Tuesday, September 15, 2009

Lehman failure one year later

Someone asked me about the Obama Speech yesterday on the anniversary of the Lehman failure. Good talk. Some strong points but unclear how we will deal with the key issues. The recurring theme is uncertainty about policy. This is the old dynamic inconsistency issue of monetary policy but applied to fiscal and regulatory behavior. How do we know what the government will do and when. If we do not know or cannot measure their possible action then, we are left in a state of uncertainty.

For example, what is the solution or what are we going to do about systemic risk and the "too big to fail" problem? It is not clear who will be receive a bail-out. Who is too big to fail? If this issue is more fluid, then there is more uncertainty. We actually merge banks that are going to fail to make bigger institutions which will be all the harder to let fail in the future.

What about coordination of regulatory issues across countries. This is not not a US issue but a global issue and there is significant uncertainty on what this will mean for many institutions that see most of their business within the US.

Another example of the uncertainty issue is the current article in the WSJ by Prof Cochrane and Zingales of the University of Chicago, "Lehman and the Financial Crisis; The lesson is that institutions that take trading risks must be allowed to fail". The article discusses the point that Lehman should have been allowed to fail, but the real focus was on the fact that the financial markets started to have real problems when Treasury asked for the $700 billion TARP money. The uncertainty of what was needed and why created a the market scare. Again, the uncertainty of what the government will do created a flight to quality.

I could go on with other issues but the point is straightforward. The idea that there are simple "common sense" solutions is flawed. The law of unintended consequences is present. There will not be easy banking solutions.

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