Why Washington Won't Prevent Another Meltdown

The U.S. can’t rely on the proposed House bill to protect the economy from another crash. Relying on regulators won’t work, says Jeff Madrick—instead, the government should start by dividing banking activities.

10.28.09 12:56 AM ET

Various financial experts, nearly all of whom failed to forecast the Crash of 2008-09, now claim that the answer to stanching future credit calamities is to rein in the giant financial institutions— somewhat. These advocates cover the waterfront, from the right, left, and center.

The bill now being put together in the House Banking Committee will give the government the ability to unravel financial institutions, even to the point of leaving their shareholders with nothing when they are already in trouble. It also will provide the federal government the money to do so by assessing the banks. The lack of such a so-called resolution authority is what kept it from unwinding Lehman Brothers in the first place.

Commercial banks with access to the Fed discount window should not be allowed to invest depositor money in securities investments other than plain-vanilla government and low-risk corporate debt.

The idea is to prevent the snowballing of a catastrophe into an ever bigger one. But there is no persuasive reason to believe that even if the Treasury or the Fed had such authority, they would have taken the steps back in September 2008. There was enormous pressure then to let the market decide, even if it meant major institutional failures. In his recent book, In Fed We Trust, The Wall Street Journal’s David Wessel argues that the Treasury and Fed together could have figured out some way to save Lehman or straighten it out cautiously if they had really wanted. He is almost surely right.

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Meanwhile, what has happened to prevent future failures? That was the original intent of the Obama administration white paper of last June. Almost as an afterthought, the House bill will give the government an option to raise capital requirements on any institution deemed too big to fail. The idea, first discussed well more than a year ago under the Bush administration, is to reduce “systemic” risk by giving some regulator—one candidate is the Federal Reserve—the power to single out institutions that, if they fail, would bring the rest of us down. The notion gained adherents as night follows day when the markets froze the day after the collapse of Lehman Brothers.

But, despite widespread acceptance, this too is a pipe dream. First, what are the standards for determining who is too big—or too interconnected—to allow to fail? Is there really a bright line here? Would Bear Stearns have been declared a too-big-to-fail institution, or even Lehman Brothers? Such minor details have been brushed under the rug.

More to the point, it is taken for granted that newly chastised regulators will be both wise and cautious enough to implement the higher capital (and liquidity) requirements on such firms, and stick to them forever after. This is simply a Panglossian idea, policy as wishful thinking. Perhaps they are right now. But who can safely predict that in the future the regulators won’t succumb to the lures and blandishments of the rich and powerful once again?

In other words, when times turn better, which is when regulation is most needed, the concept of regulatory adjustment of the too-big-to-fail institutions just won’t work. The big and powerful will argue successfully that as in the last good times they don’t need the tight capital restrictions. Risk is not what it once was, they will say with a straight face. They may even produce a computer model, supposedly improved over VAR and other misleading mid-2000s calculations, to prove the point and attempt to induce memory loss of recent sad events. Then the big institutions will argue that the higher capital costs are restricting their ability to provide the nation the capital it needs. And, after all, the big institutions—they will make very clear to the Fed chairman and the Treasury secretary in closed-door sessions designed to ensure that democracy works—are also the lowest-cost providers of finance in the world.

If the experience of recent years is a guide, the regulators in Washington will almost certainly cave in. Soon there will be institutions too big to fail again that indeed will fail again. And, again, even with the resolution authority, the government will hesitate to wipe out powerful shareholders and take over failing financial institutions from powerful management. Historical myopia must be an evolutionary defense mechanism of the human species. How else can we explain its persistence?

What should happen instead? At the least, there should be higher capital requirements, as well as liquidity requirements, set for all commercial banks and shadow banks, as well—that is, investment banks and hedge funds. Further, there should be no distinctions between the big and not-so-big, because the consequences of failure of any moderate-size institution can be enormous. Once set, these requirements should be held constant. Remaining steadfast will take all the willpower Washington can muster.

But the above is only a second-best solution. More useful still would be to divide banking activities, as an increasing number of observers such as Paul Volcker and the Bank of England’s Mervyn King are now saying. Commercial banks with access to the Fed discount window should not be allowed to invest depositor money in securities investments other than plain-vanilla government and low-risk corporate debt. To abide by this, the management of financial institutions should also be held liable by law; it will be potentially criminally fraudulent if they invest far afield. Investment banks should invest as they see fit, but subject to more stringent capital requirements and leverage restrictions cited above, and they can trade only in transparent markets where prices are known to all—obviously, on open exchanges. This is the honest and effective path, but unlikely to be taken.

The too-big-to-fail approach of Washington and the widespread advocacy of something along the lines now proposed in the House are simply naïve, politically oriented reactions to crisis. A regulator is subject to the influence of the times and of those being regulated. It is called regulatory capture. Leaving decisions to the ad hoc judgment of such regulators only opens the door to future errors. The Fed already has plenty of such ad hoc authority over monetary policy. Let’s not give it more. Until we hear Washington speak about regulatory capture, we won’t really minimize the prospects of another credit crash.

Jeff Madrick is a contributor to The New York Review of Books and a former economics columnist for the New York Times. He is editor of Challenge magazine, visiting professor of humanities at Cooper Union, and senior fellow at the New School's Schwartz Center for Economic Policy Analysis. He is the author of Taking America, The End of Affluence (Random House) and The Case for Big Government.