As the Obama administration reveals its plans
for overhauling financial regulation, one question it has never
answered squarely is just why Washington has been so concerned,
over the last two years, with bailing out large financial
institutions.
In August 2007, the U.S. Federal Reserve saw
the chaos triggered by the bursting of the housing bubble as a
liquidity crisis -- essentially a matter of banks mistrusting one
another because of the unknown quantities of dubious assets on
their books. So the Fed poured additional liquidity into the
system to prevent contagion.
By March 2008, it became clear that the problem
was not just liquidity, but solvency. So the U.S. Treasury decided
to rescue the troubled investment bank Bear Stearns, forcing it
into a shotgun marriage with JPMorgan Chase and providing an
extraordinary $30 billion dowry from taxpayers to lubricate the
deal.
Then, during the summer of 2008, new threats
emerged as two other organizations deemed "too big to fail" veered
toward collapse: Fannie Mae and Freddie Mac, the two giant
mortgage companies that are "government-sponsored enterprises"
with private-sector shareholders. In September, the Treasury felt
compelled to step in and rescue them as well.
Soon afterward, to avoid looking like an easy
touch, government officials allowed Lehman Brothers to be forced
into bankruptcy, but the market reaction to that was so bad that
they immediately reversed course, rescuing American Insurance
Group with a combination of Treasury and Fed resources and asking
Congress to approve a $700 billion Troubled Asset Relief Program.
Then Treasury Secretary Henry Paulson initially planned to use the
money to buy toxic assets from financial institutions. But that
approach ran afoul of political pressures to avoid doing favors
for financiers, so Paulson switched tactics and began to provide
capital infusions to the financial institutions directly (in order
to offset their financial losses on mortgage-backed securities,
collateralized debt obligations, and other troubled holdings).
The Federal Reserve, meanwhile, introduced new
mechanisms to buy financial assets in the marketplace. With the
Term Asset-Backed Securities Loan Facility (TALF) -- the Fed’s
effort to resuscitate a functioning securitization market --
direct public-sector support for the private financial system will
be extended to commercial real estate-related securities,
securitized small-business loans, and whatever else the Fed
chooses. The Federal Deposit Insurance Corporation, finally, has
extended its guarantees of small bank deposits to nearly all bank
deposits as well as bond issues of depositary institutions.
All this adds up to unprecedented trillions of
dollars of public support for the financial system, an
intervention that has generated substantial criticism. Many
observers would have preferred to let big banks and financial
institutions in trouble fail and be forced to restructure. Other
critics accepted the principle of rescue, on the grounds that
laissez-faire alternatives would have even worse consequences, but
argued for full-fledged nationalization; since the government was
going to be responsible for keeping the troubled firms in
business, they reasoned; why not take the firms over directly?
Even those who generally accept the actions of the semi-divine
trinity -- first Paulson-Bernanke-Geithner, and now
Bernanke-Geithner-Summers -- resolved to make sure that nothing
like this could happen again by pressing for cutting the banks
down to manageable size and barring them from using excessive
leverage.
Critics of the bailouts have raised a number of
valid points that policymakers have so far shied away from
confronting directly. Usually, such behavior means critics are
right. But in this case, it doesn’t. There are actually several
good arguments for why the government’s stepping in to preserve
large private banks is a good idea -- but few officials have made
them, most likely because they think the public wouldn’t find the
reasoning persuasive enough to justify spending such vast sums and
mortgaging the country’s future.
1. Big banks finance risk-takers. The U.S.
economy needs risk-takers to provide financial services to the
majority of citizens and businesses who are risk averse. For
example, retirees who want to protect against a sharp downturn in
the stock market using put options (contracts in which the buyer
acquires the right to sell a financial instrument later at a
predetermined price) need financial institutions able to sell
them. And a U.S. architectural firm bidding, say, for the right to
build a new shopping mall in Brazil, yet unversed in foreign
currency risks, needs to be able to rely on a bank or other
financial institution with the size, experience, and foreign
connections to minimize those risks. Risk-takers such as hedge
funds play an instrumental role in all this, and banks need to be
large in order to accumulate the talent and facilities necessary
to finance them. Small and medium-sized banks have tried but
simply cannot do it.
2. Big banks finance deals, especially big
ones. Large-scale mergers and acquisitions, as well as
transactions involving private equity funds, normally require
financing packages that are arranged in advance with complete
secrecy. Moreover, even simply advising one side or the other in a
big M&A transaction requires an immense array of expertise in a
variety of disciplines: legal, regulatory, accounting, government
relations, and media relations. Big banks that have been
traditionally active in this area have these skills or know how to
retain them.
3. Big banks can trade in size in global
capital markets. Small and medium-sized banks cannot keep up with
the large scale and quick tempo of international capital markets.
Only large banking institutions can maintain ongoing relationships
with giant counterparties including multinational corporations,
central banks or other government agencies, and sovereign wealth
funds. With the United States running chronic balance-of-payments
deficits, it is in the national interest to have banks large
enough to maintain such relationships in order to facilitate large
capital inflows.
4. Big banks are in the derivatives business,
small and medium-sized institutions are not. Admittedly, this does
not sound like a recommendation, given how many large financial
institutions have gotten in trouble recently through mismanagement
of their derivatives units. But derivatives are not going away --
credit default swaps, for instance, offer immense benefits to
users because they vastly reduce the cost of managing portfolios
of corporate bonds, mortgage-backed securities, and other
securitized instruments. In the future, counterparty risk will be
taken far more seriously, which will mean more in-depth vetting of
trading partners. This process is often possible only with big
institutions, because it takes highly trained specialists to pore
over the numbers and ask the right questions about the financial
health of major counterparties.
5. Big banks run big IT operations. There are
immense economies of scale in niches such as corporate cash
management, credit-card back office, mortgage servicing,
securities custody, and performance attribution. They will not
disappear. Studies that seem to show a lack of economies of scale
in banking are not wrong, just badly designed. Although there are
not many economies of scale in credit analysis, only a handful of
large banks with global reach can perform highly computerized
back-office servicing functions.
The above points explain why financial
institutions grew so large and why that was and remains a
generally good thing for the economy as a whole. But what about
arguments that the government should never again allow such firms
to grow "too big to fail"?
There are indeed problems with massive
bailouts, particularly the danger that they will create "moral
hazard" -- an incentive for institutions to behave recklessly in
the future on the assumption that the government will bear the
losses if anything goes wrong. But the appropriate way to prevent
such behavior is not to limit the size of financial institutions,
but rather to reform their corporate governance.
Board members of banks have been treated more
strictly than board members of other corporations since 1991, when
the Federal Deposit Insurance Corporation Improvement Act was
passed to overcome the abuses that led to the savings and loan
crisis of the 1980s. For example, members of boards of depository
institutions are limited in the number of boards they can serve
on, and they must accept personal liability for the decisions of a
failed institution. Since then, the system has worked reasonably
well for smaller banks (but not for larger institutions, where
most board members are simply ill-equipped to stay on top of the
immense amount of detail involved)..
Further improving board oversight of bank
management must be a top priority in any attempt to construct a
safer and sounder financial system. The current category of
independent directors, which brings to the boardroom people of
diverse backgrounds and business experience, is not necessarily
bad. But it is not enough. There should be a second kind of
independent board member, as well -- essentially, a category of
"professional directors" -- who are elected directly by
shareholders. These directors would chair the three most important
board committees -- audit, risk management, and compensation.
Such a reform could materially strengthen the
ability of banks and other important financial institutions to
move ahead without stumbling into new risks. That is because
professional directors -- unlike even well-intentioned amateur
ones -- would have both the skills and incentive to execute their
duties with a high level of care. If they performed haphazardly or
casually, they would risk losing the stature necessary to continue
to serve on boards of other companies. Their livelihoods would
depend, in other words, on their willingness to understand exactly
what a bank is doing, what risks it is taking, and how proficient
top management is in running a complex business.
Whatever else the Obama administration focuses
on in its regulatory reforms, it should not waste time or effort
trying to limit financial institutions’ size. Responsible board
oversight and governance is much more important.