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 Congress are as dangerous as the reckless congressional activity that helped to precipitate the disaster in the first place.

The public no longer sees Wall Street as the catchphrase for the American financial sector but as a symbol of greed and excess. That's not an unsophisticated stereotype. The wreckage is manifest. Most of the traditional banks and investment firms, along with the so-called shadow banking system in the United States--and indeed in Europe--have been seriously damaged and in some cases destroyed. Five major investment banks, all in New York, have either disappeared (Lehman Brothers, Bear Stearns, Merrill Lynch) or been transformed into bank holding companies (Morgan Stanley, Goldman Sachs). Hundreds of small banks and nonbank lenders have totally disappeared. The financial system buckled because it had too much debt, not nearly enough equity capital, and too much irrational exuberance.

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 Ferrari. Money market funds undermined deposit accounts in banks; commercial paper undermined the business of short-term lending to big corporations; high-yield bonds had the same effect on lending to smaller companies; and the securitization of mortgages on homes and office buildings, along with other debts such as auto loans and student loans, transferred scrutiny of this method of finance from the original lending officers--who understood the quality of these loans and their risk--to the capital markets, which hadn't a clue about the risks of the paper they were buying and sold it to people who were, if possible, even more clueless. They were all relying on rating agencies whose assessments have proved misleading at best. The original lenders did not suffer the consequences of bad loans. They had an incentive to take on still more risky loans. This is why the securitization market, making up more than a third of all U.S. finance, virtually collapsed.

Fannie Mae and Freddie Mac, which dominated the housing market with an implicit government guarantee, were supposed to be rock solid. But they were building on sand, pressured mainly by Democrats in Congress and tempted by their own greed to lend to home buyers who couldn't afford what they promised to pay. Mix in (well-paid) financial mismanagement and the hundred million or more dollars contributed to congressional election funds that helped discourage regulation, and you end up with the catastrophe that forced us to nationalize Freddie and Fannie. Now we face losses thought to be many multiples of the original government estimates of $25 billion.

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 Bill Clinton and Congress revoked the act, thereby accelerating financial consolidation through mergers and acquisitions. So we got huge firms whose failure could bring down the whole pack of cards. The too-big-to-fail phenomenon led to bailouts with taxpayer money, provoking a deep-seated public anger that has been further aggravated by the recent pile of executive bonuses.

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 Treasury Department and the Fed were placed in the unhappy triage position doctors face on the battlefield: choosing which institutions should die and which should be saved.

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 Lehman Brothers and Bear Stearns and the giant insurer AIG.

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 Wall Street's wild ways, but it does not deal with the financial consequences of the failure of giant investment banks or other financial institutions.

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 Europe and Asia. The too-big-to-fail institutions employ millions of Americans and operate around the world, participating with similarly large financial partners to execute diverse and large transactions. They offer a full range of products and services, from loan underwriting and risk management to local lines of credit, providing billions of dollars of financing to states and municipalities as well as firms of all sizes. Should we fragment and constrain the system and cap the size of banks, it would undoubtedly limit the competitive level of service, breadth of products, and speed of execution. Clients could turn to foreign banks that don't face the same restrictions. Ill-judged reform could undermine one of the most important ingredients of American global power: our financial know-how, intellectual firepower, and size.

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 Capitol Hill, but there is no other institution--certainly not Congress itself--that has the sophisticated understanding and detailed knowledge to monitor the financial health of the banking firms and that possesses the relative degree of independence from political pressures that the Fed has exhibited over many years. The Federal Reserve may have fumbled a bit in the evolution of a bubble economy. But once the crisis hit, it was the Federal Reserve, under Ben Bernanke, whose innovative, imaginative response to the crisis literally saved the financial world. Bernanke's Fed found new ways to pump liquidity into the credit markets that were on the verge of a total freeze-up. This could only have happened because of the Fed's political independence, experience in and understanding of the financial world, and wideranging authority. No one could respond better than the Fed if the next crisis is anywhere near as severe as the last one.

Should Congress undermine the Fed's monetary policy function, we would face a worldwide collapse of confidence in the dollar that would inevitably lead to higher interest rates. Congress is always playing the blame game, but it would be incredibly irresponsible at this point to undermine the Fed and its capacity to handle the new financial world that we will all be living in.

 

Financial Crisis, Enron, Hurricane Katrina Examples of Leadership Gone Wrong
Tamara Lytle

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
Paul Greenberg

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
Arianna Huffington

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.

 

(c) 2009 U.S. News & World Report

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