Editor’s note: This is Part 1 of a multipart series. Read Part 2, "‘Wind-down’: a bailout alternative," and Part 3, "The failure of ‘too big to fail.’ "
The financial crisis and its lingering aftermath have revealed serious vulnerabilities in our financial system. The challenges are comparable to those posed by the great depression of the 1930s. Yet the approaches taken to date to fix the problems have been fitful, fragmented and frenzied, rather than deliberate and thoughtful. That’s what makes me think we need a financial commission to sort things out.
Of course, the political process is most receptive to reform while memories of the crisis remain strong and its aftereffects are still being felt. But there is a serious downside to legislating reform while we are so close to what happened. Reform proposals tend to focus on preventing the same sequence of events that we very recently lived through.
This is reminiscent of the old adage about generals preparing to fight the last war. The next potential financial crisis is going to be different from the last one, just as that one was very different from the savings-and-loan crisis of the early 1980s.
There is another very serious drawback to legislating reforms while memories of what happened are still fresh. Many of the proposals are suffused with hostility toward groups that are viewed as malefactors, especially "bankers" and "Wall Street," which have almost become curse words.
It’s easy to be mad, especially if you have been burned by the crisis in some way, but it is not a good backdrop for the thoughtful legislative reforms that we need.
Nothing disrupts the process of rational thought quite so much as the prior conviction that the problems were caused by the greed of wicked people. But the fact is that commercial bankers, investment bankers and mortgage bankers were not suddenly caught up in an epidemic of greed — they have always been greedy.
Usually, their greed has acceptable, even good results for society, but occasionally a business and regulatory environment arises in which it leads to disaster. If we intend to prevent another crisis, that environment should be the focus.
To examine the issue properly requires a coherent approach that is most appropriate to a commission with a broad mandate. In the best of all worlds, the findings of such a commission would precede legislative proposals. The articles in this series are agenda suggestions for such a commission.
They are organized in terms of six major issues, which are summarized briefly below. Future articles will deal with the separate issues in more detail.
Is there a way to allow the failure of firms that are now viewed as "Too Big to Fail" (TBTF)?
One of the most traumatic and disruptive features of the recent financial crisis was that the government was forced to rescue firms that had behaved recklessly. These firms were TBTF, meaning that the repercussions from their failure would have destabilized the entire system.
Draconian measures that would require TBTF firms to shrink drastically in size and complexity are probably not feasible. Aside from that, is there any way to reduce the repercussions of failure to the point where allowing failure becomes a viable option for regulators?
Why have regulators failed to prevent excessive risk-taking by TBTF firms? …CONTINUED
If there is no acceptable way to convert TBTF firms into firms that are not TBTF, a way must be found to prevent such firms from getting into trouble in the first place by effectively regulating their risk exposures.
But if we expect regulators to do better next time, we better understand why they struck out the last time, and fix the deficiencies. In particular, why haven’t capital requirements worked the way they are supposed to?
If capital requirements can’t do the job, what can?
It is essential that the regulatory net be made wide enough to cover all the firms that might become important players in the next emerging bubble leading to a crisis. This calls for a systemic risk regulator whose jurisdiction is not limited to conventional industry boundaries.
But the regulator must have tools that will work, which regulators now do not have. Is there a tool that would either remove some of the profit from taking excessive risk during a bubble period or require that firms taking on these risks increase their capacity to bear loss?
How should we redesign the housing finance system?
The system today is in shambles, largely because of the shutdown of the private secondary market. The federal government underwrites nine of every 10 loans, and the remaining private market sliver is in danger of becoming dominated by a small number of very large originators.
The first priority should be to reestablish a private secondary market, but do we want to resurrect the model that collapsed? Or should we adopt the Danish model, which has never crashed in more than 200 years?
What should be done with Fannie Mae and Freddie Mac?
Are the agencies today working at cross-purposes to the administration’s plan to stimulate recovery? In the long run, should they be entrusted to administer a program to develop a private secondary market?
How do we make consumer protection effective?
How can mandatory disclosure systems and other consumer protections be improved, and where should responsibility for it be placed?
The writer is professor of finance emeritus at the Wharton School of the University of Pennsylvania. Comments and questions can be left at www.mtgprofessor.com.
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