Gary H. Stern, the co-author of “Too Big to Fail: The Hazards of Bank Bailouts,” said policy makers largely ignored the warnings contained in the title when the Brookings Institution published the book in 2004.That seems important to me. There is no good reason for implicit or explicit insurance of any bank liability holders other than small depositors. Taking away the implicit insurance can only help the moral hazard problem.
Mr. Stern, who retired last year as president of the Minneapolis Fed, is lukewarm about the bill. “It tries to address the problem but it’s half a loaf at best,” he said. “It doesn’t address the incentives that gave rise to the problems in the first place.”
In Mr. Stern’s view, ending “Too Big to Fail” should subject uninsured creditors — bondholders — to losses if the bank fails. Without that fear, he said, unsecured creditors will not exert discipline on the banks by monitoring their risk-taking and pricing their loans appropriately. Mr. Stern said the bill in the Senate is vague about how such creditors would be treated if the government were to seize and dismantle a failing bank.
One commenter yesterday made an important point about Greece. I think the underlying principle is that monetary policy, fiscal policy, and financial regulation are inextricably linked. I'm wondering if the EU is not doomed to fail given how it was set up. How can one have a monetary union without somehow linking the fiscal authorities of the members with the central bank? The simplest solution in the current context would seem to be that, if the other EU members want to keep Greece in the club, the ECB should just take on more of its debt. It can sterilize by selling some other assets. My guess is that the rules the ECB operates under do not allow it to do this. Maybe someone can fill me in on what the rules are. What exactly is on the ECB balance sheet?
One last point. I'm beginning to think that the following might be an optimal arrangement. Why not have a setup where the central bank is the sole regulatory authority, with all large financial institutions having reserve accounts and access to the central bank's lending facility? The central bank would have authority to regulate financial institution risk, and the power to take over any institution and resolve it, if it deems it insolvent. Also: no deposit insurance.