Why the Current Muddle-Through Approach to the Banking Crisis May Not Succeed by Nouriel Roubini

Why the Current Muddle-Through Approach to the Banking Crisis May Not Succeed
By Nouriel Roubini | May 8, 2009

What shall we make of the recently announced results of the stress test? Are they credible? Will they restore confidence in our battered financial system? Will the current approach to resolving the financial crisis work, be effective and minimize the fiscal costs of the financial bailout?

.... the current muddle through approach of colossal regulatory forbearance and bailout of the financial system has some serious risks and shortcomings (see my two recent op-eds with Matt Richardson in the WSJ and the FT for an elaboration): it significantly increases the fiscal costs to the taxpayer of bailing out financial institutions (their shareholders and creditors); it creates the mother of all moral hazard distortions as literally trillions of dollars of financial resources have been used to backstop the financial system and bailout reckless bankers and traders and investors; it ends up with a persistent and possibly long-term government control and partial ownership of parts of the financial system; it does not resolve the too-big-to-fail problem as big banks are not broken up or given incentives to break themselves up; it risks to keep alive zombie banks leading to a more persistent credit crunch, economic stagnation, deflation and debt deflation; it leads to problems of medium term fiscal sustainability as the large fiscal cost of the bailout of the financial system creates serious public debt dynamics problems over time; it creates a serious exit strategy problem for monetary policy as the tripling of the monetary base and the central bank purchase of toxic and illiquid assets risks to eventually lead to price inflation or to another asset and credit bubble unless the massive creation of liquidity is mopped up as soon as the real economy recovers; and it may end up with a cosmetic reform of the regime of regulation and supervision of the financial system as soon as the financial crisis looks like beginning to bottoming out.

Indeed many Wall Street voices are starting to argue that the crisis is over, that bull times are back, that they don’t need further government support (while still being on the government dole in twenty different Fed/FDIC/Treasury bailout/subsidy programs/funds), that they can repay TARP money (using the $350 bn of funds that they borrowed at near 0% interest rates with a FDIC full guarantee of interest and principal), that the government should not over-regulate the financial system, that controls on bankers compensation are misguided, that no fundamental change of the financial system and of its regulation is needed. This is the self-serving chatter that we are starting to hear from the same reckless lenders, bankers and investors whose greed and wildly distorted bonus/compensation schemes – together with regulators that were asleep at the wheel and believing in self-regulation that means no regulation – caused the worst economic recession and financial crisis since the Great Depression. This is the new spin of those whose fake (as not being risk-adjusted) gains/profits/bonuses were privatized in the bubble times when fake wealth and bubble profits were created and whose trillions of dollars of losses have now been fully socialized and paid for by the taxpayer. Their arrogance is only second to their shameless Chutzpah.

One can only hope that policy makers will resist these siren calls can and design a reform of the regime of regulation and supervision of financial institutions (more capital, less leverage, more liquidity, incentive compatible compensation with a bonus/malus system, higher capital charges to deal with – and possibly break-up – too-big-to-fail financial institutions, global regulatory standards that prevent jurisdictional arbitrage, etc.) that reduce the risk that a financial crisis of this proportion will happen again.

Please read the complete article at:

http://www.rgemonitor.com/blog/roubini/256694/ten_reasons_why_the_stress_tests_are_schmess_tests_and_why_the_current_muddle-through_approach_to_the_banking_crisis_may_not_succeed