Monday, December 7, 2009
Economic Crisis Ebbs, Systemic Risks Don't
By MARK WHITEHOUSE Markets have bounced back. Economies are recovering. U.S. unemployment is showing signs of easing. But as the worst crisis since the Great Depression appears to be passing, we could be setting the stage for the next one. While policy makers breathe a collective sigh of relief, they're making little progress in addressing deeper flaws that the crisis laid bare: an unwieldy banking system, unreliable financial plumbing and a global economy that encourages and depends on heavy borrowing by the U.S. Bankers and regulators say that fixes require careful consideration. But as the darkest days of the crisis fade from memory and the world's biggest banks get back on their feet, political impetus for reform may be waning. "We're wasting the crisis," said economist Richard Portes of the London Business School. Here's a status report on three big issues: Banks Banks have recovered so well that they're even bigger and more complex. The world's 10 largest banks account for about 70% of global banking assets, compared with 59% three years ago, according to Capital IQ and the Bank for International Settlements. The bigger and more complicated banks become, the less able governments will be to let them die if they get into trouble. If banks -- and their creditors -- know taxpayers will rescue them, they're prone to take greater risks. Economists worry that if the costs of bailouts keep growing, governments could find themselves unable to borrow enough to cover them. Andrew Haldane, executive director for financial stability at the Bank of England, estimated the support given to U.S. and U.K. banks in the current crisis at nearly three-quarters of annual economic output. "Today, perhaps the biggest risk to the sovereign comes from the banks," he wrote in a recent paper. "It's a doom loop." One way to break the vicious cycle of bigger banks and bigger bailouts is to change the rules so governments find it easier to let them fail. Banks could be required to prepare "living wills," describing how their assets would be dealt with if they went bankrupt -- and, if they operate across borders, which government would be responsible for which piece. If bank managers couldn't write a will that made sense, they would have to simplify their operations, and possibly sell some of them off. To make it less likely that taxpayers would have to invest money in bank shares, as they did recently, banks could be required to issue bonds that would turn into stock in times of trouble. This "contingent capital" would force bondholders to share the pain -- something that didn't happen in the most recent round of bailouts. Some policy makers support living wills and contingent capital. The Financial Stability Board, the international body responsible for figuring all this out, won't come up with specific proposals until October 2010. For now, the focus is on making banks less likely to fail -- requiring them to set aside more capital and keep more cash on hand for emergencies. Even though most governments agree that's prudent, negotiating details for common rules is proving difficult. Markets The crisis exposed the hazards of the plumbing in the market for credit derivatives, where investors buy and sell insurance against bond defaults. Big banks, such as J.P. Morgan Chase & Co., stand at the center of the market, acting as the main counterparties for anyone who wants to buy or sell. It's worth about $10 billion a year in revenue for the banks. But it can descend into chaos if one fails. Because the deals are private and a firm can do business with many different banks, regulators don't know whether any one firm is taking too much risk -- one reason risks taken by American International Group Inc. remained under the radar. Most economists, and the Obama administration, agree on a solution: Push most players in the market to do business through a central clearinghouse that would stand between the parties in trades and guarantee obligations, and require firms to report their trades to regulators and the prices of trades to the public. Some progress has been made. In the U.S., 15 Wall Street banks have pledged to do more than 90% of their eligible credit and interest-rate derivative trades through central clearinghouses by year end. Lawmakers are mulling a proposal to mandate central clearing of all standardized derivative contracts. But about 10 different clearinghouses are vying for the business. That, said Darrell Duffie, a Stanford University expert on derivatives, makes the market no less risky, because the failure of any one of those clearinghouses could wreak havoc. "I'm in favor of this," he said. "I'm just very worried that it's going wrong." Global Balance As the U.S. recovers from recession, one widespread worry: The vast and persistent disparity between what the U.S. earns and what it spends requires the U.S. to borrow heavily from abroad -- especially from China and other Asian nations where people tend to save most of the money they make selling goods to -- you guessed it -- U.S. consumers. The danger is that the vast "savings glut" will fuel another bubble, as many analysts believe it did with the U.S. housing market. Most international efforts have focused on getting China to allow its currency to strengthen against the dollar. That would make Chinese exports less competitive in the U.S., but would do little good in the long run as Vietnam, Cambodia and other exporters took China's place. "To think that this is the magic answer is overstating the case tremendously," said Raghuram Rajan of the University of Chicago's Booth Graduate School of Business. The long-term fix is to get U.S. consumers (and their government) to save more and Asian consumers to spend more. That could be done by boosting taxes on consumption, say gasoline, or by taking away incentives to borrow, such as the tax deduction on mortgage interest. In China, a better social safety net could make people feel more comfortable about saving less and spending more. On these fronts, though, there has been a lot of talk and little action.