Zuckerman: How to Carefully Fix the Financial System

Let the Federal Reserve oversee new regulations for finance giants.

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The bailout was maddening in coming to the rescue of institutions that had behaved recklessly, but a much larger number would have failed had the government not stepped in. The Treasury Department and the Fed were placed in the unhappy triage position doctors face on the battlefield: choosing which institutions should die and which should be saved.

The too-big-to-fail firms thus lie at the heart of the current crisis. Some are now even bigger, in part because the government had to sponsor and support several mergers that made them larger. The financial industry is now even more concentrated—and the former delinquents get special treatment.

Even before the recent panic, systemically important banks enjoyed serious advantages over their less important rivals, advantages often created by government regulation. The Basel II standards on bank capital allowed large financial firms to hold less capital and equity, often at no more than 2 percent of their total assets, considerably less than their smaller counterparts. The theory was that large meant diversified and sophisticated and, therefore, less risky. Come again? The presumption of safety in size, now proved false, means that the costs of being wrong are now much larger than was commonly realized. The too-big-to-fail financial firm is today a reality that must be acknowledged and dealt with by new legislation, affecting not only commercial banks but theshadow banking system as well. Surely, the conclusion must be that the price large banks pay for the privilege of size should be significantly increased. If they benefit from explicit or implicit protection from the government, they should not be able to ride free on the backs of taxpayers. Their risk of failure should be reduced in one of two ways: by increasing capital requirements or by providing the option for the banks to be smaller or less systemically important. This can be affected either by narrowing what businesses they can be in or by making them less interconnected. In the worst-case scenario, the final backstop has to be bankruptcy or dissolution. A new resolution mechanism will have to unwind these too-big-to-fail institutions through a series of well-ordered procedures that do not imperil the whole economy.

Other risky conduct should be constrained. The "too big" firms should not be allowed to borrow too heavily against their assets. Proprietary trading and other risky financial ventures should be regulated. The prescription is easy to envisage. What's hard is the enforcement. How do we make these rules stick without adversely affecting our market-based system of credit in our free-market economy?

For instance, the federal government's seizure of troubled financial institutions raises serious questions: how, fairly, to detect and eject faulty management, how to protect innocent shareholders, how to change the terms of loans already in contracts. But government can no longer be hamstrung when it sees danger, even in regulating nonbank financial institutions such as the failed investment banks Lehman Brothers and Bear Stearns and the giant insurer AIG.

Some suggest an absolute separation between commercial banks and investment banks. Commercial banks enjoy some government guarantees in return for regulation of their risk taking. Investment banks and other nonbank financial players could have more leeway to trade risky assets with the explicit understanding there would be no bailouts. This could shield the banks from Wall Street's wild ways, but it does not deal with the financial consequences of the failure of giant investment banks or other financial institutions.

Bear in mind that size, for all the crisis it helped to bring, has also greatly benefited the U.S. economy, enabling our big financial firms to compete against others in Europe and Asia. The too-big-to-fail institutions employ millions of Americans and operate around the world, participating with similarly large financial partners to execute diverse and large transactions. They offer a full range of products and services, from loan underwriting and risk management to local lines of credit, providing billions of dollars of financing to states and municipalities as well as firms of all sizes. Should we fragment and constrain the system and cap the size of banks, it would undoubtedly limit the competitive level of service, breadth of products, and speed of execution. Clients could turn to foreign banks that don't face the same restrictions. Ill-judged reform could undermine one of the most important ingredients of American global power: our financial know-how, intellectual firepower, and size.