Saturday, June 30, 2012

Living Wills

Regulation can spur innovation. Usually it is finding new, interesting ways to break the spirit of the law while abiding by the letter of the law. Doing things in a way that are technically speaking "legal" - that is, of course, if you have millions of dollars sitting around to pay legal fees in order to defend your claim.
Consumer Financial Protection Bureau

This is the basis of opposition against the newly-created Consumer Financial Protection Board (CFPB)  inside the Federal Reserve. They have a mission to protect consumers against fraud. What is fraud? Whatever the CFPB decides it is, with some limitations put in Dodd-Frank. It protects the spirit of the law and not the letter of the law, that is why there is so much fierce opposition to it by the banks. The opponents of it want to neuter it before it can get off the ground by changing the structure of the organization to one that they find less threatening. This type of regulatory environment can inspire more, not less, financial innovation. The same old game won't work, anymore.

Some of the largest banks have to submit living wills today to the SEC. A document explaining exactly how they will be unraveled in a crisis. Combine these with the stress tests that the banks have to go through and it creates an exit strategy to Too Big to Fail. The implicit government bailout is no longer a guarantee.

This had a funny impact on the market. It became a competitive advantage to be too big and too unwieldy to manage, much less fail. Being a Too Big To Fail bank meant that other banks and financial institutions were willing to lend money to them at a lower interest rate because they had an extra assurance that they were going to get their money back. Since the government was not going to let them go under, then they could not default on their debt. Less risk. Lower interest rates. A competitive advantage over everyone else.

TBTF might be on its way out the door in name, but the implicit assumption still might be there - especially as long as Ben Bernanke is the head of the Federal Reserve. Requiring living wills from these institutions will do something funny, again - they will lower interest rates further. How so? 


A living will lets creditors know where they lie in the pecking order of who gets paid when without having to fight tooth and nail in bankruptcy court. Banks can go to their lenders and say, "We are good for the money. Even if we weren't, the government won't let us fail. Even if we do fail, you will still get your money quickly anyways - since there is no risk on your part, give us the money as cheaply as possible." And they will.


Don't be surprised if smaller banks start creating living wills - not because they have to - but because they want in on these lower interest rates. Regulation can spark innovation.


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