CHAPTER EIGHT
WE HAVE MADE A FULL TOUR DE TABLE in searching for the underlying causes of this crisis. As I write, financial sectors around the world have been brought back from the brink through a combination of government guarantees, injections of capital, and central bank lending. Rock-bottom interest rates continue to bail out banks at the expense of savers: if banks can borrow at almost no interest and lend at a hefty spread, it is hard for them not to make money. Government spending across the world seems to have helped maintain activity, though it is still uncertain whether heavily indebted households, especially in the United States, will take up the task of spending when the government stimulus runs out. The most likely prognosis is for a period of relatively slow growth and mounting government debt obligations in industrial countries. Fortunately, though, we have stopped following the path of the Great Depression. Costly as this crisis will prove, it could have been worse.
The fault lines and fragilities I have identified will not, however, simply go away with the passage of time. Some of them, indeed, are deepening. They will need to be addressed directly. But even while politicians sense the need for reforms, public distrust is growing for anything that has to do with the status quo. Radical proposals traverse the blogosphere—though with all the upheaval, the public tolerance of the additional uncertainty associated with change is also low.
The public has lost faith in a system where the rules of the game seem tilted in favor of a few. Some of the bailout proposals, put together over sleepless weekends, seem poorly thought through at best and tainted by corruption at worst. Rolling Stone's Matt Taibbi has called Goldman Sachs—a bank with alumni in every corner of the government, and, despite its protestations to the contrary, a significant beneficiary of the rescue—a “blood-sucking vampire squid.”1 The epithet seems to have stuck, epitomizing the public mood. Tin-eared bankers have not helped, paying themselves huge bonuses soon after being rescued by an ongoing public bailout, and, perhaps more infuriatingly, expressing surprised hurt at the public reaction.
The private sector, however, is not alone in deserving blame. There is substantial evidence that government intervention and regulatory failure had as much of a role to play in this crisis as private-sector failure: indeed, it was the coming together of the two that had the most severe consequences. The temptation for politicians, however, will be to blame, and reverse, every precrisis trend on the grounds that it is somehow associated with, and hence responsible, for the crisis—and the trend was toward a greater role for the private sector. The targets for the forces of reaction are obvious. The public has expressed widespread revulsion against the liberalization that led to more vibrant financial markets and freer financial institutions. The forces against globalization— the greater integration of countries through trade, multinational firms, capital flows, and migration—are also regrouping, gaining succor from the natural willingness to look abroad for the roots of one’s problems. Diehard socialists are celebrating the grand crises that they see as harbingers of the collapse of capitalism.
Finance, markets, globalization, and free-enterprise capitalism will endure beyond this crisis. But recent events do ask us to make hard choices, not about capitalism itself, but about the form of free-enterprise capitalism we desire. If we do not mend the fault lines, we could well have another crisis, albeit different in its details from the current one. Another crisis will tax already stretched public and household finances, as well as the fraying political consensus behind the system, perhaps to breaking point. Reform will then be much harder. Instead of testing providence, we should take this crisis as a wake-up call for reform.
We have hard choices to make, as the good and the bad are typically closely intertwined. Radical positions that see the system as fundamentally broken are popular. They fit in with the public mood, and they are easy to tout in these times, their greatest merit being their distance from the current system.
In defending the basic structure of a system that has failed, I face the risk of being dismissed as a conservative, an unregenerate apologist, or worse, a toady of banking interests that favor the status quo. But although systemic failure does imply the need for serious reform, it does not mean that a radically different system would be better. I believe we have to work to fix the system, but there is a lot worth keeping. So the choices I propose are not necessarily meant to shock: they are meant to fix the problems I have identified, which are serious indeed. I start with the financial sector, where so many fault lines meet.
To begin, we have to take a stand on whether the financial sector actually helps the process of economic growth and well-being or whether it is just a sideshow, an irrelevance that makes its presence felt only by imploding periodically. If the latter is the case, then reform is easy: prohibit many of the current activities of the financial sector, create a few stable monopolies, regulate all remaining activities very closely, and forget about the sector for the next few decades. Serious economists and policy makers have called for such reforms, broadly under the rubric of “making finance boring.” If the financial sector is central to economic growth, though, reform becomes more challenging, because we have to limit finance’s ability to do damage while harnessing its creative energies. This is the challenge I address in this chapter.
To make the debate more concrete, I outline polar-opposite positions on a specific issue: expanding access to credit. I argue that it is both democratic and efficient to continue to expand the range of choices people have. Regulatory reform that attempts to do otherwise will not survive in the long run, especially in a democracy. The real issue confronting us, therefore, is how to harness the benefits from financial development while limiting its instability. I outline some of the principles that reforms will need to respect and then take on the concrete issue of how we can reduce the incentive to take on tail risk that was so pervasive during the current crisis. I end with thoughts on how to make the system resilient to unforeseen dangers.
The financial sector is, in many ways, the brain of a modern economy. When it functions well, it allocates resources and risk effectively and thereby boosts economic growth while also making lives easier, safer, and more fulfilling. It broadens opportunity and attacks privilege. It works for all of us. Of course, when it works poorly, as it has done recently, it can do enormous damage while benefiting a very few.
A narrower concern, but one that touches every household, is whether access to finance is so dangerous that some people should be kept from it, or their access severely regulated. Diametrically differing views exist on whether broadening access to borrowing through developments such as credit cards, home equity loans, and payday lending is good or bad. One view is that the democratization of credit is an eminently desirable development.2 It allows households to borrow against future income and smooth their consumption and expenditure over time, while also affording small entrepreneurs the ability to start their ventures: many a small venture has been started through borrowing on credit cards.
Proponents of this view make the fundamental assumption that most households are rational and responsible: they will borrow only as much as they need, with full awareness of the consequences. Any attempt to constrain their choices is paternalistic and unwarranted. Indeed, proponents of this view use the term credit to denote borrowing. Credit, according to the Random House Dictionary, is defined as “confidence in a purchaser’s ability and intention to pay,” and the term accords well with traditional American optimism about the future. If the best is yet to come, why not borrow against it and make today better still?
The opposite view is that borrowing is immoral, a giving in to temptation. Those who are indebted have no self-control and no sense of personal responsibility. Some of the blame goes to financiers (cast as loan sharks), who hold out easy access to lending, and some goes to marketers and advertisers who instill in the unsuspecting public desires for goods they do not need. Nevertheless, the overall consequence of broadening access to financing is, according to this view, over consumption and overindebtedness, a temporary, illusory prosperity that leads eventually to poverty and remorse. Proponents of this view prefer the term debt, denoting obligation. There is a long tradition reflecting this view in the United States, epitomized by Benjamin Franklin in Poor Richard’s Almanac: “But, ah, think what you do when you run in debt; you give to another power over your liberty. If you cannot pay at the time, you will be ashamed to see your creditor; you will be in fear when you speak to him, you will make poor pitiful sneaking excuses, and by degrees come to lose your veracity, and sink into base downright lying; for, as Poor Richard says, the second vice is lying, the first is running in debt.”3
Credit as a key to opportunity and as a means to the consumption you deserve, or debt as sin and as a mortgaging of a future you will never have—these two opposing views run through American history, with the former gaining ascendancy during boom times and times of rising inequality, and the latter gaining ground in downturns, when sobriety or rank pessimism returns. They represent a way of rephrasing the question I started with earlier: do we want to harness finance’s creative energies, or do we think finance is so dangerous that most people should not have access to it and it should be stuffed back in the box it came from? Society’s attitude toward financial reform hinges on whether it believes people and firms, by and large, can be trusted to make sensible financial decisions when given the means to do so.
The academic debate on this question is not conclusive. Even as research in behavioral economics tells us that some people make consistent mistakes in their financial decisions, it also tells us that a lot of behavior is rational and sensible. Indeed, as I argue throughout this book, it is typically not the rationality of the decision makers that is a problem. Rather, it is whether the apparent payoffs from decisions fully reflect the costs and benefits to society. Our goal should be to make decision makers internalize the full consequences of their decisions, rather than prevent them from making decisions altogether.
More generally, even if we conclude that some people took on too much debt during the boom, shutting off their access to some markets or limiting their financial choices (typically through legislation restricting the products, prices, or institutions they have access to) is paternalistic, undemocratic, and the surest way to ensure that the protected never have the opportunity to learn or improve themselves. Of course, we need to ensure they are given every opportunity to understand why certain choices are poor choices and to recognize the mistakes people traditionally make so that they can change their behavior. We should also ensure that they are protected from rank predators. But limiting choice is not the answer.
Free societies do revert to more paternalism and more constraints on choice following a crisis. It is natural to blame the crisis on the greater freedom to choose: if only choice had been more restricted (and, of course, with hindsight, it is crystal clear what the restrictions should have been), we would not have made the bad choices that were made, or so goes the thinking. The overall trend in civilized democratic societies, however, is to expand choice for all, not constrain it, let alone constrain it for only some. From a practical standpoint, regulations that limit choice may be popular in the aftermath of a crisis but will inevitably be whittled away as the memories of the crisis fade. And enacting regulations that will soon be outmoded and voted down carries an inherent cost: it creates a momentum for deregulation among the public that could go too far. It is better to get regulation right than to err in either direction.
In sum, if we reject the view that finance is a largely useless activity, or that we can keep its benefits only for a select and knowledgeable few, then the purpose of reform should be to draw out what is best in finance for the largest number of people while minimizing the risk of instability.
What guiding principles must reforms adhere to? Let me outline the key ones and then go on to a concrete example.
A healthy financial system that benefits citizens requires competition and innovation. Oligopoly implies easy profits for the incumbents, profits they are loath to jeopardize by taking on risk. By contrast, the goal of broadening access, to reach new and underserved customers as well as future innovators, requires a financial system that is willing to take reasonable risks, and thus it requires competition. This is not a popular view at a time of crisis in a free-market economy, for the natural tendency is to blame the market and factors like competition that make it free.
One of the main concerns during the Great Depression was that prices were too low, and the mistaken diagnosis was excessive competition. The New Deal solution was to prop up prices by forming cartels. To smooth the political path for the needed legislation, words like “economic cannibalism” and “cut-throat price slashing” were used to describe competition.4 Formerly “rugged individualists” became “industrial pirates.” Regulations meant to create cartels and suppress competition became “codes of fair competition,” while various forms of officially sanctioned collusion were described as “cooperative behavior.” Of course, incumbent firms were fully complicit in the regulation and cartelization of the economy, for it made things easier for them.
The concerns during the recent crisis centered primarily on the underpricing of risk. Once again, it would be tempting but wrong to blame competition between banks. The right approach would be to reduce the various distortions to the pricing of risk that stem from actual and potential government intervention, as well as from herd behavior. We should not worry so much about rugged individualism as about undifferentiated groupthink, for that is the primary source of systemic problems.
A competitive system is also likely to produce the financial innovation necessary to broaden access and spread risk. Financial innovation nowadays seems to be synonymous with credit-default swaps and collateralized debt obligations, derivative securities that few outside Wall Street now think should have been invented. But innovation also gave us the money-market account, the credit card, interest-rate swaps, indexed funds, and exchange-traded funds, all of which have proved very useful. So, as with many things, financial innovations span the range from the good to the positively dangerous. Some have proposed a total ban on offering a financial product unless it has been vetted, much as the Food and Drug Administration vets new drugs. This proposal probably goes too far, as many products are minor tweaks on previous ones, are not life threatening, and cannot really be understood until tried out. Modest and free experimentation should be allowed but proliferation limited until regulators are satisfied they understand the innovation well, and the systemic risks it poses have been dealt with.
More generally, in an ever-changing global economy, stasis is often the greatest source of instability, for it means the system does not adapt to change. Competition and innovation, by contrast, help the system adapt, and if properly channeled, are key to ensuring variety, resilience, and therefore dynamic stability. Critics will be quick to point out that competition and innovation lead to greater instability during the run-up to a crisis: after all, securities like the CDO squared and the CDO cubed were so devilishly difficult to price that they had no market once mortgages started defaulting. However, it is not competition per se, but rather the distorted banker incentives and the distorted price of risk that led to the creation of these instruments.
As I argue in Chapter 7, some of the incentives to take excessive risks may have resulted from a breakdown of internal governance within banks, and some from a breakdown of external governance. These mechanisms need to be fixed, and I discuss some options below. But the primary reason for a systemic breakdown is invariably the underpricing of risk. One reason for underpricing is irrational exuberance: initial, moderate underestimates of risk feed on each other until they become a frenzy. Usually, though, such bubbles rarely occur out of the blue. The underpricing of risk in the period leading up to the recent crisis stemmed, in part, from anticipated government or central bank intervention in markets. And certainly, since the crisis hit, the Treasury and the Fed have intervened massively in markets, thus verifying the expectations. We need to find a way to dispel the notion that the government or its agencies will prop up a market, whether the market for housing or the market for liquidity.
As damaging as government intervention to help specific markets is government intervention to prop up specific financial institutions. The essence of free-enterprise capitalism is the freedom to fail as well as to succeed. The market tends to favor institutions that are protected by the government from failing, asks too few questions of them, and gives them too many resources for their own good. Moreover, such protection distorts the competitive landscape. We have to aim for a system in which no private institution has implicit or explicit protections from the government, one in which every private institution that makes serious mistakes knows it will have to bear the full costs of those mistakes.
As we emerge from the panic, righteous politicians feel the need to do something. Regulators, with their backbones stiffened by public disapproval of past laxity, will enforce almost any restrictions, while bankers, whose frail balance sheets and vivid memories make them eschew any risk, will be more accepting of such restrictions. But we tend to reform under the delusion that the regulated institutions and the markets they operate in are static and passive, and that the regulatory environment will not vary with the cycle. Ironically, faith in draconian regulation is strongest at the bottom of the cycle, when there is little need for participants to be regulated. By contrast, the misconception that markets will govern themselves is most widespread at the top of the cycle, at the point of maximum danger to the system. We need to acknowledge these differences and enact cycle-proof regulation, for a regulation set against the cycle will not stand. To have a better chance of creating stability throughout the cycle—of being cycle-proof—new regulations should be comprehensive, nondiscretionary, contingent, and cost-effective.
Regulations that apply comprehensively to all levered financial institutions are less likely to encourage the drift of activities from heavily regulated to lightly regulated institutions over the boom. Such a drift has been a source of instability, because its damaging consequences come back to hit the heavily regulated institutions in the bust, through channels that no one foresees. For example, the asset-backed securities that Citigroup had placed in thinly capitalized off– balance sheet vehicles came back onto its balance sheet when the commercial paper market dried up, contributing immensely to Citigroup’s troubles. We have to recognize that because all areas of the financial sector are intimately interconnected, it is extremely hard to create absolutely safe areas and imprudent to ignore what happens outside supposedly safe areas.
Regulations that are nondiscretionary and transparently enforced have a greater chance of being adhered to, even in times of great optimism. Compliance can be more easily monitored by interested members of the media and the public, thus offering some check on the regulator. The regulated also have a good sense of how regulations will be implemented. One example of such regulation is the FDIC Improvement Act of 1991, which mandates that regulators take a series of ever more stringent actions against a bank as its regulatory capital drops below specified levels. The weakness in the act is that regulatory capital is hard for the public and the press to measure in real time, so it is difficult to gauge whether regulators are following through on the requirements of the law. Nevertheless, the act suggests a possible direction for new regulation.
Wherever possible, regulations should come into force only when strictly necessary: they should be triggered by adverse events rather than be required all the time. Such contingent regulations have two effects. First, because they kick in only some of the time, they are less cumbersome than regulation that is not contingent, and banks will not invest as much ingenuity in trying to evade them. Second, the level of the regulatory requirement—such as the required level of capital—can then be increased if necessary, so that it has the desired effect when really needed.
Finally, regulations that are not particularly costly for the regulated to implement or for the regulator to enforce are less likely to be evaded or ignored. Moreover, they are likely to have more staying power as memories of past problems fade.
Let us apply all these principles to a concrete question: how do we prevent the systematic tail risk taking that nearly destroyed the financial system? I have focused on two related examples of tail risks—the risk of default embedded in senior asset-backed securities and the liquidity risk inherent in financing potentially illiquid assets with very short-term debt. I examine detailed proposals for reducing such risk, because measures that seem reasonable at first glance often raise more concerns on closer examination.5
As I argue in Chapter 7, there are huge incentives at every level in the financial system to take on these tail risks if they can be concealed from those assessing performance. Those giving up the tail risk are willing to pay a premium to do so, while those taking it on and downplaying the eventual risk of payout can treat the premium as pure profit, the product of their natural brilliance rather than merely a compensation for risk. The premium paid by those selling the risk increases in proportion to the anticipated loss if the risk actually hits (they pay more if they think earthquakes will do more damage); and the higher the premium, the more of the risk the sellers are willing to take on (because they do not anticipate being around when their firms have to make good the loss). Too many firms will be eager to take on risks that have extremely costly consequences, and they will compete to take the risk at too low a price. The net result is that too much of the risk will be created.
Matters grow worse if, because of the extent of risk taking, everyone anticipates that when the risk actually materializes, the government or the Federal Reserve will be drawn in to support the markets underlying the tail risk, or the institutions taking it on. In that case, those taking on the tail risk will find it worthwhile even if it is common knowledge that they are doing so, because the government backstop will make it profitable. Few financial institutions will want to be left out of the orgy of risk taking. So what starts off as an attempt to take on hidden risk and fool the market will, if enough firms get in on the act and induce an anticipation of government intervention, become an overt and profitable play that is rewarded by the market.
If tail risk is knowingly taken, or knowingly encouraged by securities markets, the way to deal with it is to alter incentives throughout the corporate hierarchy, the financial firm’s liability structure, and its regulatory structure. One seemingly obvious way to reduce the perverse incentive to take tail risk before risk taking becomes systemic is to do away with all pay tied to performance: to pay bankers like bureaucrats. Of course, firms can offer other rewards for performance, such as status and promotions, that are harder to eliminate. And even if it were possible to prevent evasion of the rules, there would be another obvious downside; bankers would have no incentive to work hard or take calculated risks. In today’s competitive, fast-moving economy, bureaucratic bankers would not be an improvement over the status quo. What we need from bankers is competent risk management, not complete risk avoidance. So we have to find ways to reduce the incentive to take tail risk even while rewarding bankers for performance so that they continue to offer innovative products that meet customer needs and lend to the risky but potentially very successful start-up.
This means that wherever possible, the risk taker should suffer targeted penalties if the risk materializes, so that society does not feel the need to absolve them because the innocent, the connected, or the politically vocal will suffer alongside. Of course, extremely high penalties will deter even ordinary risk taking, so the penalties will have to be appropriately calibrated. It may also well be that no one, including markets, can anticipate some risks. To deal with such possibilities, it is necessary to build some private sector buffers to absorb shocks, as well as make the system resilient to them. I will now be more specific.
The most obvious form of tail risk taking is conducted by individual traders or company units, as was the case at AIG’s Financial Products Division, whose staff benefited from the extraordinary profits and associated huge bonuses on the way up and were retained with high bonuses to clear up the mess they created on the way down. One way to make units internalize small-probability tail risks that senior management or risk managers may not see or understand is to hold a significant part of a unit’s bonuses in any year in escrow, subject to clawbacks based on the unit’s performance in subsequent years—a suggestion I made before banker bonuses became a political football.6 Simply put, if a trader makes a hefty bonus this year, only a fraction should be paid out to her this year, with the remaining amount held back by the bank to be paid out over time on condition that her positions do not lose all the money earned this year in subsequent years. This will give the trader a longer horizon, creating some uncertainty about whether any tail risk she takes could actually hit before her bonus is paid, thus giving her greater incentive to avoid it.
Of course, such a compensation structure will be effective only if a trader knowingly takes tail risks, not if she is unintentionally guided into taking them. Crude limits on the positions individual traders or units are allowed to take, and mandatory diversification requirements, may also be necessary, not so much to prevent tail risk taking but to minimize the loss if it does occur.
The proposals above to manage tail risks presume that top management wants to curb such risk taking. I have discussed a number of reasons why CEOs might not want to do so, such as their desire to match the profits shown by other risk-taking managements and their insouciance about the downside because they believe that the government will intervene. Some old-time bankers reminisce fondly about the time when investment banks were partnerships, and partners had their entire wealth at stake. Given the size of banks today and their international sprawl, it would be difficult to convert them back into closely held partnerships in which mutual monitoring by partners inhibits excessive risk taking. And forcing banks to shrink might not make them safer. We have also seen that simply giving management an equity stake may not be enough—they realize enormous gains if the risk taking pays off but have limited liability if it does not.
Instead it may be useful to consider ways to place some of the burden of risk on top management, without necessarily having entire classes of claims being subject to that risk. For instance, the Squam Lake Working Group (a non-partisan group convened by Professor Ken French of Dartmouth College after the recent crisis to propose reforms) has suggested not only holding back some portion of top management bonuses and reducing them if there are future losses—much like the clawbacks I discussed earlier—but also writing these “holdbacks” down if the firm has to be bailed out in any way. Thus the holdbacks would serve as junior equity and give strong incentives to management to take precautions to avoid a bailout.
The financial firm’s board is meant to be another check on mismanagement. But even when tail risk taking is not in the shareholders’ interests, the bank’s board of directors may not be an effective source of deterrence. Board members are generally poorly informed when they are truly independent, and excessively cozy with management when they are not. Lehman’s board, for instance, consisted of very respectable independent directors. But at the time it filed for bankruptcy in 2008, of the ten-member board, nine were retired, with four over the age of 75.7 One was a theater producer, another a former Navy admiral. Only two had direct experience in the financial services industry. Although advanced age is no disqualification, it typically suggests some remove from the cut-and-thrust of modern finance. Such a board, whose risk committee met only twice a year, had only limited ability to monitor Lehman’s risk taking.
Boards can be strengthened by requiring more financial services expertise of directors, as well as by drawing them from outside Wall Street. Furthermore, a board can obtain better information if the risk managers in the firm are required to report directly to it on a regular basis. The board’s risk committee should also have regular meetings to discuss firmwide risk with unit heads across the firm, without top management present, so that they have a sense of what is going on from those who are closest to the action. Of course, if competent boards are propelled by the same risk-taking incentives as top management, we will have to look elsewhere for ways to discipline risk taking.
Could bank supervisors play a role in monitoring risk taking by top management, as a second line of defense beyond the board, so to speak? Some commentators, including, famously, Alan Greenspan, were skeptical that supervisors would be able to do so. Supervisors are typically less well paid than private sector executives, though they have more job security. Except for those really motivated by public service, supervisors tend to be either less talented or extremely risk averse, neither of which is a particularly helpful attribute in modulating private sector risk taking. Nevertheless, supervisors have two strengths that can make them useful checks on private risk taking. First, they have different incentives: they focus more on the small-probability risks of disaster than does the private sector. Second, they can demand data from firms across the industry and obtain a very good picture of where risk concentrations are building up. Because the tail risks that matter most are those that the whole system is exposed to, well-informed supervisors can monitor aggregate financial-sector exposures and warn firms that are taking too much risk to cease and desist.8 The key is to be neither so intrusive that supervisors constantly substitute their judgment for that of the private sector nor to be so laissez-faire that they ignore systemic risk buildup.
For such a system to work, we need better information. Currently, far too few financial institutions know on a daily basis what their risk exposures are: what might happen if interest rates move up by 25 basis points, if Italian government bonds are downgraded, or if a bank in Ohio is seized by regulators. As a consequence, the regulators and supervisors do not know, either. That AIG was in deep trouble seemed to be news to the regulators who were attempting to deal with Lehman’s impending failure—in part because AIG had found itself a weak regulator by buying a small savings and loan and ensuring its banking activities were regulated by the Office of Thrift Supervision.9 In this day and age, for a regulator to be uninformed is unconscionable. Much of the process of acquiring and analyzing information can be automated. Regulators can require that this information be shared with them on a continuous basis, offering standard procedures and models with which to calculate the exposures. Standardization would be especially useful in the case of illiquid securities, assets, or positions, for which each institution currently calculates values and exposures in its own way, so that their reports are not comparable.
Of course, supervisors rarely find the right balance between intrusion and laissez-faire, and political pressures tend to make them excessively lax in booms and conservative in downturns, just the opposite of what their behavior ought to be. If the gathered information were made public, however, it could offer a measure of public oversight over supervision. For instance, once the information about aggregate exposures and individual financial-firm exposures was put together, much of it could be shared with the markets, after some delay, in a way that could be easily digested. Supervisors would be forced to explain their actions (or inaction) if exposures were seen to be excessive.
Regulatory authorities are often unwilling to reveal too much detail about exposures for fear that this may trigger the very panic they seek to avoid. Clearly, the wrong time to start revealing exposures is when the public is anxious about bank health. The right moment to start is in normal times, when no one is likely to panic. After that, if data on exposures are made public on a regular basis, the public can exert steady and healthy pressure on the financial firms.
Public exposure can reduce tail risk taking in its early stages, for tail risk is of significant value to management at that stage only if the public is unaware of the extent of the company’s exposure to risk. Bond holders will typically not be happy to learn that the hundreds of millions in dollars of profits made in the past quarter came from taking on trillions of dollars’ worth of exposure to particular rare events.
Public exposure can work by making the financial claimants on a financial firm check excess risk taking. Of course, equity holders, who get much of the benefit, may actually favor tail risk taking if the financial firm’s equity cushion is thin relative to the size of the firm: they have little to lose. So a larger capital cushion is necessary to deter risk taking. Below, I suggest ways that such capital can be raised. Also, as I argue above, many debt holders—not just insured depositors but even holders of long-term unsecured debt—thought they would be bailed out by the government, so the interest rate they demanded did not adjust upward as the financial firm took more risk. But debt holders could be an effective constraint on risky behavior if they bore the downside risk, for their future anticipated losses would be reflected in the higher interest rate they demanded from the financial firm. If interest rates move up substantially on a large portion of the financial firm’s debt when it takes more risk, thereby reducing profits, both management and the board may be deterred from risky behavior. At the very least, such an increase in rates paid will be a strong signal to the public and to regulators that the financial firm is taking substantially more risk. Therefore, regulatory reform should focus on ensuring that an important segment of a financial firm’s debt holders know they should expect painful losses if the financial firm takes too much risk.
But neither equity holders nor debt holders will worry much once risk taking becomes so systemic that the market comes to rely on government intervention to prop up markets when the risk hits. In that situation, management and stockholders or bondholders unite to see risk taking as a value-maximizing activity. And if the firm is deemed too systemically important to be allowed by the authorities to fail, the financial firm’s investors are unlikely to ever bear the full cost of big losses. This is a situation tailor-made for encouraging tail risk taking, because the firm makes a lot of profits in good times—everyone purchases tail risk insurance from firms like AIG that will be propped up by the government—and AIG runs to the government for a bailout if the costly tail risk ever hits. Let us take these situations in turn.
With the government so heavily involved in mortgage lending, both directly through the FHA and Ginnie Mae and indirectly through Fannie Mae and Freddie Mac, there was little chance that the market for housing finance, especially subprime housing finance, would be left unsupported even if a big shock hit. Similarly, the Fed and Treasury have supported virtually all the big banks that chose to take liquidity risk.
Clearly, the way to reduce tail risk taking under these circumstances is to back off from government intervention, to the extent possible. There is no inherent reason why the government should have such a large presence in the market for housing finance, other than the fact that the middle class has grown used to implicit housing subsidies. Government conservatorship of Fannie and Freddie gives it an opportunity to create true private-sector housing finance by breaking up these monoliths and creating a handful of private entities, none of which have an implicit government guarantee. At the same time, both the FHA and Ginnie Mae should be shrunk steadily. Although some think the fickleness of the private sector—as evidenced by the current drying up of private subprime housing finance—is a reason for the government to maintain its presence, it is the unsustainable levels to which house prices have been pushed, in part because of that very government presence, that has caused private finance to dry up.
Similarly, there really is no reason other than political pressure for the Fed to take us from bubble to bubble by cutting interest rates to near zero and flooding the market with liquidity. Ironically, the lesson from the Great Depression— that letting the banks go under is not a good idea—has been so well absorbed by the Fed that it is played for a patsy by the banks. One reform I discuss in Chapter 9 is to create a stronger social safety net. That would take some pressure off the Fed to keep injecting stimulus so long as jobs are not growing.
In addition, the exercise of monetary policy should be rethought to take into account its effects on risk taking by the private sector. Financial stability should become a more explicit part of the Fed’s mandate, given as much weight as employment and low inflation. The Fed ought to ask itself whether it is possible that nominal interest rates could be too low, even when the economy is in trouble. The nineteenth-century editor of the Economist, Walter Bagehot, was fond of saying, “John Bull can stand many things but he can’t stand 2 percent.” Similarly, John Doe cannot stand interest rates near zero, and when the Fed pushes short rates very low, especially when deflation is not a clear and present danger but just a possibility, savers move to holding riskier assets, pushing all manner of risk premiums down and prices up. A rock-bottom nominal short-term interest rate prompts risk taking and makes price bubbles more likely; it is unclear, however, that it is much more helpful in prompting corporate capital investment and job growth than a somewhat higher but still low nominal short-term interest rate.
Moreover, if the Fed on occasion has to cut interest rates sharply, it should be prepared to raise interest rates higher than strictly warranted by economic activity once the emergency is over. Such interest-rate policies will reward those who maintain liquid balance sheets and prevent others from becoming overly illiquid in their activities.10 It will also offset the one-sided discriminatory intervention by the Fed that favors debtors at the expense of savers.
Neither set of recommendations—disengaging from housing or following a more evenhanded monetary policy—will be easy to adopt. Powerful groups, including real estate developers and financiers, have an interest in seeing continued government involvement in real estate. Should we wait for the next deep crisis for the government to distance itself? Similarly, monetary economists and central bankers (often cut from the same cloth) will think it crazy that interest rates should be related to anything other than real activity—a point made abundantly clear by Ben Bernanke in his speech to the American Economic Association in Atlanta on January 3, 2010. As we have seen though, the financial sector can affect real activity with a vengeance. We have made the mistake of not paying attention to risk taking before; we should not make it again.
One reason why markets did not penalize financial firms that took on large amounts of tail risk was that they thought the firms were too systemically important to be allowed to fail by the government. Here again the government has substantiated these beliefs by bailing out nearly every large or interconnected bank, including, most controversially, large banks that had bought insurance from AIG. The government simply cannot afford to be seen as a soft touch by financial firms or the market. Hence one of the most important items on the reform agenda is to ensure that no private financial firm is deemed to have the protection of the government.
Entities that are widely known to be too systemic to fail not only have warped incentives, but they also have a competitive advantage over entities that do not enjoy such implicit protection: they can take on costly tail risks secure in the knowledge that they can appropriate the resulting revenues in good times while passing on the risk to the government in bad times. Equally problematic, market investors, also knowing that they will be kept whole by the government, have no incentive to discourage them. Indeed, because the strategy offers tremendous potential profits and limited losses (to the equity holders, that is), equity investors will applaud it: the most risk-loving banks had the highest stock prices before the onset of the crisis. Because bond holders will not demand a higher premium for bearing the risk of losses, banks can double up their bets with leverage. Finally, because these banks enjoy a lower cost of financing, they can grow even larger and more complex; and they have an incentive to do so to make themselves even more systemic.
When a downturn hits, the problems associated with entities deemed too systemic to fail multiply. Resources are trapped in corporate structures that have repeatedly proved their incompetence, and further resources are sucked from the taxpayer as these institutions destroy value. Confident in the knowledge that the government will come to their rescue, these institutions can play a game of chicken with the authorities by refusing to take adequate precautions against failure, such as raising equity.
Perhaps just as important are the political consequences of such rescues. It is hard for the authorities to refute allegations of crony capitalism. Aside from the stated intent of saving the economy, there is no discernible difference between a bailout motivated by the sense that institutions are systemically important and one motivated by the desire of those in authority to rescue their friends or their once and future employers. Even as conspiracy theorists have a field day, painting everyone remotely associated with the financial system into a web of corruption, the damage to the public’s faith in the system of private enterprise is enormous: it senses two sets of rules, one for the systemically important and another for the rest of us. And the conspiracy theorists do have a point: the leeway afforded to the authorities in choosing who is too systemic to fail allows tremendous scope for discretion, and hence corruption.
I have avoided referring to institutions as too big to fail. This is because there are entities that are very large but have transparent, simple structures that allow them to be closed down easily—for example, a firm running a family of regulated mutual funds. By contrast, some relatively small entities—examples include the monoline bond insurers who guaranteed municipal bonds, and Bear Stearns —caused substantial stress to build up through the system. A number of factors other than size may cause an institution to be systemically important, including its centrality to a market, the extent to which other systemically important institutions are exposed to it, the extent to which inflicting losses on the liability holders will also inflict disproportionate losses on the assets, and the complexity of the institution’s interactions with the financial system, which may render the authorities uncertain about the systemic consequences of its failure and reluctant to take the risk of finding out.
There are three main ways of dealing with these problems. First, try to prevent institutions from becoming systemically important. If they do become important, force them to have additional private-sector buffers to minimize the need for the government intervention. If, despite these buffers, they do become truly distressed, make it easier for the authorities to allow them to fail. I discuss each of these measures in turn.
A number of suggestions are circulating on how to keep institutions from becoming systemically important. The most common is to stop them from expanding beyond a certain size, an idea most closely associated with the former Fed chairman, Paul Volcker. While prima facie attractive, this proposal has weaknesses.
Although large institutions are more likely to be systemic, size is neither a necessary nor a sufficient condition. Bear Stearns was not considered large by most calculations, though it was considered connected enough to need saving. On the other hand, the mutual-fund group Vanguard manages more than a trillion dollars in assets but would probably not qualify as systemic. Not all aspects of size are equally troubling.
Moreover, even if we could be specific about the aspects of size that are troubling, banks would try to evade any restrictions on size by economizing on whatever measure served as a criterion, whether assets, capital, or profits. Crude size limits would likely lead banks to conceal a lot of financial activity from the regulator, only to have it come back to light (and to balance sheets) at the worst of times. There are many legal ways to mask asset size. Instead of holding assets on their balance sheet, banks can offer guarantees to assets placed in off–balance sheet vehicles, much like the conduits of the recent crisis. If, instead, capital were the measure, then we would be pushing banks to economize on it as much as possible; this is hardly a recipe for safety. And if it were profits, we would be inviting healthy banks to park profits elsewhere while rewarding sickly ones by allowing them to expand indefinitely.
Also, being big has some virtues. Larger banks may be better at diversifying and attracting managerial talent (including risk managers). Although a poorly managed $2 trillion bank creates immense problems for the system, the problems could be even greater with one hundred banks of $20 billion in size, each of which has taken similar risks. What is important is not size per se but the concentration and correlation of risk in the system, as well as the extent of exposure relative to capital. Indeed, in the past regulators have intervened to bail out a system because entities were too numerous to fail—the forbearance displayed to the U.S. savings and loan industry in the early 1980s being one example.
Instead of imposing a blanket size limit on institutions, regulators should use more subtle mechanisms, such as prohibiting mergers of large banks or encouraging the breakup of large banks that seem to have a propensity for getting into trouble. Entities such as the Federal Trade Commission already have such authority. Although there are always concerns about whether regulators will use these sorts of powers arbitrarily, they are no more difficult for legislators and courts to oversee than are powers based on anticompetitive considerations.
Turning to proposals to limit activities by insured banks through some modern version of the Glass-Steagall Act of 1933, these again seem less attractive on further reflection. Obviously, some activities of a large bank add considerably to risk and opacity. To the extent possible, these should be clearly separated in legal entities that are not affected by the bank’s failure. For instance, banks should not attempt to use client assets that are pledged to them in their prime brokerage units (units that lend securities, offer loans, and undertake asset management functions for clients, typically hedge funds) in further transactions.11 The commingling of client assets with the bank’s own funding activities reduces transparency, increases risk, and was an important reason why many investment banks experienced runs in the current crisis, as clients tried to withdraw their assets before they got entangled in the bank’s bankruptcy. Of course, such a separation would increase a bank’s cost of borrowing, but the benefits here might outweigh the costs.
Proprietary trading—in which the bank uses its balance sheet, partly funded by government-insured deposits, to take speculative positions—is another activity that has come in for censure. The reason critics want to ban it is, in my view, wrong, but there is another reason to consider limiting it. Critics argue that proprietary trading is risky. It is hard to see this as an important cause of the crisis: banks did not get into trouble because of large losses made on trading positions. They failed because they held mortgage-backed securities to maturity, not because they traded them. Regional banks have failed by the dozen because of loans they made for commercial real estate, an activity that no one is talking of prohibiting. It is a fallacy to think that just because certain activities are prima facie riskier than others, keeping banks from those activities will make banks safer overall. In truth, if banks want to take risk, they can simply go further down the spectrum of risk in any of the activities permitted to them. For example, so long as they can lend, they can freely make unsecured, long-term, “covenant-lite” loans to heavily indebted firms. The focus should be on limiting their overall incentive to take risks and their propensity to join with other banks to take risks as a herd, rather than to ban a specific activity, unless the activity has no redeeming financial purpose.
Nevertheless, there is another reason for considering ways to limit proprietary trading. Banks that are involved in many businesses obtain an enormous amount of private information from them. This information should be used to help clients, not to trade against them.12 Banks effectively have an unfair informational advantage over the rest of us in trading: they can use inside information, despite the presence of firewalls within a bank that are meant to prevent sensitive client or market information from being shared with traders. This advantage should be reduced by limiting proprietary trading. I say limiting because some legitimate activities, including hedging and market making, could be hard to distinguish from proprietary trading. A crude overall limit on a bank’s trading for its own account, no matter what the purpose, is one possibility, but it suffers from the same problems as any crude limit has. Perhaps an initial crude limit, refined over time with experience, as was the case with capital requirements, may be the way to go.
The best way to keep institutions from becoming systemically important might not be through crude prohibitions on size or activity but through the collecting and monitoring by regulators of information about interinstitution exposures as well as risk concentrations in the system. The regulator could ensure, through command and control, that the system is not overexposed to any single source of risk, institution, or class of institutions. Regulators themselves would need to be monitored; hence, as I suggested earlier, information on exposures should be released periodically and publicly, after the passage of an appropriate amount of time. Such measures would be less dramatic and punitive than size or activity limits but more easily enforced and probably more effective.
Despite the best efforts of the authorities in discouraging financial institutions from becoming systemic, some institutions will become so. Perhaps some will have special capabilities that enable them to dominate certain product markets or customer clienteles; others may just be highly efficient and thus big. Whatever the reason, once a systemically important institution becomes seen as such, it will automatically enjoy some advantages in funding and in selling its products. To offset these advantages, regulators can require these institutions to hold more capital. Equity capital is costly.13 The implicit tax on the institutions (because equity capital is a more expensive form of financing for financial institutions than debt) would serve to offset their financing advantage, and, by creating additional buffers, make it less likely that they will become a drain on the taxpayer.
Precisely because equity capital is costly, regulators need to think of ways to achieve the necessary size of capital buffers without imposing huge costs that banks will try to evade. Regulators could put less emphasis on additional permanent-equity capital and more on contingent capital, which is infused when the institution or the system is in trouble. In one version of contingent capital, systemically important banks could issue debt that would automatically convert to equity when the bank’s capital ratio falls below a certain value.14 In another, systemically important levered financial institutions would be required to buy fully collateralized insurance policies (from unlevered institutions, foreigners, or the government) that would infuse capital into these institutions when they are in trouble.15
Both convertible contingent debt and capital insurance are exposed to significant downside risk and, if properly priced by the market, will be the proverbial canary in the coal mine: they will reflect the market’s perception of the extent of risk taking by the firm. Of course, for the risk to be properly priced, everyone should know that the authorities will not bail out this class of claims, no matter how they treat the rest of the firm. One reason the authorities bail out financial-firm claim holders is that they do not know whether these claims are held by other financial firms: by letting the claims bear losses, they could be precipitating a cascade of failures. It is therefore important that regulators prohibit any levered financial firms from holding contingent convertibles or writing capital insurance (or, for that matter, holding unsecured long-term debt issued by other leveraged financial firms). Instead mutual funds, pension funds, and sovereign wealth funds should be the holders of choice.
By requiring systemically important entities to have stronger buffers against failure, regulators would reduce the likelihood that they would take advantage of their status. If a firm is made near fail-safe by its equity cushion, the prospect of government protection against failure confers little advantage.
In dire crises, some systemically important firms may eat through their capital and be close to failure no matter how good the prior supervision or how ample the equity buffers. If some of their activities are essential to overall economic health, we need to figure out how to “resolve” them—to keep the core businesses running while imposing appropriate costs on investors. One of the key objectives of a resolution mechanism is to impose appropriate losses on debt holders so that debt holders do not merrily acquiesce in equity holders’ tail risk taking without demanding an additional risk premium, confident they will be bailed out by the government if necessary.
Regulators currently do not have resolution authority over nonbank financial firms or bank holding companies, and proceedings in ordinary bankruptcy court would take too long: the financial business would evaporate in the meantime. It is therefore essential for regulators to obtain resolution authority, which would effectively allow them to function as a bankruptcy court. One reason that bankruptcy proceedings are slow is that the court needs to determine all the assets and liabilities of a firm before it decides what can be preserved and who should bear the losses. With simple bank structures, all this information is readily available. But systemically important institutions generally have far from simple structures. Some of the complexity simply builds over time, as firms are put together through mergers or start businesses across borders; some comes from attempts to avoid taxes or hide activities from regulatory authorities; and some comes simply from untidy management. Lehman had more than six hundred subsidiaries when it filed for bankruptcy.
Because it is a nightmare to resolve such an institution today, let alone do it quickly, bailouts may seem like the only practical option. One way out, however, is to put the onus of the task back on the financial institutions themselves. Every systemically important institution should meet with regulators periodically to review its “living will,” a plan that would enable it to be resolved quickly— ideally, over a weekend—in the event of imminent failure. Such a plan would require institutions to track and document their exposures much more carefully and in a timely manner, probably through a much better use of technology. To prevent this from becoming merely a cursory formality, much of the detail in a living will could be released to the public and markets in a form that is easy to digest.
Because it might well be impossible to anticipate all contingencies, the living will might be of limited use in guiding the actual resolution of an institution. Nevertheless, it could be immensely useful in simplifying bank structures. Not only would the need to develop a plan give such institutions the incentive to work with regulators to minimize organizational complexity and improve the ease of resolution, but it might indeed force management to think the unthinkable during booms, thus helping it avoid the costly busts. Most important, it would convey to the market the message that the authorities are serious about allowing the systemically important to fail. As we leave the crisis behind, this will be the most important message to convey.
Having discussed how we can reduce tail risk seeking, as well as the related problem of having entities that are considered too systemic to fail, let me turn to the possibility of unknown unknowns. Thus far, I have argued for ways to reduce the likelihood of crises stemming from acts of commission. But we also have to address the possibility of crisis stemming from events and circumstances that no one was aware of or could anticipate; we must acknowledge that even with the best incentives in the world, a combination of mistakes, irrational beliefs, and sheer bad luck could plunge us into crisis again. We have to find ways to make the system more resilient to acts of omission—indeed, to make it robust no matter what the source of the problem. Almost certainly, the trigger will not be subprime mortgage-backed securities the next time around.16 Put differently, we need not only to enforce the fire code to reduce the possibility of fires: we also need to install sprinklers.17
Clearly, resources are important to deal with any crisis. In the current crisis, one reason industrial economies did not suffer the typical fate of emerging markets is that their governments could promise to guarantee bank liabilities to quell a panic, and those promises were credible. However, the crisis has stretched the finances of industrial countries, with a number of governments having lost their top ratings. To be prepared once again for emergencies, they have to restore government financial health by paying down debt, using some combination of tax hikes and expenditure cuts in a manner that does not have too adverse an impact on growth. I discuss U.S. policies on these issues in more detail in the next chapter.
Although it is important to have resources, making them readily available is not always a good thing. Proposals are currently being debated that would make resources easily available to the government and the central bank to carry out rescues, thus avoiding the kind of uncertainty that set off a near-panic in the weeks before Congress passed the Troubled Asset Relief Program in 2008.18 Such a move would be a mistake because it would legitimize rescues. Would a treasury secretary ever let a large institution go under again if Congress had sanctioned rescues by providing ready access to funds? We should not make the process of appropriating resources to carry out rescues any easier. As Walter Bagehot rightly felt, systemic financial firms and markets should have some uncertainty about what will happen if they get into trouble. Having Congress debate rescues certainly adds uncertainty and some oversight, and Congress has shown an ability to act when needed—though it may have taken the treasury secretary going down on bended knee before the Speaker of the House to make it happen!19 Having one or two large firms experience severe distress, or even fail, before the cavalry comes to the rescue is not a bad idea pour encourager les autres.
A system becomes fragile if it is overly reliant on any single institution, market, regulator, or regulation. We need real redundancy and variety—multiple pathways for providing any financial service, without too much reliance on any one path. For instance, as the subprime market heated up, too many investors started depending on ratings. It did not matter that different rating agencies provided those ratings or that the investors were diversified across a variety of mortgage-backed securities: what was compromised was the rating process itself. When suspicions rose about ratings, the entire market collapsed. To provide real redundancy and variety, we need not only multiple players at each level of the securitization process but also multiple ways of financing mortgages other than through securitization.
One way to obtain variety is to impose uniform regulation across institutional forms. For instance, banks in Europe issue covered bonds, which are essentially bonds issued against a pool of mortgages. They are similar to mortgage-backed securities, except that the investor in these bonds can ask the bank to pay what is owed if the pool of mortgages proves insufficient to cover the bonds. Banks in the United States chose to securitize mortgages instead and held many of them in off–balance sheet vehicles that came back on their balance sheets in times of trouble. In retrospect, covered bonds might have been a more transparent way of holding mortgages and might have given banks more incentive to be careful. But capital requirements favored off–balance sheet vehicles. Lighter, more uniform regulation across institutional forms would allow for greater institutional variety and more efficient, less regulator-determined, ways of undertaking activities.
We should, however, recognize that when more institutions come under the same regulatory umbrella, we open the door to a different mistake: if the regulator makes a mistake, she coordinates more institutions into following it. For example, because regulators around the world required very little capital to be held against super-senior mortgage-backed claims, banks around the world loaded up on them and took enormous losses together. By contrast, a number of large hedge funds stayed clear of these securities, partly because the hedge funds were not subject to capital regulation. Regulatory mistakes are particularly harmful because the regulator coordinates the regulated into following the mistake: the wider the ambit of the regulator, the more problematic the mistake.
There is, therefore, a trade-off. By spreading the regulatory net uniformly, we ensure that no institutions are favored or disadvantaged and that the institution most suited to an activity undertakes it. But we also increase the impact of regulatory mistakes. One way to mitigate this effect is to reduce the extent to which regulators embed what are essentially judgment calls—such as the amount of capital to be held against a certain activity—in regulations. Light, effective regulation is less liable to have serious consequences in the event of mistakes.
Finally, to ensure variety, we should not privilege any particular institutional form. An enormous source of privilege for banks is deposit insurance: if an institution happens to be funded with a certain form of demandable debt, that is deposits, the deposits are fully backed by the government’s deposit insurer on payment of a nominal fee. No other institutional form has its short-term debt thus insured.
I asked earlier whether the activities of insured banks should be restricted. Perhaps a better question is whether banks should have deposit insurance at all. This may be a strange question to ask at a time when governments all over the world have guaranteed all the debt issued by their banks, not just the small, already insured deposits. But that is precisely the reason for my question. Deposit insurance is not meant to quell panics by preventing bank runs: the government, as we have recently seen, takes care of that. Instead, it merely protects individual banks from market discipline. Put differently, with implicit government guarantees all over the place, should we not strive to remove explicit government guarantees where we can?
One reason for insuring deposits was to provide a safe means of savings to households where none existed. Today, this rationale is archaic—a money-market fund invested in Treasury bills can provide that safety. A well-diversified money-market fund invested in highly rated commercial paper and marked every day to market is almost as safe and should not experience the kinds of runs experienced by funds that were not marked to market during this crisis.20
Another important reason for insuring deposits was to ensure that the payment system would be relatively safe: unregulated, unsafe, uninsured entities could not pollute it and cause the system to freeze. But now that technological advances, such as real-time gross settlement payments, make it possible to protect the payment system from the failure of any payer, even this rationale is weak.
Deposit insurance does help keep small, undiversified banks in business. To the extent that these small banks are important in making loans in the local community—to the local bakery or toy shop—they have some economic and social value. One possibility is to retain deposit insurance for small and medium sized banks in return for their paying a fair insurance premium, but to reduce it progressively for larger banks until it is eliminated.
Clearly, if banks are seen as too big to fail, eliminating deposit insurance is moot, as the bank will be bailed out anyway. The United Kingdom deposit insurance system, which was partial, did not prevent Northern Rock from getting into trouble or the government from coming to the rescue. The point of eliminating deposit insurance, however, is to make depositors think before they make a bank too big. Unlike depositors in the United Kingdom (where all bank deposits were partially insured, and therefore depositing in a large bank was significantly safer), depositors in large banks under my proposal would have the choice between being fully insured in a small bank and largely uninsured in a large bank. Such a measure would place some constraints on the growth of seriously mismanaged larger banks while also leveling the playing field.
Phasing out deposit insurance does not mean doing away with regulation. Because the government will continue to step in when the financial sector gets into deep trouble, it will have to regulate financial institutions. But it can regulate large institutions more uniformly, based on their capital structure (their capital and short-term debt) and the nature of their assets (their holdings in illiquid securities and, in illiquid loans) rather than on the basis of whether they have a banking license.
It is not easy to contemplate doing away with deposit insurance. Few depositors today can recall a time when deposits were not insured. Yet uninsured banks existed for centuries. With alternative ways of ensuring the safety of household investments (such as money-market deposits) and safe payments, and with banks already protected enough from discipline because of recent events, perhaps it is time we did away with an archaic privilege.
Before concluding, I raise a final issue. I have focused on ways to ensure that the government is not easily drawn into supporting specific markets or private institutions. I have assumed that the government, like Caesar’s wife, is above suspicion. The public has widespread concerns that it is not, as a quick survey of the blogosphere and cable news networks (admittedly not an unbiased sample of the public) suggests, and some of these concerns are justified. When a U.S. Treasury employee goes directly from running the biggest bailout fund in history to work for a company that runs the biggest bond fund in the world, and when another Treasury employee goes from organizing financial-sector rescues directly to running one of the banks that is most in need of rescue, the public’s trust is strained. No matter how honorable the intentions of the individuals in question (and I have no doubt that they are honorable) or how careful the new employer in avoiding conflicts of interest, the deals, to put it mildly, stink.
Even as the private financial sector has displayed a tin ear for the political consequences of such behavior, its alumni in the government apparently fail to understand the difficulty. In normal times, the revolving door between government and the private sector has enabled governments around the world to attract tremendous talent, even while underpaying grossly. And in normal times, the conflicts of interest inherent in the revolving door are small. In downturns, however, they may be enormous: the government’s coffers are fully open, and a stroke of a pen or a key can send billions of dollars of public money in one direction or another. The rules governing the revolving door have to be reexamined.
There is a broader question of whether government action is influenced excessively by Wall Street. I believe that when Wall Street alumni occupy powerful positions in the government or the Federal Reserve, they do what they think is best for the United States. But what they think accords with their Wall Street training and with the opinions of the people they talk to—and these people also are all largely from the Street. Cognitive capture is a better description of this phenomenon than crony capitalism.21 The nexus needs to be broken, possibly by recruiting talent from outside Washington and New York, and even from outside finance, to staff critical positions in the Treasury—former career regulators, corporate executives with finance experience, and, dare I say, academics. Diversity will be key to improving trust.
How do we preserve the benefits of the democratization of finance while ensuring that the system does not permit excessive risk? The answers I propose in this chapter are not so dramatic as doing away with the private sector or gagging and binding it, as suggested by Progressives, or doing away with all government and regulation, as suggested by the ideological Right. The problems emanated at the interfaces between the private sector and the government—the location of the fault lines—but since we cannot do away with either side, realistic reforms have to work on managing the interface. We are, however, in the position of someone asking for directions and getting the response, “Well, I wouldn’t start from here.”
The supercharged financial sector, having taken full advantage of the implicit guarantees embedded in the government’s desire to push housing credit and promote employment growth, has ended up flat on its back. The government has then delivered on the guarantees to the best of its ability and, in fact, done more. It now has the task of convincing the financial sector that it will not do so again.
But the government has not withdrawn from housing finance: in fact, it is even more tightly enmeshed now. Even if it were to take care of the political compulsions that draw it in to supporting some markets and hence the financial sector, it still has to convince the financial sector that no entity is too systemically important to be allowed to fail. So the key question in financial sector reform is, How do we get the private sector to price risk properly again, without assuming government intervention? The proposals in this chapter offer a path.
The thrust has to be using transparency to draw the interested public into monitoring the relationship between the government or regulator and the financial sector. Much of what I propose falls short of the dramatic remedies that some desire. But the words of Justice Louis Brandeis, from a letter of 1922, are as apt for financial-sector reform as elsewhere: “Do not believe that you can find a universal remedy for evil conditions or immoral practices in effecting a fundamental change in society (as by State Socialism). And do not pin too much faith in legislation. Remedial institutions are apt to fall under control of the enemy and to become instruments of oppression.”22 His proposed alternative was what we would now call transparency, which he referred to as publicity: “Publicity is justly commended as a remedy for social and industrial diseases. Sunlight is said to be the best of disinfectants; electric light the most efficient policemen.”23
I now turn to the reforms that are needed in the U.S. economy, focusing on how to improve access to quality education and how to strengthen the safety net.