Rules could lead to more risk

This article originally appeared in the Knoxville News-Sentinel on Sunday, November 2, 2008

Having had to manage the federal agency overseeing credit unions during the last period of financial stress for depository institutions, I have an appreciation for the pressures faced by today's federal regulators. Nevertheless, I am struck by the differences in approaches.

At the National Credit Union Administration, we aggressively deregulated to make credit unions more flexible and better able to handle financial crises. The opposite is occurring today. Instead, the government's reaction has been to limit the ability of the financial system to cope with stress and has put in place rules that have the potential to make the financial system more risky.

Consider the following. First, the cornerstone of the federal bailout package is the purchasing of "toxic" assets from the financial institutions. In order to improve their balance sheets and attract more capital, the government must overpay for those assets. If they were purchased at market value, then the worth of the institution is unchanged. They would remain capital impaired and would either have to raise capital in a down market or go out of business. If the government overpays, then it encourages more risk-taking by the institutions who know that the upside to the downside risk is that they will be bailed out. In finance this is called "moral hazard."

Second, the government is injecting $250 billion of preferred stock into selected banks, whether they want it or not, with $125 billion going into the largest nine institutions. With the injection comes restrictions on CEO pay. As the noted compensation expert Frank Glassner has pointed out, such restrictions will result in the most able managers leaving for private equity firms or firms without such constraints. This means that some of our most important institutions will be managed by less competent executives.

More risk and less competence is not a good combination.

Third, the bailout bill raised deposit insurance coverage to $250,000. Research in finance shows that deposit insurance encourages managers to take more risk. Institutions no longer have an incentive to limit risk for fear that depositors will withdraw their money. This is another example of moral hazard. What is truly dangerous is the current proposal in Congress to remove deposit insurance ceilings all together. This would increase moral hazard and would lead to a drain from mutual funds while increasing the risk-taking of insured firms.

Lastly, the government's purchase of assets is simply a bad idea. There is a better solution. The Fed has been lending funds to liquidity-strapped banks at the discount window since 1913. It lends the money at the discount rate while holding the bank's assets as collateral. When the loan is repaid, the bank gets back its collateral. Here, the Treasury could have loaned institutions funds at the discount rate with their toxic assets held as collateral. When the loan is repaid, the institutions get their assets back. This would be far less expensive to the taxpayer than the current program and eliminate the moral hazard problem.