“We Need…to Reconstruct the Financial System So That s Much of It As Possible Can Fail, With Pain to the Interested Parties, But Not to The System”

John H. Cochrane – Professor of Finance, University of Chicago Booth School of Business – says in his prepared testimony to the House Committee on Financial Services (where he will testify at 9 am today):

We need Wall Street to reconstruct the financial system so that as much of it as possible can fail, with pain to the interested parties, but not to the system…

Too large to fail must become too large to exist…

Cochrane, like fellow panelist Jeffrey Miron, thinks that bankruptcy and other traditional remedies get a bad rap:

Regulators fear “systemic” effects of bankruptcy, but if you ask what they are, you typically find technical problems that are readily solved. Some examples:

• Lehman and Bear Stearns both experienced runs on their brokerage businesses. If you own stocks in a brokerage account, there is no more reason you should have to go to bankruptcy court to get them – or pull them out in a panic ahead of time — than you should need to go to court to get your car out of the repair shop if the auto dealer fails. Putting a “ring fence” around brokerage accounts in bankruptcy, or otherwise separating “systemic” brokerage from risk-taking, solves this problem, removing the incentive to run.

• Many investors found collateral tied up in foreign bankruptcy courts. Others, knowing this problem, “ran,” refusing to renew short term debt even against good collateral. This is easy to fix. Collateral is collateral, it’s yours if the other side defaults!

• Money market funds holding Lehman debt suffered a run, since they promise steady $1 value. There is no reason money market funds can’t seamlessly trade at net asset value any time the value falls below $1, removing entirely the incentive to run. Money market funds are not mom-and-pop bank accounts…

Needless to say, the right answer to this problem is to limit and clearly define, rather than expand and leave vague, the presumption that everyone will be bailed out…

The major systemic problem last fall was the freezing of short-term debt markets. There are many classic remedies to this problem, including limits on how much systemic activity can be supported by rolling over short-term debt, (the FDIC won’t let a bank finance a loan portfolio with overnight debt!) intervention by the Fed as lender of last resort, and removing uncertainty about government action.

We should focus on this question. A broad guarantee that no financial institution can fail is not the answer.

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