Canada's superintendent of financial institutions, Julie Dixon, has an intelligent and important op-ed piece in the Financial Times suggesting that what she calls "embedded contingent capital" -- "a form of self-insurance pre-funded by private investors" -- is a better way of protecting banks than a government bailout fund raised by a tax.
One of her objections to the tax-created bailout fund -- she doesn't say it, but such a tax-created bailout fund is the route backed by both Treasury Secretary Timothy Geithner and FDIC Chairman Sheila Bair, though they have a disagreement over whether the fund should be created before ("ex-ante") or after ("ex-post") another crisis -- is that, as she puts it, it "could lead to concerns about what to do with such a fund over time." In other words, the risk that the politicians or bureaucrats in charge of an ex-ante bailout fund might either spend it on other things (raiding it like the Social Security "Trust Fund") or invest it in the same stuff whose collapse in value will make the use of the fund necessary (like AAA-rated mortgage-backed securities). The risk of an ex-post bailout fund is that the healthier banks end up getting taxed to bail out their less responsible competitors.
I see at least three issues with her proposal, though.
The first is that it is unclear from her piece how this "embedded contingent capital" is going to be created. She suggests it might be part of a bank's ordinary debt issuance (that's the embedded part.) But won't that raise the bank's cost of capital, thus raising interest rates for borrowers, and reducing returns for bank shareholders? Ms. Dixon's piece essentially acknowledges that it will, but says the effect will be somehow minimized. Anyway, without a requirement from the government to do this, why would any bank want to do it? And if it is a requirement from the government, isn't it effectively a tax, just under a different name?
The second question is what triggers the conversion of the contingent capital. She writes, "An identifiable conversion trigger event could be when the regulator is ready to seize control of the institution because problems are so deep that no private buyer would be willing to acquire shares in the bank." It seems to me there is a difference, subtle but significant, between a conversion triggered by a regulator and one triggered by bank management, or, better yet, by a shareholder vote. One gives the government, which already has a lot of power, even more power, while the other gives the bank's owners more power.
The third point is Ms. Dixon's assertion: "governments would not guarantee any bank or provide emergency capital unless conversion of contingent capital had taken place." If governments are still going to provide emergency capital to banks even after the implementation of this embedded contingent capital plan, that would seem to be a point against it. We thought the intention of these "reforms" was to avoid future bailouts, not just to put one more line of defense in place before the bailouts.
The issues involved here may seem relatively obscure, which is why Ms. Dixon's op-ed is in the Financial Times and not the New York Times or the New York Post. But they are actually pretty important issues for Americans to get a handle on before Congress passes financial "reform" in an effort to give President Obama another political victory that the Democrats can run on in 2010 and 2012. The left all loves Canada because it has government health care already and because its banks endured the crisis better than America's. Now here is Canada's top bank regulator warning that private self-insurance for banks is a better idea than a Geithner-Bair Goldman Tax-generated government bank bailout fund. Will anyone listen to her? Or will Congress just rush along on its merry way toward a vote that will allow it to declare that the financial system has been "reformed," just like health care?
