NOVEMBER 25, 2009
Finding the Right Fix for 'Too Big to Fail'
By MORTIMER ZUCKERMANIn 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. The long history of financial panics wrecking American lives had led to what we thought was a tight regulatory system. But the system did not keep pace with fast-moving changes in the financial industry.
It is true that the Federal Reserve, perched at the top of the financial system, 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 a very low 1% 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.
It is also true that the wisdom that led to the Glass-Steagall Act, which separated commercial banks from investment banking during the Great Depression, was discarded. 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 would bring down the whole house 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 too-big-to-fail firms, in short, 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 presumption was that big meant diversified and sophisticated and, therefore, less risky. That presumption proved false.
The dangers posed by a too-big-to-fail financial firm surely must be dealt with by new legislation, and one change needed is 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 one of two ways: by increasing capital requirements or by providing the option for the banks to be smaller or less systemic. This can be done 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 through a series of well-ordered procedures that do not imperil the whole economy or adversely affect our market-based system of credit.
Some also suggest that we go back to Glass-Steagall, and once again separate investment from commercial banks. This could keep the banks at least shielded 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.
Moreover, it must be remembered that the size of many of our financial institutions, despite its role in bringing on the crisis, has also greatly benefited the U.S. economy. Size, for example, enables our big financial firms to compete against others in Europe and Asia.
The too-big-to-fail institutions 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 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 any radical limits on the size of financial firms are imposed, we should test whether we can accomplish our goals through new regulatory measures, including lowering permissible leverage by imposing higher capital liquidity requirements. Regulators also should have 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.
And however we go about protecting the financial system, it is critical that the Federal Reserve remain at the center of new regulatory efforts. The Fed may be less popular today on Capitol Hill, but there is no other institution—certainly not Congress—with the sophisticated understanding and detailed knowledge to monitor the financial health of the banking firms. No other institution possesses the relative degree of independence from political pressures that the Fed has exhibited over many years.
The central bank may have fumbled a bit in the evolution of the bubble economy. But once the crisis hit, it was the Fed, under Chairman Ben
Bernanke, whose innovative, imaginative response to the crisis literally saved the financial world.Mr. 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 independence, experience in and understanding of the financial world, and its wide-ranging 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, we could face a world-wide 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 irresponsible to undermine the Fed and its capacity to handle the new financial world that we will all be living in.
—Mr. Zuckerman is chairman and editor in chief of U.S. News & World Report.
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