Systemic Task

Sunday, March 29, 2009

"HAPPY FAMILIES are all alike," Tolstoy wrote. "Every unhappy family is unhappy in its own way." And so it is with financial booms and busts. The prosperity we enjoyed until last year looked like previous upswings: easy credit, rapid financial innovation, appreciating asset prices and -- finally and fatally -- a certain blindness to risk. The current crash, however, has presented U.S. policymakers with original problems. Just as the Panic of 1907 highlighted the need for a Federal Reserve System and the Great Depression called forth federal deposit insurance, the burning issue today is what to do about institutions -- such as American International Group, Bear Stearns or Lehman Brothers -- that are not banks but are so large and so intertwined with other institutions that their collapse would threaten the entire system.

Last week, the Obama administration unveiled an outline for a new financial regulatory structure, the key part of which aims at this problem of "too big to fail." Treasury Secretary Timothy F. Geithner asked Congress to give an unspecified agency authority to identify and supervise financial institutions -- whether banks, hedge funds, investment banks or insurance firms -- whose size, indebtedness and degree of interconnection pose "systemic risk." He sought authority to take over such firms when their finances turn sour, much as the Federal Deposit Insurance Corp. takes over troubled banks today. The objective is to equip government to do what it did not do in the current crisis: spot trouble brewing in the so-called "shadow" financial sector and resolve it without a series of ad hoc taxpayer bailouts.

This is a popular concept; Mr. Geithner's proposals track closely a report this year by the Group of 30, a financial policy organization led by Paul A. Volcker, a former Federal Reserve chairman and an economic adviser to President Obama. It is also a reasonable one -- in principle. The high flight and precipitous fall of AIG's Financial Products division illustrates what can go wrong when a lightly regulated firm bets vast amounts all over the world. To be sure, hedge funds, blameless in the current situation, may not seem to need federal regulation. However, back in 1998, the near-collapse of Long-Term Capital Management, a hedge fund, almost brought on a crisis. One might question the need for an alternative to the old-fashioned method of resolving failed firms: bankruptcy. But Mr. Geithner's proposal reflects the unhappy results of letting Lehman Brothers go that route.

Still, we wonder about the details. If the Federal Reserve gets the job of naming and supervising systemically risky companies, as many expect, won't that embroil the central bank in endless lobbying and litigation? But if not the Fed, then who? How will the government collect insurance premiums for the necessary bailout fund? Can anyone devise purely objective criteria for systemic risk, or is this a case of "You know it when you see it"? And if that's true, would the new plan create so much uncertainty that it deters not only dangerous financial growth and innovation but the healthy kind, too?

Mr. Geithner left most of these matters to negotiation with Congress. Obviously, new regulatory authorities cannot substitute for market discipline -- or the regulators' willingness to actually use whatever authority they have. Indeed, if there had been more such willingness in the past few years, we might not be having this debate now. Still, properly designed new structures may help stabilize the system, at least until a new source of instability we cannot foresee triggers the next crisis.

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