Amid last fall's financial chaos, executives from Wachovia, at the time the fourth-largest commercial bank in the country, had bad news for their regulators: They were broke. Federal officials deliberated and decided Wachovia was so important to the economy that the government had to save it.
It was only the latest in a series of financial institutions that regulators had deemed "too big to fail." In the preceding months, the government had bailed out Fannie Mae, Freddie Mac, and Bear Stearns, and Congress had passed the controversial $700 billion bill to fund yet more financial-sector rescues. Some of the institutions, like the insurance company American International Group (AIG), weren't even banks.
When the news of Wachovia's failure first reached Federal Deposit Insurance Corporation (FDIC) Chair Sheila Bair, she wanted to liquidate the bank and cut into the pocketbooks of its investors -- as she had done with Washington Mutual, the largest U.S. bank failure ever, a few days prior. But Tim Geithner, then president of the New York Federal Reserve Bank, argued strenuously for Bair to invoke her agency's "too big to fail" exception and spend more money to cover the costs of the bank's sale. He worried another collapsing bank would only intensify the financial panic at a time when the government's hands were tied. (While the FDIC can liquidate a commercial bank like Wachovia, the Fed doesn't have the tools to shut down financial institutions, only the ability to prop them up with loans.)
Geithner, now the Treasury secretary, made the right decision at the time, but it was a terrible precedent to set. Sending the message that the government won't let large banks fail in a crisis gives them an unfair advantage over their smaller competitors. Worse, if bankers are rewarded for success and insulated from failure, there is little incentive for prudence and smart management -- the problem of moral hazard.
Of all the Orwellian phrases to arise from our financial crisis -- "troubled assets," "stress tests," "capital infusion" -- "too big to fail" is perhaps the most hated and least understood. Many populists and progressive economists have called on the Obama administration to bust up the banks and make them smaller. "Just break them up," economist Dean Baker argues. "We don't have to turn Citigroup and Bank of America into hundreds of small community banks, just large regional banks that can be safely put through a bankruptcy."
The administration hasn't pursued that course of action, in part because of the political power of the banks and in part because breaking them up isn't as easy as it sounds -- it is hard to know what the right size for a bank is, especially in an increasingly global financial market. Further, the importance placed on the issue of size is deceptive: The problems that caused the 2008 crash also had to do with leverage, liquidity, and the complex connections between banks. The banks tied themselves into knots neither they nor their regulators could untie.
"The problem we have had isn't that institutions were too big -- it was that there was no uniform way to let them fail without causing an absolute market meltdown," Arthur Levitt, the widely respected former Securities and Exchange Commission chair, told the House Financial Services Committee in September.
If we want to clean up the financial mess, we have to realize that the size of institutions is a secondary problem. We must also accept that some facets of our current system are here to stay. Shrinking the financial sector will be slow going, so we're best off watching it more closely, forcing institutions to put stronger safety nets in place, and, most important, helping them fail gracefully when they make mistakes.
The logic behind "too big to fail" is that if a large financial firm or corporation goes under, it can drag along not just its own investors, creditors, and employees but also entire industries. But it's not merely a question of size. Neither Lehman Brothers nor Bear Stearns were among the largest banks in terms of assets, but their roles in the market gave their troubles an outsize negative effect on the broader economy. In other words, when we say "too big to fail," what we actually mean is "systemically risky" for any number of different reasons.
"It's just so nice and simple to say, 'If it's too big to fail, why don't we just keep them from getting big?'" says Diana Farrell, a top White House official working on financial regulation. She points out that some Japanese and European institutions are much larger than their U.S. counterparts, suggesting that size alone does not explain risk. "Let's recognize we live in a sophisticated economy that is going to require large, interconnected, complex firms. Let's make sure that we recognize them, ensure they do not pose a risk to the system," and guarantee they follow stricter rules.
The Obama administration's plan to restructure the financial system, which is wending its way through Congress, has sparked a complex battle between political parties, consumers, and industry stakeholders. At press time, the legislation included powerful changes like establishing a Consumer Financial Protection Agency, but its approach to systemic risk has come under fire because it appears to enshrine the problem, not solve it.
The administration proposes rearranging the regulatory system so that most national banks are under one supervisor, while the Federal Reserve and a council of regulators monitor risk throughout the system. Any institution -- bank or not -- that becomes systemically risky will be regulated by the Fed and subject to higher standards of capital, liquidity, and leverage. In theory, this will make large institutions less likely to fail and also encourage them to shrink themselves, because higher regulatory standards will hurt their bottom lines by putting a price on the public consequences of their systemic risk. Other reforms -- to compensation structures, derivatives trading, and rating agencies -- are designed to provide more information to regulators and better incentives to the market in order to complement efforts to control systemic risk. Equally important, the Fed will be able to observe all of the institution's activities as well as those of its subsidiaries. No more surprises, like the discovery that AIG was connected to almost every other major financial institution in the world.
"That does what we were unable to do in the case of AIG ...which is to provide the regulator a fully consolidated view of all activities, whether in the U.S. or otherwise, whether a depository institution or otherwise," Farrell says. "That itself becomes one of the critical prevention tools for systemic failure."
Those rules will be backstopped by a requirement that institutions keep an up-to-date scheme -- a funeral plan -- for how to wind down their operations in the event of failure. Most important, there will be new legal mechanisms, called "resolution authority," that regulators can use to shut down financial institutions while avoiding protracted bankruptcy during a crisis. Resolution authority will give the FDIC the power to do what it does best -- arrange for the orderly liquidation of not only small banks but also big, international financial institutions.
"Being among the largest, most interconnected firms does not come with any guarantee of support in times of stress," Deputy Treasury Secretary Neal Wolin told a room full of bankers in September. "The presumption should be the opposite: Shareholders and creditors should expect to bear the costs of failure. ... The resolution authority ... allows the government to impose losses on shareholders and creditors without exposing the system to a sudden, disorderly failure that puts everyone else at risk."
But some critics warn that by designating more firms as systemically important, the government is implicitly guaranteeing prevention of their failure -- and therefore broadening the amount of public money at risk. These critics want the administration to limit federal oversight to commercial banks and bar them from speculating in the markets or running investment funds that might put depositors at risk. While that is a good idea, the problem is, time and time again, institutions that aren't banks have found ways to engage in banking. Failing to include them in systemic risk regulation would be willfully blind. Regulation needs to be based on the principle that if it quacks like a bank, it should be treated like a bank.
The danger in the Obama administration's plan is that regulators, who are often too close to the banks, may not have the courage required to seize a failing institution -- it might always be easier to fund the bankers through another bailout. One simple solution to this problem would be to eliminate regulators' ability to provide capital for banks or guarantee their liabilities, making liquidation the only option. But that cuts down on regulatory flexibility and is strongly opposed in the Treasury Department.
Within the FDIC, there is support for letting the systemic-risk exception apply only to markets, so that any costly measures in extremis will not benefit specific institutions. Perhaps the kind of restrictions that progressives wanted to put on the initial bailout loans -- strict compensation limits, firing existing management, and even more stringent rules -- should be codified so they will be clear if and when bailouts are needed again. The goal would be to penalize executives, not institutions, so the people at banks have the incentive to perform.
Regulatory reform is not just about providing new structures and tools. Reform is also about putting in place politicians and regulators who are willing to take the banks to task. The administration's proposed approach to the problem of systemically risky institutions would require the secretary of the Treasury to green-light any response to their failure, whether that response is bankruptcy, government-assisted liquidation, or even another bailout. That means direct political accountability to the president instead of the "Republic of the Central Banker" that we saw in 2008 as the Fed single-handedly undertook massive efforts to protect the financial system without any checks on its power -- or its spending.
Looking back on last fall's argument between Geithner and Bair over what to do about Wachovia, it's clear that Bair was right in principle -- using federal money to keep bad banks alive isn't a good idea. Geithner was right in practice -- letting another bank fail would have only intensified the financial panic at a time when the Fed didn't have the right tools to solve the problems further bank failures would cause. What we need is a rulebook that doesn't force regulators to choose between those two approaches. We need a system designed by someone like Tim Geithner -- and run by someone like Sheila Bair.
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