Tuesday, April 14, 2009

market participants were no longer sure that the financial institutions they were dealing with would be rescued


The Obama administration and Congress are now
filling in the details of a long-anticipated plan for
reorganizing and restructuring financial regulation.
It is no exaggeration to say that the proposal will
create what are essentially government-sponsored
enterprises (GSEs) like Fannie Mae and Freddie
Mac in every sector of the financial economy.
The principal elements of the administration’s
plan are these:
• Establishing a federal agency as the systemic
regulator of the financial system
• Giving that agency the authority to designate
“systemically important” financial institutions
and establish a special regulatory
structure for these firms
• Providing a mechanism for the government
to take control of financial institutions when
and if it decides that their failure will create
“systemic risk”
To be sure, there are differences between the
implicit government backing that Fannie and Freddie
exploited and a designation as a “systemically
important” firm, but in competitive terms, these differences
are minor. Designation as a systemically
important firm is, in effect, a certification by the
government that a firm is too big to fail—its failure,
in theory, will create systemic risk—and this status
will be seen in the markets as lowering its risk as
a borrower. Lower risk will translate into lower
Financial Services Outlook
1150 Seventeenth Street, N.W., Washington, D.C. 20036 202.862.5800 www.aei.org
Reinventing GSEs: Treasury’s Plan for
Financial Restructuring
By Peter J. Wallison
In late March—timed to impress the G20—the Obama administration revealed its plan for regulating and restructuring
the U.S. financial system. There were no surprises; its approach, presented by Treasury Secretary Timothy
Geithner, endorsed both a single powerful systemic regulator, with authority to designate and regulate “systemically
important” institutions in every financial sector, and a system for liquidating or bailing out financial firms that might
cause a systemic breakdown if they failed. Although presented as a way to prevent a repeat of the current financial
crisis, the proposals will, if implemented, seriously impair competitive conditions in all U.S. financial markets—
enhancing the power of large companies that are designated as systemically important and threatening the survival
of those that do not receive that endorsement. Underlying the plan is the erroneous belief—shattered by the catastrophic
condition of the heavily regulated banking sector—that regulation can prevent risk-taking and failure.
Although the plan could get through Congress if the financial industry remains inert and apathetic, the weakness
of the administration’s case suggests that it is vulnerable to determined opposition.
March/April 2009
Peter J. Wallison (pwallison@aei.org) is the Arthur F. Burns
Fellow in Financial Policy Studies at AEI.
Key points in this Outlook:
• A thorough analysis of the Obama administration’s
financial regulation proposal.
• Firms deemed “too big to fail” will receive
competitive advantages.
• A special resolution system will be a recipe
for repeated bailouts.
• The cases of AIG and Lehman do not provide
a rationale for the administration’s plans.
• A systemic risk regulator is not a seer.
• The financial world, largely silent about the
administration’s proposal, should speak up
about its flaws.
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funding costs, exactly the advantage that allowed Fannie
and Freddie to drive all competition from their market.
Indeed, it may well be that the systemically important
firms will be more formidable competitors than Fannie and
Freddie, which were restricted by their charters from
expanding beyond their secondary market role. There is
no indication that systemically important firms will be
similarly restricted.
In light of the competitive danger that the administration’s
proposal creates for smaller firms, the lack of any
adverse reaction thus far in the financial services sector is
surprising. It is also surprising that the administration would
back a plan that will inevitably create more firms—rather
than fewer—that are too big to fail. It is not hard to understand
why the largest firms might not see the plan as a
threat; they might believe that the government support they
receive will be more helpful than harmful in the future. But
it is harder to understand why there seems to be so little
vocal opposition at this point from the many smaller firms—
insurance companies, securities firms, hedge funds, and
finance companies—that will be forced to face governmentaided
competition. Perhaps they believe that these changes
are inevitable. There is little else to explain the support for
the idea from such organizations as the U.S. Chamber of
Commerce and the Securities Industry and Financial
Markets Association—two organizations that are normally
skeptical about excessive regulation and object to the
government picking winners and losers. This Outlook will
review the administration’s plan in detail, show the weakness
of the administration’s argument, and outline why and
how it will make major changes in the structure of and competitive
conditions in the financial sector of the economy.
The Administration’s Plan
In congressional testimony on March 26, 2009, Secretary
Geithner described the major features of the administration’s
To ensure appropriate focus and accountability
for financial stability we need to establish a single
entity with responsibility for consolidated supervision
of systemically important firms. . . . That
means we must create higher standards for all
systemically important financial firms regardless of
whether they own a depository institution, to
account for the risk that the distress or failure of
such a firm could impose on the financial system and
the economy. . . .
[W]e must create a resolution regime that provides
authority to avoid the disorderly liquidation of
any nonbank financial firm whose disorderly liquidation
would have serious adverse consequences on
the financial system or the U.S. economy. . . .
Depending on the circumstances, the FDIC and the
Treasury would place the firm into conservatorship
with the aim of returning it to private hands or a
receivership that would manage the process of winding
down the firm.1
The last sentence makes clear that this is not simply a
proposal for winding down failed financial institutions in
an orderly way; instead, it contemplates a “conservatorship,”
which would allow the government to take control
of a failing company and restore it to financial health. This
approach complements the idea that systemically important
firms are too big to fail and creates the vehicle that
would actually prevent their failure. Underlying the plan,
of course, is the glaringly false assumption that regulation
can prevent excessive risk-taking and failure by financial
firms. One glance at the catastrophic condition of the
heavily regulated banking industry should convince anyone
who thinks about it objectively that regulation is
not the panacea its proponents suggest. The administration
has not yet decided what agency would be the systemic
regulator, and it has not formally named the agency that
would have the authority to take over and resolve or rescue
failing or failed nonbank financial firms. The Federal
Deposit Insurance Corporation (FDIC) seems to be the
frontrunner for the resolution agency; the Federal Reserve
has been mentioned frequently as the likely systemic regulator,
2 but this raises serious policy issues.3
The Consequences of Designating Firms as
Systemically Important
The dangers to competition inherent in the administration’s
plan arise in two ways: direct benefits to firms that
offer products enhanced by the apparent financial soundness
of the firm that offers them, and indirect benefits
through a lower cost of funds for firms that are perceived to
be less risky than their competitors. In insurance, for example,
where the financial soundness of a company could
make a competitive difference, the companies that can
boast that they are too big to fail are likely to be more successful
in attracting customers than their smaller competitors.
Similarly, but more indirectly, firms that can boast that
they are systemically important and thus too big to fail
would—like Fannie Mae and Freddie Mac—appear less
risky as borrowers than firms that are not protected by the
government, and this will produce lower financing costs.
Eventually, these firms will be able to use their superior
financing opportunities to drive competition from their
markets. Overall, the systemically significant firms will
be subject to less market discipline, will be able to take
more risks than others, will grow larger in relation to
others in the same industry, and will gradually acquire
more and more of their less successful competitors. Eventually,
we will see a market much like the housing market
that Fannie and Freddie came to dominate, with a few
giant companies, chosen by the government, that have
pushed out all significant competition.
It is, of course, possible that the opposite could occur.
The companies that are designated as systemically significant
could face so much costly regulation that they
become less profitable than their competitors. Indeed,
some supporters of designating systemically significant
firms have argued that systemically important firms will
face such onerous regulation that no firm will want the
honor. But this seems unlikely. Yes, it is possible to regulate
systemically important companies so strictly that they are
not able to compete effectively with others, but such a
policy would be self-defeating. If regulation so impairs
the operations of systemically important companies that
they cannot carry on their businesses efficiently, that will
only mean they will have to be bailed out sooner. The failure
of companies under regulatory supervision is a serious
indictment of the regulator’s effectiveness, and regulators
try hard to avoid it. Regulatory forbearance—refusal to
step in and close failing institutions—is a product of this
tendency and one of the most significant causes of the
savings and loan (S&L) and banking crisis of the late
1980s and early 1990s. So pervasive was regulatory forbearance
for S&Ls and banks during that period that a
policy called “prompt corrective action” was written into
the Federal Deposit Insurance Corporation Improvement
Act of 1991 (FDICIA), the tough banking legislation that
was supposed to prevent future widespread bank losses.
As discussed below, it has not worked as hoped. Regulatory
forbearance seems to continue. The twenty-one banks
that have been resolved by the FDIC over the past year
have averaged losses on assets of 24 percent,4 even though
prompt corrective action was intended to enable institutions
to be closed before they had suffered any losses. Contrary
to the notion that regulators could be tough on
systemically important firms, experience shows that they
try to help their regulated clients succeed.
The Administration’s Plan for Resolving
or Rescuing Failing Financial Firms
The extraordinary FDIC losses on failing banks should be
a warning to anyone who contemplates a nonbankruptcy
system for resolving failed or failing financial institutions.
In the few cases in which regulators will actually close
institutions under the administration’s plan, the losses
will be expensive for taxpayers. In most cases, however,
regulatory forbearance will ensure that excuses will be
found to rescue most financial firms, also at taxpayer
expense. A rescue not only avoids embarrassment for the
regulator but is also generally approved by Congress
because it saves jobs and avoids financial disruption. It can
be safely predicted, accordingly, that for the largest institutions—
those designated as systemically important—the
new resolution system will simply become a bailout system,
with the taxpayers handed the bill. The capital markets
understand this tendency on the part of regulators. That is
why the administration’s proposal for a special resolution
system for failing financial firms increases the likelihood
that the capital markets will see systemically important
firms as less likely than others to be allowed to fail, and
thus less risky as borrowers.
Secretary Geithner defended this portion of his plan by
suggesting that it is merely doing for nonbanks what the
FDIC already does for banks. This argument omits the key
reasons for FDIC’s resolution process—why it exists and
who pays for it. Commercial banks and other depository
institutions perform a special role in our economy. They
offer deposits that can be withdrawn on demand or used to
pay others through an instruction such as a check. If a
bank should fail, its depositors are immediately deprived of
the ready funds they expected to have available for such
things as meeting payroll obligations, buying food, or
paying rent. Because of fear that a bank will not be able to
pay in full on demand, banks are also at risk of “runs”—
panicky withdrawals of funds by depositors. Although runs
can be valuable and efficient market discipline for insolvent
banks, they can be frightening experiences for the
public and disruptive for the financial system. The unique
attribute of banks—that their liabilities (deposits) may be
withdrawn on demand—is the reason that banks, and
only banks, are capable of creating a systemic event if they
fail. If a bank cannot make its payments to other banks,
the others can also be in trouble, as can their customers.
That is systemic risk, but it is unlikely to be caused by
any other kind of financial institution because these
financial institutions—securities firms, hedge funds,
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insurance companies, and others—tend to borrow for a
specific term or to borrow on a collateralized basis. Their
failures, then, do not cause any immediate cash losses to
their lenders or counterparties. Losses
occur, to be sure, but those who suffer them
do not lose the immediate access to cash
that they need to meet their current obligations.
It is for this reason that describing
the operations of these nondepository
institutions as “shadow banking” is so
misleading. It ignores entirely the essence
of banking—which is not simply lending—
and how it differs from other kinds of financial
Because of the unique effects that are
produced by bank failures, the Fed and the
FDIC have devised systems for reducing the
chances that banks will not have the cash to meet their
obligations. The Fed lends to healthy banks (or banks it
considers healthy) through what is called the discount
window—making cash available for withdrawals by
worried customers—and the FDIC will normally close
insolvent banks just before the weekend and open them
as healthy, functioning institutions on the following
Monday. In both cases, the fears of depositors are allayed
and runs seldom occur. Although Secretary Geithner is
correct that the administration’s plan would, in effect,
extend FDIC bank resolution processes to other financial
institutions, for the reasons outlined above, there is much
less reason to do so for financial institutions other than
banks. Indeed, as discussed below, if the market had been
functioning normally in September 2008, both AIG and
Lehman Brothers could have been allowed to fail without
severe market disruption.
There is also the question of funding. Funds from some
source are always required if a financial institution is either
resolved or rescued. The resolution of banks is paid for by
the premiums that banks pay for deposit insurance; only
depositors are protected, and then only up to $250,000.
Unless the idea is to create an industry-supported fund
of some kind for liquidations or bailouts, the Geithner
proposal will require the availability of taxpayer funds
for winding up or bailing out firms considered to be systemically
important. If the funding source is intended to
be the financial industry itself, it would have to entail a
very large tax. The funds used to bail out AIG alone are
four times the size of the FDIC fund for banks and S&Ls
when that fund was at its highest point—about $52 billion
in early 2007. If the financial industry were to be taxed in
some way to create such a fund, it would put all of these
firms—including the largest—at a competitive disadvantage
vis-à-vis foreign competitors and would, of course,
substantially raise consumer prices and
interest rates for financial services. The
24 percent loss rate that the FDIC has suffered
on failed banks during the past year
should provide some idea of what it will
cost the taxpayers to wind up or (more
likely) bail out failed or failing financial
institutions that the regulators flag as systemically
important. The taxpayers would
have to be called upon for most, if not all,
of the funds necessary for this purpose. So,
while it might be attractive to imagine the
FDIC resolving financial institutions of all
kinds the way it resolves failed or failing
banks, it opens the door for the use of taxpayer funds to
protect the regulators of all financial institutions against
charges that they failed to do their jobs properly.
Sometimes it is argued that bank holding companies
(BHCs) must be made subject to the same resolution
system as the banks themselves, but there is no apparent
reason why this should be true. The whole theory of
separating banks and BHCs is to be sure that BHCs could
fail without implicating or damaging the bank, and this
has happened frequently. If a holding company of any
kind fails, its subsidiaries can remain healthy, just as the
subsidiaries of a holding company can go into bankruptcy
without implicating the parent. If a holding company
with many subsidiaries regulated by different regulators
should go into bankruptcy, there is no apparent reason
why the subsidiaries cannot be sold off if they are healthy
and functioning, just as Lehman’s broker-dealer subsidiary
was sold to Barclays Bank immediately after Lehman
declared bankruptcy. If there is some conflict between
regulators, these—like conflicts between creditors—
would be resolved by the bankruptcy court. Moreover, if
the creditors, regulators, and stakeholders of a company
believe that it is still a viable entity, chapter 11 of the
Bankruptcy Code provides that the enterprise can continue
functioning as a “debtor in possession” and come
out of the proceeding as a slimmed-down and healthy
business. Several airlines that are functioning today went
through this process, and—ironically—some form of
prepackaged bankruptcy that will relieve the auto
companies of their burdensome obligations is one of
the options the administration is considering for that
industry. (Why bankruptcy is considered workable for the
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Over time, the process
of saving some firms
from failure will
weaken all firms in the
financial sector. Weak
managements and bad
business models should
be allowed to fail.
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auto companies but not financial companies is something
of a mystery.) In other words, even if it were likely
to be effective and efficient—which is doubtful—a special
resolution procedure for financial firms is unlikely to
achieve more than the bankruptcy laws now permit.
In addition to increasing the likelihood that systemically
important firms will be bailed out by the government,
the Geithner resolution plan will also raise doubts about
priorities among lenders, counterparties, shareholders, and
other stakeholders when a financial firm is resolved or
rescued under the government’s control, rather than in a
bankruptcy proceeding. In bankruptcy, a court decides
how to divide the remaining resources of the bankrupt
firm. Even in an FDIC resolution, insured depositors have
a preference. It is not clear who would get bailed out and
who would take losses under the administration’s plan.
In any event, the current bankruptcy system is regarded as
potentially “disorderly,” although why a resolution by a
government agency will be more orderly has not been
specified. In any event, it is likely that favored constituencies
will seek, and probably get, more of the available funds
in a windup or a bailout carried out by a government
agency than they would in a normal bankruptcy. Given
that bailouts are going to be much more likely than liquidations,
especially for systemically important firms, a special
government resolution or rescue process will also
undermine market discipline and promote more risktaking
in the financial sector. In bailouts, the creditors will
be saved in order to prevent a purported systemic breakdown,
reducing the risks that creditors believe they will be
taking in lending to systemically important firms. Over
time, the process of saving some firms from failure will
weaken all firms in the financial sector. Weak managements
and bad business models should be allowed to
fail. That makes room for better managements and better
business models to grow. Introducing a formal rescue
mechanism will only end up preserving bad managements
and bad business models that should have been allowed to
disappear while stunting or preventing the growth of their
better-managed rivals. Finally, as academic work has
shown again and again, regulation suppresses innovation
and competition and adds to consumer costs.
With all these deficiencies in the administration’s plan
for creating systemically important companies—together
with a special liquidation or bailout system as an alternative
to bankruptcy—it is useful to consider the administration’s
rationale for such an extraordinary change in
the financial sector’s structure and competitive conditions.
It appears, in this connection, that the administration is
resting its case on only two events—the failure of Lehman
Brothers and the rescue of AIG—as the reasons for
advancing its extraordinary plan. Both examples, as discussed
below, are inapposite. AIG should not have been
rescued—saving the taxpayers $200 billion—and
Lehman’s failure was not the disruptive incident that has
been portrayed in the media and elsewhere. Indeed, if the
market had been functioning normally when Lehman
failed, its failure, like Drexel Burnham Lambert’s in 1990,
would have caused little market disruption.
The Exaggerated Significance of AIG
and Lehman
Secretary Geithner has defended his proposal by arguing
that, if it had been in place, the rescue of AIG last fall
would have been more “orderly” and the failure of Lehman
Brothers would not have occurred. Both statements
might be true, but would that have been the correct policy
outcome? Recall that the underlying reason for the administration’s
plan to designate and specially regulate systemically
important firms is that the failure of any such
company would cause a systemic event—a breakdown in
the financial system and perhaps the economy as a
whole. Using this test, it is clear at this point that neither
AIG nor Lehman is an example of a large firm creating
systemic risk.
In a widely cited paper, John Taylor of Stanford University
concluded that the market meltdown and the
freeze in interbank lending that followed the Lehman and
AIG events in mid-September 2008 did not begin until
the Treasury and Fed proposed the initial Troubled Asset
Relief Program funding later in the same week, an action
that suggested (along with then–treasury secretary Henry
M. Paulson’s warnings of imminent doom) that financial
conditions were much worse than the markets had
thought.5 Taylor’s view, then, is that AIG and Lehman did
not have any causal relationship to the meltdown that
occurred later that week.
Since neither firm was a bank or other depository
institution, this is highly plausible. Few of their creditors
were expecting to be able to withdraw funds on demand to
meet payrolls or other immediate expenses, and later
events and data have cast doubt on whether the failure of
Lehman or AIG (if it had not been bailed out) would have
caused the losses many have claimed. Advocates of
broader regulation frequently state, and the media dutifully
repeat, that the financial institutions are now “interconnected”
in a way that they have not been in the past.
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This idea reflects a misunderstanding of the functions
of financial institutions, all of which are intermediaries
in one form or another between sources of funds and users
of funds. In other words, they have always been interconnected
in order to perform their intermediary
functions. The right question is
whether they are now interconnected in a
way that makes them more vulnerable
to the failure of one or more institutions
than they have been in the past, and there
is no evidence of this. The sections below
strongly suggest that there was no need to
rescue AIG and that Lehman’s failure was
problematic only because the market was in
an unprecedentedly fragile and panicky
state in mid-September 2008.
AIG Should Have Been Sent to Bankruptcy.
AIG’s quarterly report on Form 10-Q for
the quarter ended June 30, 2008—the last
quarter before its bailout in September—
shows that the company had borrowed, or
had guaranteed subsidiary borrowings, in
the amount of approximately $160 billion,
of which approximately $45 billion was
due in less than one year.6 Very little of this
$45 billion was likely to be immediately
due and payable, and thus, unlike a bank’s
failure, AIG’s failure would not have created an immediate
cash loss to any significant group of lenders or counterparties.
Considering that the international financial markets
are more than $12 trillion, the $45 billion due within a
year would not have shaken the system. Although losses
would eventually have occurred to all those who had lent
money to AIG, they would have occurred over time and
been worked out in a normal bankruptcy proceeding, after
the sale of its profitable insurance subsidiaries.
Many of the media stories about AIG have focused on
the AIG Financial Products subsidiary and the obligations
that this group assumed through credit default swaps
(CDSs). However, it is highly questionable whether
there would have been a significant market reaction if AIG
had been allowed to default on its CDS obligations in September
2008. CDSs—although they are not insurance—
operate like insurance; they pay off when there is an actual
loss on the underlying obligation that is protected by the
CDS. It is much the same as when a homeowners’ insurance
company goes out of business before there has been a
fire or other loss to the home. In that case, the homeowner
must go out and find another insurance company, but
he has not lost anything except the premium he has paid.
If AIG had been allowed to default, there would have been
little if any near-term loss to the parties that had bought
protection; they would simply have been
required to go back into the CDS market
and buy new protection. The premiums for
the new protection might have been more
expensive than what they were paying
AIG, but even if that were true, many of
them had received collateral from AIG
that could have been sold in order to defray
the cost of the new protection.7 CDS contracts
normally require a party like AIG
that has sold protection to post collateral as
assurance to its counterparties that it can
meet its obligations when they come due.
This analysis is consistent with the
publicly known facts about AIG. In mid-
March, the names of some of the counterparties
that AIG had protected with CDS
became public. The largest of these counterparties
was Goldman Sachs. The obligation
to Goldman was reported as $12.9 billion; the
others named were Merrill Lynch ($6.8 billion),
Bank of America ($5.2 billion),
Citigroup ($2.3 billion), and Wachovia
($1.5 billion).8 Recall that the loss of CDS
coverage—the obligation in this case—is not an actual
cash loss or anything like it; it is only the loss of coverage
for a debt that is held by a protected party. For institutions
of this size, with the exception of Goldman, the loss of
AIG’s CDS protection would not have been problematic,
even if they had in fact already suffered losses on the
underlying obligations that AIG was protecting. Moreover,
when questioned about what it would have lost if
AIG had defaulted, Goldman said its losses would have
been “negligible.” This is entirely plausible. Its spokesman
cited both the collateral it had received from AIG under
the CDS contracts and the fact that it had hedged its AIG
risk by buying protection against AIG’s default from third
parties.9 Also, as noted above, Goldman only suffered the
loss of its CDS coverage, not a loss on the underlying debt
the CDS was supposed to cover. If Goldman, the largest
counterparty in AIG’s list, would not have suffered substantial
losses, then AIG’s default on its CDS contracts
would have had no serious consequences in the market.
This strongly suggests that Secretary Geithner’s effort to
justify the need for a systemic regulator is based on very
Financial firms have
always been
interconnected in order
to perform their
intermediary functions.
The right question is
whether they are now
interconnected in a way
that makes them more
vulnerable to the failure
of one or more
institutions than they
have been in the past,
and there is no
evidence of this.
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weak or exaggerated data. AIG could have been put into
bankruptcy with no costs to the taxpayers. A systemic
regulator would have rescued AIG—just as the Fed did—
amounting to an unnecessary cost for U.S. taxpayers
and an unnecessary windfall for AIG’s counterparties. We
will probably never know why the Fed decided to bail
out AIG, but the most likely reason is that it simply panicked
at the market’s reaction to the Lehman failure.
Lehman’s Failure Did Not Cause a Systemic Event.
Despite John Taylor’s analysis, it is widely believed that
Lehman’s failure proves that a large company’s default,
especially when it is “interconnected” through CDSs, can
cause a systemic breakdown. For that reason, Secretary
Geithner contends, there should be some authority in the
government to seize such a firm and keep its
failure from affecting others. Even if we accept, contrary to
Taylor, that Lehman’s failure somehow precipitated the
market freeze that followed, it does not support the proposition
that, in a normal market, Lehman’s failure would
have caused a systemic breakdown. In fact, analyzed in
light of later events, it is evidence for the opposite conclusion.
First, after Lehman’s collapse, there is only one example
of any other organization encountering financial
difficulty because of Lehman’s default. That example is the
Reserve Fund, a money market mutual fund that held a
large amount of Lehman’s commercial paper at the time
Lehman defaulted. This caused the Reserve Fund to “break
the buck”—to fail to maintain its share price at exactly one
dollar—and it was rescued by the Treasury. The fact
that there were no other such cases, among money market
funds or elsewhere, demonstrates that the failure of
Lehman in a calmer and more normal market would not
have produced any significant knock-on effects. In addition,
when Lehman’s CDS obligations were resolved a
month after its bankruptcy, they were all resolved by
the exchange of only $5.2 billion among all the counterparties,
a minor sum in the financial markets and certainly
nothing that in and of itself would have caused a market
So, what relationship did Lehman’s failure actually
have to the market crisis that followed? The problems that
were responsible for the crisis had actually begun more
than a year earlier, when investors lost confidence in the
quality of securities—particularly mortgage-backed securities
(MBS)—that had been rated AAA by rating agencies.
As a result, the entire market for asset-backed securities of
all kinds became nonfunctional, and these assets simply
could not be sold at anything but a distress price. Under
these circumstances, the stability and even the solvency of
most large financial institutions—banks and others that
held large portfolios of MBS and other asset-backed securities—
were in question.
In this market environment, Bear Stearns was rescued
through a Fed-assisted sale to JPMorgan Chase in March
2008. The rescue was not necessitated because failure
would have caused substantial losses to firms “interconnected”
with Bear, but because the failure of a large financial
institution in this fragile market environment would
have caused a further loss of confidence—by investors,
creditors, and counterparties—in the stability of other
financial institutions. This phenomenon is described in a
2003 article by George Kaufman and Kenneth Scott, who
write frequently on the subject of systemic risk. They point
out that when one company fails, investors and counterparties
look to see whether the risk exposure of their own
investments or counterparties is similar: “The more similar
the risk-exposure profile to that of the initial [failed company]
economically, politically, or otherwise, the greater is
the probability of loss and the more likely are the participants
to withdraw funds as soon as possible. The response
may induce liquidity and even more fundamental solvency
problems. This pattern may be referred to as a ‘common
shock’ or ‘reassessment shock’ effect and represents correlation
without direct causation.”11 In March 2008, such an
inquiry would have been very worrisome; virtually all the
large financial institutions around the world held the same
assets that drove Bear toward default.
Although the rescue of Bear temporarily calmed the
markets, it led to a form of moral hazard—the belief that
in the future governments would rescue all financial
institutions larger than Bear. Market participants simply
did not believe that Lehman, just such a firm, would not be
rescued. This expectation was shattered in September
2008 when Lehman was allowed to fail, leading to exactly
the kind of reappraisal of the financial health and safety
of other institutions described by Kaufman and Scott.
That is why the market froze at that point; market participants
were no longer sure that the financial institutions
they were dealing with would be rescued, and thus it was
necessary to examine the financial condition of their
counterparties much more carefully. For a period of time,
the world’s major banks would not even lend to one
another. So what happened after Lehman was not the
classic case of a large institution’s failure creating losses at
others—the kind of systemic risk that has stimulated the
administration’s effort to regulate systemically important
firms. It was caused by the weakness and fragility of the
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financial system that began almost a year earlier, when
the quality of MBS and other asset-backed securities
was called into question and became
unmarketable. If Lehman should have
been bailed out, it was not because its failure
would have caused losses to others—
the reason for the designation of
systemically important firms—but because
the market was in an unprecedented
condition of weakness and fragility.
Thus, the two examples that Secretary
Geithner has used to push his plan are
inapposite. AIG should clearly have been
sent to bankruptcy court, and Lehman’s
failure was only important because it
caused market participants to reappraise
the risks of dealing with one another in an
unprecedented market environment—in
which almost every large financial institution
was already weak and possibly insolvent.
Regrettably, the administration is
using these two inapposite examples—its
only examples—to set in place an entirely
new, broader, and wholly unnecessary system
of regulation and resolution. In the
unlikely event that the worldwide financial markets in the
future were to again become fragile and fearful, it would be
far better to have an ad hoc response from the U.S. government
than to establish a vast new regulatory structure
today for an event that is a wildly remote possibility.
The Weak Case for Designating
Systemically Important Firms
Even if there were facts that made it sensible to designate
systemically important companies today and create a
special system of resolution for them, major questions
would still be unresolved.
How Would Systemically Important Firms Be Identified?
Even if a systemic event could be caused by the failure of a
systemically important firm, how would we identify such a
firm in advance? Secretary Geithner has cited numerous
criteria in addition to size, including reliance on shortterm
funding or whether it is a source of credit for households.
12 There are no examples of a large financial
institution’s failure actually causing a systemic event for
the simple reason that, in every case of a large bank’s failure,
it has been bailed out. When other kinds of financial
institutions have failed, no systemic disruption has
occurred. In theory, for the reasons outlined earlier, the
failure of a large bank could result in a systemic
breakdown, but on what basis would
nonbanks be designated as systemically
important? Experience provides no answer.
Making things tougher for the proponents
of the administration’s plan is the fact that
the only examples we have contradict their
assumptions. Not only have large nonbank
financial institutions such as Drexel Burnham
failed without causing a systemic
event, but the failure of quite small firms
have caused what some might consider
systemic events, even though no one would
have classified them as systemically important
in advance. For example, when two
tiny securities dealers—Bevill, Bresler and
ESM—failed in the mid-1980s, Paul Volcker,
then chairman of the Federal Reserve
Board, told Congress: “The failure of some
dealers operating at the periphery of the
market . . . did have severe repercussions
for some customers. The insolvency of a
number of thrift institutions was precipitated,
while other institutions involved in financing or
servicing the fringe dealers were placed in some jeopardy.
In our highly interrelated and interdependent financial
markets, these developments carried at least the seeds of
more widespread systemic problems.”13 This comment
provides an indication of how malleable the concept of
systemic risk can be. In another well-known case, the 1976
failure of Herstatt Bank, a small German bank, caused a
breakdown in the international payment system, although
Herstatt would not have been on anybody’s list of systemically
important institutions when it failed.14 What
the Herstatt case shows is that regulating systemically
important firms does not provide any assurance that
systemic risk will be avoided. It creates the dangers to
competition discussed above, suppresses innovation, and
raises costs, but it does not make the financial system
materially safer.
Anyway, Would Regulation Work? Even if we assume
that it is possible to determine in advance which firms will
cause systemic risk, would regulation prevent it? Although
this idea is central to the administration’s case, all the
evidence we have points the other way: regulation is simply
not effective in preventing risk-taking and failure. The
Regulation adds costs
and reduces
competition and
innovation. If it does
not produce outcomes
that are better than
market discipline—
and it certainly has not
when we compare
unregulated hedge
funds and regulated
banks—it should not be
imposed on industries in
which government
backing is not present.
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evidence is too clear to be ignored. After the S&L debacle
in the late 1980s and early 1990s—a financial crisis in
which most of the S&L industry as well as almost 1,600
commercial banks failed—Congress adopted FDICIA.
At the time, this legislation was considered extremely
tough banking legislation—so much so that, in a speech to
a conference at the Federal Reserve Bank of Chicago in
1992, Alan Greenspan, then chairman of the Federal
Reserve Board, complained that the law created too many
restrictions on banks.15 Greenspan might have had it
right; sixteen years after the adoption of FDICIA, we
entered the worst U.S. banking crisis since the Depression,
and perhaps the worst of all time.
This does not say much for the effectiveness of regulation,
and it certainly does not provide a basis for believing
that if we were to extend safety-and-soundness regulation
beyond banks to other areas of the financial sector, we
would be doing anything to prevent another crisis in the
future. Indeed, there is significant evidence that regulation
introduces moral hazard and makes the failure or weakness
of regulated entities more likely. One example of this is the
contrast between hedge funds—unregulated as to safety
and soundness—and commercial banks, which are heavily
regulated for this purpose. Hedge funds have long been
targets for lawmakers looking for opportunities to impose
new regulations.16 Yet, the current crisis was caused by
regulated banks, not hedge funds, and although some
hedge funds have failed, no hedge funds have had to be
bailed out by the government because they might create
systemic risk. Moreover, hedge funds have performed
much better than regulated banks in protecting their
investors against losses. As Houman Shadab testified
recently before Congress: “Even throughout 2008, while
hedge funds have experienced the worst losses in their
entire history as an industry, they have still managed to
shield their investors’ wealth from the massive losses
experienced by mutual funds and the stock market more
generally. From January through October 2008, the U.S.
stock market lost 32 percent of its value while the average
hedge fund lost approximately 15.48 percent.”17 Bank
stocks, of course, have performed worse than the stock
market as a whole.
It is difficult, then, to escape the conclusion that regulation
would not achieve any of the objectives that the
administration has set out for it and that the motivation to
broaden regulation and extend it to other areas of the
financial economy is ideological, rather than based on facts,
evidence, or even experience. Regulation adds costs and
reduces competition and innovation. If it does not produce
outcomes that are better than market discipline—and it
certainly has not when we compare unregulated hedge
funds and regulated banks—it should not be imposed on
industries in which government backing is not present.
Finally, the proponents of systemic regulation argue
that the administration’s plan should be adopted because
we have already bailed out so many firms that it is impossible
to return to a world in which there is no systemic
regulation. In other words, the moral hazard already
created by the bailouts that have occurred justifies new
and broader regulation. The cat, as they say, is out of the
bag. Leaving aside the absurdity of the government getting
more power because it made errors in the use of the power
it had already been given, the trouble with this argument
is that it treats the current financial crisis as an event that
is likely to recur in the future. However, this crisis—
involving as it does all developed countries and virtually
all major financial institutions—is an unprecedented
event that has required unprecedented actions by the
government. To use the current crisis as a basis for a
major policy change like that which the administration
has proposed, it is necessary to believe that a worldwide
meltdown of financial institutions will be a routine event
in the future. But given the fact that nothing like this
has ever happened before, there is no reason to believe
that after the current crisis is over the financial markets
will continue to expect bailouts of large nonbank financial
A useful analogy is the Fed’s current role in addressing
the problems of the financial sector. Because of the severity
of the crisis, the Fed has been working hand in glove
with the Treasury Department to provide funds for bank
rescues and bailouts. If the markets were to take this cooperation
as a precedent for the way the Fed will act in the
future, they could well conclude that the Fed is no longer
a truly independent central bank. However, most people
in the financial markets probably understand that the
Fed’s extraordinary actions today will not create precedents
for the future and that, when the current crisis is
over, the Fed will act to show its independence of the
Treasury, with its reputation for objectivity in its decisionmaking
The Fed and Treasury are well aware of this problem
and recently issued a joint statement pointing out that
“[a]ctions that the Federal Reserve takes, during this
period of unusual and exigent circumstances, in pursuit of
financial stability . . . must not constrain the exercise of
monetary policy.”18 In other words, the mere fact that
some extraordinary and unprecedented actions had to be
- 10 -
taken to deal with this crisis does not mean that everything
in our financial system has changed. The same is true
for the structure of the financial system itself. It should be
designed for what is likely to occur in the future, not for a
situation like the current unprecedented crisis.
The administration is attempting to build a case for a
wholesale restructuring of the financial markets on the
basis of two inapposite examples—AIG and Lehman. The
fundamental changes its plan entails—the establishment
of a powerful regulator with the authority to designate certain
firms as systemically important and a system for
resolving or rescuing financial institutions other than
banks—will seriously impair competition in the financial
sector and threaten to create large companies that are not
significantly different in their competitive effect from
Fannie Mae and Freddie Mac. Up to now, there has been
little resistance from the financial sector, but the administration’s
case for this vast change in financial regulation
is so weak—and the result of implementing its plan so
troubling—that concerted financial industry opposition is
likely to develop.
1. Timothy F. Geithner, written testimony (Committee on
Financial Services, U.S. House of Representatives, March 26,
2009), available at www.house.gov/apps/list/hearing/financialsvcs_
dem/geithner032609.pdf (accessed April 8, 2009).
2. See Damian Paletta, “U.S. to Toughen Finance Rules,” Wall
Street Journal, March 16, 2009.
3. See, for example, Peter J. Wallison, “Risky Business: Casting
the Fed as a Systemic Risk Regulator,” Financial Services Outlook
(February 2009), available at www.aei.org/publication29439.
4. Calculation by the author, based on Federal Deposit Insurance
Corporation press releases and available upon request.
5. John B. Taylor, “The Financial Crisis and the Policy
Responses: An Empirical Analysis of What Went Wrong” (Working
Paper 14,631, National Bureau of Economic Research,
Cambridge, MA, January 2009), 25ff, available at www.nber.org/
papers/w14631 (accessed April 8, 2009).
6. American International Group, 10-Q filing, June 30, 2008,
7. A full description of the operation of credit default swaps
appears in Peter J. Wallison, “Everything You Wanted to Know
about Credit Default Swaps—but Were Never Told,” Financial
Services Outlook (December 2008), available at www.aei.org/
8. Mary Williams Walsh, “A.I.G. Lists Banks It Paid with U.S.
Bailout Funds,” New York Times, March 16, 2009.
9. Peter Edmonston, “Goldman Insists It Would Have Lost
Little if A.I.G. Had Failed,” New York Times, March 21, 2009.
10. See Peter J. Wallison, “Everything You Wanted to Know
about Credit Default Swaps—but Were Never Told.”
11. George G. Kaufman and Kenneth Scott, “What Is
Systemic Risk and Do Regulators Retard or Contribute to It?”
The Independent Review 7, no. 3 (Winter 2003). Emphasis added.
12. Timothy F. Geithner, written testimony, March 26,
13. Paul A. Volcker, statement (Subcommittee on Telecommunications,
Consumer Protection and Finance, Committee on
Energy and Commerce, U.S. House of Representatives, June 26,
1985), 1–2.
14. George G. Kaufman and Kenneth Scott, “What Is
Systemic Risk and Do Regulators Retard or Contribute to It?”
15. Alan Greenspan, remarks (Twenty-Eigth Annual Conference
on Bank Structure and Competition, Federal Reserve Bank
of Chicago, May 7, 1992), available at http://fraser.stlouisfed.org/
(accessed April 8, 2009).
16. See, for example, Senate Finance Committee, “Grassley
Seeks Multi-Agency Response on Lack of Hedge Fund Transparency,
Expresses Alarm at Risk to Pension-Holders,” news
release, October 16, 2006, available at www.senate.gov/~finance/
press/Gpress/2005/prg101606.pdf (accessed February 4, 2008).
17. Houman B. Shadab, testimony (Committee on Oversight
and Government Reform, U.S. House of Representatives,
November 15, 2008).
18. Board of Governors of the Federal Reserve System and U.S.
Department of the Treasury, “The Role of the Federal Reserve in Preserving
Financial and Monetary Stability,” news release, March 23,
2009, available at www.federalreserve.gov/newsevents/press/monetary/
20090323b.htm (accessed April 2, 2009).

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