The Richmond Fed Misses The Point On Moral Hazard

This article from the Richmond Fed is well worth a read:

A large portion of the safety net is ambiguous and implicit, however, meaning that it is not spelled out in advance. For decades the federal government has proven its willingness to intervene with emergency loans when institutions seen as "too big to fail" (TBTF) are on the brink of collapse. Market participants conduct their business making educated guesses about which institutions may be supported in times of distress.

Indeed. At least Richmond has identified the decades-long problem, and not tried to pin this on the last couple of years. In fact, the modern era of "too big to fail" began with Continental Illinois.

Why?

Remember, the FDIC exists to protect depositors. But it has no "or else" in its governing laws, just as the Fed doesn't. As a consequence it is free to liberally interpret its mandate -- and it does. That interpretation has, since Continental Illinois, included tilting resolution choices toward protecting boldholders.

Then there's Paul Volcker, who allowed banks to lie about balance sheets -- intentionally -- when they got in trouble so they could earn their way out of the hole. Yes, he threatened to close them if they didn't get their butts in gear on recapitalizing, but the fact of the matter is that the institutions in question were bankrupt, and he willfully and intentionally ignored that.

And of course we have Lehman, which The NY Fed had to know was functionally bankrupt over a month before it blew up, because Citibank refused a tri-party repo transaction with Lehman over the lack of acceptable collateral. By definition, a tri-party repo involves the third party, in this case the New York Fed. So Geithner and the NY Fed (and thus the FOMC) had to know (or willfully averted their eyes) that Lehman was bust -- well before the public knew.

The problem with protecting bondholders is that there's no reason for a bondholder to care what a bank is doing with his money if he has no risk of loss. When the government will step in and make him whole by twisting the law, and the mandates allegedly in the charters of their institutions to prevent realizing losses that should fall upon bondholders, market discipline is eviscerated.

At the root of these problems is the lack of sanction. "Prompt Corrective Action" (12 USC Section 1831o) contains the word "shall" peppered liberally through its text. But not once does the phrase "or else" (or its equivalent) appear.

Likewise, the Fed's charter contains the word "shall" in the mandate to maintain stable prices. Yet nowhere in the Federal Reserve Act does the phrase "or else" appear.

While I am glad to see articles such as the Richmond Fed published, my cynicism is unbroken. Until we see "or else" appear in partnership with each "shall" in federal regulation and law, there will be no end to the looting. An alleged law without an "or else" is no law at all -- it is a mere suggestion, and both can be and will be violated whenever the political winds so suggest.