How Dodd-Frank Doubles Down on 'Too Big to Fail'

How Dodd-Frank Doubles Down on 'Too Big to Fail'
Two major flaws mean that the act doesn't address problems that led to the financial crisis of 2008.
http://online.wsj.com/news/articles/SB10001424052702304691904579345123301232800 
By Charles W. Calomiris And Allan H. Meltzer WSJ, Feb. 12, 2014 6:44 p.m. ET

The Dodd-Frank Act, passed in 2010, mandated hundreds of major regulations to control bank risk-taking, with the aim of preventing a repeat of the taxpayer bailouts of "too big to fail" financial institutions. These regulations are on top of many rules adopted after the 2008 financial crisis to make banks more secure. Yet at a Senate hearing in January, Elizabeth Warren asked a bipartisan panel of four economists (including Allan Meltzer ) whether the Dodd-Frank Act would end the problem of too-big-to-fail banks. Every one answered no.

Dodd-Frank's approach to regulating bank risk has two major flaws. First, its standards and rules require regulatory enforcement instead of giving bankers strong incentives to maintain safety and soundness of their own institutions. Second, the regulatory framework attempts to prevent any individual bank from failing, instead of preventing the collapse of the payments and credit systems.

The principal danger to the banking system arises when fear and uncertainty about the value of bank assets induces the widespread refusal by banks to accept each other's short-term debts. Such refusals can lead to a collapse of the interbank payments system, a dramatic contraction of bank credit, and a general loss in confidence by consumers and businesses—all of which can have dire economic consequences. The proper goal is thus to make the banking system sufficiently resilient so that no single failure can result in a general collapse.

Part of the current confusion over regulatory means and ends reflects a mistaken understanding of the Lehman Brothers bankruptcy. The collapse of interbank credit in September 2008 was not the automatic consequence of Lehman's failure.
 
Rather, it resulted from a widespread market perception that many large banks were at significant risk of failing. This perception didn't develop overnight. It had evolved steadily and visibly over more than two years, while regulators and politicians did nothing.

Citibank's equity-to-assets ratio, measured in market value—the best single comprehensive measure of a bank's financial strength—fell steadily from about 13% in April 2006 to about 3% by September 2008. And that low value reflected an even lower perception of fundamental asset worth, because the 3% market value included the value of an expected bailout. Lehman's collapse was simply the match in the tinder box. If other banks had been sufficiently safe and sound at the time of Lehman's demise, then the financial system would not have been brought to its knees by a single failure.

To ensure systemwide resiliency, most of Dodd-Frank's regulations should be replaced by measures requiring large, systemically important banks to increase their capacity to deal with losses. The first step would be to substantially raise the minimum ratio of the book value of their equity relative to the book value of their assets.

The Brown-Vitter bill now before Congress (the Terminating Bailouts for Taxpayer Fairness Act) would raise that minimum ratio to 15%, roughly a threefold increase from current levels. Although reasonable people can disagree about the optimal minimum ratio—one could argue that a 10% ratio would be adequate in the presence of additional safeguards—15% is not an arbitrary number.

At the onset of the Great Depression, large New York City banks all maintained more than 15% of their assets in equity, and none of them succumbed to the worst banking system shocks in U.S. history from 1929 to 1932. The losses suffered by major banks in the recent crisis would not have wiped out their equity if it had been equal to 15% of their assets.

Bankers and their supervisors often find it mutually convenient to understate expected loan losses and thereby overstate equity values. The problem is magnified when equity requirements are expressed relative to "risk-weighted assets," allowing regulators to permit banks' models to underestimate their risks.

This is not a hypothetical issue. In December 2008, when Citi was effectively insolvent, and the market's valuation of its equity correctly reflected that fact, the bank's accounts showed a risk-based capital ratio of 11.8% and a risk-based Tier 1 capital ratio (meant to include only high-quality, equity-like capital) of about 7%. Moreover, factors such as a drop in bank fee income can affect the actual value of a bank's equity, regardless of the riskiness of its loans.

For these reasons, large banks' book equity requirements need to be buttressed by other measures. One is a minimum requirement that banks maintain cash reserves (New York City banks during the Depression maintained cash reserves in excess of 25%). Cash held at the central bank provides protection against default risk similar to equity capital, but it has the advantage of being observable and incapable of being fudged by esoteric risk-modeling.

Several researchers have suggested a variety of ways to supplement simple equity and cash requirements with creative contractual devices that would give bankers strong incentives to make sure that they maintain adequate capital. In the Journal of Applied Corporate Finance (2013), Charles Calomiris and Richard Herring propose debt that converts to equity whenever the market value ratio of a bank's equity is below 9% for more than 90 days. Since the conversion would significantly dilute the value of the stock held by pre-existing shareholders, a bank CEO will have a big incentive to avoid it.

There is plenty of room to debate the details, but the essential reform is to place responsibility for absorbing a bank's losses on banks and their owners. Dodd-Frank institutionalizes too-big-to-fail protection by explicitly permitting bailouts via a "resolution authority" provision at the discretion of government authorities, financed by taxes on surviving banks—and by taxpayers should these bank taxes be insufficient. That provision should be repealed and replaced by clear rules that can't be gamed by bank managers.
 
Mr. Calomiris is the co-author (with Stephen Haber ) of "Fragile By Design: The Political Origins of Banking Crises and Scarce Credit" (Princeton, 2014). Mr. Meltzer is the author of "Why Capitalism?" (Oxford, 2012). They co-direct (with Kenneth Scott ) the new program on Regulation and the Rule of Law at the Hoover Institution.

Number of new antibacterial-drug approvals in the US

Source: Drug Makers Tiptoe Back Into Antibiotic R&D. By Hester Plumridge
As Superbugs Spread, Regulators Begin to Remove Roadblocks for New Treatments
WSJ, Jan 23, 2014
http://online.wsj.com/news/articles/SB10001424052702303465004579322601579895822

MRSA Infections, swine effluent lagoons, and farm consolidations

Answering to some comments in a book review, 'In Meat We Trust,' by Maureen Ogle (http://online.wsj.com/news/articles/SB10001424052702303482504579177742158078278), WSJ, Dec. 17, 2013 6:36 p.m. ET:

A recent paper* in a FAO publication summarizes advances in hog manure management. Obviously, the cases mentioned are small in comparison with the great consolidated farms, but even so, there are multiple ways to manage better the effluents and some useful ways to profit from the lagoons/catchments are shown here.

@Mr Evangelista: I got access to the paper** you mentioned. If interested you may ask for it. I'd like, though, to calm down things. As it says other paper*** published at the same time, which it is likely it is the one Mr Blumenthal mentioned:

"In 2011,we estimated the overall number of invasive MRSA infections was 80 461; 31% lower than when estimates were first available in 2005"

The reasons are not well understood (several explanations are offered), but that is not relevant now. The important idea is that despite increasing consolidation of farm operations and an increasing population (from approx 295 million in 2005 to approx 311 million in 2011), there are 31% less MRSA infections.


References

* Intensive and Integrated Farm Systems using Fermentation of Swine Effluent in Brazil. By I. Bergier, E. Soriano, G. Wiedman and A. Kososki. In Biotechnologies at Work for Smallholders: Case Studies from Developing Countries in Crops, Livestock and Fish. Edited by J. Ruane, J.D. Dargie, C. Mba, P. Boettcher, H.P.S. Makkar, D.M. Bartley and A. Sonnino. Food and Agriculture Organization of the United Nations, 2013. http://www.fao.org/docrep/018/i3403e/i3403e00.htm

** High-Density Livestock Operations, Crop Field Application of Manure, and Risk of Community-Associated Methicillin-Resistant Staphylococcus aureus Infection in Pennsylvania. By Joan A. Casey, MA; Frank C. Curriero, PhD, MA; Sara E. Cosgrove,MD, MS; Keeve E. Nachman, PhD, MHS; Brian S. Schwartz, MD,MS. JAMA Intern Med. Vol 173, No. 21, doi:10.1001/jamainternmed.2013.10408

*** National Burden of InvasiveMethicillin-Resistant Staphylococcus aureus Infections, United States, 2011. By Raymund Dantes, MD, MPH; Yi Mu, PhD; Ruth Belflower, RN, MPH; Deborah Aragon, MSPH; Ghinwa Dumyati, MD; Lee H. Harrison, MD; Fernanda C. Lessa, MD; Ruth Lynfield, MD; Joelle Nadle, MPH; Susan Petit, MPH; Susan M. Ray, MD; William Schaffner, MD; John Townes, MD; Scott Fridkin, MD; for the Emerging Infections Program–Active Bacterial Core Surveillance MRSA Surveillance Investigators. JAMA Intern Med. Vol 173, No. 21, doi:10.1001/jamainternmed.2013.10423

Views from Japan: Abe Visit to Yasukuni Shrine

Views from Japan: Abe Visit to Yasukuni Shrine

1  Abe Visit to Controversial Japanese Shrine Draws Rare U.S. Criticism. By George Nishiyama
Visit to Yasukuni Raises Concern Premier Shifting Focus From Economy to Nationalistic Goals
Wall Street Journal, Dec. 26, 2013 3:04 p.m. ET
http://online.wsj.com/news/articles/SB10001424052702304483804579281103015121712

[...]

Mr. Abe visited Tokyo's Yasukuni Shrine on Thursday, triggering strong criticism from Beijing and Seoul, but also a rare disapproval by Washington, which has pushed the Asian neighbors to mend ties that are strained by territorial disputes and differences over wartime history.

Many Asian nations that suffered from Japan's wartime actions view Yasukuni as a symbol of Tokyo's past militarism because it honors not just Japan's war dead but also some convicted World War II war criminals, including Hideki Tojo, who was prime minister for most of the war.

"The United States is disappointed that Japan's leadership has taken an action that will exacerbate tensions with Japan's neighbors," said the U.S. Embassy in Tokyo on its website, in an unusual direct criticism of Japan's leader by its main ally.

Mr. Abe has repeatedly said he regretted not visiting the shrine during his first tenure as prime minister from 2006 to 2007 and said his critics misunderstood his intentions. "I offered my respects to those who lost their precious lives for our country, and prayed that their souls may rest in peace," he told reporters after the visit. "I have no intention at all of hurting the feelings of the Chinese or the South Korean people."

Although a well-known conservative who has stated that changing the pacifist constitution drafted by the occupying U.S. forces was his "life's work," Mr. Abe had adopted an economy-first policy after taking office in December 2012, putting his nationalist agenda on the back burner.

His so-called Abenomics policy featuring government spending and monetary stimulus has spurred consumption, resulting in the Japanese economy recording the strongest expansion among industrialized nations in the first half of this year, although the country's growth rate slowed in the third quarter.

The improved economy has helped make Mr. Abe one of the most popular Japanese leaders in recent years, with his support ratings hovering around 60% for most of the past year.

All of that has come as a relief to Washington, which faces a rising military power in China and is wary of the regional tensions developing into physical confrontations. The U.S. has also tired of a revolving door of short-lived Japanese prime ministers.

During an October visit to Tokyo, U.S. Secretary of State John Kerry and Defense Secretary Chuck Hagel paid respects at the Chidorigafuchi National Cemetery, a tomb for Japan's unknown war dead, in a move widely seen as a message to Mr. Abe that there are alternatives to Yasukuni.

While Mr. Abe had refrained from going to Yasukuni until Thursday, on the anniversary of his taking office, some of his cabinet ministers had visited, each time inviting protests from China and South Korea. Mr. Abe's visit, the first by a prime minister in seven years, drew angry responses from the neighbors.

China's foreign minister summoned Japan's ambassador to protest and criticized Thursday's visit as the latest attempt by Mr. Abe to gloss over Japan's militaristic past. "Under these conditions, not only does the Japanese leader not show restraint, but instead makes things worse by manufacturing another incident over history," spokesman Qin Gang said in a statement. "Japan must bear all the consequences arising from this."

Seoul also decried the move. "Our government cannot but deplore and express anger about Japanese Prime Minister Shinzo Abe's visit to the Yasukuni Shrine despite concerns from neighboring countries and the international community," said Yoo Jin-Ryong, a South Korean spokesman.

Analysts in the region agreed the move would further deteriorate relations. The development is severe, said Wang Shaopu, director of Japan Institution at Shanghai Jiao Tong University. "It will worsen China-Japan's already bad-enough relations."

Others said Mr. Abe had gone ahead with the visit because he felt he had nothing to lose given that ties were already frayed. While he has visited all of the Association of Southeast Asian Nations, he has yet to visit China or South Korea nor has he held formal bilateral meetings with their leaders.

"Mr. Abe probably thought that a visit to Yasukuni at this point wouldn't have too much of an impact on prospects of future summits with Beijing and Seoul considering how chances already seemed slim," said Masafumi Kaneko, a senior research fellow at the Center for International and Strategic Studies at PHP Institute.

Mr. Abe's aides said what they cared about most was the U.S. reaction. "The biggest, or should I say, the only concern is what the U.S. would say," said a senior government official who was aware of the prime minister's plans in advance. He expressed confidence that the ties between the allies wouldn't be affected, noting that President Barack Obama was relying on the prime minister to help seal a deal over a trans-Pacific free-trade forum and to move forward plans to relocate U.S. troops in the region.

The government official said Mr. Abe intended to stick to making economic recovery the top priority, stressing how investors would start to see deregulatory measures—the last of the three pillars of his economic policy—in action in the new year. "We intend to keep the ball rolling for Abenomics," the official said.

But Mr. Abe may have miscalculated the U.S. response, analysts said. "The U.S. reaction was unexpected. Mr. Abe is moving to bolster the Japan-U.S. alliance, and the focus is whether they can move beyond just a military alliance, and share values," said Koji Murata, a political-science professor and the president of Doshisha University. "The U.S. may be frustrated at Mr. Abe, who is obsessed with history issues."

Diplomatic feuds have shown they can affect business interests in the region. After the previous Japanese government nationalized disputed islands in the East China Sea in September 2012, Chinese consumers boycotted Japanese products, dealing a serious blow to Japanese firms, including car makers.

But the Tokyo stock market took Mr. Abe's visit to the shrine in stride on Thursday, finishing higher. Investors said other factors, including a weaker yen, were more important than diplomatic issues.

[...]

—Alexander Martin, Kosaku Narioka and James T. Areddy contributed to this article.


2  A Japanese citizen weighs in:

hello,

this is a pretty simple issue... it's a thing about "mind" or "philosophy" for Japanese and "political" for China or Korea. it'd not been a problem until middle of 80s indeed. they are just always looking for something to claim or criticize Japan to let us compromise us one-sidedly. they are just trying to do this in the name of human-right. Japan has to be 100% evil, and they have to be 100% victims forever. so they will never forgive us no matter how we apologized.

if PM Abe didn't do it, they would find something another.

it's not known very much in other countries, but Japan's already apologized many times, paid much and supported in many ways even the countries didn't let their citizens know about that. 

major Japanese started to think it looks waste of time and effort to make a good relationship with them any longer.

more than 70% of Japanese agree with PM Abe's Yasukuni visit this time in a survey of a TV channel (this is so-called "liberal" channel). we all know he just wants to thank people who worked and died for this country, and wishes peace. 

personally, i go to the shrine when i'm in Tokyo (my grand father died in WW2).

have a good new year!

The Volcker Ambiguity - The triumph of political discretion over financial clarity

The Volcker Ambiguity. WSJ Editorial 
The triumph of political discretion over financial clarity.
Wall Street Journal, Updated Dec. 11, 2013 3:52 p.m. ET
http://online.wsj.com/news/articles/SB10001424052702304744304579250393935144268

Just in time for Christmas, financial regulators have come down the chimney with a sackful of billable hours for securities lawyers. Truly a gift that keeps on giving, the Volcker Rule adopted on Tuesday by five federal agencies will create a limitless supply of ambiguity and the need for experienced counsel.

We supported former Federal Reserve Chairman Paul Volcker's simple idea: Don't let federally insured banks gamble in the securities markets. Taxpayers shouldn't be forced to stand behind Wall Street trading desks. What we can't support is the "Volcker Rule" that was first distorted in the 2010 Dodd-Frank law and has now been grinded and twisted into 71 pages of text plus 882 more pages of explanation after three years of agency sausage-making.

The general idea is to prevent "proprietary trading," in which a bank makes trades not at a customer's request but simply for its own account. Or at least some trades. The rule's new trading restrictions do not apply when Wall Street giants are trading debt issued by the U.S. government, state and local governments, government-created mortgage giants Fannie Mae and Freddie Mac, and in some circumstances foreign governments and even local or regional foreign governments.


You'll notice a pattern here. Like so many recent financial regulations, the Volcker Rule offers banks and investors big incentives to lend money to governments rather than private businesses. One Wall Street objection to the Volcker Rule has been that it will reduce liquidity in America's capital markets. And fear of a lack of liquidity in the market for government debt—especially Treasurys and European sovereign debt—is precisely the reason politicians and regulators have gone to such lengths to exempt government bonds from Volcker. Maybe Wall Street has a point.

What we don't know about the new rule are important details that will only become clear over time. At least that's according to Commissioner Daniel Gallagher of the Securities and Exchange Commission, who dissented on Tuesday along with fellow Republican appointees Michael Piwowar of the SEC and Scott O'Malia of the Commodity Futures Trading Commission.

Mr. Gallagher said the vote occurred in "contradiction of our procedural rules for voting on major rule releases, including the longstanding guideline that Commissioners should be given thirty days to review a draft before a vote." He added, "Not until five days ago did we have anything even resembling a voting draft, giving us less than a week to review the nearly one thousand pages of the adopting rule. In short, under intense pressure to meet an utterly artificial, wholly political end-of-year deadline, this Commission is effectively being told that we have to vote for the final rule so we can find out what's in it."

Lawyers will certainly find plenty of opportunities for judgment calls that will generate all those billable hours. Banks are still allowed to make markets in securities and to underwrite the issuance of new stocks and bonds, all of which often requires them to hold securities in anticipation of customer demand.

Banks also retain some ability to hedge—to make trades for the purpose of offsetting other risks that they've taken on for clients. The work required to define the difference between legal market-making, underwriting and hedging on the one hand and illegal proprietary trading on the other will now be ample enough to spark a new building boom at downtown D.C. law offices.

Rest assured banks will find loopholes. And rest assured some of the Volcker rule-writers will find private job opportunities to help with that loophole search once they decide to lay down the burdens of government service.

The long, convoluted Volcker process and result illustrate the central problem of Dodd-Frank: the belief that regulators given ever more discretion to craft ever more complicated regulations will yield a safer financial system. The Bank of England's Andrew Haldane and Vasileios Madouros have shown the opposite is true. The complexity of banking rules before the crisis failed to prevent catastrophic risks and made the job of addressing the crisis harder by obscuring the true condition of giant banks.

Especially with banking regulation, simple rules that are difficult for lobbyists and bankers to game are likely to work far better. Bankers would know what to expect and couldn't cry ambiguity if they crossed a line. And regulators would be far more likely to spy violations. The danger with this Volcker Complexity is that we'll get litigation, investing loopholes, and greater financial costs, but not a safer system.

New meat regulations could spark a trade war with Canada and Mexico and will raise costs

This Label Will Raise the Cost of Your Steak. By Scott George and Randy Spronk
New meat regulations could spark a trade war with Canada and Mexico.
Wall Street Journal, Dec. 5, 2013 6:42 p.m. ET
http://online.wsj.com/news/articles/SB10001424052702303670804579234642364948248

Right before Thanksgiving, while Congress was on break, federal meat labeling regulations took effect that could result in Americans paying higher prices on everything from beef and pork to apples and maple syrup. While legislators, as part of the continuing farm bill negotiations, are considering a fix to the Country of Origin Labeling (Cool) statute, the regulations implementing it went into effect Nov. 23.

The new Cool rules require more detailed labels on meat derived from animals born outside the United States. Labels must now list the country in which livestock were born, raised and slaughtered. For example, a package of rib-eye steak might be labeled: "Born in Canada, Raised and Slaughtered in the United States."

The previous Cool rules required less detailed labeling, such as "Product of Canada and the United States." Ironically, the U.S. Department of Agriculture issued the new rules in May in an effort to improve the previous Cool rules, which the World Trade Organization last year ruled discriminated against Canada, Mexico and other U.S. trading partners.

Not surprisingly, Canada and Mexico are also fighting the new, more stringent rules at the WTO. Should the trade organization rule in their favor, our North American neighbors will likely retaliate against U.S. products through tariffs that will limit U.S. exports and kill American jobs. Canada, the second-largest export market for U.S. agricultural products, valued in 2012 at $20.6 billion, already has a preliminary retaliation list that includes fresh pork and beef, bakery goods, rice, apples, wine, maple syrup and furniture.

U.S. cattle ranchers and hog farmers who purchase livestock from Canada or Mexico will be affected by those retaliatory tariffs in a number of ways. Most crucially to those of us in the industry, the duties will prompt U.S. beef and pork exports to fall while American farmers and ranchers who import animals will see significant cost increases.

Alpha 3 Cattle Company in Amarillo, Texas, for example, imports roughly 38,000 feeder cattle a year from Mexico. When the original Cool law took effect in 2009, meat packers, fearing consumers would be less inclined to buy meat labeled "Product of Mexico and the United States" and incurring added costs to label mixed-origin meat, discounted Alpha 3's Mexican-origin animals by $35 a head. That alone cost Alpha 3 more than $1 million.

Under the new Cool regulations, the company expects the discount to be even higher, or for packing plants to stop processing Mexican-born cattle altogether. Why? Because under the new regulations those animals—and the meat from them—now need to be tracked, verified and segregated from U.S.-born cattle. (The 2009 law allowed co-mingling of animals.)

A Michigan hog farmer who gets most of his feeder pigs from Canada, and who took a financial hit when the labeling law took effect in 2009, has been told by the packing plant to which he sends his animals that he'll have a 10-hour window each week to get his Canadian-born hogs to market. That will be nearly impossible to accomplish—it's 32 truckloads—and it will be extremely costly.

That's because the new regulations will force the packing plant to shut down the lines processing U.S.-born hogs and switch to processing Canadian-born ones—which spend five of their six months in the U.S.—so that pork cuts can be tracked, labeled and kept separate. That's a logistical headache and a huge expense for the plant, which will likely pay the hog farmer less for his Canadian-born hogs and charge consumers more for the meat from those animals.

So why is the U.S. risking trade retaliation and prohibitive cost increases on American producers and consumers of meat? Groups that support Cool, such as the U.S. Cattlemen's Association and the Consumer Federation of America, think U.S. consumers will buy American if they see a "Product of the United States" label. But since the 2009 law went into effect, the USDA says there's been little effect on demand for U.S. meat, and that consumers buy primarily based on taste and price. Most Americans know, even if their legislators don't, that all meat products, regardless of their country of origin, must pass the same USDA safety regulations.

When the Cool proposal was first debated in Congress, the U.S. meat industry said it would be a costly program with little if any benefit to consumers. The USDA estimated it would cost $2.5 billion to implement and nearly $212 million annually over 10 years to maintain.

With our North American neighbors set to impose tariffs on dozens of U.S. products, livestock producers and meat packers facing greater costs and American consumers ultimately bearing higher prices, it appears that assessment was an understatement.

Mr. George is a cattleman from Cody, Wyo., and president of the National Cattlemen's Beef Association. Mr. Spronk is a hog farmer from Edgerton, Minn., and president of the National Pork Producers Council.