The problem of too-big-to-fail
Too Big to Fail
The failure of Lehman Brothers in Sept. 2008 made manifest the problematic reality that the amount of risk held by some financial institutions, combined with their intimate connections to many sectors of the economy, meant that the failure of just one such institution could create ripples throughout the entire financial industry. This so-called “too big to fail” problem was not limited to banks; insurance companies that had backed up the risk held by such banks also posed systemic risks.
Institutions with systemic risks pose several significant problems. Systemic risks have an implicit backing from the U.S. government because any failure to bail them out would result in national — and, as we have seen, international — economic catastrophe. Having the implicit backing of the government has political, social, and economic effects. Politically, the situation gives any company posing systemic risk enormous leverage in negotiations; socially, it creates unequal classes of private businesses; and economically, it permits these companies to make bets without exercising appropriate caution.
The most obvious solution to this problem is to prevent any situation in which the government would have to bail out a systemically important institution. This could be done, Harvard economics professor Jeremy Stein explained, simply by setting for such institutions high capital requirements that would make it virtually impossible for a bank to actually fail. The problem with this approach, notes Stein, is that the true effect of such a measure would be to push many “bank-like activities outside of banks,” to what is known as the world of shadow banking, exempt from government regulation. And, as Cornell economics professor Robert Frank pointed out in an interview with the HPR, one of the fundamental problems of this crisis was that a bunch of institutions were “walking and talking and acting like banks,” but were not “regulated like banks.”
Fed to the Rescue?
So, what is to be done about the behemoths of the financial sector? The Obama administration has proposed endowing the Federal Reserve with the power to supervise all firms that pose systemic risks; oversight powers would be given to a council made up of the heads of the major regulatory agencies. The bottom line, according to Stein, who worked at the Treasury Department from Jan. to Aug. 2009, is that the Fed is and will be the “de facto crisis manager.”
The trouble is that a large contingent, including many members of Congress, is uncomfortable with the power the Fed wielded during the crisis of 2007-8. Alex Pollock of the American Enterprise Institute told the HPR, “the Fed has itself been a big contributor to systemic risk.” Aside from concerns over accumulation of power, Pollock points to the inherent conflict of interest. It would be like putting “the fox in charge of the hen house,” he said.
“An Impossible Job”
Pollock believes that the idea of a systemic-risk regulator goes too far because it assumes that we are capable of reliably predicting financial outcomes, when our track record suggests otherwise. Pollock put it bluntly: “The systemic-risk regulator has an impossible job.” Pollock would propose a systemic-risk advisor who works to identify developing risks and then conveys that information to the regulators who can choose to take action. Overall, however, no one would have direct authority to intervene on the basis of systemic risk.
Both chambers of Congress are considering proposals that would penalize banks for becoming too big to fail, but the real and perceived advantages of size may outweigh these provisions; banks have only consolidated in the wake of the crisis. Addressing systemic risk, then, may be the most important and the most difficult task facing those who want to prevent another financial crisis down the road. Finding a way to break up institutions that are “too big to fail” may be the only way to definitively curb systemic risk.