In the grip of our Great Recession, with more job losses to come, we have yet to fix the broken financial system that is an underlying cause of this whole mess. How can we do it? Some of the ideas being talked about in the halls of
The public no longer sees
It wasn't supposed to happen like this. The long history of financial panics wrecking American lives had produced what we thought was a tight regulatory system. Why did the system fail? Because regulations didn't keep pace with fast-moving changes in the industry. It was like having a cop on a bicycle trying to catch a rogue in a
The financial system remains vulnerable to a second shock. In return for access to government liquidity, we've imposed greater regulation on the two remaining investment banks that became bank holding companies, along with constraints on other recipients of federal financial assistance. The commercial banking system is today receiving funding at very low interest rates from the government. One would think it would be easy for commercial banks to start lending again and get the economic engine restarted. But when they lend, they do it only at huge--and highly profitable--interest rate spreads. They need to accrue the new profits to absorb some of the staggering actual and potential loan losses remaining on their books.
Shouldn't the Federal Reserve Board, perched at the top of the financial system, have seen what was going on? The Fed is blamed for creating the orgy of debt by failing to see the dangers in the rapid growth of securitization and derivatives and for maintaining the federal funds rate at 1 percent in 2003-2004. Critically, while the regulators looked to their conventional issues of the safety and soundness of individual institutions, no one was responsible for protecting the entire system from the ricochets of interconnected risks. In the Great Depression, wise heads created the Glass-Steagall Act to mandate the separation of commercial banks from investment banking. In 1999, President
The bailout was maddening in coming to the rescue of institutions that had behaved recklessly, but a much larger number would have failed had the government not stepped in.
The too-big-to-fail firms thus lie at the heart of the current crisis. Some are now even bigger, in part because the government had to sponsor and support several mergers that made them larger. The financial industry is now even more concentrated--and the former delinquents get special treatment.
Even before the recent panic, systemically important banks enjoyed serious advantages over their less important rivals, advantages often created by government regulation. The Basel II standards on bank capital allowed large financial firms to hold less capital and equity, often at no more than 2 percent of their total assets, considerably less than their smaller counterparts. The theory was that large meant diversified and sophisticated and, therefore, less risky. Come again? The presumption of safety in size, now proved false, means that the costs of being wrong are now much larger than was commonly realized. The too-big-to-fail financial firm is today a reality that must be acknowledged and dealt with by new legislation, affecting not only commercial banks but theshadow banking system as well. Surely, the conclusion must be that the price large banks pay for the privilege of size should be significantly increased. If they benefit from explicit or implicit protection from the government, they should not be able to ride free on the backs of taxpayers. Their risk of failure should be reduced in one of two ways: by increasing capital requirements or by providing the option for the banks to be smaller or less systemically important. This can be affected either by narrowing what businesses they can be in or by making them less interconnected. In the worst-case scenario, the final backstop has to be bankruptcy or dissolution. A new resolution mechanism will have to unwind these too-big-to-fail institutions through a series of well-ordered procedures that do not imperil the whole economy.
Other risky conduct should be constrained. The "too big" firms should not be allowed to borrow too heavily against their assets. Proprietary trading and other risky financial ventures should be regulated. The prescription is easy to envisage. What's hard is the enforcement. How do we make these rules stick without adversely affecting our market-based system of credit in our free-market economy?
For instance, the federal government's seizure of troubled financial institutions raises serious questions: how, fairly, to detect and eject faulty management, how to protect innocent shareholders, how to change the terms of loans already in contracts. But government can no longer be hamstrung when it sees danger, even in regulating nonbank financial institutions such as the failed investment banks
Some suggest an absolute separation between commercial banks and investment banks. Commercial banks enjoy some government guarantees in return for regulation of their risk taking. Investment banks and other nonbank financial players could have more leeway to trade risky assets with the explicit understanding there would be no bailouts. This could shield the banks from
Bear in mind that size, for all the crisis it helped to bring, has also greatly benefited the U.S. economy, enabling our big financial firms to compete against others in
So before imposing any radical limits, we should test whether we can accomplish our goals by limiting excessive leverage, especially during economic boom phases when excessive risk-taking tends to occur. The necessary new regulatory measures must be strict but simple in lowering permissible leverage by imposing higher capital liquidity. Capital requirements should be designed to be countercyclical, with special rules for too-big-to-fail institutions.
Tough but discerning regulators will require the capacity to pressure erring firms, wind down some of their risk exposure, or wind down the firm itself. Never again should we be forced to choose between bailouts and financial collapse, for when banks get in trouble, their customers end up being in trouble.
The Federal Reserve should remain at the center of these new regulatory efforts. The Fed may be less popular today on
The New Orleans masses who huddled in the Superdome after Hurricane Katrina, the Enron retirees who lost their life savings, and the laid-off workers buried under the economic ruin of financial companies all live with a simple truth. Just as spectacularly as great leadership can spark success, failed leadership can bring down cities, businesses, and economies
Triumph of the Hysterical or A Word from the Little Old Lady
I had this powerful urge to proclaim that The End Is Near, and generally do a Paul Krugman. They were placing all their bets on black -- dark, funereal black -- when the Panic of 2008 hit, which they insisted on confusing with the Great Depression.
Will Unemployment Disaster be Obama's Katrina
Just as Katrina exposed critical weaknesses in the priorities and competence of the Bush administration, the unfolding unemployment disaster is threatening to do the same for the Obama White House.
Free Markets, Free Muslims
Jon B. Alterman
Vali Nasr's new book, Forces of Fortune, was written largely in the exuberant phase of Dubai's story, but it is being published in a more sober time. It reflects some of the old enthusiasm for the notion that 'the Dubai model' -- a multiethnic, capitalist society insulated from violence and ideology -- could save the Middle East from a downward spiral of intolerance and political extremism.
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