MINSKYONTHEREREGULATIONANDRESTRUCTURINGOFTHEFINANCIALSYSTEM

WillDodd‐FrankPrevent“It”fromHappeningAgain?1

April2011

1PreparedwiththesupportofFordFoundationgrantno.1080‐1003‐1onFinancialStabilityandGlobalandNational(Re)regulationinLightoftheSub‐primeCrisis.

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CONTENTS

Preface 3

Introduction 5

Chapter1.WillDodd‐FrankPrevent“It”fromHappeningAgain? 7

Chapter2.MinskyonWhatBanksShouldDo 32

Chapter3.AMinskyIndexMeasuringFinancialFragility 42

Appendix.IndexeswithEqualWeightforAllVariables 56

References 58

RelatedLevyInstitutePublications 62

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PREFACE

Thismonograph ispartoftheongoingLevy InstituteresearchprogramonFinancial InstabilityandtheReregulation of Financial Institutions andMarkets funded by the Ford Foundation. This program hasundertakenaninvestigationofthecausesanddevelopmentoftherecentfinancialcrisisfromthepoint

ofviewofthelateLevyInstituteDistinguishedScholarHymanP.Minsky.

ThemonographdrawsonMinsky’sextensiveworkonregulationtoreviewandanalyzetherecentDodd‐Frank Wall Street Reform and Consumer Protection Act enacted in response to the crisis in the USsubprimemortgagemarket, and to assesswhether this new regulatory structurewill prevent “It”—a

debt deflation on the order of the Great Depression—from happening again. It seeks to assess theextenttowhichtheActwillbecapableofidentifyingandrespondingtotheendogenousgenerationoffinancialfragilitythatMinskybelievedtobetherootcauseoffinancialinstability.

ButMinskyalsobelievedthatregulationshouldbelinkedtothestructureofthefinancialsystem.Oneof

themajordrawbacksofthecurrentlegislationisthatitdoesnotproposeanalternativetothefinancialstructurethatproducedtherecentcrisis.Indeed,Minskyviewedthe“declineoftraditionalbanking”asoneofthecausesoffinancialinstability,andhehadveryclearviewsonwhattheidealstructureshould

look like. ForMinsky, any regulatory regimemust be consistent with, and sensitive to, the evolvingnatureof financial innovation,andshouldseektofostertwocriticalstructuralobjectives: (1)ensuringthe long‐term stability of the financial system, and (2) promoting the capital development of the

economy.

ThemonographthusbuildsonMinsky’sviewsasexpressedinhispublishedwork,hisofficialtestimony,andhisunfinisheddraftmanuscriptonthesubject.Inparticular,hisviewsareinconcertwiththosewho

believethattheonlywaytomakethelarge,“toobigtoregulate,andtoobigtofail”banksistobreakthemdownintosmallerunits.Thereisaclosecorrelationbetweenthe“originateanddistribute”modelof banking that produced the crisis and large bank size. Smaller banks, more closely linked to their

borrowers and the community, would provide the possibility of restoring the “originate and hold”banking model that concentrated on the creditworthiness of borrowers rather than maximizing thegenerationofdoubtfulassetstobesoldviasecuritization.Itwouldalsochangetheincentivestructure

andthelevelofearningsofthefinancialsector.

Irrespective of the emergent financial structure, regulators will have to be more cognizant of theendogenousprocessesthat,inMinsky’sview,aretherootoftheinstabilitythatproducescrisis.Indeed,one of the tasks of the new Financial Stability Oversight Council is to identify and takemeasures to

present financial instability. This monograph provides suggestions on how Minsky’s analyticalframeworkcanbeusedtodevelopmeasuresof financial instability, in the formof fragility indices forvarioussectorsoftheeconomytohelpregulatorsdetectemergingcrises.

Whether the Dodd‐Frank Act “to promote the financial stability in the United States by improving

accountabilityandtransparencyinthefinancialsystem,toend‘toobigtofail,’toprotecttheAmericantaxpayer by ending bailouts, to protect consumers from abusive financial services practices, and for

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other purposes”will be able to fulfill the promise of its title is an open question.Minsky repeatedlypointedoutthatafinancialcrisis,ratherthanbeingapeculiarevent,isthenaturalresponseofmarkets

toaperiodofrelativestabilityand innovations inriskmanagement.Hearguedthat issuesof financialinstabilitywere not important simply because of their impact on the financial system, but because astable financial system is central to the productive investment needed for income growth and full

employment.

Indeed, thiswas themainobjectofMinsky’s research at the Levy Institute.His proposal for financialstabilitywas to shift emphasis fromcapital‐intensive investment in growth to investment in jobsas ameans of ensuring both stability and an equitable income distribution. Employment,Minsky argued,

shouldbe themajor objectiveof economicpolicy,with government acting as employer of last resort(ELR). A direct, federally funded employment guarantee program, one providing a job opportunity toany individual willing and able to work, would act as an automatic economic stabilizer, enabling

households to meet their financial commitments and substantially reducing the impact of financialshocks.

AsMinskywroteinhislandmarkworkStabilizinganUnstableEconomy,“Aneweraofreformcannotbesimply a series of piecemeal changes.Rather, a thorough, integrated approach to our economic

problemsmustbedeveloped;policymustrangeovertheentireeconomiclandscapeandfitthepiecestogetherinaconsistent,workableway:Piecemealapproachesandpatchworkchangeswillonlymakeabadsituationworse” (2008 [1986],323).Thishasbeenoneof theorganizingprinciplesof theproject

thathasgeneratedthismonograph.

DimitriB.PapadimitriouPresident,LevyEconomicsInstitute

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INTRODUCTION

The demise of the new‐millennium real estate and commodity boom has come to be known as the“Minskymoment.”EconomistsversedinHymanMinsky’sspecificationofhedge,speculative,andPonzifinancingschemesquicklyidentifiedtheconditionsinthemarketforsecuritizedsubprimemortgagesas

aPonzischemeofcolossalproportions.Thosefamiliarwiththeprocessbywhichthescarcityofliquiditycangenerateadebtdeflationwerealsoquicktoseetherapidtransmissionofdistress inthefinancialmarkets into the full‐scale depression fromwhichwe have yet to emerge. Aside from themajor life

supportmeasures(TARP,thestimulusbill,ZIRP,andQE),themajorresponsehasbeenthatwecannotlet“It”—anotherGreatDepression—happenagain.Manyrecognizethatradicalchangesarerequiredintheregulationsgoverningthefinancialsystemtomakesurethatsuchwidespreadsupportmeasureswill

neveragainbenecessarytopreventthecollapseofthefinancialsystem.Congressthusmovedrapidlytowrite and approve a major overhaul of financial market regulations, with the rallying cry that theAmericantaxpayerwillneveragainberequiredtofinancethebailoutofWallStreetandWallStreetwill

neveragainbringaboutthecollapseofMainStreet.

But in this response to the crisis, discussion of Hyman P. Minsky has virtually disappeared, to bereplacedbymorepragmaticlobbyistsseekingtodefendvestedinterests.Althoughpoliticallyexpedient,thisisunfortunate,sincethemajorityofMinsky’sworkwasgeneratedbyaninterestinthedesignofa

financialsystemandfinancialregulationsthatwouldmakesurethat“It”wouldnothappenagain(seeMinsky 1964, 1972). His continual refrain in this work was that the financial structure should bedesigned in such a way as to ensure that it provides the necessary support for the financing of the

productive investment needed by the economy, without generating excessive financial fragility (seeWray2010).Here,Minskywasarealist.Hebelievedthatthenormalcompetitiveprofit‐seekingprocess

would lead financial institutions to adopt innovations in their management of liquidity thatcircumventedexistingregulations,whichwouldleadtoanendogenousprocessofincreasinginstability.Thus, while regulations to support financial stability would be important, they could not outlive the

naturalevolutionoffinancingoperationsthataccompaniedwhatheconsideredthenormalprocessbywhichstabilityengendersfragility.Chapter1ofthismonographthusseekstoprovideaMinskyanviewonthecurrentregulatoryprocess. Ithighlightsthefactthatthe introductionof landmark legislation is

lessimportantthanitsimplementationandmonitoring.

MinskybelievedthattheNewDeallegislationwastheexpressionofaliabilitystructurethatwasalreadyoutmodedwhen itwas introducedandwasnotappropriatetothe increased influenceofgovernmentthatwouldsubsequentlyemerge(Minsky1986,87).Thisgeneratedendogenous forcesthatsoughtto

erode the effectiveness of the legislation through administrative decree, legal interpretation, andlegislativerelief(seeKregel2010).Inparticular,theprocessofsecuritizationthatliesattheheartoftheshift from “originate and hold” to “originate and distribute” that played such an important role in

subprimelendingcouldnothaveoccurredwithoutaseriesofadhocadministrativeandlegaldecisions,each of which appeared to respond to industry best practice, but which culminated in producing astructural change in financial operations that was highly unstable. Much of this same process, built

around granting banks “all such incidental powers as shall be necessary to carry on the business of

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banking”(asitwasexpressedinsection16ofGlass‐Steagall),providesthejustificationfortheinclusionin the Dodd‐Frank legislation of a series of exemptions from regulation when associated with the

provision of client services that sharply reduces the effectiveness of the reforms. The expedient ofmoving suspect activities from the insuredbankingentity toarm’s‐lengthaffiliates simplyencouragesand concentrates the growth of such activities inwhat has come to be called the “shadow banking”

sector,withaverylowprobabilityofregulation.

Chapter 2 presents a survey ofMinsky’s contributions to the debate over the reformof the financialstructurethatwasunderwayintheUnitedStatesinthe1980sandearly1990s,drawingonpublications,testimony,andanuncompletedmonographthathewasworkingonat the timeofhisdeath in1996.

Since a tenet of Minsky’s view of regulation is that financial innovations will always keep financialinstitutionsonestepaheadofregulatorsandsupervisors,hebelievedintheimportanceofreactingtothosechangesbeforetheyproducedfinancialfragility.

The recent financial legislation creates a Financial StabilityOversight Council chargedwith identifying

unstablepracticesinfinancial institutions.Chapter3thusprovidesanattempttoformulateafinancialfragility index that might be of use in satisfying the Council’s mandate and that could be used byregulatorsto intervenetomakesurethenaturalprocessof financial innovationdoesnotallow“It”to

happenagain.Thispreemptiveapproach to financial stabilityalsohighlights the roleof supervisors intheimplementationofregulationsandtheidentificationofinappropriatefinancialpractices.

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CHAPTER1.WillDodd‐FrankPrevent“It”fromHappeningAgain?

TwoApproachestoFinancialRegulation

The starting point for HymanMinsky’s approach to financial regulationwas the observation that thesubjectcouldnotbediscussedonthebasisofatheoryinwhichfinancialdisruptionwasimpossible.Theproblem is thatmainstream, intertemporalequilibriumposits theexistenceofmarkets for contingent

contractsforeventsatallfuturedatesandstatesoftheworld.Thus,allpossibleriskscanbehedgedandcounterparties can always honor their commitments in any possible outcome.Given that all possibleoutcomescanbeinsuredagainst,thisapproachtoequilibriumimpliestheabsenceofinsolvencies.Itis

theequivalentofthepunterputtingmoneyoneveryhorseintherace:hewillalwayshaveawinner.Ifreal‐worldexperienceproducesdifferentoutcomes, this isnot the resultofmarket failure,but rathertheabsenceofarequirementthatmarketsallowagentstoenterintothefullcomplementofcontingent

contracts.Thus,orthodoxyembraces thebelief that themarketproducesequilibriumandencouragesthedevelopmentandintroductionofallnewfinancialinstrumentsandcontractstoallowtherealworldtooffercompletemarkets.

This was the approach of the Federal Reserve under Alan Greenspan and the belief that a wider

distributionofriskacrossmarketparticipants,intermediatedbytheexchangeofthesenewinstrumentsinnewmarkets,wouldprovideamorestablefinancialsystem.Thenewinstrumentswouldtransferriskmoreefficientlytothosemostwillingandabletoholdit.Buttheemphasiswasonthecreationofthese

newinstrumentsratherthanonthecreationofnewmarketsandtheconditionsrequiredtomakethemarketsmoreefficientandcompetitive.Theproductinnovationthatwasencouragedandproducedbycompetition amongst financial institutions was in general limited to over‐the‐counter (OTC) bilateral

tradingorthecreationofbespokestructuredlendingvehiclestailoredtotheneedsofindividualclients.Thefinancialincentivestotheoriginatorsofnewfinancialproductsledtoanemphasisonthesaleofthe

productstothosewillingtobearrisk(orthoseunabletorecognizeit)ratherthanontheredistributionofrisktothosemostabletobearit.

In the development of these new financial products banks initially played the traditional role ofintermediarybetweenclientswithoffsettingfinancialrequirements.Buttheyeventuallyfoundthatthey

could profit from acting as principal in these trades, taking position with their own capital. As anexample,theinitialdevelopmentofinterestrateswapssawbanksbringingtogetherhigher‐creditfixed‐rate and lower‐credit floating‐rate borrowers, providing reduced interest costs for both parties and

earningacommissionfromthesavings.Butthefailuretofindmatchingclientssoonledbankstoofferswapstooneclient,warehousingtheothersideofthetrade.Thisallowedbankstoprovideoff‐the‐shelfinterest rates swap services to clients. Eventually, this temporary service was seen to provide

opportunitiesfortradingprofits,andthebanksbecameprincipalcounterpartiesfortheirswapclients.Provisionofclientservicesasamarket‐makingdealerandproprietarytradingthusbecame inexorablylinked.

Theresultofsuch initialswapcontractswasan increase inrisk,asthe lender’sriskofrepaymentofa

traditionalbank loanwas replacedby theriskofnonperformancebyboth thebuyerandsellerof the

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swap. However, this increased risk was augmented when banks shifted from the role of mereintermediaries,without risk in the transaction, to takingprincipalposition.Andrather than leading to

the development of new markets that were transparent and self‐regulated, the activity remainedbilateral, with information only available from perusal of the aggregate data presented in financialstatementsandregulatoryfilings.Mostfinancialinnovationsfollowedthispath,leadingtoanincreasein

proprietarytradingbybankstofacilitatetheofferofbilateral,nonmarkettransactions.Butinthiscase,themarketswere far fromperfectornonexistent, information far from full, and the reduction in riskmorethanoffsetbytheincreaseincounterpartyriskandprincipaltradingbyfinancialinstitutions.

Minsky,ontheotherhand,believedthatregulationcouldonlybediscussedwithinatheorythatallowed

forfinancialdistressasanendogenousoccurrenceinthenormaldevelopmentoftheeconomicsystem.Eveninthepresenceoftheperfectoperationofcompletemarkets,Minsky’sapproachsuggestedthatthe financial system would become increasingly exposed to financial disruption and, eventually, a

systemic breakdown in the form of a financial crisis. It was to fill this gap in existing theory that hedeveloped the financial instability hypothesis, to provide a framework for discussing regulation thatmight provide a more stable, and more equitable, financial system. Despite the formulation of this

approachinthe1960sanditscontinuedadaptationandadjustmenttoevolvingconditions infinancialmarkets,ithasneverbeenusedasthebasisforregulationofthefinancialsystem.Nowthattherecentfinancial meltdown has been dubbed a “Minsky moment,” perhaps it is time to recognize that the

greatestcontributionofhistheoryisprovisionofabasisfortheformulationoffinancialregulation.

A.Changestotheregulatorystructurebeforethecrisis

Oneofthemost importantconsequencesoftheapplicationofmainstreamgeneralequilibriumtheory

astheframeworkforfinancialregulationwasthedecisiontoreplacetheGlass‐SteagalllegislationwiththeFinancialServicesModernizationActattheendof1999.TheGramm‐Leach‐Bliley(GLB)Act,as it’s

commonlyknown,abolishedthesegregationoffinancialinstitutionsbyfinancialactivitythathadbeenimposed under Glass‐Steagall and instead allowed for the creation of integrated financial holdingcompaniesthatcouldprovideanycombinationoffinancialservices.Thiswastheculminationofalong‐

terminitiativeorchestratedbythefinancialservicesindustrytorepealtheNewDeallegislation.Itwasbasedontheargumentthatthereweresubstantialeconomiestobeachievedbycross‐salesoffinancialservices and the resulting possibility to increase the internal cross‐hedging of risks within large

multifunction financial conglomerates. It was claimed that the symbiosis across different financialserviceswouldincreaseincomesforfinancialserviceprovidersaswellasdecreasetherisksbornebythelargerinstitutions.

In addition, it was argued that no other country had legislation similar to Glass‐Steagall, and foreign

institutions were generally allowedmultifunction financial institutions. Thus, the new legislation wasrequiredtoallowUSinstitutionstocompeteonalevel,globalplayingfield.Thisargumentwasspecious,since US regulations did not apply to US institutions’ global operations, and foreign institutions

operatingintheUnitedStateswereingeneralsubjecttoUSregulations.

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The introduction of integrated multifunction financial service corporations had two importantconsequences. First, it implied that financial holdings companies would be much larger than either

commercialdeposit‐takingbanksornoninsuredinvestmentbankshadbeeninthepast,sinceexpansionwouldnotbelimitedtotheprovisionofanyparticularserviceashadbeenthecaseunderGlass‐Steagall.Inthecaseof investmentbanks,sizehadbeenconstrainedbytheprohibitiononraisingcoredeposits

andtheirpartnershipstructure.Thelatterconstraintwasremovedwheninvestmentbanksconvertedtolimited‐liability public companies to raise capital in equity markets. Until the deregulation of capitalmarkets the 1970s, the NYSE forbade such listing; the move was initiated by the brokerage firm

Donaldson,Lufkin&Jenrette,tobefollowedinthe1980sbythelargerinvestmentbanks,thelastbeingGoldmanSachs,inpreparationfortherepealofGlass‐Steagallin1998.

Second,theeconomiesofscaleandriskreductionthatresultedfrominternalcross‐hedgingofpositionsmeantthatriskwasmorebroadlyspreadacrossdifferentactivities,andthusincreasedthecorrelation

of risksacrossdifferentactivities.However,as reportedbytheSeniorSupervisorsGroup,2even if thisdidoccur,itappearsthattherewasverylittlesharingofinformationconcerningexposuresindifferentfunctionsoftheconglomeratefinancialinstitutions—whathascometobecalledthe“silo”mentalityof

financialmanagement, inwhich informationremains isolated ineachseparateactivityof the financialinstitution. The result of cross‐hedging and product integration was the creation of financialconglomeratesthatwerebothtoobigandtoointegratedtoallowanyofthemtoberesolvedwhenthey

becameinsolvent.Indeed,ratherthandistributingrisktothosemostabletobearit,riskwasdistributedandredistributeduntilitbecameimpossibletolocatewhowasinfactthecounterpartyresponsibleforbearing the risk.Counterparty risk thus joined themore traditional funding/liquidityand interest rate

risksfacingfinancialinstitutions.Itreplacedwhatwasinitiallythemostimportantofbankrisks:lendingorcreditrisk.

However, large size does have one undeniable benefit, given that even regulators admit that such

institutionswillnotbeallowedtofail.Ontheonehand,throughtheoperationofmoralhazarditallowsthe use of riskier, higher‐return investments, bolstering the top‐line earnings; at the same time, theimplicit guarantee of government support means that borrowing costs will be lower, bolstering the

bottom line.Smallerbankswill thus find itmoredifficult tocompete,and the resultingconcentrationmay allow larger banks to impose higher charges for customer services. InMinsky’s use of Keynes’sterminology, both borrowers’ and lenders’ risks are reduced for large conglomerate banks, and they

haveincreasedmonopolypoweroverprices.Thismaybetherealcauseofthefavorableperformanceoflargebankgroups.Butthisisnottheresultoftheefficiencyoflargebanks;itisinrealityagovernmentsubsidythatcanonlybewithdrawnwithdifficulty.

The impetus for large size was also the result of a change in the instruments of monetary policy

introducedby the globalizationof themarket forprovisionof financial services. In theUnited States,

2TheSeniorSupervisorsGroupwasformedtoassesshowweaknessesinriskmanagementandinternalcontrolscontributedtoindustrydistressduringthefinancialcrisis,andcomprisedseniorsupervisorsfromsevenfinancialagencies:theFrenchBankingCommission,GermanFederalFinancialSupervisoryAuthority,SwissFederalBankingCommission,UKFinancialServicesAuthority,and,intheUnitedStates,theOfficeoftheComptrolleroftheCurrency,theSecuritiesandExchangeCommission,andtheFederalReserve.Fortheirjointreview,seeSSG2008.

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PaulVolckerhad introducedcontrolofthemoneysupplyandattemptedto introducecapitalratiostoreducebanklendinginanefforttostopinflation.LargelyasaresultofVolcker’spolicymoves,USbanks

shiftedsomeliabilityoperationstotheEuropeaneuro‐dollarmarkettoreducethecostoffundingtheirlending.This ledtotheglobalizationofUSbanking,whichuptothatpointhadbeenlargelydomestic.Onceintheglobalmarkets,theymetglobalcompetition,inparticular,fromJapanesebanks.

AfterthecollapseoftheHerstattBankinGermanyastheresultoffailingtocompleteaninternational

transfer to US banks, which subsequently caused them losses, it became clear that all banks wereinterlinked and needed some form of common regulation. The Basel Committee thus proposed theintroductionofglobal rules forrisk‐adjustedcapitaladequacyratios.Uptothat time,monetarypolicy

had been primarily implemented through adjustment of reserve ratios, and then, more exclusively,throughopenmarket operations.While the capital ratiosweremeant tomake riskier activitiesmoreexpensivetofund,andthus lessprofitableand lessattractive,theyhadaratherperverseresult.First,

thisencouragedbankstoexpandtheiractivitiesintheriskiest,highest‐returnactivitiesineachparticularriskcategory.Second, itencouragedbanks tomoveasmuchaspossibleof their lending thathad thehighestriskweighofftheirbalancesheetsandintospecial‐purposevehicles(SPVs)thatlargelyescaped

regulationand reporting.This createdanew typeof counterparty risk, and since the creditswerenolongerformallytheresponsibilityofthebank,ittransferredcreditriskstotheSPVswhilealsoremovingthe incentivestoapplycreditworthinessanalysisofthe loansthatweremadeandthesecuritiestobe

sold to the off‐balance‐sheet entity. However,when the crisis hit, the risks came back to the banks,throughavarietyofroutes.

Asaresultofincreasedglobalization,regulatorswereconcernednotonlywiththesafetyandsoundnessof financial institutions but also with the ability of US banks to compete on a global scale. In the

international regulatoryenvironment,Glass‐Steagallwasananomaly,and inmanycountriesuniversalbanking—allowingbankstoengageinalltypesoffinancialservices—wasthenorm.Thus,inconditions

of risingUS external account deficits, supporting global expansion ofUS banks became an additionalobjectiveofregulation.Indeed,thereportproducedbyUSTreasurySecretaryPaulsonbeforethecrisisdealtprimarilywiththechangesinregulationsrequiredtoensurethecompetitivenessofUSmarketsin

trading global securities and the competitiveness of US banks in competing in international markets(USDT2008).Thiswas simplyanextensionof theposition supportedbyUSTreasuryUnderSecretaryLawrenceSummers thatargued in favorofopenentry forUS financial servicesproviders into foreign

markets,ratherthanforfreeinternationalcapitalflows.

B.Reformintheaftermathofthecrisis:TheDodd‐FrankAct

Thecurrentapproach to regulationembodied in theDodd‐Frank legislationcontinues tobebasedon

the mainstream theoretical framework that sees stability in complete markets and synergy in theprovisionandhedgingoffinancialservices.3ItthusacceptsthatUSbankswillcontinuetobelargeand

3Reuters(2011)notesthat“cross‐sellingbetweenBankofAmericaandMerrillLynch,somethingthatmanythoughtwouldbedifficult”improvedin2010;“thewealthmanagementdivision,mainlyMerrillLynchandUSTrust,tookinmorethan5,300referralsfromotherdivisionsatBankofAmerica,morethanthreetimesthereferralsin2009.Thewealthmanagementunitalsoreferredmorethan8,000clientstothecommercialand

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integrated. Indeed, Treasury Secretary Geithner has supported the view that the current size of USbanks,whichhas increased substantially as a resultof the resolutionsundertakenduring the crisis, is

desired and even necessary if they are to compete in global markets. According to aNew Republicinterviewer, Geithner “told me he subscribes to the view that the world is on the cusp of a major‘financial deepening’: As developing economies in the most populous countries mature, they will

demandmoreandincreasinglysophisticatedfinancialservices,thesamewaytheydemandcarsfortheirgrowingmiddleclassesandinformationtechnologyfortheircorporations.Ifthat’strue,thenweshouldwantUSbankspositionedtocompeteabroad....‘Idon’thaveanyenthusiasmfor...tryingtoshrink

therelativeimportanceofthefinancialsysteminoureconomyasatestofreform,becausewehavetothinkaboutthefactthatweoperateinthebroaderworld,’hesaid”(Scheiber2011).Geithnerwenton:“Nowfinancialfirmsaredifferentbecauseoftherisk,butyoucancontainthatthroughregulation.”This

wasthepurposeoftherecentfinancialreform,hesaid.4

Thus, the basic theoretical argument that large, integrated financial institutions create synergy inprovidingabroadrangeoffinancialservicesandreduceriskbypoolingismaintainedbythosewhoaremostinfluentialin“reform,”whilethedifficultiestheseinstitutionscausedinthefinancialcrisiswillbe

managedbybetterregulationandprovisionstoensurethatiftheydocollapse,theywillbeallowedtofail without requiring support from public funds. The two major pillars of the reform package areregulations to better manage the risks undertaken by large, “systemically significant” financial

institutions,andthemeanstoforcethemintobankruptcyliquidationwithouttheneedforanythingbuttemporarypublicassistance.Theproblems faced in the last crisisarenot seen to result fromthesizeand integration of multifunction institutions, but the absence of a mechanism to allow all bank and

nonbankfinancial institutionstofailwithoutpublicassistance.Thus,bankswillbeallowedtofunctionmoreorlessasbeforethecrisis,withinfinancialholdingcompanies,buttobesubjecttoclearruleson

theirrapiddissolutionratherthantheirresolution.

Minsky, on the other hand, basing his views on a theory that says financial disruption is a naturalconsequence of the operation of the system, would have argued that it is impossible to formulate

bankingandmarketsdivisions,a71percentincreaseover2009.”Notethatthisrefersprimarilytomarketingratherthancostefficiencyinprovisionofservicesorinriskmanagement.4Theinterviewcontinued:“IaskedGeithnerifhehadagrandvisionforthepost‐crisislandscape—for,say,alessbloatedfinancialsectorwithasmallerroleintheeconomy—andamapforhowtogetthere.CouldhebeafigurelikeGeorgeMarshall,whohelpedwintheWorldWarandthenremadeEuropesothatitcouldn’thappenagain?“Geithnerhunchedhisshoulders,pressedhiskneestogether,andliftedhisheelsupofftheground—analmostchildlikeexpressionofglee.‘We’regoing,like,existential,’hesaid.Hetoldmehesubscribestotheviewthattheworldisonthecuspofamajor‘financialdeepening’:Asdevelopingeconomiesinthemostpopulouscountriesmature,theywilldemandmoreandincreasinglysophisticatedfinancialservices,thesamewaytheydemandcarsfortheirgrowingmiddleclassesandinformationtechnologyfortheircorporations.Ifthat’strue,thenweshouldwantU.S.bankspositionedtocompeteabroad.“’Idon’thaveanyenthusiasmfor...tryingtoshrinktherelativeimportanceofthefinancialsysteminoureconomyasatestofreform,becausewehavetothinkaboutthefactthatweoperateinthebroaderworld,’hesaid.‘It’sthesamethingforMicrosoftoranythingelse.WewantU.S.firmstobenefitfromthat.’Hecontinued:‘Nowfinancialfirmsaredifferentbecauseoftherisk,butyoucancontainthatthroughregulation.”Thiswasthepurposeoftherecentfinancialreform,hesaid.Ineffect,GeithnerwasarguingthatweshouldbeascomfortablelinkingthefateofoureconomytoWallStreetastoautomakersorSiliconValley.’”

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regulationsthatwouldensuretheabsenceoffinancialdisruption.Regulatorsshouldthusbeconcerned,notonlybythesizeofbanks,butalsobytheiroperationsasmultifunctionfinancialserviceproviders.

Financial innovation will always be driven by regulatory arbitrage, and as a result there can be noassurance that regulations canmake large financial institutions safe fromcrisis. Indeed, thevery ideathat largebankswill be allowed to failmeans thatbankswill continue tobecomeever larger sincea

bankthatisresolvedorwoundupwillhavetohaveitsinsuredliabilitiesabsorbedbyanexistingbankorreconstitutedundernewmanagementviaabridgebank.Ineithercase,bankswillcontinuetogrowinsize.Thebestexampleofthisisthegrowthinthesizeofthelargestbanksasaresultoftheresolutionof

failedbanks in the recent crisis. Theanswer toMinsky’s rhetoricalquestion, “Can ‘It’ happenagain?”wouldonceagainbeintheaffirmative.

Finally, the approach to reform continues to support the idea that markets provide efficient pricediscovery.Thisisthecasenotonlyforthepricingoffinancialassets,butalsoforcompensation.While

manyeconomistshavenotedthedistortedincentivestructuredeterminingcompensationfortradersaswellasmanagement,theresponsehasbeenrestrictedtoproposalstointroducelimitsonthesizeandform of compensation. It has not generally been recognized that these distorted incentives are the

resultofstructural factors linkedtotheshift inthebusinessmodelemployedbyfinancial institutions.Theshiftinthegenerationofbankprofitsfromnetinterestincomegeneratedbyoriginatingloansandensuring that they do not default, to the generation of profits from fees, commissions, and trading

incomesbyoriginatingloansandsellingthemasrapidlyaspossible(ortakingpositionandunloadingitataprofitas rapidlyaspossible),producesan incentiveto takeonhigherriskexposures, reduces theriskof loss for the institutiondue to implicit government guarantees, andeffectively eliminates it for

management.

Thisismorethantheideaoftheprivateappropriationofprofitandthesocializationoflosses.Aslongaspositiontakingisfinancedwithexternalfundingtherewillbeacompensationstructurewithzeroriskof

loss and only the possibility of profit. In the leveraged buyout period in the 1980s, corporate raidersearned incomes irrespective of losses, which were the responsibility of the bond or equity holders.MichaelMilken also provided a system in which losses were not the responsibility of the junk bond

issuers,butrathershiftedtocapitalmarkets.Thecurrentexpansionof“securitization”andwhatisnowcalled “shadowbanking” functionon the sameprinciple: theoriginatorearns the feesandany short‐termprofitswhile capitalmarket investors take the losses. It is the structureof financial transactions

that generates the distorted incentives and simple limits, caps, or temporal structureswill have littleimpact on the support this system gives to increased risk taking and financial fragility. This sort ofactivity iswhatMinsky identifiedas“moneymanager”capitalism(seeWray2009,2011), inwhichthe

managerofinstitutionalfundsearnsareturnirrespectiveofresultsbuthasanincentivetotakehigherrisks because he does not participate in any losses. Since the current approach to reform leaves thebasicbusinessmodeloffinanceintact,italsoleavesthedistortionsonincentivesintact.

C.TheFinancialStabilityOversightCouncil

ThecenterpieceoftheDodd‐FranklegislationisthecreationoftheFinancialStabilityOversightCouncil(FSOC).Ithastheobjectiveofprovidingcollectiveaccountabilityforidentifyingrisksandrespondingto

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emergingthreatstofinancialstability.Tohelpminimizetheriskofanonbankfinancialfirmthreateningthe stability of the financial system, the Council has the mandate and authority to identify all

systemicallyimportantinstitutions,bothfinancialandnonfinancial,thatcontributeexcessiverisktotheoperationofthefinancialsystem;andtoavoidtheregulatorygapsthatexistedbeforetherecentcrisis.Italsohastheabilitytoapplyregulationsinadditiontothosestipulatedbytheirapplicableregulatory

agency.ThismeansthatvirtuallyanyfinancialornonfinancialinstitutionmaybedesignatedsystemicallyimportantallowingtheCounciltoimposeconditionstoeliminateanythreattofinancialinstability.TheFSOCisalsomandatedtoidentifyemergingriskstofinancialstabilityviadirectionto,andrequestsfor,

data and analyses from the Office of Financial Research, which was also created by the Act; and toformulate and compile databases of financial information from all market participants, to aid in theidentificationofunstablefinancialpracticesandconditions.

Despitethischarge,TreasurySecretaryGeithner,whoheadstheCouncil,hasstatedthatinhisviewitis

not possible to create effective, objective criteria for evaluating the risk a financial firmposes to thesystem. “It depends toomuch on the state of the world at the time. You won’t be able to make ajudgmentaboutwhat’s systemicandwhat’snotuntil youknow thenatureof the shock.” Thiswould

maketheidentificationofsystemicallyimportantfinancialandnonfinancialfirmsdifficultandmaketheidentificationofemergentrisksnearly impossible.Geithneraddedthat lenderswouldsimply“migratearound” whatever objective criteria of emergent risks or significant institutions that policymakers

developed inadvance.Withreferencetotherequirementthatresolutionof insolvent firmsshouldbeundertaken without government bailouts or taxpayer support for shareholders or management,Geithnertakesthecontraryviewthat“Inthefuture,wemayhavetodoexceptionalthingsagainifwe

face a shock that large. . . . You just don’t knowwhat’s systemic andwhat’s not until you know thenatureoftheshock”(quotedinSIGTARP2011).

TheideaofidentifyingspecificinstitutionsassystemicallysignificantseemstomissMinsky’sexplanation

oftheendogenouscreationofsystemicriskthatitisnotspecifictoinstitutions,butratheristheresultofhowthesystemevolvesovertimeanditsstructurechangesinresponsetoregulationandinnovation.OneofthefailuresoftheBISrequirements inpreventingacrisis isthattheyfunctionontheprinciple

thatifeachindividualbankcanbemadetofollowcommonlyacceptedstandardsandcodes,thennonecancontaminateanyotherbankinthesystem.Thedecisiononwhichandhowmanyinstitutionswillbeclassifiedassystemicallysignificantisstillamatterofdebatebutmaybesignificantingeneratingmoral

hazard if it creates the perception that the additional regulation and oversight applied to designatedinstitutionsprovide some sortof increasedguaranteeof solvency. The realproblem is to identify theendogenousaccretionoffragilefinancingstructures,andtorecognizetheirpotentialimpactonsystemic

stability.Anattempttoprovideamechanismtodothisispresentedinchapter3.

D.TheVolckerrule

MostoftheregulatoryactionsintheDodd‐FrankActcallformeasurestocorrectdifficultiesthathave

emergedfromthemultifunctionbankingthatwaspermittedbytheGLBAct.TheFSOCisresponsibleforimplementingthemostimportantofthesemeasures,theso‐called“Volckerrule”provisionssetoutinsection619oftheActthatcallsforlimitationsontheuseofproprietaryfundsforfinancialspeculation

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by banking entities that benefit from federal insurance, or any explicit or implicit governmentguarantees.Theseparationoftheuseofdepositors’fundsforbankbusiness‐lendingoperationsandthe

useofdepositsforanyoperationsinsecuritiesmarketsexceptthoseprovidedasacomplementtoclientservices was the fulcrum of the Glass‐Steagall regulations. The intention was to prevent banks fromusingretaildeposit funds,guaranteedbythenewgovernmentdeposit insurancefund, forspeculative

trading.Suchactivitywastobelimitedtononinsuredinvestmentbankswhosepartnersusedtheirowncapital resources to generate income by underwriting and trading in securities. In the 1980s, mostinvestment banks were transformed into limited‐liability corporations and eventually became bank

holdingcompanies,eliminatingtherelationbetweenthekindofinvestmentactivity(commercialloansorsecurities)andthekindof funding (depositsorowncapital) indistinct typesof financial institution(commercialorinvestmentbanks).

Since it is no longer possible under the 1999 Act to separate the use of deposit funds from the

proprietarytradingfinancedbybankcapital,suchtradingcanproducelossesthatjeopardizethebank’sabilitytorepaydepositors,andwouldthusrequiretheFederalDepositInsuranceCorporation(FDIC)tomeet the losses created by trading risks that were undertaken and should be borne by the bank’s

owners andmanagers. TheVolcker rule thus seeks topreclude theuseof the capital of the financialinstitutionforthepurposesofproprietarytrading—thatis,tradinginwhichthebankactsasprincipal—ifthebankqualifiesforanygovernmentsupportforlossestoitsdepositors.Theintentionoftheruleisto

preventbanksfromusinganyofitsdepositsorcapitalfundstotakeleveragedrisksonpositionswhosevalue is determined by changes in the price of financial assets, and, in particular, to limit the use ofleverage thathasbeena traditional part of such activities. In general, the leverage that is associated

with speculative and arbitrage activities is in noninsured areas such as repo markets and othercommercialborrowing,sotheruleimplicitlyseekstolimittheleveragethatcanbegeneratedbyfunding

proprietarytradinginrepomarketsorinunder‐marginedornon‐marginedover‐the‐counterderivativesstructures.

Since the rulewould exclude bank activities that provide services to clients, there is also difficulty indeterminingwhensuchprecludedactivitiesarerequiredforsupportingclientrequestsforservicesand

whentheyaresimplyforthebank’sownactivities.Forexample,abankprovidingforeignexchangeorinterestratehedgingservicesmayfinditnecessarytowarehousesuchcontractsinordertoprovidethebestexecutionforclients,anditwouldbedifficulttodifferentiatesuchactivitiesfrompureproprietary

speculation. As noted above, all these difficulties were avoided under Glass‐Steagall’s simpleproscriptiononsecuritiestradingby insureddeposit‐takingbanks.Thedifficulties inthe interpretationoftheVolckerrulewouldthusseemtostemfromanattempttoreintroduceGlass‐Steagallseparationof

activitieswithintheGLBActinwhichtheyarepermitted.

Some of the difficulties raised by the Volcker rule are dealt with in another of the major areas ofregulationintheAct:theabilityofbankstooperateandactasdealersinderivativecontracts,andtheformal transfer of derivatives clearing and trading to regulatedmarket institutions. The former deals

withtheso‐called“Lincolnamendment”thatsoughttoprohibitbanksactiveintheswapsmarketsfromreceivingvariousformsof“federalassistance,”includingfederaldepositinsuranceandaccesstotheFeddiscountwindoworanyFedcreditfacility.However,theamendmentalsocreateddifficultiesduetothe

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retentionofexistingGLBlegislationandemergedwithapush‐outprovisionthatallowedinsuredentitiestocontinuetheirderivativesactivitiesundercertainconditions.

Theregulationforbidsfederalassistanceforagenericcategory,“swapsentities,”thatisdefinedas“any

swap dealer, security‐based swap dealer, major swap participant, [or] major security‐based swapparticipant.” In turn, swap dealers and security‐based swap dealers are persons or entities that holdthemselvesoutasswapdealers,makemarketsinswaps,regularlyenterintoswapswithcounterparties

asanordinarycourseofbusinessfortheirownaccounts,orengageinanyactivitycausingthemtobecommonlyknowninthe industryasswapdealersormarketmakers.However,even ifanentity isnotclassifiedasa“swapsdealer,”itmaynonethelessbeclassifiedasa“majorswapparticipant"or“major

security‐based swap participant” subject to the regulation if it maintains “substantial positions” inswaps, or if it possesses outstanding swaps that create substantial counterparty exposure that couldhaveseriousadverseeffectsonthefinancialstabilityoftheUSbankingsystemorfinancialmarkets.

Since thisprovision,which is tocome intoeffect in July2012,wouldcreate substantialdifficulties for

banks in providing derivatives‐based client services, or in using such instruments to hedge their ownrisksvia theuseofderivativecontracts, the“pushout”provisionwouldallowbanks to retainFederalinsuranceandsupport if their swapactivitiesarecarriedout throughanaffiliate.The insuredentities

could then directly engage in their own and certain client‐based hedging activities without beingclassified as swap dealers. The affiliatesmay be created by any depository institution that is part ofeither a bank holding company or savings‐and‐loan holding company, on condition that the affiliate

complieswith sections 23A and23Bof the Federal ReserveAct and anyother requirements that theCommodity Futures Trading Commission (CFTC), Securities and Exchange Commission (SEC), and Fedmay determine necessary. In effect, this is the equivalent of the section 20 exemption under Glass‐

Steagallthatpermittedcommercialbankslimitedsecurities‐marketactivities.

Theactivitiesthatcanbeengagedinbytheinsuredentityitselfincludeactingasprincipalinswapswithcustomers in connectionwith originating loans for those customers; engaging in “deminimis” swaps

dealing; entering swap agreements for the purposes of “hedging and other similar risk mitigatingactivitiesdirectlyrelatedtotheinsureddepositoryinstitution’sactivities”;andactingasswapsentitiesforactivitiesinvolvingratesorreferenceassetsthatarepermissibleforinvestmentbyanationalbank.

Again,thesemirrorexemptionsthathadalreadybeenapprovedunderGlass‐Steagallanddidmuchtoundermineitsapplication.RegulationsspecifyingtheformalcontentoftheselimitsanddefinitionaretobeformulatedbytheSECandCFTCasappropriate.

E.Swapsandfuturesregulation

Theseexemptionsdonot,however,applytocreditdefaultswaps(CDSs)unlesstheyareclearedthroughderivatives‐clearingregulationsthatarecalledforundertheAct.Thefinancial industry foughthardto

limitreformsonthetradingofCDSstotherequirementthattheybecleared,arguingthatthiswouldbesufficient to ensure safety. However, Michael Greenberger (2010) has argued that, while clearingregulations would help to ensure capital adequacy of trading partners, this alone is not sufficient

protection. For example, Greenberger states that the following regulations are necessary as well:

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transparency of pricing and of the trading party identities, prudential and competency regulation ofintermediaries, adequate self‐regulation by the industry to help regulators, complete record keeping,

prohibitionsonfraudandmanipulation,fulldisclosuretoregulatorsandcounterparties,andcompetentprivate enforcement. This would create a structure similar to stock market rules, regulations, andoperating procedures. Exchange trading, strict antifraud requirements that are enforcedby state and

federalgovernments,andbanson“abusive”CDSsthataredesignedtocauseeconomicinjury(throughbankruptcy)wereseentobeneededtopreventarepeatoftheproblemsthatleduptothecrisis.

It is interesting that a new market in synthetic collateralized debt obligations is rapidly developing,basedonthesharpincreaseinjunkbondissuancesthathasbeenstimulatedbythelowinterestrates

andspreadsinthecorporatebondmarket.Theinstrumentsenableinvestorstotakeapositiononthejunk bond market without holding a long position in the underlying instruments. They are createdthroughderivativeson junkbond indicesand resemble the instruments thatcreatedsuchdifficulty in

themortgagemarket,whileprovidingexposuresimilartoacreditdefaultswap.It isnotclearthatthenewregulationswillbeable topreventa likecollapse in theeventofa rapid increase inpolicy rates,spreads,orjunkbonddefaultrates.

ThefullimplementationoftheVolckerandLincolnamendmentsrequiresprovisionstoshiftOTCtrading

inderivativesontofederallymandatedclearingmechanismsandregulatedmarkets.TheActthuscallsforthecreationofacomprehensiveframeworkfortheregulation,clearing,andexchangetradingofOTCderivatives.Nowdefinedas“swap”contracts,federallegislationhasalwaysexcludedthemfromsimilar

formalregulationsthatoriginatedintheinitialregulationoffuturescontractsin1922.Thisisdueinpartto the fact that futures contracts were initially developed in the agricultural sector and thus weresubject to commodity futures trading regulation monitored by the CFTC, while other derivatives

contractswereprimarilyfinancialandthereforeundertheregulatoryrubricoftheSEC.Thus,althoughfuturescontracts,whetherofafinancialorcommoditynature,couldnotbelegallytradedoutsideofa

formallyregulatedmarketwithoutaspecificexemption,otherderivativeswerealwaysfullyexemptandthusdevelopedintheOTCmarket.Thecurrentregulationthusseekstoapplytheexchangeandclearingregulationsoffuturestovirtuallyallstandardizedswapcontracts.

Whileswapsandfuturesrepresentsimilar“time”contracts,swaps,unlikefutures,werecustomizedto

thespecificcommercialhedgingneedsofbusinessesandfinancial institutions;and,asnoted,financialinstitutions initially acted as intermediaries bringing together swap counterparties in private bilateralnegotiations. Since most of these contracts were negotiated without exchange of principal, risk

exposure was limited to marginal changes in the market price of the contracts and prescriptiveregulation was not considered necessary. As banks began to take on principal positions ascounterpartiestoclientrequests,theyalsoacceptedriskonthenonperformanceofcounterparties,but

this was also considered minimal. The most popular swaps contracts were interest rate and Forexswaps,whichweregeneratedbythebreakdownoftheBrettonWoodssystemoffixedexchangeratesandhavesincebecomeanintegralpartofthehedgingintheflexibleinterestandexchangeratesinthe

international financial system. As they increased in volume, the International Swaps and DerivativesAssociationprovidedstandardizedtermsanddocumentation,reducingtheneedforspecificconditionsandbilateralnegotiation.

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ThedefinitionofswapsintheActcoversmostcommonlytradedOTCderivatives, includingoptionsoninterest rates, currencies, commodities, securities, indices, and various other financial or economic

interestsorproperty;contracts inwhichpaymentsanddeliveriesaredependentontheoccurrenceornonoccurrenceofcertaincontingencies(e.g.,acreditdefaultswap);andswapsonratesandcurrencies,totalreturnswaps,andvariousothercommonswaptransactions.

Duetotheparalleldevelopmentofcommodity‐basedandfinancial‐basedcontracts,theActdefinesand

provides for a common approach to “security‐based swaps,” which are generally swap transactionsinvolving a single security or loan or a narrow‐based security index. In broad terms, these will beregulatedbytheSECwhile“commodityswaps”willberegulatedbytheCFTC,preservingthehistorical

divisionoflaborbetweenthetwoagencies.

Anotherhigh‐volumeareaof themarket thatmightbe consideredaprimeexampleof contracts thatmightbenefitfromregulatedmarkettradingareforeignexchangeswapsandforwardcontracts.Thesecontractsareprimarilythedomainofbanksandarecurrentlyexemptfromregulatoryoversight.They

willbesubjecttoregulationundertheAct;however,giventhemajorparticipationofbanksinprovidingclient services and the traditional absence of regulation since the breakdown of the BrettonWoodssystem,theActprovidestheTreasurysecretarywiththepowertoexcludethemfromregulationifthe

contractsnegotiatedhavenotbeenstructuredtoevadethereachofthelegislation.Thisexemptionisexpectedinthenearfuture.

Banks, dealers, and other financial institutions active in the derivativesmarketsmay be classified as“(security) swap dealers”—that is, any person who holds himself out as a dealer in swaps, makes a

marketinswaps,regularlyenters intoswapswithcounterpartiesasanordinarycourseofbusinessforhisownaccount,orengagesinanyactivitycausinghimtobecommonlyknowninthetradeasadealer

ormarketmakerinswaps—andwillbecomesubjecttoregistrationandrecord‐keepingrequirements.

Given the prominent role in providing client services, a number of institutions will be exempt fromclassificationas(security)swapdealers:aninsureddepositoryinstitution,totheextentitofferstoenterinto a swapwith a customer in connectionwithoriginating a loanwith that customer; anentity that

buysorsellsswapsforsuchperson’sownaccount,eitherindividuallyorinafiduciarycapacity,andnotas“partofaregularbusiness”;andanentitythatengagesina“deminimisquantity”ofswapdealinginconnectionwithtransactionswithoronbehalfofitscustomers.

Themajorobligationof swapdealerswill be theapplicationofminimumcapital standards and initial

and variation margin requirements for swaps that are not cleared as required by the appropriateprudentialregulatoryagencyorcommission.

F.Dealingwithinsolventinstitutions

As noted, the major sections of the Act do little to reverse the trend toward larger and largermultifunctionbankconglomerates.TheActattemptstodealwiththeincreasedriskspresentedbysuchinstitutions,whethercausedbymoralhazardorsimplemanagementdeficiencies,bycreatingasystem

forthedissolutionofsuchinstitutionswhentheybecomeinsolvent. Indeed,theoverarchingthemeof

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theAct isnotsomuchtopreventcrisesastoprecludethepossibilityofusingpublicfundsinmeetinglossesor rescuing insolvent institutions. This isunderstandable considering the criticismof theuseof

theTARPprogramtosustainandrecapitalizeinsolventfinancialinstitutionswhileinsolventhouseholdswereforcedintoforeclosure.Congressclearlywantedtowashitshandsofanyresponsibilityfortheuseofpublicfundsinsupportoffinancialinstitutions.

Theabsenceofacommonlegalframeworkfordealingwithinsolventinstitutionswasoneofthemain

difficultiesnotedbyregulatorsinrespondingtotherecentcrisis.Forexample,theFederalReservehasargued that it had no mandate to act in the case of Lehman Brothers, while the Treasury had nomandate to impose bankruptcy on American International Group (AIG). In the absence of clear FDIC

authoritytoresolvenoninsured,nonbankfinancialinstitutions,directgovernmentsupportappearedtobe the sole alternative. Title II of the Dodd‐Frank Act is meant to meet this difficulty through thecreationofan“orderly liquidationauthority” (OLA) thatgives theFDICpower toseizecontrolofsuch

institutionsonthedeterminationbytheTreasurysecretarythattheythreatenthefinancialstabilityoftheUnitedStates.ItmandatestheFDICtoliquidatesuchdesignatedinstitutionssoastomaximizethevaluereceivedfromthedispositionof thecompany’sassets,minimizeany loss,mitigatethepotential

forseriousadverseeffectstothefinancialsystem,ensuretimelyandadequatecompetitionandfairandconsistenttreatmentofbiddersonassetsanddeposits,andprohibitdiscrimination.

AccordingtotheAct,implementingorderlyliquidationrequiresthattheFDICdeterminethatsuchactionis necessary for purposes of the financial stability of the United States, and not for the purpose of

preservingthecoveredfinancialcompany;ensurethattheshareholdersofacoveredfinancialcompanydonotreceivepaymentuntilafterallotherclaimsandtheDepositInsuranceFundarefullypaid;ensurethat unsecured creditors bear losses in accordance with the priority of claims; ensure that the

management and board of directors responsible for the failed condition of the covered financialcompanyareremoved(ifstillpresentatthetimeatwhichtheFDICisappointedreceiver);andnottake

an equity interest in or become a shareholder of any covered financial company or any coveredsubsidiary.

Anotherreasonfortheuseofdirectgovernmentinterventionintherecentcrisiswastheneedforrapidactioninordertopreventfurtherdeteriorationofthefinancialconditionoftheinstitutionsindifficulty

andtheriskofcontagion.However,underOLA,thedeterminationbytheTreasurysecretaryhastobemadeonrecommendationofcertaindesignatedfederal regulatoryauthorities (suchas theFSOC)andwithanevaluationofwhytheinstitutionshouldnotbedealtwithundertheBankruptcyCode,andafter

consultationwiththepresident.TheActalsorequiresthatbeforetheTreasurysecretarycanmakethedetermination that the FDIC should be appointed receiver, he must first make a requisite series ofspecific underlying findings, including that the company is in default or is in danger of default; that

shouldthecompanysodefault,theresolutionofthecompanyundertheotherwiseapplicablefederalorstatelawwouldhaveseriousadverseconsequencesforthefinancialstabilityoftheUnitedStates;thatthere are no private sector alternatives available that would avoid such adverse consequences; that

thereareno inappropriatepotential effectson the claimsor interestsof creditors, counterparties,orshareholdersthatwouldresultfromsuchappointment;andthattheseizureofsuchcompanyunderanOLAwillpreventorotherwiselimitdamagetothefinancialstabilityoftheUnitedStates(analysismust

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consider the effectiveness of such seizure inmitigating the potential adverse effects on the financialsystem,thecostofsuchresolutiontothegeneralfundoftheTreasury,andthepotentialofsuchseizure

andresolutionforincreasingexcessiverisktakinggoingforward).

IntheviewofJoshuaRosner(2011),thereisafundamentalflawintheOLAprocesscausedbythefactthat it creates twodifferent regimes underwhich a large financial firm can bewoundup: traditionalbankruptcyandtheOLA.Henotesthatthevalueofafirminits“goingconcern”stateisdependenton

theresolutionprocessemployedwhenitfails.AllnonfinancialfirmsandmostfinancialinstitutionsusetheBankruptcyCode;commercialbanksusetheFederalDepositInsuranceAct;broker‐dealersusetheSecuritiesInvestorProtectionAct.Theremaybedifferentsystemsfordifferenttypesoffirms,butthere

arenot,andthereshouldnotbe,multipleprocessesforthesamefirm.Insum,theabsoluteworstthingthat regulators cando is exactlywhat they’redoingnow: signaling to thepublic and themarkets, exante, which firms will cause systemic instability and then providing a US Treasury–funded bailout

scheme through the Orderly Liquidation Authority. Where investors have great certainty and clarityabouttheworkingsoftheUSbankruptcyprocess,theOLA’sdangeroussubjectivity, increasedopacity,preference for short‐termcreditors, andambiguity inhow itwill treat similarly situated creditorswill

onlyincreasetheuncertaintyamongcreditorsofafailinginstitutionandcausenecessaryriskcapitaltopauseatpreciselythetimethiscapitalismostneeded.

TheOLAprovisionalsomandatesthatthefinancialindustrypay(afterthefact)forthecostsofanysuchdissolutionactivityundertakenbytheFDIC.ThepowersgrantedtotheFDICasthe liquidatorarethus

verysimilartothosecurrently inusefor insuredinstitutions, including,wherenecessary,theabilitytocontinuetheoperationsofadesignatedinstitutionbymeansofanunencumberedbridgebank.TheActempowers the FDIC to establish such rules and regulations as it deems necessary or appropriate for

implementing an OLA. This is one area in which its operations concerning insured and noninsureddesignatedinstitutionswilldiffer. In itsresolutionofnormally insureddepositaryinstitutions,theFDIC

hasconsideredtheassetstransferredbyanyinstitutiontoanarm’s‐lengthSPVviastructuredfinancingsecuritizationasclaimablebysecuredcreditors.However,theFDIChasindicatedthatitdoesnotintendto apply this procedure in implementing thenewOLA, thusprotecting assets transferred to a special

entityfromtheliquidation.

OneofthedifficultiesfacedbytheFDICindealingwiththeresolutionoflargebanksisthelimitedsizeofthedepositinsurancefunds.(JustliketheFederalSavingsandLoanInsuranceCorporationinthe1980s!)Whiletheultimatesourceoffundsisthefederalgovernment,andthustheFederalReserve,theideais

thatitshouldbeself‐financing,basedoninsurancepremiachargedtotheinsuredinstitutions.Giventheleitmotif of the Act to eliminate the use of public funds to rescue the financial system, Dodd‐Frankmandatesmeasurestoincreasethesizeoftheinsurancefund,aswellasmeasurestoadaptthepremia

totheriskthatinstitutionsintroduceintothesystem.

The Act, in section 334, thus raises theminimum designated reserve ratio of fund assets to insureddeposits(DRR),whichtheFDICmustseteachyear,to1.35percent(fromtheformerminimumof1.15percent), and removed the upper limit on the DRR (which was formerly capped at 1.5 percent) and

thereforeonthesizeofthefund;requiredthatthefundreserveratioreach1.35percentbySeptember

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30,2020(ratherthan1.15percentbytheendof2016,asformerlystipulated);requiredthat,insettingassessments, the FDIC offset the effect of requiring that the reserve ratio reach 1.35 percent by

September30, 2020, rather than1.15percentby theendof 2016, on insureddepository institutionswithtotalconsolidatedassetsof lessthan$10,000,000,000;eliminatedtherequirementthattheFDICprovidedividendsfromthefundwhenthereserveratio isbetween1.35percentand1.5percent;and

maintained theFDIC’s authority todeclaredividendswhen the reserve ratio at theendof a calendaryear isat least1.5percent, inadditiontograntingtheFDICsolediscretion indeterminingwhethertosuspend or limit the declaration or payment of dividends. The FDIC has acted to exceed the

requirementsoftheAct,raisingtheDRRto2percentin2011.

The Act also requires that the FDIC amend its regulations to redefine the assessment base used forcalculating deposit insurance assessments. Under Dodd‐Frank, the assessment basemust, with somepossible exceptions, equal average consolidated total assetsminus average tangible equity. The FDIC

has proposed eliminating risk categories and the use of long‐term debt issuer ratings for largeinstitutions, using a scorecard method to calculate assessment rates for large and highly complexinstitutions, and retaining the ability tomake a limited adjustment after considering information not

includedinthescorecard.Thefinalrulewilldefinealargeinstitutionasaninsureddepositoryinstitutionthathadassetsof$10billionormoreasofDecember31,2006(unless,byreportingassetsoflessthan$10billionforfourconsecutivequarterssincethen,ithasbecomeasmallinstitution);orthathadassets

oflessthan$10billionasofDecember31,2006,buthassinceheld$10billionormoreintotalassetsforatleastfourconsecutivequarters,whetherornottheinstitutionisnew.Inalmostallcases,aninsureddepositoryinstitutionthathasheld$10billionormoreintotalassetsforfourconsecutivequarterswill

haveaCAMELSrating;however,intherareeventthatsuchaninstitutionhasnotyetreceivedaCAMELSrating, it will be given a weighted average CAMELS rating of 2 for assessment purposes until actual

CAMELSratingsareassigned.An insuredbranchofa foreignbank isexcludedfromthedefinitionofalargeinstitution.5

OntheinsuranceprovidedbytheDepositorsInsuranceFund,theActcallsintheFDICtofullyinsurethenetamountthatanymemberordepositorataninsuredcreditunionmaintainsinanoninterest‐bearing

transactionaccount.Suchamountshallnotbetakenintoaccountwhencomputingthenetamountdueto such member or depositor. The normal insurance level remains at $250,000 for each separate,normalinterest‐bearingaccount.

ManycommentatorshavesuggestedthatwhiletheFDICwasunwillingtointervenetoresolve“toobig

tofail”institutions,itwascertainlyabletodoso.ThispositionhasbeenmadeveryforcefullybyThomasHoenig (2009), president of the Federal Reserve District Bank of Kansas City, on the basis of hisexperienceindealingwiththeresolutionofContinentalIllinoisBank.TofacilitatetheabilityoftheFDIC

todealwiththeseverylargefinancialinstitutions(which,asalreadynoted,Dodd‐Frankconsidersafact

5USRegulatorsusearatingscaleof1to5basedonaseriesofindicatorstoassessthesoundnessofabank.Theyinclude(C)capitaladequacy,(A)assetquality,(M)management,(E)earnings,(L)liquidity,and(S)sensitivitytomarketrisk.

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of life), theActmandates the formulationof so‐called “livingwills” in the formof thepreparationofresolutionplansandcreditexposurereports.

TheActcallsupontheBoardofGovernorsoftheFedtorequirenonbankfinancialcompaniesandbank

holding companies that it supervises to periodically report the plan of such company for rapid andorderlyresolutionintheeventofmaterialfinancialdistressorfailure,whichshall include: informationregarding the manner and extent to which any insured depository institution affiliated with the

companyisadequatelyprotectedfromrisksarisingfromtheactivitiesofanynonbanksubsidiariesofthecompany; fulldescriptionsof theownershipstructure,assets, liabilities,andcontractualobligationsofthecompany; identificationof thecross‐guarantees tied todifferentsecurities; identificationofmajor

counterparties;andaprocessfordeterminingtowhomthecollateralofthecompanyispledged.

In addition, the Act calls for credit exposure reports covering the nature and extent to which thecompany has credit exposure to other significant nonbank financial companies and significant bankholdingcompanies,andthenatureandextenttowhichothersignificantnonbankfinancialcompanies

andsignificantbankholdingcompanieshavecreditexposuretothatcompany.

TheFedandtheFDICwill reviewthesereports,and if,basedontheirreview,theresolutionplanofanonbank financial company supervised by the Board of Governors or a bank holding company is notcredibleorwouldnot facilitateanorderly resolutionof thecompany, shallnotify thecompanyof the

deficiencies intheresolutionplan;thecompanyshallresubmittheresolutionplanwithinatimeframedeterminedbytheFedandtheFDICwithrevisionsdemonstratingthat theplan iscredibleandwouldresult in an orderly resolution, including any proposed changes in business operations and corporate

structuretofacilitateimplementationoftheplan.

The“livingwill”isthusdesignedtoshowexantethatsomefirmsaretoobigtofail,andwillclearlyputthemajorburdenonlargemultifunctionbankswithcomplexglobaloperations,suchasCitigroup,Bank

ofAmerica, JPMorganChase,GoldmanSachs,andMorganStanley.Theheadof theFDIChas recentlysuggestedthattheinabilityofabigbanktoprovideacredibleresolutionplanwouldbeaconditionforrequiringthat itbebrokenupbythetransformationof its foreignoperations into foreignsubsidiaries

subjecttoforeignregulators, inordertorealign its legalstructureand, ifnecessary,makeiteasierforregulatorstoliquidatethebank.“Iftheycan'tshowtheycanberesolvedinabankruptcy‐likeprocess...thentheyshouldbedownsizednow,”saidFDICChairmanSheilaC.Bair(quotedinClark2011).Theaim

of orderly liquidation is to avoid a repeat of 2008,when the Bush administration bailed out AIG andotherfirmsbutnotLehmanBrothers.Lehman'sbankruptcyvirtuallyfrozecapitalmarkets.

Aswillbeseen inchapter2,Minskyalwayspromotedsmallerbanking institutionsasawaytoensurelocalmanagementandlocalknowledgecouldbeusedintheassessmentofcreditworthiness.Hefavored

the imposition of the originate‐and‐hold bankingmodel, which would have incentive structures thatpromoted financial stability rather than risk taking. Finally, he believed that promotion of small‐to‐medium‐sized financial institutions would be more consistent with a general policy biased against

concentrationofeconomicpower—inboththefinancialandnonfinancialsectors.HewouldthushavebeenlesswillingtoemphasizeanOLAandresolutionplansandmoreinfavorofbreakingupthelarge

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financial holding companies. It is interesting that under Glass‐Steagall, bankswere given one year todivest themselves of their securities affiliates and other prohibited activities, and there were no

difficultiesinmeetingthistimetable.

G.Provisionofliquidity

ThemaininstrumentofFederalReservesupportduringthecrisiswasitsauthoritytoopenthediscount

windowinurgentandexigentcircumstances,asstipulatedinsection13(3)oftheFederalReserveAct,tovirtuallyanyfinancialornonfinancialinstitutionagainstvirtuallyanytypeofcollateral.AsaresultoftheexpressdesireofCongresstoensurethatnosupportbegiventofailingfinancialinstitutions,theDodd‐

Frank Act seeks to ensure that the Fed’s discretion to provide emergency support to insolventinstitutionsdoesnotcircumventanOLA.TheActthuscallsontheBoardofGovernors,“inconsultationwith the Secretary of the Treasury, to establish the policies and procedures to ensure that any

emergency lendingprogramor facility is for thepurposeofproviding liquidity tothefinancialsystem,and not to aid a failing financial company, and that the security for emergency loans is sufficient toprotecttaxpayersfromlossesandthatanysuchprogramisterminatedinatimelyandorderlyfashion.

ThepoliciesandproceduresestablishedbytheBoardshall requirethataFederalreservebankassign,consistentwithsoundriskmanagementpracticesandtoensureprotectionforthetaxpayer,alendablevaluetoallcollateralforaloanexecutedbyaFederalreservebank”(Sec.1101[a]).

Inaddition,theActrequirestheFedtoestablishprocedurestoprohibitborrowingfromprogramsand

facilitiesby insolventborrowers. Further, it limits theabilityof theBoard toestablishanyemergencyfacilitywithoutthepriorapprovaloftheTreasurysecretary,and,ifapprovalisobtained,toreportwithinsevendaystotheSenateCommitteeonBanking,Housing,andUrbanAffairsandtheHouseCommittee

on Financial Services, providing the justification for the assistance; the identity of the recipients; thedate, amount, and form in which the assistance was provided; and complete particulars of the

assistance.Theparticularsincludeduration;collateralpledgedandthevaluethereof;all interest,fees,andother revenueor itemsof value tobe received inexchange for theassistance; any requirementsimposed on the recipient with respect to employee compensation, distribution of dividends, or any

other corporate decision in exchange for the assistance; the expected costs to the taxpayers of suchassistance;andsimilarinformationwithrespecttoanyoutstandingloanorotherfinancialassistance,tobereportedevery30days.

Andifsuchreportingwerenotsufficient,theActgivesthecomptrollergeneraloftheUnitedStatesthe

powertoconductaudits, includingonsiteexaminations,of theBoardofGovernors,aFederalReserveBank,oracredit facility, if thecomptrollerdeterminesthatsuchauditsareappropriate,solely forthepurposeofassessing,withrespecttoacreditfacilityoracoveredtransaction,theoperationalintegrity,

accounting,financialreporting,andinternalcontrolsgoverningthecreditfacilityorcoveredtransaction;theeffectivenessofthesecurityandcollateralpoliciesestablishedforthefacilityorcoveredtransactioninmitigatingrisktotherelevantFederalReserveBankandtaxpayers;whetherthecreditfacilityorthe

conduct of a covered transaction inappropriately favors one ormore specific participants over otherinstitutions eligible to utilize the facility; and thepolicies governing theuse, selection, or paymentofthird‐partycontractorsbyorforanycreditfacilityortoconductanycoveredtransaction.

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FromhisveryearlyworkonthereformoftheFeddiscountwindow,Minskyarguedthattheemergencyactionsprovidedbysection13(3)shouldbemadepermanentandpartoftheordinaryoperationofthe

discountwindow.ForMinsky,thereasonwasquiteobvious:thereisonlyonefinancialinstitutionthatdoes not face a liquidity constraint, and that is the Federal Reserve. As Chairman Bernanke hasreiterated, the Fed has the ability to provide liquidity at the push of a computer key. In a complex,

layeredfinancialsysteminwhicheveryinstitution’sliabilitiesmusthaveahigherliquiditypremiumthanitsassets,all institutionsultimatelyrelyonthebankingsystemforsupport inthecaseofashortfallofcashinflowsandtheneedtorefinancetheirliabilities.AndthebankingsystemreliesontheFed.Thus,

limitingdiscountlendingtothebanksmeansallowingaliquiditycrisistomorphintoaninsolvencycrisisin the rest of the financial system before it reaches the banks and access to the discount windowbecomesanoption.Bettertolenddirectlytotheinstitutionsfacingliquiditydifficulties. Indeed,this is

whattheFeddidinthecurrentcrisis,anditisthesourceofthecriticismthattheagencywasbailingoutinsolvent institutions. However, the problem was that the Fed extended the reach of the discountwindowonlyafteracrisisbrokeout. ItprovidedsupportonlyafterBearStearnswas indifficulty,but

thenextendedsupport toallequivalent institutions.Thesamewastrue in thecaseofLehman,whichwasallowedtofail—andthenthewindowwasopenedtootherbroker‐dealerinstitutions.ForMinsky,itwouldhavebeenmuchbetter toopen thewindowto these institutionsasamatterof course,which

mighthavepreventedtheirdeclineintoinsolvency.Useoftheliquidityfacilitiesearlyonalsocouldhavebeenmadetransparent,leavingtheFedlessopentothecriticismthatitwaspickingwinningandlosers.

ForMinsky,openingthewindowwouldhaveprovidedtheFedwitha“window”intotheoperationsoftheinstitutionsseekingsupport,whichwouldhavealerteditmuchmorequicklytotheconditionoftheir

balance sheets. Insteadof continually arguing that the crisiswas contained, the Fed, had it been thelendertoallfinancialinstitutions,wouldhaveknownmuchearlierhowmuchthedeclineinhouseprices

andthemarketsforsecuritizedstructurehadimpactedallfinancialinstitutions.

H.Thefutureofsecuritization:Riskretention

Formany,abuseofsecuritizationwasattherootofthefinancialcrisis.Itwascertainlyacrucialpartof

theshifttotheoriginate‐and‐distributebusinessmodeladoptedbymostlargefinancialinstitutionsandthe riseofoffbalance sheetentitiesand shadowbanks. It alsowasa sourceof significant fraudulentactivity.ItisthereforenotsurprisingthatDodd‐FrankActshouldproposeregulationofthesestructures.

However,thenewregulationsarenotextensiveandare limitedtothe impositionofrequirementsforcredit risk retention requirements of not less than 5 percent for securitizers and, in certaincircumstances, originators of asset‐backed securities. Issuers of aQualified ResidentialMortgage (the

characteristicsofwhichhaveyettobedefinedbyregulators)ortheoriginatoroftheassetthatmeetsminimum underwriting standards to be determined by the appropriate regulatory agencies will beexemptfromtheriskretentionrequirement.Thisisbasedonthepresumptionthatifbankshadretained

some risk, theywould have beenmore diligent inmonitoring the quality of themortgages that theysecuritized.Yet,inactualfact,oneofthecausesofthelargelossesexperiencedbyinstitutionsengagedin securitization was that they had voluntarily retained a substantial amount of investment‐grade

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tranchesofsubprimesecuritizations.Indeed,inthiscase,havingskininthegamedidnotleadtogreaterconcernforassetqualitybutwas,rather,acauseofincreasedinstability.

In a study prepared under themandate inDodd‐Frank, the FSOC (2011) offers several principles and

recommendationsthatshouldinformthedesignofarisk‐retentionframework,soastostrengthenthesecuritizationprocessandfacilitateeconomicgrowthbyallowingmarketparticipantstopricecreditriskmoreaccuratelyandallocatecapitalmoreefficiently.

The study argues that a risk‐retention framework should seek tomeet the following objectives: align

incentiveswithoutchangingthebasicstructureandobjectivesofsecuritizationtransactions;provideforgreater certainty and confidence amongmarket participants; promote efficiency of capital allocation;preserve flexibility as markets and circumstances evolve; and allow a broad range of participants to

continuetoengageinlendingactivities,whiledoingsoinasafeandsoundmanner.

Arisk‐retentionframeworkcanbestructuredinanumberofwaystomeettheseobjectives.Theformofriskretention,allocationofriskretentiontovariousparticipants inthesecuritizationchain,amountofriskretention,allowancesforriskmanagement,andexemptionsfromriskretention—allareimportant

variables in the design of any such framework. Although a risk retention framework can help alignincentives and improveunderwriting standards, themacroeconomic implicationsof risk retention arecomplex. A risk‐retention framework can incent better lending decisions and consequently help

strengthen the quality of assets underlying a securitization. It may also help mitigate some of theprocyclical effects that asset‐backed securitization can have on the economy. However, if overlyrestrictive, risk retention could constrain the formation of credit, which could adversely impact

economicgrowth.Thechallengeistodesignarisk‐retentionframeworkthatmaximizesbenefitswhileminimizingitscosts.

It is interesting that the accounting conditions that determinewhether or not securitizations can be

consideredoff‐balance‐sheetnonrecoursesalesofassetsmakenoreferenceto“riskretention,”leadingto the possibility that the frameworkwill not necessarilymake these structuresmore transparent orbettermonitored. According to the Federal Reserve’s report to Congress on risk retention (Board of

Governors 2010), a recourse agreement requiring the originator or holder of assets to absorb apercentageofthecreditlossfortheassetsaftersalewouldnotappeartonegateanyoftheconditionsrequired for consolidation on the issuer’s balance sheet. However, it goes on to note that if the risk

retention requirements increase the instances of consolidation of the assets and liabilities of an ABSentity,theagenciesshouldconsidertheincentivesthatsuchanoutcomewouldcreate.

This raisesanumberof issues.First, regulatorycapital requirements forbanking institutionsgenerallystatethatconsolidatedassetsmustberiskweightedinthesamewayasassetsonthebalancesheetthat

havenotbeensecuritized.Inaddition,ifbalance‐sheetassetsaresubjecttoeitherimpairmentanalysisonaperiodicbasisor fair‐valuemeasurement, thiswouldthenapplytosecuritizedassetsthatdonotqualify forexclusion. If theseassets requireanallowance forcredit losses, including loansand leases,

thiswillaffectearningsandregulatorycapital.Assetsmeasuredatfairvalue,includingmanysecurities,also will affect earnings and regulatory capital. The impact on earnings and capital may continue to

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encourage institutions to engage in deal structuring for the purpose of achieving off‐balance‐sheettreatment. This may lead to the same arbitrage of activities that plagued Basel I, creating a wedge

betweeneconomic risk and regulatory risk of thebankportfolio.UnderBasel I riskweights, financialinstitutionswereencouragedtoretain theriskiestassets ineachcategory. Insteadofsolelyeconomicfactors determining an appropriate level of credit and liquidity protection necessary for asset‐backed

security (ABS) issuances, institutionsmightdesiretoretainonlytheminimumlevelofriskrequiredbyregulation,iftheminimumlevelenabledtheinstitutiontoavoidconsolidation.Similarly,companiesmaybe encouraged as a result of those earnings and capital effects to avoid consolidating assets and

liabilitiesbycedingpoweroverspecialentitieswhenitisnotfeasibletolimitbenefitstoanamountthatmeetsregulatoryrequirements.Forexample,institutionsmaycedepoweroverABSissuanceentities—whichinsomecasesresultsfromtheirabilitytomanageassetsheldbytheissuanceentities—byselling

servicingrightsordistancingthemselvesfromtheircustomersinordertoavoidconsolidatingtheassetsandliabilitiesoftheissuanceentities.Asaresult,itisnotclearthatthedeminimis5percent“skininthegame”thresholdsincludedinDodd‐Frankwillinhibitthedifficultiescausedbyoff‐balance‐sheetentities

intherecentcrisis.Itisalsodoubtfulthatthesestructureswill,infact,isolatetheinstitutionsfromtheimpactoftheperformanceoftheseassets.Indeed,intherecentcrisis,virtuallyalloftheriskofvariable‐interestentitiesandotheroff‐balance‐sheetactivitieswereeventuallysubjecttorecourseandreturned

tobankbalancesheets,furtheraggravatingthecrisis.Forexample,ifthefeesandtradingprofitsearnedbysecuritizingriskyassets isbelievedbybanks tomorethanoffset therisk tocapitalof retaininga5percentshareof“skininthegame,”thentheruleswillnotchangebehavior.Andthereistheadditional

danger that, due to off‐balance‐sheet commitments, the true share could be much higher. Reformsshouldnotbebasedonthepresumptionthatbankswanttoavoidrisks.Further,perceivedriskdepends

ontheoperatingenvironment—the“greatmoderation”loweredperceivedriskacrossthespectrumofassets.Thatalsochangedbehavior,becausetherewardforriskfell.Thiswasprobablyabigimpetustobankactivitiesthatappearedtoshiftriskbutinfactdidnot.

Finally,itshouldbenotedthattheSEChadinstigatedchangesintheregulationofsecuritizationbefore

the passage of the Dodd‐Frank Act and has continued the process of consultation prior to final rulemakinginthisarea.Securitizationhadbeenpracticedsincethe1970swithoutincidentuntiltherecentcrisis.Theobjectiveshouldbetopreservetheprinciplebyproducingregulationthatpreventsinstability.

I.Capitalandleverageratios

Somecommentatorsbelievethattheshifttowardsecuritizationwasdrivenbytheintroductionofrisk‐weighted capital ratios in the Basel requirements, which increased the costs of certain types of

investments forbanks.Thereareotherexpertswhoargue that these requirementshavebecome toodetailed and too onerous, and should be replaced by simpler, traditional capital‐to‐gross‐assets andliquidityratios.Despitethesecriticisms,theActmandatestheappropriatefederalbankingagenciesto

establish minimum leverage and risk‐based capital requirements on a consolidated basis for insureddepository institutions, depository institution holding companies, and nonbank financial companiessupervisedbytheBoardofGovernors.Theminimumleveragecapitalrequirementsproposedshouldnot

bequantitatively lowerthanthegenerallyapplicableleveragecapitalrequirementsthatwereineffect

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for insured depository institutions as of the enactment of the Act. In addition, the federal bankingagencies aremandated to develop capital requirements applicable to insured depository institutions,

depositoryinstitutionholdingcompanies,andnonbankfinancialcompaniessupervisedbytheBoardofGovernorsthataddresstherisksthattheactivitiesofsuchinstitutionspose,notonlytotheinstitutionengaging in the activity but also to other public and private stakeholders in the event of adverse

performance, disruption, or failure of the institution or the activity. Such rules shall address, at aminimum, the risks arising from significant volumes of activity in derivatives, securitized productspurchased and sold, financial guarantees purchased and sold, securities borrowing and lending, and

repurchase agreements and reverse repurchase agreements; concentrations in assets for which thevaluespresentedinfinancialreportsarebasedonmodelsratherthanhistoricalcostorpricesderivingfromdeepandliquidtwo‐waymarkets;andconcentrationsinmarketshareforanyactivitythatwould

substantiallydisruptfinancialmarketsiftheinstitutionwereforcedtounexpectedlyceasetheactivity.

Given international agreements, the impact of these provisions is to leave the determination of suchratiostotheBaselCommittee,anditsproposalsunderBaselIII,whichwerenotavailableatthetimetheActwasdrafted.

J.Reformofcreditratingagencies

Creditratingagenciesand, inparticular,nationallyrecognizedstatistical ratingorganizations(NRSROs)havebeenthoughtbymanytobeatthecenterofmuchofwhatwentoninthemarketcrisis,especially

in the area of structured products. The agencies have come under significant criticism for theirmethodologies,lackofprocedures,andconflictsofinterest.Attemptstoreformtheroleofcreditratingagencies have been ongoing, reinforced with each financial crisis that breaks out without any prior

indicationofcreditweaknessappearingintheratingsissued.TheseregulatorychangeshavesoughttoprovideanavenueforanincreaseinthenumberofNRSROsandtoremovetheirroleinregulation,but

regulationshavenotbeenprovidedfortheNRSROsthemselves.Forexample,onSeptember17,2009,the SECmoved to eliminate references toNRSROs in the “References inRules and Forms”under theSecuritiesExchangeActof1934,theInvestmentCompanyActof1940,theExchangeAct,theSecurities

Act,theInvestmentCompanyAct,andtheInvestmentAdvisersAct.

TitleIXoftheDodd‐FrankActbreakswiththehands‐offtreatmentandcallsforthecreationofanOfficeof Credit Rating with the authority to fine credit rating agencies, to administer the rules of the SECregarding the practices of NRSROs. The Office will examine all NRSROs at least annually, with each

examinationtoreviewthefollowing:theNRSROs’establishedproceduresforassigningratings,whetherconflictsof interest areeffectivelymanaged, theNRSROs’ ethicspolicy,NRSROcorporategovernanceprocedures; and the processing of complaints. TheOffice of Credit Ratingwill publish annual reports

summarizingthefindingsoftheexaminationsoftheNRSROs.

AllNRSROswillberequiredtoestablish,maintain,enforce,anddocumentaneffectiveinternalcontrolstructurefordeterminingcreditratings.Theymustsubmitannualinternalcontrolsreports,attestedtoby theCEO, to the SEC that describemanagement’s responsibility to establish andmaintain effective

internal controls for determining credit ratings. NRSRO compliance officers must prepare certified

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annual reports and submit those reports to management and the SEC. All NRSROs must discloseinformationoneachinitialcreditratingassignedandonanysubsequentchangestoacreditrating.This

informationmustbepreparedtoallowusersofthecreditratingtoevaluatetheaccuracyofratingsandtocomparetheperformanceratingsofNRSROs.Further,NRSROswillhavetodisclosetheiruseofthirdpartiesforduediligenceefforts,andifanNRSROismadeawareofcredibleandsignificantinformation

fromother sources, itmust consider that information in assigning a rating. TheAct also requires theremovalofallreferencestocreditratingsinvariousotherstatutoryschemes—amongthem,theFederalDeposit Insurance Act, the Federal Housing Enterprises Financial Safety and Soundness Act, the

InvestmentCompanyAct,andtheExchangeAct—inordertoeliminateoverrelianceoncreditratings.AllFederal agencies must substitute references in regulations to credit ratings with other standards ofcreditworthiness.

In addition, the SECmust commission a study regarding the feasibility or desirability of standardizing

credit ratings for all NRSROs, standardizing stress testing, requiring a quantitative correspondencebetweencreditratingsandarangeofdefaultprobabilities,andstandardizingcreditratingterminology;and the Government Accountability Office must conduct a study to evaluate different methods for

compensatingNRSROs in order to createmore incentives for providing accurate ratings, aswell as astudyonthefeasibilityanddesirabilityofcreatingan independentprofessionalorganizationforratingNRSRO analysts. Thus,major reform of the operation and role of NRSROs remains to be determined

afterthecompletionofthemandatedstudies.

Akeypartofthenewprovisionsdealswiththestructureoftheratingagencies.EachNRSROisrequiredto have a board of directors, at least half of whom are independent. The board is charged withoverseeing the implementationof internal controls regardingpoliciesandprocedures fordetermining

ratings, as well as compensation and promotions within the organization. It is also responsible foroverseeingthemanagementofconflictsofinterestthroughtheimplementationofappropriatepolicies

andprocedures.

The organization is required under the Act to maintain a documented, effective system of internalcontrolsfordeterminingratings.TheCommissionischargedwithrequiringthateachNRSROprepareanannualreportregarding itscontrols.Thereportmust includeanattestationbytheCEOthatdescribes

the responsibility of management for establishing and maintaining the system. Each NRSRO is alsorequiredtodesignateacomplianceofficer.Thatofficercannotperformcreditratingsorparticipate inmarketingor salesactivities. Likewise, thecompensationof theofficer cannotbe tied to the financial

performanceoftheorganization.Rather,itmustbearrangedtoassureindependence.

The compliance office is chargedwith preparing an annual report addressing changes in the internalcompliance procedures and code of ethics of the organization. The report must also examinecompliancewiththesecuritieslawsandtheorganization’spoliciesandprocedures.TheSECisrequired

toreviewthecodeofethicsandconflictof interestpolicyoftheorganizationannually,andwhenevertherearematerialchanges.

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The Act also addresses the “revolving door” issue between NRSROs and their clients. In this regard,Dodd‐FrankrequiresthateachNRSROreporttotheSECanycasewhere,withinthepreviousfiveyears,

aseniorofficeroftheagency(andcertainotheremployees)ishiredbythesponsororunderwriterofasecurityforwhichtheagencyissuedacreditratinginthe12monthspriortothehiring.

SeveralsectionsoftheActaddressthepotentialliabilityorlitigationdefensesofNRSROs.Theseincludethe application of expert liability. NRSROs will now be liable under section 11 of the Securities Act.

Dodd‐FrankoverridesRule436,whichexempted theseorganizations frombeing consideredpartof aregistration statement. Accordingly, to include a report in a registration statement, consent from theNRSROwillhavetobeobtained.TheCommissionisrequiredtoremovetheexemptionforcreditrating

agencies under Regulation FD. The Act also requires all federal agencies to review and modifyregulationstoremovereferencesorrelianceoncreditratings,andtosubstituteanalternativestandardof creditworthiness. The Act specifies that statementsmade by credit rating agencies are subject to

liability in the same manner as those of accounting firms and securities analysts under the federalsecuritieslaws.

Finally, Dodd‐Frank requires the preparation of studies and reports that may impact the futureregulationofcreditratingagencies.TheseincludeareporttoCongressonthecreditratingprocessfor

these products within 24 months of conclusion. It must include a study regarding the feasibility ofestablishinganindependentorganizationtoassignNRSROstodeterminecreditratingagencies,areportontheindependenceofNRSROsandhowthisimpactsratings,astudyonthefeasibilityanddesirability

ofstandardizingcreditratingterminologyacrosscreditratingagenciesandassetclasses,andastudyofalternativemeansforcompensatingNRSROstocreateincentivesformoreaccurateratings.

TheSEChadalreadymadesomeregulatoryreferencestoassigningratingsonavoluntarybasisin2009,

buttheActnowmakesthisobligatory.TheSEChasindicatedthatitwillresuscitateaplanitproposedin2008, whereby rating references will be removed from the simplified registration form designed toexpeditetheprocessforaprimaryofferingofpublicsecurities.Companiescanqualifyforthisprocessif

thedebtisgivenaninvestmentgraderating,soanalternativewillneedtobeproposed—forexample,ahistoryof issueofmore than$1billion innonconvertibledebtsecuritiesovera three‐yearperiod.Analternativewillalsoneedtobeprovidedforthequalificationofsecuritiesheldbymoneymarketmutual

funds.

Thedifficulties surrounding the removalof ratings from formal regulationsand the suspensionof theliabilityexemptionforNRSROsisvisibleinthefactthatSECregulationsrequiringcreditratingsforpublicsecuritizationissuesremaintobeeliminatedatafuturedate,whiletheremovalofthelegalliabilityfor

ratingstheyissuewentintoeffectuponpassageoftheAct.Asaresult,theratingagenciesannouncedthat they would no longer allow their ratings to appear in registration documents for newsecuritizations.ImmediatelyafterthepassageoftheAct,theSECwasforcedtoannounceasix‐month

ratings exemption in registration statements for securitizations other than those issued as privateplacementsunderRule144a.

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K.Theroleofhedgefundsandthereforms

Whilehedgefundssufferedsubstantiallossesofbothassetvalueandclientsasaresultofthecrisis,itisgenerallybelievedthattheyplayedlittleroleinthegenesisofthecrisisandthosethatwerenegativelyimpactedhavebeen closed throughnormalprocessesof asset redemption—althoughwith significant

restrictionsonthetimingofpayouts.Thus,theDodd‐Franklegislationdoesnotcreatesubstantialnewregulations forhedge funds. The twobasicprovisions are thepossibility that the FSOCmay classify alargefundassystemicallyimportant,andthussubjecttoadditionalregulationssimilartothoseapplied

tootherregulatedinstitutions;orasamajorswapsparticipantorswapsdealer,andthussubjecttotheswapsregulationdiscussedabove.

The other basic change is the requirement on registration and record keeping. For funds in themanaged‐asset rangeof$25million to$100million, registration is required in the stateof residence,

unless the state does not have an exam requirement; if funds operate in more than 15 states thatrequire registration, thenSEC registration substitutes. For fundswithmanagedassetsexceeding$100million,SECregistrationisrequiredunlesstheassetsareunder$150millionanddealonlywithprivate

funds.Asnotedabove,theVolckerruleprohibitsbanksfromowningmorethanacertainshareofhedgefunds.Thisregulationismeanttoensurethatabankmightuseahedgefundinthesamewayitusesasecuritiesaffiliate.

Asnoted,thereareexemptionsthatdependonthesophisticationandnetwealthoftheinvestorinthe

caseofprivatesalesofassetsbycertainfinancialinstitutions.Thevalueoftheinvestor’shouse,whichhasuntilnowbeenincludedinthecalculationofnetinvestorwealthwillbeexcluded,althoughthismayseemacaseofactingafterthehorsehasbolted.

On theother hand, given the restrictions placedonbanks’ proprietary and speculative activities, it is

likelythathedgefundswillcontinuetogrowinsizeandnumber.Indeed,manybankshaveshutdowntheirproprietarytradingdeskshaveshiftedpersonnelintoclientassetmanagementunitsorseentheir

best traders leave to form stand‐alone hedge funds—often with the backing of the bank they areleaving.

L.Multipleandoverlappingregulatoryauthorities

One of the criticisms that have traditionally beenmade of US financial regulation is the existence ofmultiple regulatory agencies, often with overlapping mandates. This is in part due to the federalstructureof theUnitedStates,which leaves jurisdictionovercertainactivities to the individual states.

Forexample,whiletheConstitutionforbidstheissueofcurrencybythestates,itdoesnotpreventthemfromcharteringbanks,with theresult that there isanoverlapbetweenstateand federal regulations.Whenthefederalgovernmentattemptedtoregainitsmonopolyontheissueofbanknotesinorderto

provideauniform,nationalcurrency,itcreatedtheOfficeoftheComptrolleroftheCurrencytooverseethenationalbanksthat issuedthenotes.Thrift institutionshadtheirownstateandfederalregulatorystructure,andwhentheFederalReservewascreated,it,too,tookonregulatorypowers,overseeingthe

issueof Federal Reservenotes. The introductionof deposit insuranceunder theNewDeal led to the

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creationoftheFDICtooperatethatsystem,aswellasthecreationoftheSEC.TheCFTCwascreatedtooversee agricultural futures. The current reform legislation does not resolve this problem, and only

eliminates one regulatory agency, the Office of Thrift Supervision (OTS). There are few thrifts still inexistence,andtheOTChadareputation for laxoversight,which ledtoagencyshopping; thiswastheregulatoryagencythatwasresponsibleforAIG,andCountrywidemadeacquisitionsdesignedtobringit

undertheauthorityoftheOTC.

On the other hand, the Federal Reserve’s regulatory responsibilitieswere sharply increased, and it isnowchargedwithoverseeingallsystemicallyimportantinstitutionsaswellasthoseclassifiedassuchbytheFSOC.Asaresult,thepotentialconflictbetweentheFed’sroleindesigningandimplementingprice

andoutputstabilizationpolicyandundertakingtheresponsibilityforfinancialstabilityassigneditbytheAct have substantially increased. Minsky continually highlighted the fact that these two regulatoryfunctions would be competing rather than complementary, and that this conflict would increase

financial fragility in the system. This conflict can be seen in the current criticisms of the quantitativeeasing policy implemented by the Fed in order to restore financial stability, but which many see asinflationary.MinskywasmoreconcernedwiththoseperiodsinwhichtheFedwouldusetightmonetary

policytodampenthelevelofactivityandatthesametimecausespeculativefundingunitstobecomePonziunitsastherestrictivepolicycausedcashinflowstoshrink.Anexamplewouldbetheincreaseininterestratesatthebeginningof1994,whichproducedabondmarketcrashandareductioninglobal

wealththatwasmuchlargerthanthestockmarketbreakof1987.

Itwas for this reason thatMinskyargued in favorofagreater role for thecentralbank inpromotingfinancial stability, given itspositionasunconstrained lender to the restof the system; inexchange, itwouldleaveeconomicpolicytothefiscaldecisionsoftheTreasury.Despitethefactthatmanyitscritics

havesuggestedthattheFedhasusurpedthefiscalpolicyroleoftheTreasury,ithasnonethelessseenitspower over economic policy increased as its role inmaintaining financial stability has grown. Indeed,

manyarguethatthenextfinancialcrisismaybegeneratedbythewithdrawalofquantitativeeasingtocounter inflation,with the rise in interest rates causingcollapsingbondpricesand losses for financialinstitutionsandhouseholdsontheirholdingsofwhattheyconsideredtobesafeassets.

RatherthanusingvariationsintheFedfundsrateandopenmarketpurchasesandsalestoattemptto

influence the decision of financial institutions to fund the spending decisions of the private sector,Minsky favored more direct influence over bank lending by ensuring that financial institutions werealways short reserves; that is, that the normal state of affairs would be for financial institutions to

borrowfromtheFedatthediscountwindow.Byprovidingmostreservesthroughlending(ratherthanthroughopenmarketpurchases),theFedcouldinfluencelendingbychoosingassetsitwouldacceptfordiscounting.Inthismanner,itwouldrefusetodiscountassetsthatresultedfromwhatitperceivedtobe

imprudentlending(e.g.,subprimemortgagesinarealestatebubble).ItwouldalsoprovidetheFedwithmore immediate information on the lending activities, and the associated innovations, of financialinstitutions. As a lender to financial institutions, the Fed would have access to their portfolios—and

could issue warnings and “cease and desist” orders as necessary. This is a system that has beenpracticedwith success inGermany,where financial institutionswere normally “in the bank”—that is,usingBundesbankcreditonanormalbasis.

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M.CanDodd‐Frankprevent“It”fromhappeningagain?

While Dodd‐Frank containsmany generic proposals for improvements to supervision, regulation, and

resolutionof financial institutions, its full implementationwill requireover200rule‐makingprovisionsbyregulatoryagencies,over60specialreportsand,andanadditional22reports.ItthusplacesnotonlymajorresponsibilityforsuccessoftheActinthosebodiesresponsibleforwritingthespecificrulesbut

also an even greater burden on the supervision of those rules. There are some, such as a formerchairmanoftheBoardofGovernors,whobelievethatthisisamissionimpossiblethatwillcausetheActtofail.

Thus, the final formwill be largely determined by the interaction between the political incentive for

reformandtheabilityofthevariousgovernmentagenciestofulfilltheintentionsofthelegislationandthesupervisorybodiestomonitorcompliance.However,asnoted,themostimportantfailingisthatitleavesinplacetheunderlyingbusinessmodelforfinancialinstitutionsandthecontradictionsinherentin

the 1999 legislation that were at the core of the crisis. Indeed, the underlying logic of the Fed andTreasury rescue operations has been to restore this system. If the problemwas the structure of thefinancialsystem,thenDodd‐Frankwillnotpreventanothercrisis. It is likelythatthenextcrisiswillbe

handled in a better manner. However, since the reforms do not envision a policy to reduceconcentrationandsize,resolutionwillinvolveinstitutionsatleastasbigasthosethatfacedproblemsin2007.ThenextchapterwillexamineMinsky’sviewonfundamentalreform—reformthatwouldinclude

restructuringofthefinancialsector.

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CHAPTER2.MinskyonWhatBanksShouldDo6

Introduction

Chapter1indicatedthatnoneoftheregulatorychangesthathavebeenintroducedcorrespondtowhatHymanMinskywould have recommended. It has also beennoted thatmanyof themeasures are anattempttoreintroducespecificaspectsofGlass‐SteagalllegislationtotheGramm‐Leach‐Blileyworldof

multifunction financial holding companies. In addition,mostof thesemeasureshaveexemptions thatare based on the provision of client services, reminiscent of the interpretations of the “business ofbanking” clause in section16of the1933Act thateventually gutted itof its rigor.While thisprocess

tookover30yearsinthecaseofGlass‐Steagall, it isnotencouragingthatit isalreadywrittenintotheDodd‐FrankAct.

But there is another basic difference between the current regulations and Glass‐Steagall. The 1933legislationhadaveryclearideaofthecausesofthesystem’scollapseandthedesiredstructureofthe

reformed financial system (see Kregel 2009). Regulations were drafted and introduced to produce afinancial structure thatwouldbe stable. Basically, theproblemwas located in the securities affiliatesthat used “other peoples’money” to speculate in capitalmarkets (often in the shares of the parent

firm).Theregulationsproducedasystem inwhichcommercialbankscouldnotoperatesuchaffiliatesanddepositscouldnotbeusedtofinancespeculationonpricechangesincapitalmarkets.

ThereisnosuchclarityinDodd‐Frank.Themainproblemtobesolvedappearstobetheuseofpublicfundstorescuefailed institutions.Thefinancialstructurethatultimatelywillemergewillbethesame

the current one: large, multifunction institutions generating incomes from originate‐and‐distributeoperations.Theonlychangeisthatthezeroriskoflossincentivestructurewillbereplacedbythethreatofbankruptcy,whichevenexpertsconsidertobeunrealistic.Thisthenleavesopenthequestionofwhat

the ideal financial structure should look like. And this means answering the question of what thefinancialsystemshoulddo.

A.Designingthefinancialsystemforstability

Minskyconsideredthefollowingtobetheessentialfunctionsofthefinancialsystem:

• asafeandsoundpaymentssystem;

• short‐termloanstohouseholdsandfirmsand,possibly,tostateandlocalgovernment;

• asafeandsoundhousingfinancesystem;

• a range of financial services, including insurance, brokerage, and retirement savingsservices;

• long‐termfundingofpositionsinexpensivecapitalassets.

6Formoredetail,seeWray2010.

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There isnoeconomicreasonwhytheseservicesshouldbeprovidedbyasinglefinancial institutionorconglomerate. Indeed, the New Deal reforms of the 1930s aimed at preventing this, while the 1999

Modernization of Financial Services Act promoted it. However,Minsky recognized that Glass‐Steagallhadalreadybecomeanachronisticbytheearly1990s.Heinsistedthatanynewreformsmusttakeintoaccounttheacceleratedinnovationsinbothfinancialintermediationandthepaymentsmechanism.He

believedthesechangeswerelargelymarketdriven,andnotduetoderegulation.Tosomedegree,the1999Actcodifiedwhathadalreadytakenplace.

Inanuncompleteddraftbookmanuscript(writtenbetween1991and1993),MinskydealtindetailwithaUSTreasuryproposalfor“modernizing”thefinancialsystem.Thisdocumentmaderecommendations

for “safer, more competitive banks,” by “strengthening” deposit insurance, weakening Glass‐Steagalland state limits on branching, allowing corporations to own banks, and consolidating regulatorysupervision in the Treasury at the expense of reducing the role of the Fed. Minsky argued that the

Treasuryproposalwasatbestsuperficialbecauseitignoredshadowbanks.Whilehewascriticaloftheapproach taken to rescue the FDIC (recall thatmost thrifts had failed andmany of the largest bankswere in difficulty as a result of the collapse in real estate investments at the end of the 1980s), he

agreed that deposit insurance had to be strengthened. He argued thatweakening Glass‐Steagall andremoving limitationsonbankbranching representedanattempt to “fix something that isnotbroke,”becausesmall‐tomedium‐sizedbanksaremoreprofitableduetotheirpracticeofrelationshipbanking.

Hesawnoreasontoalloworpromotetheriseofhegemonicfinancialinstitutionsoperatinginnationalor internationalmarkets andproviding abroad scopeof financial services.Asmanyothers have longargued, the economies of scale associated with banking are achieved at the size of relatively small

banks.

MinskywasnotswayedbytheTreasury’sargumentthatbankswerebecominguncompetitivebecausethey could not branch across state lines or because certain practices were prohibited to them. He

believed that repealing these constraints would simply reduce the profitability of the smaller,relationship‐orientedbanks.Herecognizedthatthesmallerbankswouldlosemarketshareanyway,duetocompetition fromshadowbanks.Hence, thesolutionwouldnotbe found inpromotingbigger, less

profitablebanksthatwerenotinterestedinrelation‐orientedbanking.Rather,Minskyarguedinfavorofallowinggreaterscopetotheactivitiesofthesmallcommunitybanks—adefenseagainstencroachmentbyshadowbanks.

Wemightcallthis“intensifying”bankingbyallowingeachsmallinstitutiontoprovideagreaterrangeof

services,asopposedtopromotingbranchingandtheconcentrationofpowerinthehandsofafewlargebankholdingcompanieswithavarietyofsubsidiaries.

InaproposalfordevelopmentofthenewlyindependentEasternEuropeannations,Minskystatedthatthe critical problem was to “create a monetary and financial system which will facilitate economic

development, the emergence of democracy and the integration with the capitalist world” (Minsky1992c, 28). Except for the latter goal, this statement applies equallywell to promotionof the capitaldevelopmentoftheWesternnations(seealso,Minsky1993).

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B.Promotingthecapitaldevelopmentoftheeconomy

In Minsky’s view, capital development of the economy can be “ill done” in two main ways: the

“Smithian”wayandthe“Keynesianway.”Thefirstrefersto“misallocation”:thewronginvestmentsarefinancedbythefinancialsystem.Thesecondreferstoaninsufficiencyof investment,whichleadstoalevelofaggregatedemandthatistoolowtopromotehighemployment.The1980ssufferedfromboth,

butmostly from an inappropriate financing of investment, especially in the boom in commercial realestate investmentthat left largeamountsofuninhabitedorpartially finishedhousingandcommercialrealestateprojects.(Healsoarguedthattheleveragedbuyoutboomofthe1980swasanotherexample

of“illdone”financebecauseitloaded“cashcows”withunserviceabledebt.)Minskywouldsurelyhaveconsidered the property boomof the 2000s “ill‐done,” “Smithian” capital development, since far toomuchfinanceflowedintothecommercialandresidentialrealestatesector.

In the 1980s, the deregulated thrifts, which did not hold mortgages and had employed reduced

underwritingstandards,hadfundingcapacitythatflowedintocommercialrealestate;inthe2000s,themania for risky (high‐return)asset‐backed securities fueled subprime lending. Inadiscerninganalysis,Minsky argued that theway themortgageswere packagedmade it possible to sell off a package of

mortgagesatapremiumandenabletheoriginatorandtheinvestmentbankingfirmstowalkawayfromthe deal with a net income and no recourse from the holders. The instrument originators and thesecurityunderwritersdidnothazardanyoftheirwealthonthe longer‐termviabilityoftheunderlying

projects.Obviously, insuchpackaged financingtheselectionandsupervisory functionsof lendersandunderwritersarenotaswelldoneastheymightbeifthefortunesoftheoriginatorswereathazardoverthelongerterm(Minsky1992b,22–23).

The implication is ratherobvious:goodunderwriting ispromotedwhentheunderwriter isexposedto

thelonger‐termrisks.ThisbringsustoMinsky’sskepticalbanker:“Whenwegotothetheaterweenterintoaconspiracywith theplayers to suspenddisbelief.The financialdevelopmentsof the1980s [and

1990s and 2000s!] can be viewed as theater: promoters and portfoliomanagers suspended disbeliefwith respect to where the cashwould come from that would [validate] the projects being financed.Bankers,thedesignatedskepticinthefinancialstructure,placedtheircriticalfacultiesonhold”(Minsky

1992a,37).Asaresult,thecapitaldevelopmentwasnotdonewell.Decentralizationoffinancemaywellbethewaytoreintroducethenecessaryskepticism.

Decentralizationplusmaintainingexposure to riskcould reorient institutionsback towardrelationshipbanking.Unfortunately,mosttrendsinrecentyearshavefavoredconcentration.Theissuessurrounding

theresponsetoinstitutionsthatare“toobigtofail”datesbacktotheproblemscreatedinthe1970sbytherapidexpansionofbankssuchasContinentalIllinois,andgivesanobviousadvantagetothebiggestbanks. These banks benefit from financing costs below those of smaller institutions because of the

implicit guarantee that they will be rescued by government intervention. Small local banks will besubject to higher costs as they attempt to offset this disadvantage by attractingmore local deposits,opening more offices than necessary. They will also face higher costs for “wholesale” deposits in

nationalmarkets.EveninthecaseofFDIC‐insureddeposits(whichcarrynodefaultrisk),smallerbanks

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paymore simplybecauseof themarket’sperception that theyare riskier, since theywill be resolvedratherthanrescuediftheyfacedifficulty.

AsaresultoftheFed’sresponsetothecrisisin2008,whatwereformerlynondeposit‐takinginvestment

banksarenowallowedtoattractFDIC‐insureddepositstofinancetheirspeculativeinvestments,andtorelyonFedandTreasuryprotection should their risky tradesgobad.A smallbank ishardpressed tocompete with these large institutions, which have not only FDIC‐insured liabilities but also the

protection of uninsured deposits afforded institutions that are “too big to fail.” The interest rate“subsidy” they receive is sufficient to make even big, inefficient institutions more profitable thansmaller,moreefficientones.

C.Howtorestorerelationshipbanking

How can the system be reformed to favor relationship banking that seems to bemore conducive topromoting the capital development of the economy? First, it would be useful to reduce government

protectionsforlessdesirablebankingactivities.Thegovernmentcurrentlyprovidestwoimportantkindsofprotection:liquidityandsolvency.LiquidityismostlyprovidedbytheFed,whichlendsreservesatthediscountwindowandbuysassets(inthepast,mostlygovernmentdebt,butinrecentyearstheFedhas

boughtprivatedebtaswell).Refusingtoprovideliquidityisnottherightwaytodisciplinethefinancialsystem.Minsky always advocated extending discount window operations to include a wide range offinancialinstitutions.IftheFedhadlentreserveswithoutlimittoallfinancialinstitutionswhenthecrisis

first hit, the liquidity crisis probably could have been resolved more quickly. Hence, this kind ofgovernmentprotectionshouldnotberestrained.

Thesecondkindofprotection,againstdefault, ismoreproblematic.Deposit insuranceguarantees fullpaymentoncertainclassesofdeposits—nowupto$250,000.Thisguaranteeisessentialforclearingat

par and for maintaining a safe and secure payments system. There is no good reason to limit FDICinsuranceto$250,000,sothecapshouldbelifted.Thequestionis,whichtypesofinstitutionsshouldbe

allowed tooffer suchdeposits?Or rather,which typesof assetswouldbeeligible for financingusinginsured deposits? Some considerations would include riskiness of assets, maturity of assets, andwhether purchase of the assets fulfills the public purpose: the capital development of the economy.

RiskyassetsputtheFDIConthehook,sinceitmustpayoutdollarfordollar;butiftheFDICresolvesafailing institution, it receives only cents on each dollar of assets. In his discussion of the Treasury’sproposal for rescuing the FDIC,Minskymade clear that “cost to theTreasury” shouldnotbeamajor

concern(anotherreasonforremovingthecap: it isnot importantto limit theTreasury’s lossestothefirst$250,000ofadeposit).

Forthesamereason,whileriskinessofassetsfinancedbyissuinginsureddepositsshouldbeaconcern,potential losses for theFDICarenot theproblem.AsMinskyargued, theseguaranteesare in fact the

responsibilityoftheFederalReserve,whichwillalwaysbeabletomeetthem.Further,thematurityofassets isno longeraconcern if theFedstandsreadyto lendreservesasneeded;abankcouldalwaysmeetdepositwithdrawalsbyborrowingreservesatthediscountwindow,so itwouldnotneedtosell

longer‐termassets.Hence,themajorargumentforlimitingtheabilityoffinancialinstitutionstofinance

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assetpositionsbyissuinginsureddepositsisthatgovernmenthasalegitimateinterestinpromotingthepublicpurpose.Banksshouldbepreventedfrom issuing insureddeposits inamannerthatcausesthe

capitaldevelopmentofthecountrytobe“illdone.”

Banksthatreceivegovernmentprotectionintheformofliquidityand(partial)solvencyguaranteesareessentiallypublic‐privatepartnerships.Theypromotethepublicpurposebyspecializinginactivitiesthattheycanperformmorecompetentlythanthegovernmentcan.Oneoftheseisunderwriting:assessing

creditworthinessandbuildingrelationswithborrowersthatenhancetheirwillingnesstorepay.Overthepast decade, a belief that underwriting is unnecessary flowered and then collapsed. Financialinstitutionsdiscovered that credit rating scores couldnot substitute forunderwriting, inpartbecause

thosescorescanbemanipulated,butalsobecausetheeliminationofrelationshipbankingchangesthebehaviorofborrowersand lenders.Thismeans thatpastdefault ratesbecome irrelevant toassessingrisk(ascreditratingagenciesseemtohavediscovered).Ifbankswerenotunderwriting,whywouldthe

governmentneedthemaspartners?Thegovernmentcouldjustfinancedirectlythoseactivitiesthat itperceives to be in the public interest: home mortgages, student loans, state and local governmentinfrastructure,andevensmall‐businessactivities(commercialrealestateandworkingcapitalexpenses).

Whereunderwritingisnotseentofulfillapublicpurpose,thenthegovernmentcansimplycutoutthemiddleman.

Indeed,therehasbeenmovementinthatdirectionwiththedecisiontobringstudentloansbackundergovernmentcontrol.Whenthegovernmentguaranteesdepositsaswellas loans (e.g.,mortgagesand

studentloans),thebanks’rolebecomesmerelytoprovideunderwriting.

D.Restoringprofitabilitytorelationship‐basedbanking

Theproblembanks have facedover the past threeor four decades is the “cream skimming” of their

business by uninsured financial institutions, or “shadow banks” (which Minsky argued had beenproduced by the rise of what he calledmanagedmoney). Uninsured checkable deposits inmanaged

funds (such as money market mutual funds) offered a higher‐earning and relatively convenientalternative to insured deposits, allowingmuch of the payments system to bypass banks. InMinsky’sview,creditcardsalsodivertedthepaymentssystemawayfrombanking(althoughthelargerbanksnow

dominatethecreditcardbusiness).

Atthesametime,banksweresqueezedontheothersideoftheirbalancesheetbythedevelopmentofthecommercialpapermarket,whichallowedfirmstoborrowshorttermatinterestratesbelowthoseon bank loans (sometimes, firms could even borrow more cheaply than some banks). Larger banks

recaptured some of that business in fees earned by providing credit line guarantees for issuers ofcommercialpaper.

Butthesecompetitivepressurescausedbankstoabandonexpensiverelationshipbankinginfavoroftheoriginate‐to‐distribute model. There is no simple solution to these competitive pressures, although

Minsky offered some ideas.Minsky argued that policy shouldmove tomake the payments system aprofitcenterforbanks.“OneweaknessofthebankingsystemcentersaroundtheAmericanschemeof

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payingforthepaymentssystembythedifferentialbetweenthereturnonassetsandtheinterestpaidondeposits.Ingeneraltheadministrationofthecheckingsystemcostssome3.5percentoftheamount

ofdepositssubjecttocheck.Ifthecheckingsystemwereanindependentprofitcenterforbanks,thenthebankswouldbeinabetterpositiontocompetewiththemoneyfunds”(Minsky1992a,36).

Itmaynotbedesirabletoreturntotheconditionsoftheearlypostwarperiod,whenbanksandthriftsmonopolized thepayments system;however, in the1800s the federalgovernmenteliminatedprivate

banknotesbyplacingataxonthem.Inasimilarmanner,transactiontaxescouldbeplacedonpaymentsmade throughmanaged funds,or these fundscouldbemadesubject to formal regulationby theFedandlegalreserverequirementsandpreferentialtreatmentgiventopaymentsmadethroughbanks,to

restorea competitiveedge. In addition,banks couldbeoffered lower, subsidized, fees foruseof theFed’s clearing system. Minsky (1992d) also held out some hope that by substituting debit cards forchecks, banks could substantially lower their costs and increase their profits from operating the

paymentssystem—somethingthatdoesseemtobehappening.

Partoftheproblemtoday isthattheFedrequiresthataportionofabank’sfundingcomefromretaildeposits. As mentioned above, Minsky believed this causes local banks to incur excessive costs byopeningmoreofficesthannecessaryinordertocompeteforretaildeposits.Partofthereasonforthe

NewDeal’sRegulationQwaspreciselytoeliminatecompetitionforsuchdeposits,onthebeliefthatitraisedthecostsofsuchfundsandallowedlargereservecitybankstoattractdepositsfromsmallerruralbanksandinvesttheminstockmarketspeculation.

Thebiggest“brandname”banksmoreeasilyattractretaildeposits,andtheyalsohavetheadvantage

thattheyareperceivedtobesafer.Thisadvantagecouldbeeliminatedifbankscouldfundthemselvesby borrowing reserves on demand at the Fed and their cost of funds would be the Fed’s overnight

interestrate—plusany“frowncosts.”7Some,includingMinsky’sone‐timeLevycolleagueRonniePhillips(1995a,1995b),havecalledforareturntothe100percentmoneyproposalofIrvingFisherandMiltonFriedman,wherebydeposit‐issuingbankswouldbeallowedtoholdonlyFedreservesandTreasurydebt

asassets.Minskyarguedthatthisproposallosessightof“themainobject:thecapitaldevelopmentoftheeconomy.Thekeyroleofbankingislendingor,better,financing”(Minsky1992a,36–37).Tobesure,Minsky did not categorically reject the narrow bank proposal. He simply believed such a proposal

addressesonlyaperipheralproblem:thesafetyandsoundnessofthepaymentsandsavingssystems.Itdoes not directly address promotion of the capital development of the economy. However, to thedegree that the payments system can be made a profit center, this helps to promote relationship

banking.Thiswillprobablyrequiresomeseparationof“shadowbanks”frombanksthatareallowedtorunthepaymentssystem.

7Forthisreason,WarrenMosler(2010)hascalledfortheeliminationofanyrequirementthatbanksmaintainaspecifiedproportionoftheirfundingintheformofretaildeposits.

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E.Alternativefundingsourceforrelationshipbanking

Thealternativeapproach is toprovidebankswitha secureandcheap sourceof funding.Rather than

using deposits, they might simply borrow at the Fed to finance their positions in assets. Recall theSmithianproblemandtheKeynesianproblem:banksmightfinancethewrongprojects,andtheymightnot finance the right amount. Opening the discount window to provide an elastic supply of reserve

fundingensures thatbanks can financepositions in asmanyassets as theydesire at the Fed’s targetrate.(Asdiscussedabove,theFedwould lendreservesondemandandremovefinancingbymeansofretaildeposits.)ThisdoesnotguaranteethatwehavesolvedtheKeynesianproblem,sincebanksmight

finance toomuch or too little activity to achieve full employment. Offering banks unlimited fundingaddressesonlytheliabilitysideofbanking;itleavestheassetsideopen.Itissomewhateasiertoresolvethe “too much” part of the Keynesian problem: the Fed or other regulators can simply impose

constraints on bank purchases of assets when banks are financing too much activity. For example,duringtherecentrealestateboomitwasobvious(except,apparently,tomainstreameconomistsandtomanyattheFed)thatlendingshouldbecurtailed.

Theproblemisthattheorthodoxresponsetotoomuchlendingistoraisethefederalfundstargetrate.

And because borrowing is not very interest sensitive, especially in a euphoric boom, ratesmust risesharplytohavemucheffect.Further,raisingratesconflictswiththeFed’sgoalofmaintainingfinancialstability,since—astheVolckerexperimentshowed—interestratehikesthataresufficientlylargetokilla

boomare also large enough to cause severe financial disruption (something like three‐quarters of allthriftsweredriven to technical insolvencyduring theS&Lcrisis). In fact,Minskyarguedthat theearly1990sbankingcrisiswasdue to theaftermathof theVolckerexperimentofadecadeearlier. Indeed,

thisrecognitionispartofthereasonthattheGreenspan/BernankeFedturnedto“gradualism,”aseriesofverysmallratehikesthatarewelltelegraphed.Unfortunately,marketshaveplentyoftimetoprepare

andtocompensateforratehikes,whichmeansthatlendingisevenlessinterestsensitive.

For these reasons, rate hikes are not an appropriatemeans of controlling bank lending. Instead, thecontrolsshouldbedirect:raisingdownpaymentsandcollateralrequirements,andevenissuingcease‐and‐desist orders to prevent further financing of some activities. For a while, imposing capital

requirementswasseenasaproperwaytoregulatebanklending:highercapitalrequirementsnotonlymake banks safer but also constrain bank lending, unless the banks can raise capital. Unfortunately,neitherclaimwascorrect.HighercapitalrequirementswereimposedintheaftermathoftheS&Lfiasco,

andcodifiedintheBaselagreements.Ratherthanconstrainingbankpurchasesofassets,bankssimplymovedassetsandliabilitiesofftheirbalancesheets.

Basel also imposed risk‐adjustedweightings for capital requirements to encouragebanks to hold lessrisky assets, for which they were rewarded with lower capital requirements. Unfortunately, the

regulationshadunintendedconsequences since thebanks supportedprofitsby lending in the riskiestpositions ineachclassandworkedwith investmentbankstocreatecreditguaranteesthatreducedoreliminatedcapitalrequirements.

Finally,Minsky(1986)arguedthat,allelsebeingequal,highcapitalratiosnecessarilyreducethereturn

onequity (andhence, thegrowthofnetworth), so it isnotnecessarily true thathighercapital ratios

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improvebanksafety,sincetheymeanlowerprofitability.Indeed,withhighercapitalratiosbanksmustselectahigher risk/returnassetportfolio toachievea targeted returnonequity (TymoigneandWray

2009).Again, if regulatorswant toconstrain thegrowth rateof lending,directcredit controlsmaybemoreefficient.

SolvingtheSmithianproblemmaythusrequiredirectoversightofabank’sactivity,mostlyontheassetsideofitsbalancesheet.Financialactivitiesthatfurtherthecapitaldevelopmentoftheeconomyneed

tobeencouraged;thosethatcauseittobe“illdone”needtobediscouraged.OneofthereasonsthatMinskywantedtheFedtolendreservestoallcomerswassothatprivateinstitutionswouldbe“inthebank”—thatis,indebtedtotheFed.Asacreditor,theFedwouldbeabletoaskthebankerthequestion,

Howwillyourepayme?

The Federal Reserve’s powers to examine are inherent in its ability to lend to banksthroughthediscountwindow.Asalendertobanks,eitherasthenormalproviderofthereservebasetocommercialbanks(thenormaloperationpriortothegreatdepression)

orasthepotentiallenderoflastresort,centralbankshavearighttoknowledgeaboutthe balance sheet, income and competence of their clients, banks and bankmanagements.Thisisnomorethananybankbelievesithastherighttoknowaboutits

clients.(Minsky1992d,10)

TheFedwouldasktoseeevidenceforthecashflowthatwouldenablethebanktoserviceloans. It iscommonpracticeforacentralbanktolendagainstcollateral,usinga“haircut”tofavorcertainkindsofassets(e.g.,abankmightbeabletoborrow100centsonthedollaragainstgovernmentdebtbutonly

75 cents against a dollar of mortgage debt). Collateral requirements and haircuts can be used todisciplinebanks—toinfluencethekindsofassetstheypurchase.

Examination of a bank’s books also allows the Fed to look for risky practices and keep abreast of

developments.TheFedfailedtoappreciatetheriskofthecrisisthatbeganin2007, inpartbecauseitgenerally supplied reserves in open market operations rather than at the discount window. Forcingprivatebanks“intothebank”gavetheFedmoreleverageovertheiractivities.Forthisreason,Minsky

opposed the Treasury’s proposal to strip the Fed of some of its responsibility for the regulation andoversight of institutions. If anything, he would have increased the Fed’s role, and used the discountwindowasanimportanttoolforoversight.

F.Promotinganalternativetomegabanks:Communitydevelopmentbanks

Minskyworriedthatthetrendtowardmegabanks“maywellallowtheweakestpartofthesystem,thegiantbanks,toexpand,notbecausetheyareefficientbutbecausetheycanusethecloutoftheirlarge

assetbaseandcashflowstomakelifeuncomfortableforlocalbanks:predatorypricingandcorners[ofthemarket]cannotberuledoutintheAmericancontext”(Minsky1992d,12).Further,sincethesizeofloansdependsonthecapitalbase,bigbankshaveanaturalaffinityforthe“bigdeals,”whilesmallbanks

servicesmallerclients:“A1billiondollarbankmaywellhave80milliondollars incapital. It thereforewould have an 8 to 12million dollarmaximum line of credit. . . . [In theUS] context thismeans the

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normal client for such banks is a community or smaller business: such banks are small businessdevelopmentcorporations”(ibid.).

For this reason, Minsky advocated a proactive government policy to create and support small

communitydevelopmentbanks (CDBs) (Minskyetal.1993).Verybriefly, theargumentadvancedwasthatthecapitaldevelopmentofthenationandofcommunitiesisfosteredviatheprovisionofabroadrange of financial services. Unfortunately, many communities, lower‐income consumers, and smaller

and start‐up firms are inadequately provisionedwith these services. For example,many communitieshost farmorecheck‐cashingoutletsandpawnshops thanbankoffices.Manyhouseholdsdonotevenhaveaccesstothetransactionsystembecausetheydonothaveacheckingaccount.

Small businesses often finance activities using credit card debt. Indeed, some credit card companies

offerspecialcreditcardservicesinsupportofthefinancingofsmallbusinessesthatdonothaveaccesstobanklending.Minsky’sproposalwouldcreateanetworkofsmallcommunitydevelopmentbankstoprovide a full range of services—a sort of universal bank for underserved communities and small

businesses:

• apaymentsystemforcheckcashingandclearing,andforcreditanddebitcards;

• securedepositoriesforsavingsandtransactionbalances;

• householdfinancingforhousing,consumerdebts,andstudentloans;

• commercialbankingservicesforloans,payrollservices,andadvice;

• investmentbanking services fordetermining theappropriate liability structure for theassetsofafirm,andplacingthoseliabilities;and(6)assetmanagementandadvicefor

households.(Minskyetal.1993,10–11)

The institutionswouldbekept small, local,andprofitable.Theywouldbepublic‐privatepartnerships,withanewFederalBankforCommunityDevelopmentBankscreatedtoprovideequityandtocharter

and supervise the CDBs. Each CDB would be organized as a bank holding company. Examples of itscompositionwouldbe:anarrowbanktoprovidepaymentsservices,acommercialbanktoprovideloanstofirmsandmortgagestohouseholds,aninvestmentbanktointermediateequityissuesandlong‐term

debtoffirms,andatrustbanktoactasatrusteeandtoprovidefinancialadvice.Suchinstitutionshavelong been present in Europe, serving special groups such as farmers (Raiffaisen banks), smallbusinessmen(cooperativebanks),andlocalresidents(friendlysocieties).Almostalloftheseinstitutions

weremutualbanks;thatis,thedepositorsandclientsofthebanksweretheownersandbeneficiaries.

Conclusion:Promoteenterpriseandindustryoverspeculation

Overpastdecades,thebeliefthat“marketsworktopromotethepublicinterest”gainedinpopularity.

Minsky was skeptical. He believed that it was necessary to make “industry” more important than

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“speculation.”8Ifinvestmentismisdirected,wenotonlywasteresourcesbutalsogetaboom‐and‐busttrajectory.Ifinvestmentistoolow,wenotonlysufferfromunemploymentbutalsoachieveprofitstoo

lowtosupportcommitments,leadingtodefault.Further,whenprofitsarelowin“industry,”problemsarise in the financial sector, since commitments cannotbemet. In that case, individualprofit‐seekingbehaviorleadstoincoherentresults,asfinancialmarkets,labormarkets,andgoodsmarketsallreactin

amannerthatcauseswagesandpricestofall,generatingadebtdeflation.Unfortunately,thingsarenotbetterwheninvestmentistoohigh:itgeneratesincreasedlayeringoffinancialcommitmentsandhighprofits that reward unnecessary innovation, leading to greater risk taking and eventually producing a

financial structure that is too fragile. As Minsky always argued, the really dangerous instability in acapitalist economy is in the upward direction—toward a boom. That is whatmakes a debt deflationpossible,asassetpricesbecomeovervaluedandtoomuchunserviceabledebtisissued.

8EchoingKeynes(1936),“Thepositionbecomesseriouswhenenterprisebecomesthebubbleonawhirlpoolof

speculation”(chap.12,159).

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CHAPTER3.AMinskyIndexMeasuringFinancialFragility9

Introduction

If the Financial Stability Oversight Council (FSOC) is to become capable of “identifying threats to thefinancial stability of the United States” as mandated in Dodd‐Frank, it will require a comprehensiveframeworktounderstandandmeasurefinancialfragility.Suchanindexcanbedevelopedonthebasis

ofHymanMinsky’sanalytical framework.Themainpurposeofsuchan index istoprovidesupervisorswith an understanding of how the financial practices that economic units use to acquire assets arechanging,andhowthesepracticesgenerateMinskyanfinancialinstability.Theobjectiveisnottodetect

financial crises or economic recessions, but rather to provide supervisory bodieswith the knowledgerequiredtoallowthemtointerveneproactivelytopreventacrisisfromoccurring,oratleasttolimititsimpactonthenonfinancialbusinesssector.Theideaistostopdangerousfundingpracticesbeforethey

candegenerateintofinancialinstability.

Concentration on changes in the impact of funding practices on financial fragility would provide analternativemeasureofriskcomparedtolowdefaultratesonlendingand/orrisingprofitabilitythatmaynot necessarily reflect financial strength (this was exemplified by the recent housing boom, which

recorded very low default rates and high profitability until the end of 2006). The idea behind theconstructionoftheindexisthatinterventionshouldoccurwellbeforeanunsustainableincreaseinassetpricesbecomesself‐generating.

Whilethereisalargebodyofliteraturethatfocusesondevelopingearlywarningsystemsforfinancial

crises (Tymoigne 2010; Galati and Moessner 2010), most financial crises involve events that areunforeseen. A more appropriate approach is to follow Minsky's insight and focus on the growth offinancial fragility during periods of economic stability. In his view, significant economic and financial

crisesaretheresultofa longprocessduringwhichtheeconomicandfinancialsystembecomesmorefragile.Theideaistoplacefocusonposition‐makingrisk,andthereforeontheriskofdebtdeflation—

somethingthatsupervisorshavehadatendencytoignore.

Itshouldalsobeclearthatidentifyingfinancialfragilityisnotequivalenttoidentifyingtheexistenceofasset‐price bubbles. Indeed, the three degrees of financial fragility defined by Minsky—hedge,speculative, and Ponzi—are independent of the efficiency of markets in pricing assets to reflect

underlyingfundamentals.Asthefootnotebelowshows,thecash‐flowdefinitionofPonzifinance10hasa

9Forafullerpresentation,seeTymoigne2011a.10Ponzifinancemeansthataneconomicunitisnotexpectedtogenerateenoughnetcashflowfromitsroutineeconomicoperations(NCFO),nortohaveenoughcashreservestomeetthecapitalandincomeservicingdueon

outstandingfinancialcontracts(CC).Attime0,itisexpectedthatthefollowingappliesuntiladaten:

E0(NCFOt)<E0(CCt)∀t<n

NotethatthisimpliesthatPonzifinanceinvolveswhatMinskycalled(defensive)position‐makingoperations,i.e.

refinancingandassetliquidation.Moreprecisely,Ponzifinancereliesonanexpectedgrowthofrefinancingloans

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corollary balance‐sheet definition. This highlights the fact that Ponzi finance does not require theexistenceofabubble(i.e.,thattheassetprice[PA]beaboveits“fundamental”value,howeverdefined);

it just requires rising prices of collateral assets or other assets held by the entity involved in a Ponziprocess. The aim is to detect debt‐deflation risks that result from the interaction between debt andassetvalueson theupside.Theeconomymay thusbehighly fragileeven if there isnobubble,anda

bubble may exist but financial fragility may be limited because of the limited recourse to externalfunding.Inthatcase,adebtdeflationprocessmaynotbeinoperation,sinceextensivedebtfinancingisnotinvolved.

FinancialFragilityIndex:ConstructionandInterpretation

A.Construction

Inorder tobuild the financial fragility index,Ponzi finance is takenasapointof reference.The indextries to capture as many elements of the cash‐flow definition and the balance‐sheet definition as

possible. FollowingMinsky, the framework builds an index on the basis of macroeconomic variablesrelatedtothefundingmethods.TwomajordatasetsaretheFlowofFundsoftheFederalReserveBoardandtheNationalIncomeandProductAccounts(NIPA)oftheBureauofEconomicAnalysis,butthereare

additional datasets used. All of the datasets are available on a quarterly basis, and each of them issmoothed by calculating a four‐quarter moving average. A quarterly annual growth rate is thencalculatedon thebasisof themovingaveragedata.Thenext step is toassignweights toeachof the

variablesidentified.

GiventhatPonzifinanceisthepointofreference,greaterweightisgiventovariablesthatmostdirectlyreflect refinancing and liquidation pressures. Minsky’s framework provides clues to the ordinalimportanceof the relevant variables but doesnot provide an indicationof their cardinal importance.

Thus,theactualvaluegiventotheweightsmustbedeterminedbyexperienceandintuition.Aswillbediscussedbelow,thetrendmovementsinnetworthordebt,whilerelevant,arenotinthemselvesasign

ofdistressandarethereforeassignedasmallerweight.

Ontheotherhand,variablessuchasthedebt‐serviceratio,refinancingvolume,andproportionofliquidassetsrelativetodebtareassigneda largerweight.However,the importancegiventothesevariableswill depend on how well the available data reflect refinancing and liquidation pressures. Thus, the

(LR),and/oranexpectedfullliquidationofassetpositionsatgrowingassetprices(PA)inordertomeetdebt

commitmentsonagivenlevelofoutstandingdebt(L).

E(CFPM)=∆LR+∆PAQA>0and∆(E(CFPM)/L)>0

NotethatPonzifinanceisdefinedindependentofthefundamentalvalueofassetprices,howeveronechoosestodefinethisfundamentalvalue.Atthemicroeconomiclevel,aneconomicunitthatusesPonzifinancetofundits

assetpositionsishighlyfragilefinancially.Atthemacroeconomiclevel,ifamajorityofeconomicunitsisinvolvedinPonzifinancetheeconomicsystemishighlypronetodebtdeflationbecauseposition‐makingrisk(i.e.,

unavailablerefinancingsourcesanddeclineinmarketliquidity)ishigh.

44

weight assigned to a specific variable will vary with respect to its relation to the definition of Ponzifinanceandinrelationtoitsreliability.11

Consider the impact of the trend evolution of net worth (or the debt‐to‐asset ratio) and its weight

attributedintheindex.Minskysuggestedadistinction:

With speculative finance, net worth and liquidity can increase even as debt isrefinanced, whereas for a Ponzi unit net worth and liquidity necessarily decrease.(Minsky1986,340)

While Ponzi finance does ultimately lead to a decline in net worth, thismay not be reflected in therecordeddatauntildefensiveposition‐makingoperationsactuallyoccur.Moreover,ifassetsarevalued

onamarketbasis,and if theirpricegrowsfastenoughtocompensate forhigherdebtor fewer liquidassets, the decline in net worthmay be avoided (Minsky 1964, 213ff.). In that case, the solvency ofeconomicunits involved inaPonziprocessmaydependhighlyon theexpectedcontinuationof rising

assetpricesratherthanonthecapacitytogenerateanincomefromtheownershipoftheasset.

Ponzi positions can result due to mistakes (income is lower than expected) and adverse shocks (amemberofthehouseholdbecomesunemployed).Forexample,aborrowermightexpectincometoriseinorder toenablepaymentcommitments tobemetoutof income. If incomedoesnot rise, thenthe

additionaldebt‐service requirements cannotbemetexceptby takingonevenmoredebt (capitalizinginterest). In thosecases,networthusuallydeclinesgiveneverythingelse,andasMinskyused to say,sometimesa lendergets trapped: refusingto lendtoaPonziunitcan forcebankruptcy,sothe lender

might choose to lend on the hope that the financial position can be turned around and the cost ofbankruptcyavoided.

WewillnottrytodetectdirectlythesesourcesofPonzifinanceastheyareimpossibletouncoverinthedataandarepotentiallylessdamagingfortheeconomy.Wewilltakeabroaderapproachandfocuson

Ponzi financing that involvesdeliberateunderwritingbasedonexpectedasset‐priceappreciation,andthereforeonexpectedrisingnetworthduetorisingassetprices.Let’scallthemcollateral‐basedPonzischemes;theymayormaynotinvolvedfraud.InthistypeofPonziprocess,continuedaccesstoPonzi

financingrequiresthatexpectednetworthcontinuestogrow,especiallyifthereisnoexpectationthatincomefromtheuseofassetswillevercoverdebtcommitments.Indeed,refinancingatlowcosts(notonlyintermsofinterestratebutalsointermsofdownpaymentsormargins)cannotoccurifnetworth

goesdown; 12and ifnetworthgoesdown, liquidationofassetsmakes itdifficulttocoveroutstanding

11Inordertocheckbrieflythesensitivityoftheindextochangesinweights,theannexshowswhattheindexwouldlooklikeifallvariableshadthesameweight.Themainimplicationswouldbeahighergrowthrateforfinancialfragilityonaverage,withasimilarpatternoverall.12Honestbankershavenoincentivetorefinanceprojectsthatareneverexpectedtogeneratearisingnetworth.Bankersinvolvedinfraudmaybeindifferentaboutthesuccessofaloanbecausetheirfortunedoesnotdependonit;therefore,theymaybewillingtoproviderefinancingregardlessoffuturenetworth.Inthiscase,thefinancialsuccessofabankerwilldependonlootingitscompany,andbycontinuingthefraudschemehewillbecomewealthyattheexpenseofhiscompany(Black2005).

45

debts.Ofcourse,aPonziunitmightbeabletohidethefactthatitsnetworthisdeclining,preservingitsaccesstorefinancing.

Overall, net worth is of limited use in detecting financial fragility because rising net worth is not

necessarily a sign of financial health, while declining net worth is not necessarily a sign of financialproblems.Infact,aneconomicunitinvolvedinPonzifinancecouldrecordshort‐termprofitsandrisingnetworthintheshortperiod.13Butwhentherequiredrefinancingceases,thatmayproduceinsolvency,

andwhen insolvencyhas already appeared, networth is of nouse in identifying fragility. In the end,whatwewouldliketomeasureisborrowingagainstexpectedincreasesinassetpricesandnetworth.However,we cannot obtain data on expected asset price appreciation. Hence,wemust use data on

actualassetpricesandnetworth,sorisingnetworthisusedasacriterionfordetectingPonzifinance.

B.Interpretation

Atthemacroeconomic level, financial fragilitywillgrowovertimebecauseof thecompoundingeffectandthevolumeeffect.CompoundingreferstothelengthoftimeeconomicunitshavebeeninvolvedinPonzifinance.Asthelengthoftimeincreases,refinancingandliquidationneedsgrowbecausethesize

ofinterestpaymentsduegrowsexponentially.Thevolumeeffectreferstothefactthat,asmorepeopleare involved in Ponzi finance, financial fragility grows. Therefore, the longer and more widely Ponzifinanceisused,themoredestructivethedebt‐deflationprocess.

Thegoaloftheindexistocapturechangesinthefundingmethodsthateconomicunitsusetofundtheir

activities. FollowingMinsky’s framework,duringperiodsofeconomic stability, financial fragilitygrowsand accelerates asmore people become involved in Ponzi processes and the longer these processespersist.Theindexthusmeasureshowfasttheriskofdebtdeflationgrows,giventhelengthoftimeover

whichPonzifinancewasusedandthevolumeofPonzifinancethatoccurredpriortoacrisis.

C.Limits

Obviously, the index isonly as reliable as the variables andweightsused.As shownbelow, thereareintrinsic limitstothedata,which inturn limitsthecapacitytodetectrefinancingand liquidationrisks.The variables chosen are proxy macroeconomic variables that may overestimate or underestimate

actualrisks.Andasnotedabove,thechoiceofweightsisnotwithoutitsownproblems.

13WeknowthatP/E=P/A*A/E;thatis,thereturnonequity(profitoverequity)isequaltothereturnonassets

(ROA)multipliedbytheleverageratio(assetsoverequity).Collateral‐basedPonzifinanceusuallyinvolveshigherleverage,andtherefore,giventheROA,higherROE.ThistypeofPonzischememayhelptoimprovetheROEintwo

otherways.First,adebt‐inflationprocessmaybegeneratedthatbooststheROAthroughcapitalgains.Thissortofdynamicwillapplywhenalotofeconomicunitsareinvolvedinacollateral‐basedPonziprocess(thetypical

exampleistherecenthousingboom).Second,ifPonzifinanceiscombinedwithfraudulentpractices(whichdoesnothavetobethecase),higherROAmayalsobeachievedforashortperiodoftime(Black2005).Inbothcases,

however,thegainintermsoftheROAwillnotlast.

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ItisimportanttorememberthatPonzifinanceisbasedonexpectationaboutthefuture.Theremaybenocurrentneedtorefinanceorliquidateinordertomeetcashcommitments,andPonzipositionsmay

not materialize if net cash flows from core operations turn out to be higher than expected, and/orinterestratesturnouttobelowerthanexpected,and/orborrowingforalongermaturitythanexpectedisavailable.Infact,thedisappointmentofexpectationsispartoftheinternaldynamicsofthefinancial

instabilityhypothesis.However, ifthestatedoesmaterializeandposition‐makingoperationsareused,theindexshouldcapturetheirimpactonfragility.

Thefactthatexpectationsareinvolvedhastwoimplicationsforempiricalanalysis.AfirstimplicationisthatPonzi financialpracticeswillbegoingon inunderwritingproceduresbefore theyare captured in

actual data about refinancing operations, debt levels, and other variables (Kregel 1997; Suzuki 2005;Knutsen and Lie 2002). Thus, macroeconomic data will tend to capture the development of Ponzifinancewithadelay.Inordertodealwiththisissue,itisimportanttomonitorhowloanunderwritingis

done, as in traditional bank supervision. Following Minsky, there are two central questions to bedeterminedatthis level:Willdebtsberepaid?(expecteddefaultrateandrecoveryrate)andHowwillrepayment of debts occur? (sources of cash flows for repayment and amount of defensive position

makingoperationsneeded).AsMinsky(1975)noteddecadesago,thissecondquestionisnotusuallytheconcern of banking supervisors, who tend to concentrate on detecting fraud and mismanagementthroughverificationofdocumentation.

D.Thefinancialfragilityindex

The financial fragility index was constructed for the household sector; the nonfinancial, nonfarm

corporate sector; and the financial business sector. While economic units within the household andnonfinancial sectors are relatively homogenous in terms of their financial activities, the financialbusinesssectorcontains firmswithverydiverse financialpurposesandmethodsofoperation.Further

elaborationoftheindexwillhavetoreflectthesedifferences.

E.Householdsector

The availability of data for the household sector made possible the construction of two indexes: ageneral index that checks households’ funding practices, and a funding index that focuses on thefinancialpracticesunderlyingtheacquisitionofhousing.

The overall index includes outstanding total liabilities (L), net worth (NW), debt‐service ratio (DSR),

monetary instruments relative tooutstanding liabilities,orMLR (monetary instruments includedollar‐denominated currency, demandand timedeposits, andmoneymarketmutual fund shares), cash‐outrefinancemortgage loans as a proportion ofmortgage refinancing loans overall (COR), and revolving

consumerdebt(RCD).AlldatacomefromtheFederalReserveBoard(FlowofFundsandotherdatasets)exceptthecash‐outrefinancedata,whichcomesfromtheFederalHousingFinanceAgencyandisshowninFigure1.

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Figure1.Cash‐outRefinanceasaProportionofAllRefinanceMortgages

Source:FHFA(Loanpurposesbyquarter:http://www.fhfa.gov/Default.aspx?Page=87)

Eachdatasetisusedtocapturesomeaspectsoffinancialfragilitythatcanbeclassifiedintorefinancingriskandliquidationrisk.LandDSRmeasurethedebtburdenandsocapturebothrisks.MLRisusedtocapturetheliquidationrisk;thatis,theriskthatoneneedstosellilliquidassetstomeetdebtpayments.

CORandRCDareusedtocapturerefinancingrisk.

Inordertodeterminetheweightputoneachvariableitisnecessarytodeterminewhichvariablesmostaccuratelymeasure refinancing riskand/or liquidation risk.Asexplainedabove,even though theyareessentialtofinancialfragilitydynamics(e.g.,growingnetworthisnecessaryforPonzifinancetogrow),

net worth and outstanding debt are not as reliable an indicator of financial problems as the othervariables, so theyaregivena lowerweight.DSR is thevariable thatmoredirectlymeasures thedebtburden,andsoitisgivenahigherweight.AhigherweightisalsogiventoMLRbecauseitisabletomore

directly capture liquidationpressures.Finally, variables thatmeasure refinancing riskaregivena totalweightof30percentthatisequallysplitbetweenCORandRCD.Theweightsonthosevariablesarenotlarger because they are specific to some economic activities (housing and consumption) rather than

generaltothehouseholdsector.Thus,theyarenotrelevantforhouseholdsthatdonotholdmortgagedebt. As shown below, when specific economic activities are analyzed, more weight can be put onrefinancingvariablesiftheyareconsideredsufficientlyreliable.

Theindexiscalculatedasfollows:

IH=0.1DL+0.1DNW+0.25DDSR+0.25DMLR+0.15DCOR+0.15DRCD

withIH∈[0,1]andDXadummyvariableforvariableX,definedasfollowsforallvariablesexceptMLR:

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ForMLRwehave:

Inordertocapturetheintensityofthegrowthoffinancialfragility,someallowanceismadetoaccount

fordifferencesingrowthrates,butforthemostpartthedirectionoftheindexisdrivenbythesignforthegrowthrateofeachvariable.

The home funding index follows the same logic but focuses exclusively on homeownership (a similarindexcouldbebuiltforconsumption).Itcontainsthefollowingvariables:homemortgageofhouseholds

(L), home price index (P), proportion of cash‐out refinance (COR),mortgage financial obligation ratio(MOR),andratioofmonetaryassetstomortgagedebt(MMR).Theindexforhouseholdhomefundingisconstructedasfollows:

IHHF=0.1DL+0.1DP+0.2DCOR+0.3DMOR+0.3DMMR

with IHHF∈ [0,1].Dummyvariablesworkexactly inthesamewayaspresentedabove.Moreweight is

put on MOR and MMR because they are the variables that most directly reflect debt burden and

liquidationrisk.CORisalsogivenahighweightbecauseitprovidesaproxyofmortgagerefinancingrisk.However,COR isnotgivenashighaweightasthepreviousvariablesbecause itonlyreflectscash‐outrefinanceloansasaproportionofrefinancingloansratherthanasaproportionofallmortgages.Similar

totheprevious indicator,risinghomepricesandrisingmortgagedebtsarenotbythemselvessignsofgrowingfragility.Eventhoughtheyarenecessaryforfragilitytogrow,theyarenotintrinsicallysignsofrefinancing risk or liquidation risk, so they are given a lower weight. The index will be higher if all

variables behave simultaneously in a specific fashion. A high growth of the debt‐service ratio is notenoughtohaveahigh indexvalue,but if refinancinggrowssimultaneously,homepricesrise,andtheliquidityratiodeclines,thentheindexwillbeveryhigh.

TheindexesarepresentedinFigure2andFigure3.Theavailabilityofdata limitedtherangefromthe

first quarter of 1992 to the third quarter of 2010. If one studies the household funding index, thefragilityofthehouseholdsectorhasgrownquiterapidlyoverthepasttwodecades.Thesecondpartofthe1990srecordedrisingfragilityduetoaconsumptionboombasedoncreditthatwasencouragedby

the stock market boom. Leveraged speculation in financial markets and house funding methods (asshownbelow)alsoplayedaroletowardtheendofthe1990s. Inthenewmillennium,thegrowthof

49

financial fragility increased rapidly from 2002 onward. Today, financial fragility is declining, ashouseholdspayofftheirdebtsandsave.However,giventhatfinancial fragilitygrewrapidlyfora long

periodoftime,theleveloffinancialfragilityremainshighandtherepaymentofdebtsandrebuildingofsavingshaveledtoamassivedeclineinhomeprices.

Thebroadviewofthecauseoffinancialfragilityinthehouseholdsectorcanbeexaminedmorecloselybylookingatthefundingofahome.AsonecanseefromFigure3,thefragilityofhousefinancinghas

grown rapidly since the end of 1999. At that time, some FOMC members were already becomingconcerned,amongthem,JerryJordan:

Therearepeoplemakingrealestate investments forresidentialandotherpurposes inthe expectation that prices can only go up and go up at accelerating rates. Thoseexpectationsultimatelybecomedestabilizingtotheeconomicsystem.(QuotedinFOMC1999,123)

FedGovernorGramlichhadsimilarconcerns,especially in relation tosubprime lendingandpredatorylending.The2001recessionledtoashortdeclineinthegrowthoffragility,butitwasbackinfullforce

from 2002 and at its maximum from 2003 until the end of 2006. Without that brief recession, thehousingboomwouldprobablyhavestarted(andfinished)muchearlier.

Figure2.HouseholdIndex

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Figure3.HomeFundingIndex

Thisreflectsthepointmadeearlierthattheindexisnotdesignedtopredicteconomicrecessions.Thus,whilethehomefundingindexishighbeforethe2001crisis,thismostprobablyisnotadirectcauseof

the crisis, since fragility had just started to accumulate. This should not, however, have preventedsupervisorsfrominvestigatingunderwritingpractices(seeTymoigne2011b),becausethepracticesthatledtothecurrenthousingcrisisemergedasearlyas1999.Thelengthymortgagecrisis,stilloccurringas

theeconomicrecessionofficiallyended in thesecondquarterof2009, isdirectly relatedtothehomefunding index, which was high for an extended period of time. This is where the index is useful: itdetects the accumulation financial problems, even if the latter may not have immediate negative

economicconsequences.

F.Financialbusinesssectorandnonfinancial,nonfarmcorporatesector

Indexes can alsobedeveloped for thebusiness sector, but data availability shrinks dramatically. Two

coredatasetsareunavailable: thedebt‐service ratioand refinancingvolume.Thedebt‐service ratio isapproximatedbytheinterest‐serviceratio(ISR).Theinterest‐serviceratioisequalto:

ISR=monetaryinterestpaid/after‐taxsourcesofincome

Sources of income are equal to net operating surplus plus income receipts on assets. Net operatingsurplusisaproxyforthenetcashinflowthatresultsfromproduction.Itisequaltothemonetaryvalue

of production (sales and changes in inventories), less charges induced by production (intermediateconsumption, compensation of employees, taxes on production and imports less subsidies, andconsumptionof fixedcapital),and inventorycapitalgains/lossesareeliminated. It isameasureof the

51

monetary returnonassetsused inproduction,whichexcludesany capital gainsor losses (HodgeandCorea2009;Guitierezetal.2007;Evansetal.2002).14

Ideally, all elements that do not generate a cash inflow or cash outflow should be excluded. For

example, higher inventories are not a source of cash inflows and principal servicing generates cashoutflows. In addition, following Minsky, cash inflows and outflows should exclude any exceptionalfinancialgains thatareunrelatedtoroutinebusinessoperations. Ifabusiness routinelymakesmoney

fromtheturnoverofassets,thisshouldbeincludedinthesourcesofincome(Minsky1962,1972).Thedata fromNIPAdoes not allow such an adjustment, and the Flowof Fundsdataset does not providecash‐flowdataforthebusinesssector.Figure4showstheinterest‐serviceratioforthecorporatesector.

Eventhoughthereisanaggregatevalueforincomereceiptsfromassets,thelatterisnotdisaggregated

by industry. The only disaggregated component is interest received, which is available on an annualbasis. The fact that interest received is the only component available is not too limiting, since itrepresents over 80 percent of asset incomes. The bigger challenge is that the data is only available

annually. To dealwith this problem, quarterly datawere created through extrapolation and by usingmovingaverages.

14Netoperatingsurplusisnotcorporateprofit.Interestpaymentsaremadeoutofnetoperatingsurplus,notcorporateprofit.Corporateprofitisequaltosourcesofincome,lessusesofincome;or,alternatively,thesumofretainedearnings,corporateincometaxes,anddividendsdistributed.Morespecifically,thefollowingholdsintheNIPAtablesforthebusinesssector(corporateandnoncorporate):

Sourcesofincome=usesofincome+corporateprofit

Thiscanbebrokeninto:

Netoperatingsurplus+assetincomereceipts=assetincomepayments+netbusinesstransferpayments+proprietor'sincome+rent+corporateincometaxes+dividendspaid+retainedearnings

Fromthat,onecanderivecorporatenetoperatingsurplus(HodgeandCorea2009,NIPA1.14):

Corporatenetoperatingsurplus=corporateprofitwithIVAandCCadj+netinterestreceipts+netbusinesstransferpayments

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Figure4.Interest‐serviceRatio:CorporateSector

Sources:BEA(NIPA,Tables1.14,7.11)

One of the main drawbacks of the ISR is that it excludes principal servicing. This is an importantcomponent,becauseprincipalservicingmay,inpart,capturerefinancingpressures.Indeed,theshorter

the maturity of outstanding debt, the higher the principal service given outstanding debts, and thegreaterthepressuretorolloverdebt. Inordertoaccountforrefinancingpressuresinsomeways,theproportion of short‐term debts relative to total debts is used. The amount of short‐term debt is

providedforthenonfinancial,nonfarmcorporatesectorbutnotforthefinancialbusinesssector;forthelatter,short‐termdebtsareapproximatedbythesumofmoneymarketmutualfundliabilities,federalfundsandsecurityrepurchaseagreements,andopen‐marketpaperoutstanding.Monetaryauthorities’

liabilitieswereremovedfromtheliabilitiesofthefinancialbusinesssector.Figure5andFigure6providetheproportionofshort‐termdebtsforeachsector.

53

Figure5.ProportionofShort‐TermDebt:FinancialBusiness

Source:FederalReserveBoard

Figure6.ProportionofShort‐TermDebts,Nonfinancial,NonfarmCorporateBusiness

Source:FederalReserveBoard

Note:Thereisabigdropintheproportionaround1973.ThisisduetoalargeincreaseintheamountofmiscellaneousliabilitiesresultingfromachangeinthecomputationofFlowofFundsdata.

54

Aside from refinancing needs and the debt‐service ratio, the other variables used are very similar tothose used for the household sector measure, and the index works in a similar fashion. For both

businesssectors,theindexisconstructedinthefollowingway:

I=0.125DL+0.125DNW+0.3DISR+0.3DMLR+0.15DST

Theweightsareassignedinafashionsimilartothatforhouseholds.However,agreaterweightisgiventoliabilitiesandnetworthandalowerweightisgiventotheproportionofshort‐termdebts,sincethelatter is not necessarily a good proxy for refinancing needs. Figure 7 and Figure 8 show the index of

financialfragilityforeachsector.Giventhelimiteddataavailability,theindexescouldonlybecomputedfromthefirstquarterof1954tothefourthquarterof2009.

Themoststrikingaspectofthesetwoindexesisthatthefinancialsectorismuchmorepronetofinancialfragilitythanthenonfinancialsector,whichissomethingthattheMinskyanframeworkpredicts.Ifone

focusesonwhathappenedinthelasttwodecades,thegrowthoffragilityinthenonfinancialsectorwashigh,especiallyattheendofthe1990sandtheendof1980s.Forthefinancialsector,thefragilitywasveryhighattheendofthe1980s,mostofthesecondhalfofthe1990s,andfrom2004until2007.The

tranquilpost–WorldWarIIperiod,extendingtothelate1960swasalsocharacterizedbyarapidgrowthofthefragility inthefinancial industry,asbanksleveragedonthemassiveamountof liquidsecondaryreserveassetstheyhadaccumulatedduringthewar(Minsky1983).

Figure7.IndexofFinancialFragility:Nonfinancial,NonfarmCorporateSector

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Figure8.IndexofFinancialFragility:FinancialBusiness

With the collapse of Lehman Brothers at the end of 2008, the financial system recorded massive

instability—thedirectresultofalongperiodofrapidlygrowingfinancialfragilityfrom2004to2007.Thisillustrateshowtheindexcanprovideasignaltofinancialsupervisorsthatdistressmaybeaccumulatingeven when there is little evidence from traditional indicators such as default rates, risk premia,

profitability,andsoon.Today,thefragilityoffinancialfirmsisdeclining;asbusinessesarewounddown,leveragedeclinesandrestructuringoccurs.

Conclusion

TheindexoffinancialfragilitypresentedhereisbasedonMinsky’sframeworkofanalysis,usingexistingmacroeconomicdata.Moreprecisely,the indexfocusesonananalysisofhoweconomicunitsactually

fund their economic activity, in order to determine if their economic activity is viable. FollowingMinsky’s hedge/speculative/Ponzi definition of financial fragility, an economic activity thatsimultaneously involves a rising debt‐service ratio, growing refinancing, rising asset prices, and a

decliningproportionofliquidassetsisnotaviableeconomicactivityandpromotesfinancialinstability.Thisistrueregardlessofhowlowdefaultratesareorhowfastnetworthisgrowing.Theindexprovidesregulatorswithameans todetect theemergenceof financial fragilitybefore itproduces instability in

theproductiveactivityof theeconomy.The indexshowsthat financialmarketdata (CDSspreads, riskpremia,andcreditratings,amongotherdata)needtobesupplementedinordertocapturetheriskof

financial instability before it occurs. Another implication of this index is that it sets a very specificresearch agenda for the Treasury’s Office of Financial Research. The amount of data available aboutsources of refinancing needs, the debt‐service ratio, cash‐inflow sources, and cash‐outflow sources is

currentlyextremelylimited.TheOffice’sresearcheffortsshouldthusbeorientedtowardimprovingourunderstandingofthefundingpracticesofeconomicunitsandfurtherdevelopmentoftheindexinordertosupporttheFSOCmandateof“identifyingthreatstothefinancialstabilityoftheUnitedStates.”

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APPENDIX.IndexeswithEqualWeightforAllVariables

HouseholdFinancialFragilityIndex

HouseholdHomeFundingFragilityIndex

57

CorporateNonfinancialBusinessFinancialFragilityIndex

FinancialSectorFinancialFragilityIndex

58

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