Preventing the Next Fire While This One Blazes
When firefighters are still struggling to extinguish the blaze, talking about fire prevention seems premature. The worst financial crisis since the Depression isn't over, yet it's time to put the best brains to work at reconstructing the financial regulatory structure so we don't go through this again.
Trying to wait until the fire is out will yield one of two bad outcomes: a simple-minded, myopic rush to regulation that will make the financial system no safer and the world economy worse off, or talk about "reform" that fades into inaction. Beginning the renovation of regulation will help speed the end of this painful episode. As Barney Frank, chairman of the House Financial Services Committee, puts it: "People...aren't going to go back into the water until we tell them we've killed most of the sharks."
Preventing all future crises is not the goal. That would be the equivalent of banning stoves and furnaces: We'd have fewer destructive fires but we'd be cold and miserable. The goal is to prevent mishaps from burning down the world economy. Here are three of the threshold questions that need pondering:
Who shall be saved, and who shall be allowed to die?
The policy of the U.S. government is that no large, interconnected financial firm can be allowed to fail because such failures threaten the broader economy. Main Street banks that take deposits are no longer the only "systemically important" institutions. Now, brokerage firms such as Bear Stearns and insurers like American International Group are too big or too intertwined with the economy to fail.
The government must draw a circle to identify which firms or kinds of firms will be saved. No more sleep-deprived government officials making case-by-case decisions on Sunday nights.
What about big hedge funds? Private-equity houses? Huge pension funds? The circle can't be drawn in indelible ink. Institutions and markets keep evolving. And firms inside the circle must pay for taxpayer-provided protection in fees (akin to the premium for deposit insurance that banks pay) or through rules that force them to hold more capital, borrow less readily or keep more cash on hand for emergencies (which means lower profits). Otherwise, investors will make risky loans to these outfits, knowing the taxpayers will bail them out. But make the charge for being "systemically important" too onerous, and big bucks and smart people will move just to the outside of the circle -- and we'll be back where we started.
How paternalistic should regulation be, and who should be the parent?
The problem wasn't only that the U.S. wasn't tough enough on Citigroup or that the U.K. mishandled mortgage lender Northern Rock. "The far bigger failure -- shared by bankers, regulators, central banks, finance ministers and academics across the world -- was the failure to identify that the whole system was fraught with market-wide risk," the head of Britain's Financial Services Authority, Adair Turner, said this year. "We failed to put together the jigsaw puzzle." So there's an emerging consensus that every country needs an overarching guardian of financial stability.
But anointing a financial-stability guardian is like sending a lone chaperone on a camping trip with a busload of teenagers: Technically someone has supervision but likely won't prevent hanky-panky. The danger is that all we do is identify an agency to take the blame when the next crisis arrives. Hence the reluctance of some inside the Federal Reserve, the leading candidate for this role in the U.S., to take the job, a reluctance matched only by the Fed's conviction that only it can possibly do the job.
Nonetheless, we're going to get a guardian, and that's better than the status quo. The question is how much power to give it. The easy answer: enough to protect the system but not so much that it micromanages business executives or consumers who may choose to take prudent risks. The harder question is whether to give the guardian enough clout to, say, impose rules on borrowing when everyone is getting too giddy or to ban particularly risky strains of loans. Or whether, instead, the guardian should be the Paul Revere of the financial system, limited to shouting warnings.
Can we install air bags in the financial system that deploy automatically?
Today's mess reflects the failure of every check on the system, from credit-rating firms to central bankers. But just as maddening are rules that encouraged and sometimes forced banks to do things that are hurting the rest of us now. That's dumb.
A bank that wanted to set aside extra reserves in good times, for instance, was blocked by accountants who deemed that to be improper "earnings smoothing." So it's time to choose between accounting rules that aspire to a Platonic ideal of truth and rules that foster stable markets and a better economy. The rules that govern the size of banks' capital cushions prompt them to raise capital at unpropitious moments like today after they've taken big losses instead of prodding them to build bigger cushions in good times. That shows the wisdom of proposals to create a new kind of bank debt that automatically converts to equity capital, triggered either by financial ratios set in advance or by government declaration of "unusual and exigent circumstances," to borrow a phrase from the Federal Reserve Act.
Getting all this right is crucial. As the reaction to the Depression proves, the changes will be far-reaching and long-lasting.
