Remarks Before the Eastern Finance Association
Washington, D.C. 

It is a pleasure to speak to you today about the changing nature of financial regulation.  And, changing indeed it is.  Just as we haven’t seen anything like the current crisis, so the way regulators are handling it is wholly unprecedented.  Some recent actions are based on old law; some from new, most notably last year’s rush job that created the TARP.  So far, regulators have said that neither old nor new law is enough to handle the biggest financial institutions – those now dubbed too big or too interconnected to fail.  However, there’s actually a lot in current law that could be put to good use not just in improving big-firm regulation, but also handling those that fail.  Today, I’ll argue for a renewed focus on current law – touched up only a bit – as the first line of defense against systemic risk.  I’m very concerned that some of the mega-solutions to systemic risk that rely on sweeping new law could in fact create more risk than they resolve.

Based on presumed failings in current law, Treasury, the FRB and FDIC have asked for a lot of new power to regulate and resolve systemically-significant firms – not that they’ve yet told us just who these in fact are.  On March 26, Secretary Geithner laid out a resolution framework.  President Obama has since told Congress to finalize both the resolution and regulatory rules by year-end, a very short turn-around since May is almost here.

In this talk, I’ll suggest that Congress should move carefully as it considers these profound changes in systemic-risk governance.  I fear that they could result in a still broader and more expensive safety net beneath systemically-significant institutions.  These colossi would then not only come in sizes too big to regulate, but also in shapes that have never before fit well under any regulatory regime.  This would make banks still riskier and put even more speculative business under the federal umbrella.  Those advocating the systemic-resolution regime think it will reduce systemic risk because big institutions will also be regulated.  However, not one of the agencies that would be charged with this new power did much with the power it had over the biggest banks and holding companies now under its supervisory thumb.  What in any new regime would guarantee that they or their successors could do better with still bigger and more complex firms?  

In fact, I think we’ve got lots of tools under current law – tweaked a bit to be sure – to handle any and all types of systemically-significant institutions.  The key here is to define and confine the risk subject to federal protection and insulate protected entities from the wild creatures outside the protected perimeter.  It’s also critical to define which customers and counterparties the federal government should protect and who should be fed to the wolves.  If everyone expects to be saved at any institution too big to be disciplined, then no one will be at real risk when dealing with a systemic institution – taxpayers sadly exempted.

The reason the market crisis became so grave so fast was that no regulatory authority saw it coming.  Because none saw it, none put in place advance rules to contain systemic risk  2 or contingency plans to address it.  When the panic began in earnest last September, this forced a play-it-by-ear response that, while it hopefully averted a complete collapse, has done little to strengthen the financial system or support real macroeconomic recovery.  Some have argued that all the requested new law is the urgently-needed first step to lasting recovery but, as I’ll outline today, I don’t agree.  I think we need some tough new rules to limit risk in institutions below which we rightly extend the Fed and FDIC safety net and contingency planning to ensure that unprotected institutions – parent holding companies most assuredly included – are cut loose to enjoy the discipline of the market or the tender mercies of the bankruptcy process.  This is not only salutory for public policy and market integrity, but also for systemic-size firms that manage themselves prudently – they should be rewarded for this, not treated indiscriminately on a par with more speculative, riskier big financial institutions.

How to Regulate Systemic Risk  

Because of the manifest disasters confronting financial regulators, there are growing calls for the Federal Reserve or, perhaps, some uber-agency, to become a systemic-risk regulator for the biggest regulated and “shadow” banks.  No one is quite sure what shadow institutions are, but they are generally viewed as big hedge funds and private- equity firms, with many also arguing that big insurers should come under the systemic- risk regime because of failures in the state-regulatory system – AIG as the starting point for this debate.  

But, of course, big isn’t always a sign of systemic risk.  Think, for example of the close shave Long-Term Capital Management gave the global financial system in 1998 even though LTCM wasn’t very large.  If hedge funds are to be brought under the systemic- risk regime, doing this only for some won’t really do much to limit systemic risk, and the same holds true for other non-banking institutions.  Similarly, some relatively small banks play critical roles in the payment-and-settlement system that warrant systemic-risk review even though size alone might not trigger governance under some new regime.  

Recognizing this, advocates of systemic-risk regulation like the Group of Thirty have recommended a multi-part subjective test to identify systemic-risk institutions.  This will, though, make the process of determining covered institutions at best uncertain and, at worst, dangerously close to one in which the government picks winners and losers.  Why winners and losers?  It’s because coupling the systemic-risk regulatory system with the new resolution one will isolate a class of companies with so huge a federal safety net beneath them that too-big-to-fail will seem like old hat.  Counterparties will naturally ride any institution in the systemic-risk corral because the prospects of loss will be sharply curtailed.  

Is there a better way?  Yes, and it’s largely do-able under current law.  The heart of systemic risk isn’t size – it’s inter-connectedness.  Cut the cord among counterparties through exposure limits and the like and systemic risk is dramatically reduced.  Put more initial capital at risk in complex structures and counterparty risk is further reduced  3 because institutions no longer have too many eggs in a single basket and the eggs are also made far more resilient.  Recognize liquidity risk and demand capital and reserves against it, and the financial system is still better protected from contagion risk.  

One need not extend a new regulatory system throughout the nooks and crannies of the financial system to limit counterparty risk and ensure capital is placed up front and on the balance sheet – one need only make long-overdue changes in the way regulated institutions are supervised and the capital requirements applicable to them.  I know this sounds too easy and I will immediately concede that fixing the current regulatory system may not be all that’s necessary for long-term reform of the U.S. financial system.  But, it’s a critical first step.  More important – it’s the right way to start.

I hesitate to raise my ancient doctoral dissertation among a group of such distinguished professors, but at great risk to myself, I’ll posit a bit of organization theory:  start small, make decisions that can be tested and reversed, and validate actions along the way.  This is known as incremental decision-making in contrast to synoptic action – that is, huge solutions that attempt to sweep all problems into a single grand scheme.  Much in the new systemic-risk regulatory framework under discussion is far too synoptic for my taste.  It might well impose a top-down regulatory structure above everything else that’s already in place to govern the financial system – adding a new layer of complex, untested supervision that makes it still harder to figure out which agency is in charge of what on which terms.  This would do nothing to end regulatory arbitrage – the game of charter and capital selection for maximum competitive advantage.  All we’d get is an added hurdle to creativity.

How to Resolve a Systemic-Risk Institution  

The grand, top-down approach to systemic-risk regulation isn’t the only synoptic proposal on the table.  We’ve also been given a comparable approach to resolving big firms once we figure out who they are.  

Secretary Geithner has asked Congress urgently to consider a Treasury systemic-risk resolution proposal now – even before the bill on who’s under it is released – because of fears about other big shoes that could drop before markets stabilize.  Key to Treasury’s request – which in broad terms is supported by the Fed and FDIC – is the view that the crises sparked by AIG and Lehman Brothers were unavoidable because of failures in current law, as was the costly – if less cataclysmic – Bear Stearns case.  

Advocates of the new systemic-risk resolution approach also bolster their cause by pointing to the hundreds of billions spent through TARP and other programs for the very biggest banks.  Here, too, they say there is no preferable option under current law.  It’s not that the banks in the big holding companies are immune from orderly resolution – that’s of course what the FDIC’s about.  Rather, advocates argue, it’s that nothing in  4 current law permits the FDIC or other regulators to handle parent holding companies and resolve all their complex counterparty claims at home and abroad.
So, the pending proposal would provide unlimited FDIC support for any parent of an insured depository, broker-dealer or insurance company.  All this does, of course, is spread the safety net far, wide and firmly below an ever larger class of organizations.  As noted, this will insulate systemic-risk firms from market discipline – creating the moral hazard that long and rightly lead to a limit on the amount of federal deposit insurance offered by the FDIC.  If no one suffers when a protected institution falters, risks will of course rise even if regulators try valiantly to prevent this.  In fact, the Treasury proposal doesn’t require any loss for anyone in a systemic resolution.  Instead, it would give the FDIC unfettered authority directly or indirectly to support a systemic institution in any way with no conditions – TARP 2.0 and then some, I think.

This won’t last long as an unalloyed win for systemic institutions.  Covered firms will be punished for this with new compensation and social-policy requirements.  Even as the new systemic-risk regime creates a cocoon for covered firms, it won’t be free.  This will, of course, have long-term and, I think, adverse impact on what we used to call the free- enterprise system.  It’s not at all unfair for Congress to condition its rescue program – once taxpayers are at risk, they get to dictate their terms.  Given this, we need to find a way to limit the risks taxpayers must take to back the nation’s financial system.  

How to do this?  First, define precisely which obligations federal protection must insulate to limit not just systemic risk, but also harm to ordinary depositors and investors who cannot be expected to undertake the complex financial analysis that should be required of institutional investors and financial counterparties.  For example, this means bringing money-market funds and similar instruments used for retail customers into the new safety-and-soundness and resolution regime.  I see no difference between a bank depositor and an MMF one – if there were any differences before, the new Treasury and FRB MMF support facilities have mooted them.  

Once we’ve better identified whom to protect, we can limit the risks taken by the institutions with which they deal through the counterparty risk-management, capital and liquidity standards I briefly described.  We can and should then separate the entities within a financial-services firm taking risks on behalf of protected individuals and entities from parent holding companies where other risk is housed.  Safety nets should be strung only beneath institutions taking known, limited and capitalized risks for vulnerable depositors and investors – not for institutional investors or counterparties who can and should look out for themselves.  

This isn’t, of course, to suggest that the parent holding companies can always be let loose in the event of a failure.  Sometimes this can and should be done – see, for example, the way the FDIC handled the WaMU failure earlier this year.  Although regulators have insisted they have no way under current law to separate an insured depository from a holding company, this was in fact done when the FDIC last summer faced the collapse of a $300 billion savings association.  To be sure, WaMU was – while huge – far simpler  5 than Citigroup, BofA or other big holding companies.  This facilitated severing the insured depository from the parent company, but the fact that it was done here points the way – under current law – to doing so for other troubled financial holding companies.  

Holding companies can and should be separated from the protected institution into what I would call an “Oldco” and “Newco” structure – sometimes also called a good-bank/bad- bank approach.  Here, the holding company – think Citigroup as a case in point – is separated from the U.S. insured depository.  The parent and its subsidiaries around the world go into the “Oldco” entity.  This is turn is converted into a bridge institution with a strong U.S. role through direct or indirect support to stabilize the entity and then quickly start a resolution through a process akin to bankruptcy.  Can this be done under current law?  Regulators say no but AIG says yes, as do GM, Chrysler and other firms now at the TARP trough.

What’s the Newco?  It’s the insured depository.  Regulators would undertake the usual resolution regime of paying off insured depositors and handling uninsured claims over time.  The insured institution can go into a conservatorship, receivership or bridge institution as provided under current law.  If the bank itself is too big to handle quickly, the bridge or conservatorship structures address that, as was made clear not just for troubled banks in recent years, but also for Fannie Mae and Freddie Mac.  There’s systemic risk and then some, but the world is struggling on after federal takeover because of the way the takeover was executed.

There should, though, be one critical change in the bank resolution process that requires new law.  Going forward, we should deal differently with “qualified financial contracts” – derivatives and the like.  We need to limit the complete protection for them now provided under bank resolution rules so that firms don’t put risky transactions under the bank umbrella and counterparties take better care of themselves at the start of a transaction and don’t adverse-select banks with which to do business.


Is any of this easy?  Of course not.  But, I’ve tried to outline a modest approach to financial-regulatory reform that I think will pay huge dividends without the risk of the synoptic solutions now being broached on Capitol Hill.  At worst, these more modest solutions will be a dramatic improvement on the current system and, if they prove insufficient, they can then be replaced with grander schemes.  But, once a grander scheme is in place, getting rid of it will be virtually impossible.  Starting with a grand design could prove a grave risk – superimposing a new regulatory architecture atop a very rickety one at which fundamental repairs were neglected.  

As we look at the shards of the U.S. and global financial system, it’s clear that a lot that can and should have been done under current law was neglected.  Regulators are rightly at work remedying their lapses and improving critical safety-and-soundness requirements.  We should let this process proceed before we conclude that it can’t work.  Top-down and bottom-up reform all at the same time will leave precious little room for profitable, energetic and innovative financial institutions.  This is nationalization through the back door.  

Regulators have also shown us what can be done under current law to handle even the biggest troubled firms because they’ve done it.  The problem isn’t that they don’t have the power to deal with a huge bank or non-bank – rather, it’s that to date the regulators have dealt inconsistently with problem cases and, when they step in, they’ve done it all too often on the fly.  They’ve had to do this because they didn’t plan ahead.  Now, they know the risks they run and can and should develop contingency plans for systemic-risk resolutions that learn from the bank, GSE, AIG, Lehman, auto and all the cases resolved for better or worse to date.  

With this in mind, let’s first address all the problems we know we’ve got because of all the goofs to date.  Once this remedial process is complete, we can then step back and determine if still more profound reform is required.  We’ll have some time here – everyone for now is on their best behavior and all sorts of credit and liquidity facilities are now in place to handle the unexpected.  Without an exit strategy from all the supports now propping up the banking system, adding a new resolution regime to this will also be back-door nationalization because we’ll throw a trillion-plus dollar promise atop trillions already in place.