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Rx for Too Big to Fail
In the wake of the financial crisis and the massive federal response, it has become fashionable to declare that “too big to fail is too big to exist.” Powerful lawmakers and popular commentators regularly endorse this notion, promising to end “too big to fail.” Although this is a laudable goal, there is a real risk of oversimplifying the problem. If tough rhetoric becomes a substitute for tough regulation, we will — tragically — miss our best shot at a financially stable future.
There are plenty of good reasons to crack down on the nation’s largest financial institutions. Many of these huge (and hugely leveraged) firms played a pivotal role in causing the crisis, inflating the bubble on the way up and driving the panic on the way down. They were also the undeserving beneficiaries of hundreds of billions in federal bailout funds. They reaped extraordinary profits in boom times and left taxpayers on the hook when things went bad. The upshot is that the nation’s largest financial institutions now live in a “heads I win, tails you lose” world of moral hazard. No wonder calls to end too big to fail have hit a fever pitch.
At present, there are two dominant strategies for eliminating the scourge of too big to fail. One is to break up the largest financial institutions, possibly with a new and improved Glass-Steagall law. The other is to perfect a bankruptcy process for super-sized financial firms so they can fail safely without the need for government assistance. The first approach seems to enjoy more support from the left and the second from the right. Unfortunately, neither plan is likely to work on its own.
While a number of major financial firms should be broken up, it is neither desirable nor feasible to destroy every vestige of scale in the financial sector — to shatter every firm that might conceivably pose a systemic threat in a crisis. Large financial institutions create a danger, to be sure, but many also deliver valuable services. And even if we wished to take all of them apart, it’s doubtful we could, as a result of both political and administrative constraints.
A new Glass-Steagall law that segregated commercial banking from other financial activities, or that limited banks’ proprietary trading, would strengthen the financial system, if crafted properly. But it could hardly be expected to eliminate too big to fail, since a great many too-big-to-fail institutions existed even before the repeal of Glass-Steagall in 1999.
The truth is, large financial institutions are probably an unavoidable feature of modern life. Even many of the most ardent opponents of big banks favor the creation of an exchange for credit default swaps, perhaps without realizing that such an exchange would itself be — you guessed it — too big to fail. Regrettably, because large financial institutions won’t go away completely, neither will the systemic risk they pose.
Those who believe the solution lies in fixing the bankruptcy code are similarly mistaken. Again, the basic idea is a good one, but will not end too big to fail. We desperately need to streamline the process of allocating losses when a large financial institution fails. But it’s simply unrealistic to believe that in the heat of a financial crisis any administration would allow a substantial number of major financial firms to fall into bankruptcy at the same time, no matter how streamlined the process. As both the Bush and the Obama administrations proved, the fear of financial Armageddon is too great.
In fact, federal interventions in 2008 and 2009, while costly, proved remarkably successful in pulling the financial system back from the brink. This marked a sharp contrast to the disastrous “liquidationist” policies of the early 1930s, when public officials (particularly at the Federal Reserve) were so afraid of moral hazard that they allowed virtually the entire U.S. banking system to collapse before intervening. The liquidationist views of that era have been thoroughly discredited, and we should not return to them now.
The answer to our problems is not to imagine we can take apart every big bank, or pretend they’ll be harmless if we simply promise not to intervene when they fail. Denial won’t work. It failed us in the past (remember all those lawmakers’ promises through the boom years that Fannie and Freddie enjoyed no federal guarantee); and it will inevitably fail us again. The answer is sound regulation, not denial.
Just as we manage the risk of auto accidents by setting speed limits (rather than by prohibiting cars or leaving the risk entirely to the market to resolve), we need to do much the same in managing the risk posed by the largest financial institutions. Above all, we must limit their leverage, restrict their off-balance-sheet activity and short-term debt, and ensure adequate liquidity. Recall that after New Deal financial regulation was put in place in the 1930s, the country didn’t suffer another major crisis until deregulation commenced nearly fifty years later — by far the longest stretch of financial stability in the nation’s history. Similarly, our best shot at preventing a future financial meltdown is to be honest about the inevitable risk posed by our biggest financial institutions, and to impose tough and targeted regulation in response.
This very conclusion was reached by the Treasury Department in its initial proposal on regulatory reform last summer, by the House in legislation passed in December, and by Senator Chris Dodd (D-CT) in his original draft bill. While the ultimate legislation must be even tougher than what has been proposed thus far, the true danger now is that thoughtfully crafted regulation will lose out to attractive, but ultimately unrealistic, plans to end too big to fail.
It might feel good to declare that we can eliminate too big to fail once and for all through a simple act of reform. But the cost of such short-term satisfaction will be far too high if it becomes a substitute for effective regulation. Tough regulation of the largest financial firms is not as sexy as muscular rhetoric about ending too big to fail; but over the long term it is the surest way to prevent another financial crisis.
— David Moss is the John G. McLean Professor at Harvard Business School and the author of When All Else Fails: Government as the Ultimate Risk Manager.
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