Current bank oversight failed to prevent the financial crisis. Let’s not prescribe more of the same business operational risk.
June 2009 | by John Olivier
The G-20 meeting in London earlier this year set the direction for reforming the regulation of financial services to prevent a recurrence of the present crisis. The causes of the current crisis resemble those of many previous ones: banks that didn’t have enough capital lent too much, too easily, relying on wholesale funding that disappeared when the inevitable concerns about asset quality arose. Yet there are important differences this time. The current problem started in what were regarded as the world’s safest and most sophisticated markets and spread globally, carried by securities and derivatives that were thought to make the financial system safer.
If regulators working on solutions resist the reflex to build incrementally on conventional wisdom and existing structures, we now have an opportunity to reshape the global regulatory system fundamentally. That will require a dispassionate assessment of the reasons for the current system’s failure. The difficult issues regulators must address include the appropriate degree of protection for financial institutions, the regulation of nonbank entities (such as hedge funds), and the determination of adequate capital levels. Brave—even radical—changes may be necessary.
Tackling ‘Too Big to Fail’
A large bank’s failure poses risks to other institutions, the financial system, and the broader economy. For this reason, regulators often step in to protect not only the bank’s depositors but also all its creditors (and sometimes shareholders) from losses they would otherwise face. Banks for which governments are likely to intervene are seen as “too big to fail” (TBTF). While this kind of protection solves the immediate problem, it increases longer-term systemic risk because creditors or investors have less reason to monitor banks they see as TBTF, and the managers of these banks have a greater incentive to take risks. Governments tried to mitigate this element of moral hazard by being deliberately ambiguous about which banks they would rescue and on what terms, but the recent rescues obliterated this ambiguity, and the world now believes that no large financial institution—bank or nonbank—will be allowed to fail in the way nonfinancial companies do.
Most proposals to address the TBTF problem, from the G-20 and others, recommend regulating and supervising large, complex financial institutions more tightly. Yet the clear message of economic history is that incentives overpower regulation. Measures are needed to prevent, or at least discourage, institutions from becoming too big to fail in the first place and to wind them down if they do. Several actions could be taken to prevent them from becoming so big that they create systemic risks. It may be possible to use antitrust approaches designed to prevent markets from becoming too concentrated.
Besides prevention, we need a cure—a system for liquidating large banks in a way that controls systemic risk but still ensures that investors, creditors, and managers bear sufficient pain to eradicate moral hazard. The United States has a tried-and-tested bank wind-down process, but it is designed for straightforward domestic commercial banking and would need to be adapted for more complex and global institutions.
Creative ideas have been proposed for handling failures by immediately transferring good assets to a new, smaller but shiny “bridge bank.” That would leave uninsured creditors with not only a “bad bank” holding troubled assets but also some equity in the new institution. It is not clear whether governments coping with the present crisis were right to rescue and continue to support so many banks. But incentives matter: no matter how big banks are regulated, there will be many more failures if they always expect to be bailed out.
A once-in-a-generation opportunity to redesign the global financial system is at hand. The broad direction of reform is clear, but the details are important and getting them wrong will prepare the way for the next financial failure. The design of reform should be careful and deliberate, based on a thorough analysis of the underlying problems. It should be sufficiently creative and innovative to provide solutions for the next twenty years instead of revising approaches that haven’t worked for the past twenty. And it should tackle issues that are difficult politically, such as the protection of TBTF institutions.