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Before discussing banking reform, it is necessary to first understand why and how financial markets operate.

For sensible reasons, people do not typically set their consumption equal to their immediate production. Not only do they like to smooth out their consumption profile over time, but they would also like to borrow against their future labor to create tools, machines, and skills (capital) that will enhance their productivity.

For the sake of expediency, I will lump a broad range of financial institutions, including insurance companies, under the umbrella term of “bank.” A bank is a sort of mediator who matches creditors and borrowers, taking in deposits on one end, and investing them in the most promising opportunities on the other. A well-performing bank finds the best investment opportunities for their creditors, while a poorly performing bank will invest in less optimal activities, and perhaps even destroy value.

Because of the intertemporal nature of bank activities, special considerations must be given to financial markets that are not given to typical goods markets. Creditors must be given guarantees that their contracts with the bank will be honored, and that their funds will not simply be stolen or blundered away. Also, because a bank is in the business of loaning out funds to borrowers, it cannot maintain the ability to return 100 percent of its deposits back to its creditors at any given time. Should the bank encounter a period of unexpectedly high deposit demand (the most extreme of which is typically called a “bank run”), it may be unable to fully and immediately pay back its creditors, even if it would be able to do so in the long run.

Theoretically, such problems could be resolved by the free market through private third parties ­— one bank agrees to cover the deposits of another, or lends funds to a bank waiting on a longer-term repayment stream, but these approaches have practical limits, and it rightly falls to the government to guarantee deposits and act as a lender of last resort (typically with a penalty rate) to illiquid banks.

The government’s proper role in financial markets is fairly straightforward. As a guarantor of deposits, the government must oversee bank activities and ensure that the bank is not placing guaranteed deposits at risk. As a lender, the government must ensure that it is not lending funds to banks that are unable to pay the government back, i.e. are insolvent.

To accomplish these goals, the government typically does three things:

First, it has a regulator that can oversee and evaluate bank holdings. This allows the government to determine when deposits are at risk, and recognize illiquidity from insolvency when lending.

Second, it has a formal mechanism for ending a bank that is unable to cover its depositors due to insolvency — rather than allow a poorly performing bank to double down on its positions and shift more risk onto depositors, the government will freeze it and broker a sale of its assets to private parties, or assume control of the bank and liquidate its holdings over time.

Third, it requires banks to maintain reserve, capital-adequacy, and leverage ratios. The simplest are reserve ratios — requirements that for every dollar loaned, the bank must maintain some fraction of that dollar on riskless reserve, ready to meet deposit demand. A reserve ratio gives the government regulator a greater margin of error to work within. At the extreme, if reserve requirements are set equal to a bank’s guaranteed deposits as a fraction of total funds (some “deposits” such as a bank’s equity, are not guaranteed by the government and can have their value fall to zero), the regulator’s job is reduced to merely detecting fraudulent accounting.

Similar in concept, but more nuanced, are capital adequacy and leverage ratios, which require banks to maintain asset profiles and debt-to-equity ratios that limit risk to guaranteed deposits. One can imagine them as intelligent reserve ratios — rather than having to hold on to some fixed ratio of riskless currency or treasury bonds, the bank can be credited for the risk of its holdings and the availability of non-guaranteed creditors to buffer against losses. For the same reserve ratio, a bank with zero equity and entirely high-risk holdings is a much greater threat to guaranteed deposits than a bank with lower risk assets (which are less likely to deviate from their expected value), and equity holders (who will eat losses in the event of asset underperformance). Some financial systems do not even use reserve ratios, preferring instead to rely entirely on capital and leverage requirements for their greater sophistication.

In the aftermath of the crisis, it is clear that the government failed, to varying extents, on all three counts.

On the first count, regulation and oversight, the government’s performance may be described as mostly satisfactory, punctuated by a few impressive failures. The majority of financial institutions that have received funds through the bailout are paying back their obligations on time (and even earning the government money, to the extent that the bailout funds were offered with penalty rates), and many insolvent banks (most notably Washington Mutual) were caught in a timely manner and liquidated with little or no adverse impact on depositors or tax payers. That said, it is clear that in some instances, the government recognized insolvency far too late and accepted significant losses, perhaps as large as $40 billion in the case of the American International Group (AIG).

On the second count, it has become apparent that some banks are “too big to fail.” This phrase is somewhat misleading — the government would have just as difficult a time dealing with the default of four smaller banks each with $250 billion in assets as it would with a single bank of $1 trillion. The trouble that arises is that we lack formalized legal mechanisms by which to take over banks and manage them until such time as they can be liquidated. A small bank can be dealt with quickly, but it is impractical to attempt to liquidate $1 trillion in assets simultaneously — such an action would lower asset prices and exacerbate the challenge of recovering depositor funds. Instead, the bank would be placed into receivership or nationalized, and bank operations would be performed by the government or a contracted entity until such time as they could be unwound or sold off. Where formal mechanisms exist, as with savings and loan associations such as Washington Mutual, the government has been successful. Where they don’t, as with insurance corporations such as AIG, the government suffered losses.

On the third count, the government’s performance has been the most disastrous of all, and perhaps can even be blamed as the ultimate cause of the crisis. A credit rating agency (CRA) evaluates the risk of different debt-based assets and assigns them ratings. These ratings then factor into the formulas used by government regulators to determine capital adequacy. For a given level of capital, reserves, and equity, a bank could meet its capital adequacy requirements (ie. demonstrate that it is properly safeguarding guaranteed deposits) by holding on to a mixture of AAA and C- debt, or it could hold mostly BB debt.

The problem is when a CRA misjudges the risk of an asset. If CRAs grade a risky asset (say, subprime mortgages) as AAA when the true underlying risk would make it closer to BBB, banks, even if they do not agree with the CRA’s judgment, have an incentive to hold more of the misrated asset — that is to say, even if they properly understood the asset’s true risk-adjusted rate of return, they would still prioritize holding it over other assets because it would allow them greater leeway to acquire riskier, higher return assets with the remainder of its portfolio. Thus, in their role as pseudo-regulatory bodies, CRAs create correlated biases within the financial system (not just within the U.S, but across all financial markets that tie capital ratios to the CRA’s risk assessment), and one convincing interpretation of the financial crisis is that the misjudgments of a few select players created a system-wide bias in favor of complex, and inaccurately rated mortgage-backed securities that misallocated real investment and created a sudden credit crunch when the securities were re-evaluated.

The House and Senate are now in the process of wrangling over measures (such as the strength of a new consumer protection agency) that are tangential to true financial reform. Instead, they should shift their attention to delivering on three core points:

First, we must strengthen our regulation and oversight so as to catch and liquidate future AIGs before they socialize losses. This will likely mean the creation of a “super-regulator” under which our current patchwork of regulatory bodies will be unified. This regulator can either be placed within the Federal Reserve (thus leveraging the Fed’s unique capabilities and related duties), or outside (better insuring the regulator’s independence and strength).

Second, we must create formal mechanisms by which insolvent bodies can be taken over and sold off. Weeks or months of inaction can mean billions in further losses to the taxpayer, and it is unacceptable that we lack means of dealing with the default of some of our largest financial institutions, such as insurers. At a minimum, analogues of the Federal Deposit Insurance Corporation’s process of receivership should exist for all classes of financial organizations, and it is advisable that these responsibilities should be centralized within a single organization trained to manage and liquidate assets over long time periods.

Last, as important as capital ratios are to modern banking, we must reform the role that private CRAs play in determining those requirements. The least we can do is bring CRAs under a system of oversight to ensure honesty and accuracy in their assessments — it is worthwhile to also consider the creation of an independent government institution, either as a replacement to, or a complement of, the existing private agencies. But even an independent and accurate rating agency can make mistakes, and so besides strengthening the ratings, we should also take steps to reformulate our capital reserve requirements so as to compensate for the potential of correlated, system-wide biases.

It is easy, given the punitive attitude being taken towards bankers, to ignore systemic reform in favor of satisfying populist pet-peeves. But while curbing executive pay may be more rewarding to legislators next November, in the long run, we need to tackle the systemic issues if we are to put our house in order.