Illustration by David Plunkert

Here’s a really scary thought. Now that the federal government has poured hundreds of billions of dollars into saving financial institutions deemed “too big to fail,” hasn’t it implicitly guaranteed similar largesse for all such institutions in the future? In its rush to help, has the government unwittingly created the mother of all moral hazards — implicit rescue guarantees as far as the eye can see?

No doubt about it, says HBS professor and economic historian David Moss. “The extension of implicit guarantees to all systemically significant institutions takes moral hazard in the financial system to an entirely new level,” he warns. But Moss has a fix: The federal government should slap tough new regulations on all firms that pose “systemic risk” — the risk that a failure of one institution could wreak havoc across the entire financial system. Among the proposed new regulations: higher capital requirements; leverage limits; FDIC-like insurance charges; and, when all else fails, a receivership process to restructure, sell, or liquidate a failing company. Bottom line, no firm should be too big to fail. At the same time, the majority of financial firms that pose no systemic risk should face relatively light regulation, ensuring their continued dynamism and innovation.

If Moss’s tough love approach to the biggest financial institutions sounds familiar, you’re right. Treasury Secretary Timothy Geithner’s proposals for fixing the broken financial system closely resemble those found in Moss’s own playbook. In this instance, the book is a Special Report on Regulatory Reform, substantially shaped by Moss and widely read in Washington since it was submitted to Congress in January by a Congressional Oversight Panel.

Congress created the five-member panel last October when it enacted the $700 billion Troubled Asset Relief Program (TARP) to rescue faltering financial institutions. Law-makers instructed the panel to monitor TARP expenditures and recommend regulatory reforms. Led by Harvard Law School professor Elizabeth Warren, the panel recruited Moss, an expert in risk management, to provide historical context to the financial crisis and a framework for reform. For his efforts, the panel acknowledged his key role “in conceptualizing and drafting” significant parts of the final product.

Not everyone on the politically divided panel bought into Moss’s analysis and recommendations. Warren and two Democrats embraced Moss’s views on the need for a systemic risk regulator. But the two Republican members issued a dissenting minority report. The partisan clash of views foreshadowed the political debate now echoing in the corridors on Capitol Hill.

The Case for More Regulation

Looking at the historical record, Moss makes a strong case that targeted government regulation of financial markets has worked in the past to lower risk and instill consumer confidence. “From the founding of the republic until 1933, the United States experienced banking panics roughly every fifteen to twenty years,” explains Moss. When the Great Depression struck, it was “in a league of its own” in severity and governmental response, he continues. With the banking system near collapse, the Roosevelt administration engineered sweeping federal intervention into the marketplace, including creation of federal deposit insurance, securities regulation, banking supervision, and the separation of commercial and investment banking under the Glass-Steagall Act. As Moss is quick to point out, there was an implicit strategy: “We insured and regulated the most systemically dangerous part of the system, the commercial banks, and we exercised a much lighter touch elsewhere, leaving the rest of the financial system to innovate, be dynamic, and do everything that markets do so well.” This targeted approach, Moss believes, helped ensure both stability and innovation in the American financial system over much of the 20th century.

In fact, for the next fifty years, the country experienced no major financial crises, the longest such period on record (see chart above). Significant financial failures returned to the marketplace in the late 1980s with the savings and loan crisis, followed by a rash of bank failures in the early 1990s that forced the government to recapitalize the FDIC’s Bank Insurance Fund. Long Term Capital Management, a largely unregulated hedge fund, came perilously close to collapse in 1998, threatening the global financial system. The tech bubble burst in 2001. Accounting scandals destroyed Enron in 2001 and WorldCom in 2002. And the current global financial crisis, the worst since the Great Depression, has yet to run its course.

It’s no accident that all these financial crises followed a concerted push by bankers, economists, and policymakers to deregulate the marketplace, says Moss. Although a deregulatory agenda was embraced by congressional Democrats and Republicans alike, President Reagan set the philosophical tone in his 1981 inaugural address when he famously observed: “Government is not the solution to our problem; government is the problem.” Thereafter, regulatory minimalism and a “market knows best” mindset took hold in Washington and on Wall Street and dominated decision-making for nearly three decades.

Lawmakers not only weakened or dismantled New Deal–era regulations, they also failed to enact new regulations to keep up with financial innovation, spurred by technology and globalization of markets, explains Moss. Over time, a huge amount of financial activity migrated away from regulated and transparent markets and institutions and into the lightly regulated or unregulated shadow markets encompassing mortgage brokers, hedge funds, private-equity funds, off-balance sheet structured-investment vehicles, and a booming market in opaque derivatives, especially credit-default swaps, he continues. By the summer of 2007, the Treasury Department estimates, the shadow banking system had accumulated assets reaching roughly $10 trillion, equivalent to total assets in the entire U.S. banking system.

Says Moss: “While new systemic threats had emerged along the way, there was little effort to regulate them, undercutting the original New Deal strategy of targeting such threats. As a result, the American financial system was left more vulnerable than ever to a major shock.”

Given this record of regulatory failure and neglect, he concludes that the current financial crisis wasn’t an unforeseeable accident. Wall Street wasn’t a victim, as some have contended, but an active participant in a gigantic mistake rooted in wrongheaded regulatory philosophy. “In too many cases, regulators chose not to use tools they already had, or they neglected to request new tools to meet the challenges of an evolving financial system,” says Moss.

Persuaded by Moss’s analysis, the Congressional Oversight Panel placed the need to identify and regulate financial institutions that pose systemic risks at the top of its list of critical problems in need of legislative repair, along with limiting leverage and reforming the credit rating system (see Setting the Legislative Agenda).

The Case against a Systemic Risk Regulator

In a lengthy minority dissent, the oversight panel’s two Republicans, Texas Congressman Jeb Hensarling and former New Hampshire Senator John Sununu (MBA ’91), caution that a rush to regulation may cause more problems than it solves. “Before embracing more government regulation as the only answer, such advocates should consider the many ways in which government regulation itself can be part of the problem,” argue Hensarling and Sununu.

At the top of their list are Fannie Mae and Freddie Mac, the failed government-created mortgage giants. Despite repeated denials by congressional leaders, the marketplace understood that both mortgage behemoths enjoyed an implicit federal guarantee against failure, contend Hensarling and Sununu. Spurred on by lawmakers eager to expand homeownership, Fannie and Freddie so distorted the housing market that they made a financial breakdown inevitable, the minority response argues. As a result, Washington, not Wall Street, is the villain in the bursting of the subprime mortgage bubble.

The minority response also faults the Federal Reserve’s monetary policy under former chairman Alan Greenspan for holding interest rates too low for too long, which inflated the housing bubble with cheap credit. And it scolds the SEC for allowing the credit rating agencies to operate like a cartel without competition or transparency, which led to disastrous ratings inflation. In short, “The economic crisis in which the country now finds itself reflects not the failure of the free-market system, but more so the result of decades of misguided government policies that interfered with the functioning of that system.”

Nonetheless, the panel’s two Republicans call for reforms, including taking Fannie and Freddie out of the investment business, simplifying mortgage disclosure documents, consolidating the federal government’s highly fractured financial services regulatory agencies, and requiring that financial institutions increase their capital during sound economic times to provide a buffer for when capital is harder to raise. While also agreeing that systemic risks need more oversight and management, the minority response strongly rejects the majority’s call for identifying systemically risky institutions and subjecting them to new capital and liquidity requirements and insurance fees.

“Once you do that, everyone in the marketplace is going to know who the federal government has identified as systemically significant, and one of two things is going to happen,” says Sununu. “Either the market will believe that these firms would be bailed out in the event of a financial crisis, so you will have created a number of new Fannie Maes and Freddie Macs and the moral hazard associated with that. Or the additional capital and regulatory requirements will put these firms at a disadvantage relative to their competitors, and you will have weakened the firms that you believe to be systemically significant. Neither is a good or appropriate outcome for the economy or the taxpayer.”

Finding a Middle Path

Neither has to happen, says Moss, who ardently believes that his approach finds a middle ground between the harm and moral hazard extremes foreseen by Sununu. Today, financial institutions deemed too big to fail already have a huge marketplace advantage — hundreds of billions of federal bailout funds unavailable to smaller firms in financial trouble, says Moss. “That gives big, complex firms a dramatic advantage that is inappropriate,” he explains. Since last fall, there’s also an implicit guarantee of government rescue for any firm that in the future may be identified as too big to fail. “What’s worse, these firms impose costs on society by creating systemic risks that they don’t have to bear on their balance sheets,” says Moss. “That’s not a situation we want to maintain.” And it’s one that his reform ideas, and proposals in the Congressional Oversight Panel’s report, attempt to address in several ways.

First, by identifying firms that pose systemic risks, free and unlimited implicit guarantees become explicit guarantees that the government can, for the first time, define and limit.

Second, companies that create systemic risk should bear the cost of insuring against it, just as commercial banks pay into an FDIC insurance pool. And the government should insist on appropriate capital standards and liquidity requirements to limit the type of risks that these firms impose on society.

Third, creating a receivership process would allow an efficient handling of failed companies. “We really need to insist that no institution is too big to fail,” says Moss. “With what I’m proposing, all systemic institutions would get limited support during a period of economic turbulence. But if that turns out not to be enough, then they are going to be taken into the receivership process and liquidated or restructured.

“One thing the critics don’t fully acknowledge is the world we live in right now,” continues Moss. “It’s one of massive implicit guarantees that are open-ended. I believe we need to be honest about these implicit guarantees, to define and limit them. That’s the purpose of this whole proposal, not to put systemic firms at a competitive disadvantage but rather to prevent them from imposing undue costs on the rest of the financial system.”

Devil’s in the Details

The general concept of regulating systemic risk has gained broad support from a wide range of influential economists, lawmakers, and interest groups. In March 2008, Treasury Secretary Henry Paulson (MBA ’70) proposed that the Federal Reserve be empowered as a super regulator to seek out and manage systemic risks regardless of the kind of financial institution posing it. Paulson affirmed his support for the idea in a March 18, 2009, op-ed article in the Financial Times.

In January, an international group of leading financiers and academics known as the Group of Thirty (G30) issued a reform blueprint that endorsed the idea. Paul Volcker, former chairman of the Federal Reserve and now a top economic adviser to President Obama, led the committee that wrote the report. G30 members included Treasury Secretary Geithner and Larry Summers, Treasury Secretary in the Clinton administration who now serves as director of the President’s National Economic Council. While they recused themselves from the G30 deliberations, both have since voiced support for a systemic risk regulator, as have Fed Chairman Ben Bernanke, the U.S. Chamber of Commerce, the American Council of Life Insurers, and the Securities Industry and Financial Markets Association.

The problem is, no one yet has shown how to measure systemic risk. “There are a number of people trying to develop the metrics right now,” says Moss. Without metrics, policymakers are forced to wing it when confronted with a financial crisis. That’s what Fed Chairman Bernanke and Treasury Secretary Paulson did when faced with the Bear Stearns crisis in March 2008. “Maybe they were right, and maybe they were wrong to force Bear’s sale to JPMorgan Chase,” says Moss. “But they looked at Bear Stearns and said, ‘If it fails, that will lead to a systemic problem.’ Same with AIG, Fannie and Freddie, and Citibank. But not with Lehman, although I think in retrospect they may believe they made a mistake on that one.”

To take the guesswork out of such judgments, HBS senior lecturer Robert Pozen, chairman of MFS Investment Management in Boston, told a Senate committee on March 4 that regulators need look no further than five factors historically associated with financial crises: inflated prices of real estate, institutions with high levels of leverage, new products falling into regulatory gaps, rapid growth in an asset class or intermediary, and mismatches of assets and liabilities.

What to measure, however, begs the question of who should do the measuring? The Congressional Oversight Panel saw merit in several options. The regulator “could be an existing agency, such as the Board of Governors of the Federal Reserve System, a new agency, or a coordinating body of existing regulators.” On Capitol Hill, Barney Frank, the Democratic chairman of the House Financial Services Committee, initially championed the Fed as a systemic risk regulator but more recently has expressed second thoughts. In the Senate, Democrat Chris Dodd, chairman of the Banking Committee, also has voiced reservations. Others have raised concerns about investing too much power in the hands of the Fed.

Pozen advised the Senate committee to tap the Federal Reserve as the super regulator but to delegate enforcement to the appropriate existing federal regulatory agencies. “If the Federal Reserve Board is going to bail out a broad array of financial institutions, and not just banks, it should have the power to monitor systemic risks so it can help keep institutions from getting to the brink of failure,” said Pozen.

Testifying the same day, the AFL-CIO’s associate counsel Damon Silvers (MBA ’95), a member of the Congressional Oversight Panel, told the Senate committee that he had “come to believe that the best approach is a body made up of the key regulators.” Given the amount of complex information that has to be collected and analyzed, an interagency group could best tap into existing expertise while functioning as a fully public and transparent body. By contrast, he noted, the Fed is not an entirely public institution, and while it can offer liquidity to troubled firms through loans, “many actual bailouts require equity infusions, which the Fed cannot currently make.”

No matter who becomes the systemic risk regulator, there’s no guarantee of satisfactory performance based on recent history. Indeed, a litany of government regulatory failures fills the minority response to the Congressional Oversight Panel’s reform recommendations. “The hallmark of past efforts to regulate the financial system has been that government regulation frequently fails,” the panel’s two Republicans argue.

For his part, Moss welcomes the minority critique and acknowledges the inevitability of regulatory errors. “But I still come out in a different place,” he explains. “By focusing attention almost exclusively on government error, it gives the impression that government can’t solve any problems. It’s as if we focused exclusively on medical accidents and concluded that it’s never safe to visit a doctor. Like doctors, lawmakers make mistakes and sometimes do more harm than good. But government can also make a very positive difference, and we know it has done so in the past. Based on that history, I think that government is a necessary and powerful entity for helping us solve some of these problems. It’s not the only part of the solution, but it’s an important part of the solution.”

Read the Congressional Oversight Panel’s Special Report on Regulatory Reform at cop.senate.gov/. Read David Moss’s working paper, “An Ounce of Prevention: The Power of Public Risk Management in Stabilizing the Financial System,” at www.hbs.edu/research/pdf/09-087.pdf.

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