. Every one answered no.

See, economists can agree on something!

An important point: The financial crisis was not a chain of dominoes, but a run. A popular theory holds that A (Lehman say) failing causes B to fail if A owed B a lot of money, and so on. This is simply not what happened. Lehman's failure made investors worry that other banks who had made similar bets might also be on the edge, so they ran to get their money out.

The principal danger to the banking system arises when fear and uncertainty about the value of bank assets induces the widespread refusal by banks to accept each other's short-term debts....

The collapse of interbank credit in September 2008 was not the automatic consequence of Lehman's failure. 

Rather, it resulted from a widespread market perception that many large banks were at significant risk of failing. 

What to do?

To ensure systemwide resiliency, most of Dodd-Frank's regulations should be replaced by measures requiring large, systemically important banks to increase their capacity to deal with losses. The first step would be to substantially raise the minimum ratio of the book value of their equity relative to the book value of their assets. 

It has been interesting to watch a consensus develop among people who think about financial stability. In 2008, ideas were all over the map, and there was a lot more support for many parts of Dodd-Frank, including the idea that regulators could keep banks from taking too much risk. It all seems to be boiling down to much more simple idea: Banks need to get money by issuing equity, a lot more equity, instead of borrowing it.

How much?

The Brown-Vitter bill now before Congress (the Terminating Bailouts for Taxpayer Fairness Act) would raise that minimum ratio to 15%, roughly a threefold increase from current levels. 

Here, Calomiris and Meltzer veer off into the land of the current debate. Sure, more equity, but how much more equity? 20%? 30%? And what's the denominator? All assets? No, surely, as then banks choose riskier assets. Risk weighted assets?  No, surely as then they game the risk weights.

These thoughts drive me to think the answer is to set a price, not a quantity. For every dollar of short-term debt, pay the government (say) 10 cents. I don't know the exact number either, but a wrong tax rate does a lot less damage than a wrong quantiative restriction.

I think they recognize that's where the discussion is -- but this is a lot simpler than the 10,000 pages of Dodd-Frank regulation!

 There is plenty of room to debate the details, but the essential reform is to place responsibility for absorbing a bank's losses on banks and their owners

Yes!  Rather than keep a fragile, short-term-debt-laden run-prone financial system, and hope that the wise guidance of regulators will keep any bank from losing money, or from being in doubt of losing money, let us construct a resilient financial system, in which investors transparently bear losses commensurate with their rewards.