Thursday, March 12, 2009

Meltzer's Bank Plan

Timmy Geithner's stress test looks at the effects of macro economic changes on bank balance sheets, an exercise surely to not generate effects larger than their standard errors. This will be manifest in the absence of standard errors in what they produce, and any scientific forecast includes standard errors.

But one might say, just stress the market by 3 standard deviations. Yet, if the market falls another 50%, one must anticipate a total collapse of the financial markets, so I think yes, if we can't figure out how to keep financial markets from going into a tailspin, it's "start over" for the American financial system. I don't think that's going to happen, I'm just saying in a scenario where banks on average are writing down their risky (ie, non-Treasury) assets by 20%, implies imagining everyone is insolvent because there is an accelerator mechanism at play here. Thus, I don't think such an exercise would shed much light on the puzzle of whom to shut down. With that scenario, the answer is trivial: everyone. Then the question is, how is the government going to replace our current financial system, as they will no doubt feel obligated to do?

Longtime Federal Reserve scholar Allan Meltzer suggests the Fed merely say they will match fund equity investors in banks. Say a bank wants $20B, if it can raise $10B, the government will add $10. If banks think they are solvent, then bank equities owners will prefer dilution to being stopped out due to liquidity concerns. If a bank is insolvent, it will find no equity investors, and so then be taken over in the way the S&L's were disposed of in the early 1990's. This has the advantage of using the market to determine who is solvent, not some arbitrary stress test.

If I were Treasury Secretary, I would do nothing. Luckily, Geithner has such low gravitas that's all he can get away with, going through the motions, generate reports, testify in front of Congress 3 times a week, that in the end does not amount to much. Thus, I am pleasantly pleased with Geitner because if he had more credibility he might actually be able to do something; given the predilections of the Obama team it would be worse than doing nothing.

1 comment:

Anonymous said...

You could at least spell Geithner's name right; that might give your writing a tad more credibility and gravitas. You should also try to kick the habit of putting commas in front of 'because' - it's poor grammar. Otherwise, I enjoy your blog.