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[Time] 48:51
Solutions to Too Big to Fail itself. What might we do to encourage more prudence on the part of creditors than now? Have to find a way to credibly put creditors of these systemic institutions at risk of loss. Can't simply say we're not going to bail you out--not credible. Preparation--very important. The reason policy-makers intervene is because of concern about spillovers. Preparation means identifying and taking steps to limit those spillover effects. Analytical question; a lot of that information is already available. Where do these institutions have exposures? Are those exposures prudent? In some cases, don't have to do anything. If it fails, you can impose losses on the creditors because you've prepared--you've done the analysis and satisfied yourself that the spillovers are manageable. In cases where you are concerned, have to use authority to reduce the chances of those spillovers. Don't want to reduce to zero--don't want a world where nobody has exposures to each other, but they can be reduced. Should be done in tranquil, sound times, not in the middle of a crisis. Two problems. Appealing, good to add transparency, but if you have a policy that says if we think you are not too systemically connected, we're going to let the chips fall where they may, you create an incentive to become more connected. Some people say Lehman's mistake was they weren't connected enough--they blew it, they should have been taking riskier bets with more people. Other side of the process: Has to be ongoing work; authorities have to be prepared to intervene. How do you keep that from being an ad hoc process that is prone to rent-seeking? Would you make them sell stuff? Head of the monitoring process will be intervening in financial institutions on an ongoing basis. Always devils in the details. Until proposal implemented won't know its strengths or weaknesses. Doesn't mean policy is random. If implemented in a consistent way, financial institutions will understand the rules and will adjust, perhaps pretty quickly. Proposal has the weakness of not having been tried; but the things that have been tried haven't worked. About the first point--idea that we should put in positions of authority people who by reputation or statements they've made at their hearings that they were plausibly people who wouldn't bail out large institutions. Suppose Gary Stern is made head of this new body in charge of systemic risk. You're a pretty credible guy--book, appeared on EconTalk, reputation. Is it imaginable that you would keep your reputation as opposed to bowing to the political pressures? That's why preparation is so important. Can't ask anybody if a financial crisis comes out of the blue without preparation that you should let a large institution go to teach the creditors a lesson. That may not pass a cost-benefit test. Cost may be too large to the economy relative to the lesson taught to the creditors. If the guy who gets to make this decision is sitting there and knows they have acted to limit spillover effects earlier, then easier to decide to not bail out the creditors, because the costs are much reduced. If you communicate to the creditors in advance, get better pricing the marketplace. Potential to set up a virtuous circle. Any traction for that idea? Not as much as might be hoped. Don't know the variety of other proposals that are around. Some proposals make sense--higher capital requirements, higher insurance premiums, greater holdings of liquid assets for systemic institutions; but by themselves they don't get to the moral hazard problem. Too big to fail policy rewards some politically powerful people. What has in fact happened over the last 15 months is that Americans have sent hundreds of billions of dollars to some of the richest people on earth.
Gary Stern on Too Big to Fail | EconTalk | Library of Economics and Liberty
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