Monday, 27 April 2009

Cleaning up messes left by banks - a nasty job but for the US Fed or for the IMF?

James Kwak makes some interesting comparisons between the recent financial crisis and the situation that US banks found themselves in the 1980's when Latin American debts were piling up in a systemically calamitous fashion. Nicholas Brady, who was Secretary of the Treasury from the end of the Reagan administration and the entire first Bush presidency, and the man for whom Brady bonds are named, has some observations about a possible structure for the financial system in the future.

Kwak quotes Brady as follows in this piece

I believe that we need a simpler system centered on deposit-based banks. Under this approach, individual accounts in the depository banks would continue to be protected up to $250,000 and these banks would have access to the country’s central bank. These institutions would not be allowed to participate in markets involving inordinate leverage or equity transactions that would risk their deposit-protecting charter. In contrast to the current mode, when asked what their primary purpose is, the banks’ chief executives wouldn’t talk first about shareholder return. Instead they would stand up and say: “Our institution’s primary purpose is to repay the depositors’ money.” . . .

The highly innovative shadow banking system with its mantra of lower transaction costs, which would continue to introduce new concepts, would fund itself from the money markets and other sources but without federal guarantees and access to America’s central bank. Institutions that currently straddle the two funding markets would have to choose which type of business to pursue.
Mr Brady's separation of the two kinds of banking sounds very sensible at first glance. But can banking and financing activities be segregated so that there is no point of contact between the two where the first set of boring banks rely on guarantees, explicit or implicit, from the more exciting shadow banking system?

There surely will be a grey zone at the interface between the two -and if the shadow system continues to conduct business in a similarly reckless fashion to the status quo ante then the same systemic problems could arise yet again as troubled assets and counter-party obligations end up being intermingled amongst the two different kinds of banks.

It's one thing to say that the shadow banks will have no federal guarantees or safety nets but when things start to go wrong and markets seize up through illiquidity will the government really take a hard line and not come to the rescue. This is especially the case if the shadow banks have cross border risks with currency instability implications.

It may come down to a choice between a Fed/Treasury clean up operation or a supra-national (IMF?) clean up operation.

I doubt whether we would see too many hands go up if we asked who favors the latter

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