Too Big To Fail A Regulatory Misstep
Noteworthy in the last two decades spate of financial meltdowns is the nature of business the culprits have. Most are financial institutions, the other two, swallowed by its fraudulent accounting procedures. Americas regulatory agencies faced the 1990s with a hefty effort to save FDICs Bank Insurance Fund (Thompson 2). Then came the hedge fund Long Term Capital Management in 1998, the accounting scandals that brought Enron down in 2001 and soon followed by Worldcom in 2002 (Thomspon 2). And recently came the subprime mortgage crisis, which spilled over and became the worst economic downturn since the Great Depression of the 1930s.
We have seen the successes of many big firms in the past two decades. Led by the dotcoms, financial might seems to be wired to companies willing to take the profitable risk that made them. Too bad we have to experience also a fair share of failures. But what is causing these huge firms to collapse Are there remedies to prevent another too big to fail problem And are these remedies good enough to solve the problem
The Mother of All Moral Hazards
Thompson says in his article that the implicit rescue guarantees as far as the eye can see are creating the mother of all moral hazards.(1) This move by the government is making matters worst. He quotes HBS professor and economic historian David Moss, the extension of implicit guarantees to all systemically significant institutions takes moral hazard in the financial system to an entirely new level. It could eventually give huge companies an opportunity to be saved, which may not be good in the long run, by the government thru the regulators when they are suffering from some kind of failure or worst the risk that a failure of one institution could wreak havoc across the entire financial system (Thompson 1). This is what we call systemic risk.
Systemic risk is basically borne out of the interdependence of firm operations and business transactions. It is this risk that was identified as the cause of the 2009 financial crisis. The crisis all started on the inability of the mortgage industry in the United States to recover unpaid housing loans. This ballooned finally giving those firms huge losses that soon affected the bigger firms, specifically investment banks that own a sizeable amount of shares in them (mortgage firms). Then, it was time for these investment banks to break apart. So big these firms are that its equity was also sold worldwide exposing and dragging overseas shareholders to this mess.
The 700 billion Troubled Asset Relief Program (TARP) bailout plan (Thompson 1) was so controversial it made the American people wince in disbelief. It was a common argument from all sides that if the government is in big deficit, how come there is that amount of money to be given for salvaging probably an entire industry. Why not give it to areas needing social bailouts Moreso, experts believe that if banks are rewarded for success and protected from failing (i.e.bailouts), there will be little incentive for prudence and smart management (Fernholz). Once again, the fear of putting another accounting scandal or a new corporate mismanagement on the map because of this bailout is inevitable.
Government Faux Pas
Thompson was clear in his article in pointing out the mistakes the government did the last two decades leading to this crisis.(2) He also discloses that President Reagan even admitted in his 1981 inaugural address that the government is not the solution to our problem government is the problem. From then on, there was regulatory minimalism for three decades allowing markets to treat its own wounds. A modern laissez-faire seemed to work despite of some smaller problems along the way. But not until the 2009 crisis that made regulators rethink.
First, there was obviously some regulatory neglect. Lawmakers failed to enact new regulations. Washington, not Wall Street, caused the bursting of the subprime mortgage bubble (Thompson 2). The past decades saw the market mechanism being head and shoulders above anything, but it did not see the government doing something as regulators relied on its existing rules. Second, the Federal Reserves policy of holding the interest rate so low for a very long time fed the housing bubble with cheap credit (Thompson 2). Per basic macroeconomic theory, if cost of credit is cheap, more people will demand for credit or loans. This is good for the credit industry and the economy as a whole, only if debtors are able and willing to pay back what they owe. But this was not the case. Lastly, the Securities and Exchange Commission worked like a cartel inflating ratings (Thompson 2) costing transparency to many.
Solving the Too Big To Fail Dilemma
The logic behind too big to fail is that large firms collapses and investors, creditors, employees and the whole industry go with it. But it is not always a question of size that defines the problem. It is also role. Some relatively huge banks or institutions that failed (like Lehman Brothers) were not the biggest. Their roles in the market compensated their lack of size (Fernholz). The geographic and investment extent of the business must also be considered. Diana Farrell, a top White House official working on financial regulation says that size alone does not explain risk. Some Japanese and European firms are even larger than its US counterparts. In a sophisticated economy, there is a need to admit that large, interconnected firms having complex networks should also be controlled in some way to prevent another crisis (Fernholz).
From Thompsons and Fernholz articles, three solutions can be devised for these financial institutions and big companies. First is to break them. Let us say, we have a big bank. We break up the bank into large regional banks not really into hundreds of small banks. That way it can be safely placed through a bankruptcy. This is a very drastic solution. Although sensible, it is costly. Dividing up a big bank into smaller big banks will exhaust operating expenses. Just looking for regional offices or locations is already expensive and time consuming. Another, according to Fernholz on banks, breaking them up is not that easy because they are that politically powerful. And he poses a question how do you measure a large bank given todays globalized financial markets. Apparently, domestic banks may benefit from this remedy if they can afford the big move. But looking at the nature of many big banks now that go global in its operations, the solution becomes really problematic.
A second solution, per Thompson, is toughening new regulations on firms that pose systemic risk. (1) One regulation is to impose higher capital requirements. This will prevent the firm to grow bigger. Or if it has to reach that height due to corporate objectives and obviously an unprecedented growth, it has to work hard enough to maintain that stage. Another is putting leverage limits on those big firms. Companies that create systemic risk should bear the cost of insuring against itand the government should insist on appropriate capital standards and liquidity requirements to limit the type of risks that these firms impose on society. Last is a receivership process to restructure, sell, or liquidate a failing company. This is an option to be taken when assistance from the government no longer helps. With these controls on capital, liquidity and leverage, firms will have little incentive to expand as they try to shrink themselves (Fernholz).
The third solution is a complete overhaul restructure the financial system. There is a need to rearrange the regulatory system so most big financial firms especially national banks will be under one supervisor, as the Fed and a council of regulators monitor risk (Fernholz). Also proposed by Fernholz under this remedy is reforming compensation structure, derivatives trading and the rating agencies. Very clear in the United States stand lately is the cutting back of executive bonuses and other compensation. CEOs and other highly ranked officers of a company get these huge incentives so as to make them work harder. The worst that happened was that it inflated across the decades of boom. Now that a recession struck, it must be just as relevant to cut down huge compensations to more normal levels. On trading, we have also witnessed the temporary ban that was placed on short selling. It was believed that short selling aggravated the crisis. Because in short selling, you can still profit even when the price of a stock or commodity is falling. A commendable part of this remedy is the resolution authority given to the FDIC for orderly arrangement on liquidation of firms, big and small. It will first inform shareholders and creditors of a firms impending demise before the system would know it.
The last two remedies or solutions are both realistic and achievable. The second remedy is an instant response from the crisis. It essentially offers short-term adjustments for abrupt shocks like the 2009 mortgage crisis. These are just rules or regulations on the firm level. To help out the industry, it first focuses on the misbehavior of firms with the belief that existing regulatory controls are enough and are not being followed. The third remedy is the most encompassing solution (and pro long-term) to the problems caused by the too big to fail policy. This remedy includes the regulator as well as the government to act out in developing a better regulatory system. Restructuring the financial system is as big as the birth of a new nation. Existing rules, laws and even the old culture of such system are subject to change or total eradication. If existing laws do not work anymore, it must be replaced for it does not serve its very purpose anymore. It has gone obsolete by the changes of the times.
Americas oversight failure during the last two decades or so only appeared last year. A strain on its old rules finally made a part of it snap and crumble. Changing the system should make sense as mistakes or imperfections, grave or simple, are bared when crisis like this happens. And it is when they come out in the open that regulators will feel the need for an institutional change.
The Federal Reserve as Super Regulator
The utmost demand for a systemic risk regulator has been the talk of the town lately. But how do you measure systemic risk And which government agency will measure it Thompson offers some insights on measuring systemic risk.(3) He quotes that there are no measures for systemic risk so far but there are five observable factors that are associated with financial crises (a) inflated prices of real estate, (b) institutions with high levels of leverage, (c) new products falling into regulatory gaps, (d) rapid growth in an asset class or intermediary, and (e) mismatches of assets and liabilities.(3) All these factors were common among the great financial crashes of the last two decades, from FDICs Bank Insurance Fund to LTCM to Enron and Worldcom until Lehman and AIG.
The Fed being touted as the super regulator must see to it that these past events should never happen again plus the fact that critics are still weary of the wrong-footed style of government control seen in history. To be one efficient super regulator, the change must first come in their own system of governance, then direct the change to its connected agencies and so on.
Conclusion
The policy of too big to fail was once so strong it safeguarded Americas big firms, mostly financial institutions, from changing consumer perception and economic slowdowns. But when the big one arrived, in 2009, all fell into ruin including the trust the taxpayers have of the government. Governments lost of oversight of this impending event and its missteps in its regulatory control and response provided the impetus for an appropriate and effective solution to solve the too big to fail problem. A financial system restructuring is the best answer for the crisis it brought. Regulators must not just focus on financial and accounting oversight but also to the strength of its political will and social responsibility.