Art Resource/©2011 C. Herscovici, London/Artists Rights Society (ARS), New York

René Magritte: La Fissure, 1949

It should be clear that among the causes of the recent financial crisis was an unjustified faith in rational expectations, market efficiencies, and the techniques of modern finance. That faith was stoked in part by the huge financial rewards that enabled the extremes of borrowing, the economic imbalances, and the pretenses and assurances of the credit-rating agencies to persist so long. A relaxed approach by regulators and legislators reflected the new financial zeitgeist.

All the seeming mathematical precision that was brought to investment, all the complicated new products, including the explosion of derivatives, that were intended to diffuse and minimize risk, did not work as had been claimed. Instead, the vaunted efficiency helped justify an explosion of weak credit and an emphasis on trading along with exceedingly large compensation for traders.

If those remarks sound critical—and they are meant to inspire caution—let me also emphasize that the breakdown in financial markets and the “Great Recession” since 2007 are also the culmination of years of growing, and ultimately unsustainable, imbalances between and within national economies. These are matters of failures of national economic policy and the absence of a disciplined international monetary system.

Take the most familiar and egregious case. The huge surpluses China has accumulated from its external trade reflect the view of the Chinese government that it is desirable to have rapidly growing export industries that support employment growth. China was willing to build up trillions of short-term dollar assets, mainly US securities paying low interest rates—and thus kept the process going. Conversely, the United States happily utilized that inflow of low-interest dollars from China to sustain heavy consumer spending—much of it on Chinese products—a growing budget deficit, and eventually an enormous housing bubble.

Or consider the current European crisis. At its roots are years of growing imbalances within the countries of the eurozone. As in other parts of the world, the ability to borrow at low rates bridged for a while the proclivities of some countries to spend and import beyond their means, while other countries saved and invested, tending to reinforce an underlying gap in productivity between national economies.

Those were fundamentally matters of public policy—the result of decisions on taxing, spending, and exchange rates; they were not a reflection of the characteristics of the financial market. But neither can we ignore the fact that financial practices helped sustain such imbalances. In the end, the build-up in leverage, the failure of credit discipline, and the opaqueness of new kinds of securities and derivatives such as credit default swaps helped facilitate, to a truly dangerous extent, accommodation to the underlying imbalances and to the eventual bubbles.

All these developments derive in some part from the complexity implicit in the growth of the so-called shadow banking system—the nondepository banks, hedge funds, insurers, money market funds, and other largely unregulated entities that grew enormously in size after 2000—a system that by June 2008 was roughly the size of the traditional banking system. In the end, the consequence was to intensify the financial crisis and to severely wound the real-world economy. Even today, four years after the first intimations of the subprime mortgage debacle, high indebtedness and leverage, impaired banking capital, and a pervasive loss of confidence in a number of major financial institutions constrict an easy flow of credit to smaller businesses, potential home buyers, and consumers alike.

Where do we stand?

The first international response has been to review the capital standards required of commercial banks. How much capital should such banks be required to retain relative to their loans? That’s an old question. Shortly after I left office as chairman of the Federal Reserve in 1987, the Basel I agreement was completed, setting out so-called risk-based capital standards for banks to be adopted by all financially important countries. That agreement was, indeed, a success. Standards for maintaining adequate capital were raised and a degree of international consistency achieved. Those goals remain critically important, and as illustrated by the Basel agreement, capital standards for banking can be agreed on and enforced by national regulators, such as central banks, rather than await legislation in individual countries.

Review of those capital standards for banks—now with the further consideration of standards for the liquidity they should maintain—is widely perceived as a central element in the current reform effort. Some would contend it is the central element. I do not want to discount the importance of such work. We do need, however, to be conscious of the practical difficulties and limitations of setting capital and liquidity requirements. Those problems have long been evident in the effort to enforce the standards established by the earlier Basel agreements. Not surprisingly, they reappear in the ongoing negotiations to strengthen those standards. We see differences in national perceptions, reinforced by intense lobbying by affected institutions, whether central banks, commercial banks, or investment banks. In establishing standards for banks the tendency may be to bend toward a least common denominator, weakening the standards and allowing them to be unevenly applied. Resisting such pressures must be a priority for regulators.


There is the larger conceptual and unsettled question of the extent to which such standards should be applied to the “shadow” banking system I have referred to. When we talk of “systemically important” shadow banks and say they should be regulated, what precisely do we mean? How will their failures affect the entire financial system? These are matters for legislation, complicated further by the need for enough international consistency to resist “forum shopping”—the transfer of operations to less well regulated countries.

The need for regulators and supervisors to take account of new institutions and markets has spawned the new phrase “macro-prudential”—to me cumbersome nomenclature. Just what it implies about the actual practice of regulation is obscure. “Systemic surveillance” or “broad market oversight” seems to convey better what is necessary and desirable. Someone, some agency, some group, should be charged with taking a holistic view toward assessing financial markets and institutions, with particular attention to the interconnections among them, whether domestic or international. Potentially dangerous inconsistencies and instabilities—the growth of the housing bubble based partly on securitized subprime mortgages would be a good example—need to be recognized and assessed. Whether that assessment need carry with it specific regulatory responsibilities and enforcement authority (for instance, setting and enforcing capital standards for “nonbanks” such as hedge funds) will likely vary from country to country. But there can’t be much doubt that success will require international consultation, exchanges of information, and in some areas coordinated action.

These days, finance flows far more freely across national borders than trade. Technology tightly links the operations of big banks and markets. Hedge funds and equity funds, securitized products—even equity markets—are more and more international by nature. Only the most draconian and destructive regulatory measures could stop this interconnectedness.

Today in Europe we see all those realities play out in real time in extreme form. Among nations dedicated to a common market and a common currency, the tensions are great. The plain implication, to me, is not to retreat from an integrated eurozone. Right now it is a question of building protection for European banks and countries that are at risk and faced with financial breakdown. But ultimately what is needed is a new institutional structure that will require greater consistency in banking and financial standards and, more broadly, will also require stronger discipline in fiscal and economic policies.

There is no compulsion to carry that process of integration so far in the world more generally. The financial breakdown and the resulting severe impact on economic activity do, however, point to the need for international coordination beyond the accepted need for common capital standards.

Among the more obvious areas is agreement on international accounting standards. The groundwork has been well advanced for over a decade. Full success, however, still awaits a definitive decision on those standards by the SEC in the United States. I would add to that a more elusive but equally important consideration: auditors who are truly independent and approach their responsibilities with a certain skepticism. American authorities are now considering, among other means to that end, a requirement that auditors of corporate accounts regularly be changed.

Given the weaknesses and conflicts exposed by the crisis, the role and structure of credit-rating agencies also need further review. So far, no fully satisfactory approach has been set out, but surely this is a matter for international consideration. Current efforts directed toward reform within the major firms such as Moody’s and Standard & Poor’s should help, but other approaches need emphasis. Reliance on the formal ratings issued by an oligopoly of the dominant credit-rating agencies could be reduced by greater, perhaps more focused, competition from other agencies. It would also help to establish standards for competent “in-house” determinations of credit standards, a matter touched upon by the Dodd–Frank legislation passed in July 2010.

More immediately important, and it seems to me more amenable to structural change, is the role of money market mutual funds (MMMFs) in the United States. By grace of an accounting convention, those funds are permitted to meet requests for withdrawals upon demand at a fixed dollar price so long as the market valuation of fund assets remains within a specified limit around the one dollar “par” (in the vernacular “the buck”). Started decades ago, money market funds today have trillions of dollars heavily invested in short-term commercial paper, bank deposits, and recently, and notably, European banks.


Free of capital constraints, official reserve requirements, and charges for deposit insurance, these MMMFs are truly hidden in the shadows of banking markets. The result is to divert what amounts to demand deposits from the regulated banking system. While generally conservatively managed, these funds are, in troubled times, demonstrably vulnerable to disturbing runs, as was highlighted in the wake of the Lehman bankruptcy after one large fund had to suspend payments. The sudden impact of that suspension on the availability of business credit in the midst of the broader financial crisis compelled the Treasury and Federal Reserve to provide hundreds of billions of dollars by resorting to highly unorthodox emergency funds to maintain the functioning of markets.

Recently, in an effort to maintain some earnings, many of those funds invested heavily in European banks. Now, with no official protection of liquidity, they are actively withdrawing those funds, adding to the strains on European banking stability.

The time has clearly come to harness money market mutual funds in a manner that recognizes both their structural importance in diverting funds from regulated banks and their destabilizing potential. If indeed they wish to continue to provide, on so large a scale, a service that mimics commercial bank demand deposits, then strong capital requirements, government insurance protection, and stronger official surveillance of their investment practices are called for. Simpler and appropriately, they should be treated as ordinary mutual funds, with redemption value reflecting day-by-day market price fluctuations.

“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.

The Independent Commission on Banking in the United Kingdom—the so-called Vickers Commission—proposed in September a more sweeping structural change for organizations engaged in commercial banking. In essence, within a single financial organization the range of ordinary banking operations—taking deposits and making loans—would be segregated in a “retail bank.” That bank would be overseen by its own independent board of directors and “ring fenced” in a manner designed to greatly reduce relations with the rest of the organization, which may be involved in investment activities, proprietary trading, and underwriting.

Apparently, customers could deal with both parts of the organization, and some limited transactions permitted between them. But as I understand it, the “retail bank” would be much more closely regulated, with relatively high capital and other stringent requirements. The emphasis of such rules would be to insulate the bank from failures of the holding company and other affiliates. There seems to be at least a hint that public support may be available in time of crisis. That presumably would be ruled out for other affiliates of the organization.

The practical and legal implications of the UK proposal remain to be defined. Surely problems abound in trying to separate the fortunes of different parts of a single organization, reflected in the length and detail of the commission’s report. Perhaps most fundamentally, directors and managements of a holding company are ordinarily assumed to have responsibility to its stockholders for the capital, profits, and stability of the entire organization, which doesn’t fit easily with the concept that one key subsidiary, the “retail bank,” must have a truly independent board of its own.

As a matter of day-to-day operations, some interaction between the retail and investment banks is contemplated in the interest of minimizing costs and facilitating full customer service. American experiences with “firewalls” and prohibitions on transactions between a bank and its affiliates have not been entirely reassuring. Ironically, the philosophy of US regulators has been to satisfy themselves that a financial holding company and its nonbank affiliates should be a “source of strength” to the commercial bank. That principle has not been highly effective in practice.

In any event, while there are differences in the structural approaches to reform in the US and UK, they are in fundamental agreement on the key importance of protecting traditional commercial banking from the risks and conflicts of proprietary trading and other investment activity. Both are consistent with developing a practical authority for resolving bank and other failures of systemically important institutions. If it is widely agreed upon internationally, that will be the keystone in a stronger international financial system.

One thing is sure: we have passed beyond the stage in which we can expect the officials of central banks, regulatory authorities, and treasuries to rely on ad hoc responses in dealing with what have become increasingly frequent, complex, and dangerous financial breakdowns. Structural change is necessary. As it stands, the reform effort is incomplete. It needs fresh impetus. I challenge governments and central banks to take up the unfinished agenda.

—October 27, 2011