Nouriel Roubini:

he events of the last few weeks - including the collapse of Bear Stearns and of other highly leveraged, illiquid and insolvent institutions that are members of the shadow financial system – have shown that non bank financial institutions are at risk of liquidity runs in the same way as banks are. The response of the Fed to this bank-like runs on non-bank institutions has been the most radical change in monetary policy and lender of last resort support by the Fed since the Great Depression: such lender of last resort support has been effectively extended to non-bank broker dealers that are among the primary dealers of the Fed. This radical extension of lender of last resort support to some non-banks has taken three forms: first, the $30 billion lending support that Bear Stearns received as part of its bailout/purchase by JPMorgan; second the new $200 billion facility that will allow all primary dealers to swap some of their illiquid assets (especially agency and private label MBS) in exchange for safe US Treasuries (the new TSLF facility); third allowing such primary dealers to access the Fed’s discount window at same terms as commercial banks (the new PDCF facility).

Odd, or not, that while the Village chatters about “entitlements” for the sick and the old, brokers in trouble are “entitled” to billions of dollars over the weekend….

As it is well known destructive bank runs on illiquid but solvent banks can be addressed via bank holidays; but the risk that such bank holidays (freezing of deposits) may lead to runs on other depository institutions has led – historically – to two alternative ways to deal with bank runs: deposit insurance and lender of last resort support by the central banks. Since these forms of support potentially lead to moral hazard – bankers gambling for redemption and making risky loans and not managing properly liquidity risk – optimal policy management of such banking risks implies that these banking/depository institutions - that benefit from deposit insurance and central bank lender of last resort support - are also subject to strict regulation and supervision of their activities; such regulation and supervision is provided in most countries by the central bank but increasingly we see other models (a unified financial services regulator outside the central bank such as the UK’s FSA or regulation/supervision spread among a variety central or local government institutions as in the US).

Now that some non-bank financial institutions that have been deemed as too-systemically-important to be allowed to fail – i.e. Bear Stearns and non-bank primary dealers – have been effectively put under the lender of last resort support umbrella of the Fed the question arises: shouldn’t these non bank institutions be regulated and supervised in the same way as banks are? I.e. be regulated by the Fed and/or have both banks and non-bank securities firms be regulated by a common new institution? Note that currently US securities firms are supervised/regulated by the SEC and have lower capital standards than banks.

This is what Hillary should be talking about, not getting The Wise Men together to solve the housing crisis; and this is what Obama should be talking about, instead of — correct me, Obama supporters — *** crickets ***. A huge systemic problem that only government can address would seem to be a fit topic for discussion during an election, eh?

sound policy suggests that securities firms should manage properly their liquidity and credit risks and that the creditors of such firms should also provide market discipline by having their claims at risk if the firm becomes insolvent: market discipline implies that such creditors should lend to such securities firms at rates that include all the relevant risks that they face. It would be a dangerous development if creditors of securities firms would be fully guaranteed in their claims as an important element of market discipline – unsecured and unguaranteed and subordinated liabilities of securities firms – would be dropped in case we were to provide deposit insurance to these firms on the same terms as banks.

This means that the only safety net that prevents destructive bank-like runs for the shadow financial system should be in the form of lender of last resort support to systemically important securities firms. Even in that case it would be most appropriate that creditors of insolvent – as opposed to illiquid – systemically important securities firms not be bailed out when such firms get in trouble. This is an important and crucial point that is relevant for the Bear Stearns case.

In the Bear Stearns case it has been argued that there was no bailout as the shareholders of Bear have been effectively wiped out. This argument is incorrect in many dimensions. First, since Bear was insolvent shareholders should have been wiped out 100%; the residual value of their equity – however little at $200m - means that they still fully own the firm and that they would benefit from increases in the market value of the firm that may derive from the liquidity support that the Fed provided if the JPMorgan deal does not go through.

Second, the Bear deal came with a huge - $30 billion – liquidity support by the Fed that has two consequences: JPMorgan was subsidized in its purchase of Bear; and creditors of Bears will not experience the losses that they would have incurred if Bear had been forced to close down. This latter point is crucial: since Bear was insolvent closing it down without the Fed loan would have implied that not only shareholders would have been wiped out 100% but also that other creditors of Bear – who lent without properly considering the significant risks that they were undertaking – would have suffered significant losses. Instead the Fed bailout made such creditors of Bear whole, a most disturbing and moral hazard laden outcome.

Third, not only Bear shareholders were not fully wiped out as they would have been if Bear had been allowed to go bankrupt; but all the senior management of Bear has been kept in place – starting with that reckless golf and bridge-AWOL Jimmy Cayne – when a proper solutions would have been to fire them all without any golden parachute or rich severance package.

So the appropriate resolution of the Bear insolvency – that would have minimized moral hazard given the Fed liquidity support - would have been to wipe out shareholders, wipe out senior management and then have Bear taken over by the government – rather than sold with a massive subsidy for JPMorgan - as public funds were being used to avoid the systemic effects of its collapse. Public money should have then be used not to bail out the creditors of Bear but rather to ensure an orderly disposal or sale of its operations including inflicting the appropriate losses on Bear’s creditors.

Instead the Fed and Treasury created the mother of all moral hazards by the way they resolved the Bear collapse: they did not fully wipe out the Bear shareholders; they did not fire any of the senior management; they bailed out the creditors of an insolvent Bear; they subsidized heavily JPMorgan’s purchase of Bear; they provided a $30 billon lifeline that subsidizes Bear shareholders and management, Bear creditors and JPMorgan; and they provided – for the first time since the Great Depression – a new massive lender of last resort support to all non-bank primary dealers in the form of two new lending facilities (the TSLF and the PDCF).

This is not the proper way to approach the serious problem of bank-like runs on insolvent or illiquid non-bank financial institutions and the issue of the appropriate redesign of a supervisory and regulatory system for a world dominated by the shadow financial system.

The reform and redesign of the now obsolete system of U.S. financial regulation and supervision is a most important policy goal.

Well, look. I’m sure we can trust the Village to do the reform and redesign. Right?