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Financial Reform: Unfinished Business

Too Big to Fail”—The Key Issue in Structural Reform

Rafael Valls Gallery, London/Bridgeman Art Library
Gabriel-Germain Joncherie: Cashier Counter with Coins, 1829

The greatest structural challenge facing the financial system is how to deal with the widespread impression—many would say conviction—that important institutions, such as the large international banks, are deemed “too large” or “too interconnected” to fail. During the crisis, creditors—and to some extent stockholders—were in fact saved by injection of government capital and liquidity amounting to trillions of dollars, reinforcing the prevailing attitudes.

Few will argue that the support was unwarranted in view of the severity of the crisis and the danger of financial collapse in response to contagious fears, with the implication that such a collapse would impose intolerable pressures on the economy. But there are real, behavioral consequences of the rescue effort that was made. The expectation that taxpayers will help absorb potential losses can only reassure creditors that risks will be minimized and help induce risk-taking on the assumption that losses will be repaid out of public funds—with the potential gains all private. Understandably the body politic feels aggrieved and wants serious reforms.

The issue is not new. The circumstance in which occasional government rescues can be justified has long been debated. What cannot be in question is that the prevailing uncertainties demand an answer. And that answer must entail three elements:

First, the risk of failure of “large, interconnected firms” must be reduced, whether by reducing their size, curtailing their interconnections, or limiting their activities.

Second, ways and means must be found to manage a prompt and orderly process for resolving the outstanding debt and other problems of firms that fail (or are on the brink of failure), minimizing the potential impact on markets and the economy without extensive official support.

Third, key elements in the approach toward the failures of banks and other financial institutions need to be broadly consistent among the major financial centers both here and abroad, where the failing institutions have critical operations.

Plainly, all these elements will require structural changes embodied in legislation. Various approaches are possible. Each is difficult intellectually, politically, and in practice, but progress in these areas is the key to effective and lasting financial reform.

I think it is fair to say that in passing the Dodd–Frank legislation, the United States has taken an important step in the needed direction. Some elements of the new law remain controversial, and the effectiveness of some of the most important elements will still be subject to administrative rules yet to be written. Most importantly, a truly convincing approach to deal with the “moral hazard” posed by official rescue efforts—the possibility that knowledge of a government backstop against failure will create an incentive for financial firms to take greater risks—is critically dependent on complementary action by other countries.

Concerning the first element I have listed, dealing with financial institutions that are “too big to fail,” the US approach in the Dodd–Frank bill sets out limited but important reforms. First, the size of the major financial institutions (except for “organic” growth) will be constrained by a cap on assets as a percent of the US GDP. That cap is slightly higher than the existing size of the largest institutions, and is justified as much by the need to limit further concentration as by the need for prudential measures in case of failure.

The newly enacted prohibitions on proprietary trading by banks and the strong limits on their sponsorship of hedge and equity funds should be much more significant. It is true that the impact of the Dodd–Frank bill on the sheer size of the largest US commercial banking organizations and the activities of foreign banks in the United States may be limited. But the new restrictions on trading are an important step in dealing with excessive risk, conflicts of interest, and, potentially, compensation practices as well. The recent large trading losses by a large Swiss bank illustrate the case for restrictions on proprietary trading by banks and for limiting participation by American institutions in sponsoring private pools of capital. At its root, the case for restriction on trading is a matter of the culture of banking institutions.

The justification for official support and protection of commercial banks is to maintain a flow of credit to businesses and individuals and to provide a stable, efficient system by which payments can be made. Those are both matters entailed in continuing customer relations, and they necessarily imply an element of fiduciary responsibility—i.e., an assurance to customers that they can trust the financial institution to protect their assets—on the part of the bank. These are the essential banking functions. It is hard—I think impossible—within a single institution to impose on those central bank functions a system of highly rewarded—very highly rewarded—impersonal trading that is not protective of client relationships. In any event, it is surely inappropriate that those trading activities be carried out by institutions benefiting from taxpayer support, current or potential.

Similar considerations bear upon the importance of requiring that trades in derivatives, which now are largely unregulated, ordinarily be cleared and settled through strong clearinghouses. The purpose of such requirements in the Dodd–Frank bill is to encourage simplicity, standardization, and better assurance of timely payment, in an area that has been rapidly growing and that is fragmented, unnecessarily complex, opaque, and, as events have shown, risk-prone.

There is, of course, an important legitimate role for derivatives and for proprietary trading. The question is whether those activities have been extended well beyond their economic utility, driven by what one astute observer has expressed as “trying to extract pennies from a roller coaster.”

One very large part of American capital markets—indeed the dominant part—is the market for residential mortgages. The financial breakdown was directly related to, and abetted by, lax, government-tolerated underwriting standards for those mortgages. The origination and huge volume of so-called “subprime” mortgages, typically securitized in large CMOs and CDOs (collateralized mortgage and debt obligations), supported the unsustainable rise in prices of homes and the housing bubble. So far the calls for large-scale structural change have not resulted in legislation, but the need for reform and the direction of change is clear.

The mortgage market in the United States has long been supported by a few government agencies, and particularly by government-sponsored but privately owned organizations. Collectively, these so-called government-sponsored enterprises (GSEs)—Fannie Mae, Freddie Mac, and the Home Loan Banks—have provided an efficient secondary market for mortgages, but in the process they have issued or guaranteed obligations rivaling the amount of publicly held Treasury securities.

The interest rates on those GSE securities have been close to those on Treasury bonds because it has been broadly assumed, quite accurately as it has turned out, that in case of difficulty the creditors would be directly or indirectly paid by the government (i.e., the taxpayer). The effect has been to permit high leverage of the GSEs—allowing large-scale borrowing against the mortgages—and to provide an indirect subsidy to the mortgage market, benefiting the GSE stockholders as well as home buyers. In the 2008 crisis, the government, confirming market expectations, took control of both Fannie Mae and Freddie Mac, assuring their continued operation despite large losses. The “moral hazard” implicitly protecting creditors of stockholding GSEs has thus been confirmed.

Today, the residential mortgage market is almost completely dependent on government support. It will be a matter of years before a healthy, truly private market can be developed, with appropriate regulatory and supervisory standards. But it is important that planning proceed now on the assumption that the inherently ambiguous role of the GSEs be ended. To the extent that a political judgment is made that particular circumstances require government support of the mortgage market, that support should be provided openly by a full-fledged government agency.

The Need for International Consensus

We cannot, and should not, contemplate a financial world so constrained by capital requirements and regulation that all failures are avoided and innovation and risk-taking are lost. As I noted earlier, we need to develop arrangements to deal with such failures that do occur in a manner that will minimize the risks to market continuity and the possibility of contagion.

Success will be dependent on complementary approaches in major markets—New York, London, continental European centers, Tokyo, Hong Kong, and before long other growing Asian markets. In essence, when failure takes place or is clearly threatened, the authorities need to be able to cut through existing, and typically laborious, national bankruptcy procedures. To do this will require new “resolution authorities” that can maintain necessary services and fulfill the immediate need for day-to-day financing while the failing organizations are liquidated, merged, or sold, whether in their entirety or piece by piece. Shareholders and management will be gone. Creditors will be placed at risk.

Such arrangements are incorporated in the Dodd–Frank law. I think it fair to say that there is a great deal of skepticism about whether these arrangements will be effective in the midst of crises, and whether market participants will continue to presume that governments will again “ride to the rescue.” Surely, that skepticism is likely to remain until the most important of the various jurisdictions—including private, national, and international systems—can be brought into reasonable alignment.

My sense is that efforts are, in fact, well under way to clear away some of the technical underbrush and to agree on procedures for intervention and exchanging information. An important element in that effort is the concept of requiring the systemically important institutions to develop “living wills.” The idea is that those institutions reorganize their various operations to the extent necessary to facilitate the sales merger, or “stand alone” arrangements for parts of the organization in the event of threatened failure.

It is evident that there is not yet full agreement on elements of the basic structure needed for banking and other financial operations. Some jurisdictions seem content with what is termed “universal banks”—i.e., banks engaging in commercial banking and the full range of investment banking and even commercial trade, for example—whatever the conflicting risks and clash of cultures involved. In the United States, there are now restrictions on the activities of commercial banking organizations, particularly with respect to trading in capital markets, hedge funds, and links with commercial firms.

Financial institutions not undertaking commercial banking should be able to continue a full range of trading and investment banking activities, and even could continue links with commercial or industrial firms. When deemed “systemically significant,” they will be subject to capital requirements and greater surveillance than in the past. However, for such institutions there should be no presumption of official support—access to the Federal Reserve, to deposit insurance, or otherwise. Presumably, for them, failure will be more likely than in the case of regulated commercial banks protected by the government safety net. Therefore, it is important that a new process for resolving the problems of risk and failure be available and promptly brought into play.

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