"Capital Adequacy, Credit Swaps, and the Central Bank: Untangling Financial Reform"
SquareTwo, Vol. 3 No. 1 (Spring 2010)
On September 14, 2008, Lehman Brothers Holdings filed for bankruptcy after the federal government and large private sector actors failed to resolve the firm’s insolvency problems in a less destructive way. The market response to the collapse can only be described as cataclysmic. The VIX, an index of volatility in the S&P 500, climbed from 21.99 on September 2 to 80.06 before year end. The VIX would not return to August 2008 levels until October 2009. The Dow Jones Industrial Average and the Nasdaq saw steep declines following Lehman, not returning to September 2 levels until December 2009. Most noticeably, the TED spread—a measure of the difference between interbank lending and US Treasury rates, widely considered to be an indicator of market credit risk—climbed more than 300 percent during and after the events surrounding the Lehman collapse.  Spreads on other sovereign debt instruments exploded as well, limiting the ability of governments to issue debt. Credit markets effectively froze as lending ground to a halt and confidence declined. On the charts of virtually any national or international market indicator, notable changes can be observed in September 2008. Markets were paralyzed and saturated with fear.
That markets responded destructively to the fall of Lehman is widely accepted and, indeed, obvious. The precise reason for the volatility is still a matter of debate. The fears of many that Lehman Brothers posed serious systemic risk to the wider economy seemed to have been confirmed, and many commentators lamented the government’s failure to save the institution. Others, however, believed that the fallout was not caused by the Lehman collapse alone, but rather that past government bailouts of failing institutions had created expectations of a similar fate for Lehman and that these dashed expectations were manifested in the markets.
The notion that such a large and interconnected institution could fail without causing at least psychological distress and market turmoil, regardless of past or future government actions, seems unlikely. Market participants probably saw the failure as a sign that additional institutions could be failing, that credit lines for all economic activity were at risk, and that the behavior of the real economy would be tied to such destruction of wealth and credit. Regardless of expectations about government behavior, Lehman Brothers was one of the largest banks in the world with activities and commitments reaching into every economic sector imaginable. In many ways, the financial system is the lifeblood of the economy, and the destruction of such a significant portion of that system was bound to have damaging consequences.
Suppose the skeptics are right, however, and Lehman’s consequences would have been milder without the presence of past government bailouts and their accompanying moral hazard. Even under such assumptions, the notion that expectations about government involvement could be absent from such a large event is dubious. The name Lehman will long be associated with the failure of government to intervene to prevent financial disaster. The fall of Lehman will be cited in future debates about whether officials should take action. In future crises, governments will be under the same political pressures to become involved as they were in 2007-2008 with the added political ammunition of “remember Lehman,” and market actors will again form expectations that the government will take action. Whether bank collapse is a problem for real economic reasons or because of shattered expectations, bank failures will always have destructive consequences and carry political costs. Of course, Lehman Brothers was just part of a much larger crisis which permeated the financial markets of the entire globe.
As a result of the financial market turmoil of the past three years, many Americans expect policymakers to take steps to reduce the likelihood of another crisis. Politicians and pundits have proposed an array of financial market reforms designed, at least ostensibly, to prevent future collapse. Senator Christopher Dodd has introduced what seems to be the most important bill on the subject, which I discuss briefly below. At the fringes, political debate takes on an ugly image as partisans of the Left label skeptics of government efficiency as free-market ideologues while partisans of the Right label advocates of reform as shameful, unpatriotic communists. Members of the LDS Church are not immune to the temptation to caricature opponents in a similar way—or become the subjects of such assertions. Understanding the nuances of financial reform can reduce these tendencies towards the fringes.
The topic of regulatory reform has been and will always be plagued with controversy and partisan discord. Many on the Right are understandably distraught at the massive amount of government intervention in markets during the past three years. Some on the Left are trumpeting the failure of markets and the need for overwhelming government involvement. As with most other issues, partisan dogma and pundits have poisoned the debate. The optimal solution will require nuance beyond the lenses of ideological orthodoxy. The following six principles should serve as arguments for the need for careful, moderate reform of financial market institutions and as guiding principles for the crafting of such reforms.
First, in the event of a financial crisis like the one of 2007-2008, complete government nonintervention is not possible—regardless of the principles of laissez-faire ideology. In spite of any and all government promises, politics will force policymakers into responding to large-scale banking collapse with bailouts and other stabilization measures; this is what social scientists call a “time inconsistency problem.” Prior to a financial crisis, policymaker incentives dictate that government promise not to intervene in the event of bank failure. These incentives exist because of “moral hazard”—the notion that market actors engage in risky behavior when they believe government will save their investments, thereby increasing the likelihood of market collapse. However, the incentives of policymakers change during the crisis when they are under tremendous pressure, political and otherwise, to save the financial sector. Hence the time inconsistency problem—the policymakers’ incentives before the crisis contradict their incentives during it. Market participants can see the problem and are likely to believe officials are bluffing when they make promises of nonintervention. Market actors will always expect government to save the banks, so the Lehman effect, whether caused by real economic factors or a shattering of expectations, is always a threat.
Further, the destruction of credit markets which can occur in the absence of government involvement may have serious long-term economic consequences. If dramatic losses of output can be prevented by swift, temporary government action, ideological demands will be ignored. Despite what some on the Right want to believe, policymakers in the Bush Administration largely subscribed to the ideology of open markets and nonintervention. Henry Paulson, Ben Bernanke, and George W. Bush all had solid Republican credentials. However, they recognized unique circumstances and acted according to economic and political needs. Whether ideological doctrines allow it or not, governments will intervene in crises—as columnist Paul Krugman notes, the notion of a hands-off approach is “a fantasy.”  Hence, if good regulation can prevent collapse, partisans of both Left and Right should endorse it. Those proposing a sink-or-swim policy in the future are not contributing usefully to the dialogue.
Second, while increased financial market regulation will be repulsive to many, moderate intervention now may prevent more radical interventions later. When given the choice between stronger rules about liquidity, for example, and government bailouts or nationalization of banks, even libertarians would prefer the moderate application of more regulation. Given political realities, this may be the choice Americans face. Partisans of the Right can only benefit from participating in the building of institutions which may prevent political demands for more direct government control of economic actors.
Third, the ability of financial markets to spread risk and provide capital to the economy must be preserved. Those who would severely restrict the ability of financial market actors to operate with leverage and engineer risk-spreading derivatives would throw the baby out with the bathwater. The distinction between Wall Street and Main Street exists only in the minds of politicians and pundits; legislation which cripples the functions of financial markets would reduce the access to capital needed by businesses and consumers of all economic sizes. Many Americans are heavily invested in the financial sector and have benefitted from profits driven by financial innovation. Further, like more standard insurance products, many financial derivatives have useful purposes for spreading risk and signaling financial strength (which I discuss more below).
In general, the crisis was not a thorough repudiation of the benefits of markets. Markets have provided growth and prosperity to millions; the lessons of the crisis should be about how to better manage the power of markets. Note also that price controls are never a good idea: the efficiency-driven market price-setting mechanism is extremely complex and involves the rapid, decentralized processing of massive amounts of information by many actors. Political officials who attempt to replace that mechanism with centralized human wisdom do so at their peril. Command economies have never lasted.
Fourth, regulation should be crafted by people with relevant expertise and training based on sound principles and long-term concerns rather than knee-jerk populist sentiments. The more likely alternative is that regulation will be crafted by members of Congress with little relevant training  facing short-term election incentives and the need to cover their own guilt  in response to overwhelming populist rage. The potential of such a process to go overboard and create counterproductive results is nontrivial. The process by which regulatory reform is carried out should be transparent and minimally political. While no process can be made apolitical, President Obama and other powerful actors in Washington can make the process as transparent as possible, with experts making proposals rather than politicians and, ultimately, lobbyists. These specialists need not be the slick Wall Street financiers who contributed to the current mess. There are a host of qualified researchers in academia and related fields, largely unconnected to the power brokers of Wall Street, who have devoted their careers to studying finance, financial crises, and institutions.
Fifth, even in light of the fourth principle, legislation should avoid giving too much power, discretion, and responsibility to human “regulators” or other financial market supervisors. Suppose experts who are well qualified and have the right motives for regulation are apolitically appointed. Even then, identifying things like systemic risk, asset bubbles, and exorbitant compensation is not an exact science.  Many well-intentioned, well-trained experts failed to predict the last crisis, and while they are more likely to predict the next one than the average person, we must not ascribe to them superhuman capabilities. We can certainly expect them to eliminate conflicts of interests, have a clean record of participation in financial markets, and demonstrate some expertise developed in an atmosphere other than the profit-driven private sector before being given any authority. This is easier said than done: it makes little sense to appoint supervisors over financial markets who have never worked in financial markets.
Sixth, increased regulation is at best a partial solution to the causes of recent and future crises. Some market actors will always seek ways around new rules—and any rules are likely to have unintended, costly consequences. Argued Elder D. Todd Christofferson, “Perhaps [more financial regulation] may dissuade some from unprincipled conduct, but others will simply get more creative in their circumvention. There could never be enough rules so finely crafted as to anticipate and cover every situation, and even if there were, enforcement would be impossibly expensive and burdensome. This approach leads to diminished freedom for everyone.”  We cannot solve every problem; some humility with regards to how much government can effectively steer markets is appropriate. In many cases creating suboptimal rules will be worse than doing nothing.
With these principles in mind, in this essay I discuss three broad areas of concern when debating regulatory reform. These include the “too big to fail” doctrine, financial instruments, and the Federal Reserve.
Too Big to Fail
During the crisis of 2007-2008, authorities in the White House, the Treasury, and the Federal Reserve acted to save several large financial institutions from failure. Why? Authorities feared that these institutions, which included Bear Stearns and AIG, posed “systemic risk” to the broader economy. In other words, the collapse of these institutions would have effects on much more than their immediate employees and clients. Not least of these would be a freezing of credit markets resulting in the inability of businesses to meet payroll and perform other activities—that is, Main Street would lose access to necessary credit and regular people would hurt. The employment and overall output loss accompanying such a collapse could have been devastating and, indeed, the decision to watch Lehman Brothers fail validated this assessment in the minds of many. Regardless of the merits of such claims, politics dictated that Washington act to reduce panic.
A variety of regulation proposals have emerged designed to prevent such actions by policymakers, none of them necessarily mutually exclusive. The core problem stemmed from Lehman’s balance sheets. Like many investment banks, Lehman Brothers was heavily leveraged. The values of its assets had declined and the bank had become insolvent. These conditions could perhaps have been prevented by higher standards of capital adequacy. Says economist James Hamilton, “The key principle for preventing the ‘bank run’ dynamics of the recent financial turmoil is to make sure that financial institutions have a sufficient cushion of equity capital to be able to absorb liquidation and delinquency losses on assets without sacrificing the institution’s ability to repay short-term creditors.”  This could be accomplished by enforcing stricter leverage requirements. Had the troubled banks in question followed this principle, bank runs may not have occurred and the need for bailouts might have been eliminated.
What amount of leverage and corresponding capital adequacy is, well, adequate? Leverage itself is not a bad thing. Debt financing of investment allows investors to engage in more investment activities and increase returns to equity for shareholders. Consequently, more capital can be made available for business finance and economic growth. However, the 30 to 1 leverage ratios enjoyed by investment banks prior to the crisis are simply too high. Further, there is evidence that many firms, through off-balance-sheet loopholes and accounting tricks, had leverage ratios even higher than this.  In general, determining what level of required capital adequacy is appropriate will be difficult and, inevitably, imperfect. The solution will probably have different requirements for different types of institutions. However, there must be better standards to discourage the exorbitant risk-taking behavior that occurred before the crisis.
An alternative approach to preventing bailouts is to limit the size of banks—ensure that no bank is too big to fail. Supporters of this approach can be found among economists throughout the political spectrum  (as can opponents ). Since bailouts are justified by their advocates in terms of systemic risk, restricting banks to a size rendering them unable to pose systemic risk could prevent the need for government intervention. The usefulness of this approach depends, first, on crises affecting banks heterogeneously, and second, on the plausibility of the largest economy in a globalized world being able to efficiently limit the size of crucial financial institutions. If all banks are affected by crises in the same way, they may collectively pose the same systemic risks as if they were fewer in number but larger. However, if banks are sufficiently diverse, they can fail without causing larger problems for the economy as a whole. This approach has the added benefit of reducing the political power of individual banks.  However, this would be seen by many as a distorting intervention into the economy which could cripple US firms in global competition. Can the US compete without the kind of depth of financial markets provided by large, interconnected banks? Perhaps more importantly, is it politically feasible to propose such a heavy-handed intervention?
A third idea involves taxing institutions based on size with the rationale that tax revenues are designed to compensate taxpayers in the event of a government bailout.  While this may not seem to do much for prevention, it is plausible if employed in combination with the creation of resolution mechanisms for insolvent firms. Rather than leaving failing firms with the option of bailout or bankruptcy, a more appropriate legal process could be designed to “wind-down” firms with minimal systemic effects and moral hazard concerns. While such a mechanism should not repay all relevant debt holders and shareholders, it could be designed to eject management, guarantee the continuation of payments and settlements, limit counterparty contagion and bank runs, and reduce the taxpayer burden.  The rules must be legally well defined and provide strong disincentives for excessive risk-taking by executives. If carefully designed and coupled with the tax on size, such a legal framework could reduce systemic risk and the burden placed on taxpayers by bailouts. If the process sufficiently limits discretion for policymakers, some political discontent could also be avoided.
Much has been said in public dialogue about complex derivatives and their danger. Some key notions should be borne in mind. First, financial derivatives are a powerful way to spread risk. Yale economist Robert Shiller has argued that what we actually need is more derivatives to more adequately spread risk out; he even proposes a new debt instrument which can be converted to capital during crises.  Such an instrument would give firms the flexibility of debt financing during good times but automatically reduce firm debt levels and increase asset levels in time of crisis. This mechanism could mitigate the panic and freezing of lending which we saw two years ago. Thus, while many people may be conditioned to recoil upon hearing the words “instrument” or “derivative,” financial innovation can be and often is employed in the service of stability and risk sharing. It is the specific nature of the instruments and the regulatory framework in which they change hands that determine their potential to cause damage.
Second, instruments like credit default swaps (CDS) are important signals of creditworthiness. These instruments allow investors to buy insurance against borrower default. Therefore, the price of a particular company’s CDS reflects expectations about their ability to fulfill debt obligations. Economists Oliver Hart and Luigi Zingales  have even suggested using the price of CDSs for regulatory purposes. If prices pass a certain threshold, regulators can force the relevant company to raise equity capital, hedging up their position against default.
A significant problem with credit default swaps, however, is that they can be purchased by anyone, even those who do not own their corresponding securities. As Wolfgang Munchau argues , this is like allowing people to take out insurance on their neighbor’s house, creating a perverse incentive structure. Not only does this make the CDS a speculative instrument, but it also makes investors benefit from default. Any reform proposals should consider legal bans on owning default swaps without owning their corresponding debt.
A crucial reform to markets for financial derivatives would include forcing them to be traded on organized exchanges or central clearinghouses wherever appropriate. Currently, many derivatives sell in over-the-counter (OTC) markets making them difficult to evaluate. If legal bans on OTC-traded derivatives are too difficult, a tax on trades could be applied. Care must be taken, however, to identify which derivatives actually cause systemic risk. Not all instruments dependant on the prices of other instruments or assets should necessarily be forced onto exchanges.
Much has also been said of asset-backed securities—specifically mortgage-backed securities. The problem with the securitization of mortgages is that it has often served to hide risks. The entities creating the initial products—mortgages—become detached from the buyers and sellers of the securitized assets. A reasonably simple fix for the problem, advocated by a host of economists , is to require that the creators of asset-backed securities retain ownership in some small portion of the product.
The Federal Reserve
The Federal Reserve led by Ben Bernanke was a prominent actor in the financial crisis. The Fed provided liquidity for markets, eased credit, orchestrated bank bailouts, and employed monetary policy, all in an attempt to limit the short- and long-term damage of the disaster. The Fed also came under fierce criticism for its activities, which were seen by some as a subversion of the democratic process. Congressman Ron Paul has again proposed more Congressional oversight of the Fed’s activities.  Certainly, the dramatic expansion of the Fed’s balance sheet is cause for concern.  On the other hand, some proposals have sought to give the Fed more regulatory and oversight authority. Whatever mistakes the Fed may have made, its actions were crucial for reducing instability and, at any rate, the central bank is better suited to some policy roles than other actors in Washington.
The gritty details about who should oversee what are beyond the scope of this essay. However, it should be noted that a regulatory role for the Fed is not unreasonable. As America’s central bank, the Fed is constantly engaged in large-scale lending. Gathering data and overseeing the banks it lends to should not be seen as an unnatural responsibility for the Fed. Further, the Fed, unlike perhaps any other government body, has the human resources for such oversight. Not only is the central bank staffed with experts on banking, its employees are also relatively free of the short-term political pressures plaguing other actors in Washington and elsewhere. This combination of expertise and superior (though imperfect) motives makes the Fed a reasonably safe bet for efficient regulation, at least when compared with Congress. 
The Fed also provides a crucial service to the economy: that of a lender of last resort. Without the Fed’s lending activities during the recent crisis, credit markets would have been much worse. Again, the ability of even small businesses to make payroll, among many other things, is dependent on the operation of credit markets. The impact on the real economy of credit reduction is nontrivial. Further, these lending activities are typically costless to taxpayers—the Fed makes loans, not grants.
Most importantly, the Fed’s autonomy over monetary policy should be preserved in any event. The evidence overwhelmingly shows that independent central banks are superior to political actors at providing price stability—and may have significant positive effects on other macroeconomic indicators.  Despite the wishes of free-market enthusiasts, political conditions preclude any return to allowing markets to set interest rates and monetary policy. The choice is between a reasonably independent central bank setting monetary policy or giving that authority instead to Congress. Historically, instances of high-inflation have been associated with political control of the money supply. Actors in the legislature face too many perverse incentives, not to mention a distressing lack of expertise, to be trusted with monetary policy. Not only do elected officials face the temptation to overheat the economy through loose monetary policy during elections, they also face incentives to reduce the real value of the rapidly increasing government debt through monetization. Attempts to increase audits of the Fed (which is already audited) and give more power over monetary policy to Congress can only lead to the deterioration of economic and political outcomes. A discussion of the Fed’s contradictory employment mandate is beyond the scope of this essay, but monetary policy, at least, must be left alone.
The Way Forward
Several early attempts at reform have surfaced in Washington. In June 2009, the Treasury Department released a “white paper” with comprehensive proposals for financial reform.  Several bills have since surfaced in Congress, the most recent and relevant of which being a plan produced primarily by Chris Dodd.  Dodd’s proposal includes reasonable rules for executive compensation (based on shareholder input), a liquidation mechanism for winding down failing firms, and authority for regulators to dictate capital adequacy ratios. These are all good ideas, provided that they are done carefully and follow the principles I outline above.
The bill does have its problems. It creates a puzzling and arbitrary distinction between large and small banks—and it removes small bank supervision from Fed responsibilities, creating bureaucratic dispersion and ignoring the fact that a large amount of small bank failures can be as damaging as a handful of large bank failures. The specifics about capital adequacy and orderly liquidation procedures have not been explained publicly—and this matters. Details about specific capital adequacy targets and, more importantly, how such targets would be determined, are not public, raising concerns about giving too much discretion to regulators. Further, the way the Obama administration handled the Chrysler situation undermined the rule of law by giving what amounted to kickbacks to unions at the expense of senior debtholders, highlighting the need for transparent crafting of restructuring rules. 
Dodd hopes to give regulators authority to force companies to close divisions engaged in risky behavior—but who decides what constitutes risky behavior? As with most acts of Congress, definitions will be vague and driven by lobbyist insertions and political horse trading. Such a clause gives regulators more discretion than is wise. The bill—already more than 1,000 pages in length—also includes a number of landmines the likes of which tend to get buried in bills of this nature. For example, it has also been criticized for the amount of red tape it adds for startup businesses, generating a drag on job creation.  In general, what is most dissatisfying about the bill is its mysterious development. Dodd has not revealed who he consulted in drafting the bill or how he and his staff developed the rules contained therein. Did he take seriously the proposals put forth by people like Charles Calomiris, Alan Blinder, or Nouriel Roubini? Did he consult the reports of groups like the NYU Stern Working Group on Financial Reform or the Squam Lake Working Group? Or did he instead rely on party doctrine and the lobbyists to which he is so connected? There is as yet no reason to believe that this has been done in good faith, given Dodd’s record of conflicts of interest.  This sort of behavior is inevitable, but voters and media should demand that President Obama make serious efforts to limit it.
It is crucial that policymakers transparently seek input from places other than Washington and the New York financial district. America’s universities are replete with people with policy experience and distinguished careers in the study of economic institutions and markets. Dozens of academic working groups have already emerged. Leaving the process entirely up to Congressional incompetence and logrolling can only lead to more unintended consequences. The stakes are too high to let the partisans play their games. President Obama can and should invest his political capital in getting the job done right.
Charles Calomiris, “Financial Innovation, Regulation, and Reform,” The Cato Journal, Winter 2009, http://www.cato.org/pubs/journal/cj29n1/cj29n1-7.pdf .
Alberto Giovannini, “Financial System Reform Proposals from First Principles,” Centre for Economic Policy Research, January 2010, http://www.cepr.org/pubs/PolicyInsights/PolicyInsight45.pdf .
Avinash Persaud, “’Too Big to Fail’ Is No Redemption Song,” VOX, February 2010, http://voxeu.org/index.php?q=node/4590 .
Michael Pomerleano, “What International Experience Tells Us About Financial Stability Regulatory Reforms,” VOX, December 2009, http://voxeu.org/index.php?q=node/4427 .
John Ciorciari and John Taylor, The Road Ahead for the Fed (Stanford: Hoover Institution Press, 2009).
Simon Johnson and James Kwak, 13 Bankers: The Wall Street Takeover and the Next Financial Meltdown (New York: Pantheon, 2010).
Arnold Kling, Unchecked and Unbalanced: How the Discrepancy Between Knowledge and Power Caused the Financial Crisis and Threatens Democracy (Rowman & Littlefield Publishers, 2009).
Carmen Reinhart and Kenneth Rogoff, This Time is Different: Eight Centuries of Financial Folly (Princeton University Press, 2009).
 Paul Krugman, ”Financial Reform Endgame,” The New York Times, February 28, 2010, http://www.nytimes.com/2010/03/01/opinion/01krugman.html (accessed March 2010). [Back to manuscript]
 A 2008 study by the Center for Economic and Entrepreneurial Literacy found that just 14 percent of members of Congress had degrees in economics-related fields. Even this disturbingly low number overstates the expertise found in Congress: it includes bachelor-level degrees in things like business, which have little to do with studying complex financial markets and institutions. The quantitative skills required alone are unlikely to be found in many of the “economics-related” degrees present, suggesting that expertise relevant to financial markets is rare or nonexistent. Eighteen percent had degrees in the humanities. See Real Time Economics, “Most Lawmakers Don’t Have Economic Education,” The Wall Street Journal, October 1, 2008, http://blogs.wsj.com/economics/2008/10/01/most-lawmakers-dont-have-economic-education/tab/article/ (accessed April 8, 2010).[Back to manuscript]
 The most recent iteration of financial regulation was drafted by Christopher Dodd. Between 1989 and 2008, Dodd and then-Senators Barack Obama and John Kerry each accepted at least $100,000 from Fannie Mae and Freddie Mac, likely in exchange for their votes against George W. Bush’s attempts to submit the GSEs to market forces which would have reduced the organizations’ dependence on risky mortgages. People with such disturbing pasts should be limited in their influence. See Lindsay Renick Mayer, “Fannie Mae and Freddie Mac Invest in Democrats,” Capital Eye Blog, entry posted July 16, 2008, http://www.opensecrets.org/news/2008/07/top-senate-recipients-of-fanni.html (accessed March 2010).
Note also that these policymakers were repeatedly warned about the risk burdens of the GSEs—including warnings by the Federal Reserve under Alan Greenspan, who has been much maligned for his part in the crisis while Dodd, Obama, and Kerry have profited from pointing fingers. Both the Fed and the Bush Administration warned Congress about the consequences of protecting Fannie and Freddie from market forces, but lobbyist contributions were more important to these officials than financial stability—especially since they could successfully blame everything on Republicans and Wall Street. See Denny Gulino, “Greenspan: Congress Has ‘Amnesia’ Re Its Part in Crisis,” iMarketNews.com, April 7, 2010, http://imarketnews.com/?q=node/11417 (accessed April 7, 2010). See also N. Gregory Mankiw, “Trying to Tame the Unknowable,” The New York Times, March 26, 2010, http://www.nytimes.com/2010/03/28/business/economy/28view.html (accessed April 7, 2010).
What is curious is that this was not largely exposed during the 2008 election. Even as Fannie and Freddie were collapsing, The New York Times never published Obama’s history with the GSEs on its front pages, reserving the item for the back page of a front-page article on a connection between a member of John McCain’s staff and the organizations. That President Obama could survive an election with this on his record should be evidence of the broken nature of American politics and the potential for politicians to develop an adequate solution. See Jackie Calmes and David Kirkpatrick, “McCain Aide’s Firm Was Paid by Freddie Mac,” The New York Times, September 23, 2008, http://www.nytimes.com/2008/09/24/us/politics/24davis.html?_r=1&oref=slogin (accessed April 8, 2010). [Back to manuscript]
 Alan S. Blinder,“It’s Broke, Let’s Fix It: Rethinking Financial Regulation“ (paper presented for the Federal Reserve Bank of Boston conference, Chatham, MA, October 23, 2009), 9. http://www.bos.frb.org/economic/conf/conf54/papers/blinder.pdf (accessed March 2010).[Back to manuscript]
 Elder Christofferson noted this in the October 2009 General Conference. See http://lds.org/conference/talk/display/0,5232,23-1-1117-34,00.html (accessed April 8, 2010). By citing it I do not imply that the quote represents the position of the LDS Church regarding financial regulation.[Back to manuscript]
 James Hamilton, “Improving Financial Regulation and Supervision,” Econbrowser, entry posted October 27, 2009, http://www.econbrowser.com/archives/2009/10/improving_finan.html (accessed March 2010).[Back to manuscript]
 Michael J. de la Merced and Andrew Ross Sorkin, “Report Details How Lehman Hid Its Woes,” The New York Times, March 11, 2010, http://www.nytimes.com/2010/03/12/business/12lehman.html (accessed March 2010).[Back to manuscript]
Arnold Kling, “Baseline Scenario: The Book,” EconLog, entry posted March 11, 2010, http://econlog.econlib.org/archives/2010/03/baseline.scenar.html (accessed March 2010).
Nouriel Roubini, “’Too Big to Fail’ Revisited,” Forbes, November 5, 2009, http://www.forbes.com/2009/11/04/too-big-to-fail-volcker-greenspan-mervyn-king-opinions-columnists-nouriel-roubini.html.
Simon Johnson and James Kwak, 13 Bankers: The Wall Street Takeover and the Next Financial Meltdown (New York: Pantheon, 2010). [Back to manuscript]
NYU Stern Working Group on Financial Reform, “Real Time Solutions for Financial Reform,” VOX, December 2009, http://www.voxeu.org/reports/financial_reform.pdf (accessed March 2010), 40.
 This political economy argument is why noted libertarian economist Arnold Kling supports the idea. See Arnold Kling, “Break Up the Banks,” NationalReviewOnline, March 31, 2010, http://article.nationalreview.com/429893/break-up-the-banks/arnold-kling?page=1 (accessed April 8, 2010).[Back to manuscript]
 NYU Stern Working Group on Financial Reform, “Real Time Solutions for Financial Reform,” 31. [Back to manuscript]
 Blinder, “Rethinking Financial Regulation”, 18. [Back to manuscript]
 Robert J. Shiller, “Engineering Financial Stability” Project Syndicate January 18, 2010, http://www.project-syndicate.org/commentary/shiller69/English (accessed March 2010). Greg Mankiw has also endorsed the idea, see Mankiw, “Trying to Tame the Unknowable.” [Back to manuscript]
 Oliver Hart and Luigi Zingales, “To Regulate Finance, Try the Market,” Foreign Policy, March 30, 2009, http://experts.foreignpolicy.com/posts/2009/03/30/to_regulate_finance_try_the_market (accessed March 2010). [Back to manuscript]
 Wolfgang Münchau, “Time to Outlaw Naked Credit Default Swaps,” Financial Times, February 28, 2010, http://www.ft.com/cms/s/0/7b56f5b2-24a3-11df-8be0-00144feab49a.html (accessed March 2010). [Back to manuscript]
James Hamilton, “What Went Wrong and How Can We Fix It?” Economics in Action, December 8, 2009, http://economics.ucsd.edu/economicsinaction/issue-1/what-went-wrong.php (accessed March 2010). [Back to manuscript]
 See http://www.govtrack.us/congress/bill.xpd?bill=h111-1207, accessed April 7, 2010.[Back to manuscript]
 James Hamilton, “Concerns about the Fed’s New Balance Sheet,” in The Road Ahead for the Fed (Stanford: Hoover Institution Press, 2009), John Ciorciari and John Taylor, eds., 67. [Back to manuscript]
 See James Hamilton, “Bank Supervision and the Federal Reserve,” Econbrowser, entry posted March 17, 2010, http://www.econbrowser.com/archives/2010/03/bank_supervisio.html (accessed April 7, 2010). Says Hamilton, “It’s striking that many of those who were instrumental in relaxing the oversight on Fannie Mae and Freddie Mac now believe that a regulatory body more directly under their political control could do a better job than the Fed.” [Back to manuscript]
Alberto Alesina and Lawrence H. Summers, “Central Bank Independence and Macroeconomic Performance: Some Comparative Evidence,” Journal of Money, Credit and Banking 25 (May 1993): 151-162.
Stanley Fischer, “Central-Bank Independence Revisited,” The American Economic Review 85 (May 1995): 201-206. [Back to manuscript]
 US Treasury. “Financial Regulatory Reform: A New Foundation—Rebuilding Financial Supervision and Regulation,” June 17, 2009, http://financialstability.gov/docs/regs/FinalReport_web.pdf (accessed March 2010). [Back to manuscript]
 Sewell Chan, “Dodd to Unveil a Broad Financial Overhaul Bill, New York Times, March 14, 2010, http://www.nytimes.com/2010/03/14/business/14bank.html (accessed March 2010). [Back to manuscript]
 This is both an example of bad restructuring procedure and the potential for politics to negatively impact these processes as President Obama rewarded long-time campaign contributors (UAW) and ignored bankruptcy law. See Ann Woolner, “Chrysler Mows Down Debtholders’ Claims in Court,” Bloomberg, June 5, 2009, http://www.bloomberg.com/apps/news?pid=20601039&refer=columnist_woolner&sid=aN_5hvV_xqHM (accessed April 8, 2010). [Back to manuscript]
 Arnold Kling, “The Ugly Side of Financial Reform,” EconLog, entry posted April 1, 2010, http://econlog.econlib.org/archives/2010/04/the_ugly_side_o.html (accessed April 7, 2010). [Back to manuscript]
 Lindsay Renick Mayer, “Fannie Mae and Freddie Mac Invest in Democrats,” op cit. [Back to manuscript]
Full Citation for This Article: Decker, Ryan (2010) "Capital Adequacy, Credit Swap,s and the Central Bank: Untangling Financial Reform," SquareTwo, Vol. 3 No. 1 (Spring), http://squaretwo.org/Sq2ArticleDeckerFinancialReform.html, accessed [give access date].
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