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Citigroup Center in New York – a symbol of ‘too big to fail’ (AP photo)

Imposing rules on the big financial firms

COMMENTARY | October 26, 2009

There’s wide agreement that the largest institutions need to be regulated but differing views on how to do it. Harvard economist David A. Moss calls for creating a new regulatory agency and having the big firms insure themselves for billions of dollars in coverage to protect themselves from failure.

(Part of our series on "Reporting the Economic Collapse.")

By John Hanrahan

Harvard Professor David A. Moss likens the nation’s “supersized” financial institutions at the onset of the nation’s economic crisis to unsupervised children playing in the school yard. With no one watching them, the children left the school yard and headed for a dangerous cliff. Just as they were about to go over the cliff, the school authorities came out and saved them.

Moss, the John G. McLean professor of business administration at the Harvard Business School, said the unsupervised financial institutions were also about to go over the cliff when federal authorities raced out and rescued them. But federal authorities – like the school authorities – should have been minding them beforehand and not letting them put themselves (and the nation’s economy and citizens) in danger.

"Top federal officials deserve a great deal of credit for rescuing the American financial system and preventing it from plunging over the cliff,” Moss said in an interview with Nieman Watchdog. “At the same time, we have to ask why many of those same officials failed to make the school yard safe in the first place. Now, the question is, will we have the will and the ingenuity to prevent this from happening again? Will we be able to impose the right rules and build the necessary fences to keep our financial institutions from getting anywhere near the edge of the cliff in the future?"

As the debate over regulation of financial institutions heats up, the major news media have an obligation to decipher the complex terms, issues and specific proposals emerging from the Obama administration, Congress, think tanks and academics such as Moss.

For his part, Moss has developed such a comprehensive plan that he said could make the “school yard” safe as well as regulating those giant financial institutions that are regarded as “too big to fail.” Without reforms, he said, these institutions have an implicit government guarantee that they will be rescued again if they take foolish risks that precipitate another financial crisis.

“The best way to address this threat is by identifying, regulating and potentially insuring systemically significant financial institutions continuously, before it strikes,” Moss wrote recently. “This would mark a major but essential reform to ensure a healthy and productive financial system for the next half-century.”

Moss laid out his proposed new system in a working paper earlier this year, and in an article in the September/October 2009 issue of Harvard Magazine, as well as in his interview with Nieman Watchdog.

Moss’s system, which along with other proposals deserves attention from Congress and the press, includes the following components:

Congress and the Obama administration should create a new regulatory agency – a Systemic Risk Review Board – which  would have the mission of identifying “financial institutions whose failure would pose a systemic threat to the broader financial system. Such determinations would be made continuously, not simply in bad times, so that a complete list of financial institutions deemed to have ‘systemic significance’ would always be publicly available.” Depending on what criteria and definitions are used, Moss said, there might be anywhere from 20 to 50 such institutions today.

Moss defined systemically significant financial institutions as ones “that are so big or deeply interconnected with other financial actors that their failure could trigger cascading losses and even contagion across the financial system.” They are many of the same institutions that last year “helped drive the crisis on the way up (by inflating the bubble) and on the way down (by provoking a fire sale in the financial markets).”

The new review board “would have broad powers to collect information, both from other regulatory agencies and directly from financial institutions themselves. All financial institutions, from banks to hedge funds, would be required to report to this body, irrespective of other regulatory coverage.” Because he wants the list of names of systemically significant institutions made public at all times, Moss said that the Federal Reserve would be the wrong agency to be the regulator since, among other drawbacks, the Fed “was never designed to be particularly transparent.” In this aspect, Moss’s plan differs from that of the Obama administration.

The financial institutions deemed to be systemically significant need to be closely regulated by the review board “to limit excessive risk-taking and help ensure their safety.” Regulatory requirements could include “relatively stringent capital and liquidity requirements” (including provisions “to limit excessive lending in boom markets and the need for fire sales in down markets”), maximum leverage ratios, “well-defined limits on contingent liabilities and off-balance-sheet activity, and perhaps also caps on the proportion of short-term debt on the institution’s balance sheet.”

A new federal capital insurance program would be created, to which systemically significant financial institutions would contribute to protect themselves (and the economy) in the event of a future financial crisis. Under this program, covered institutions “would be required to pay regular and appropriate premiums for the coverage,” with Moss’s suggested required coverage equal to 10 percent of the institution’s total assets. Claims would be paid “only in the context of a systemic financial event (determined perhaps by a presidential declaration)” and “payouts would be limited to pre-specified amounts.” For an institution with $500 billion in assets and federal capital insurance of $50 billion, “the potential payout by the federal capital insurance program in a systemic event would be $50 billion.” In return for the payout, the federal government would receive $50 billion in non-voting preferred shares – “which the affected institution would have the obligation to repurchase after the crisis had passed.”

A Federal Deposit Insurance Corporation (FDIC)-receivership type of process would be set up for failing institutions, rather than using the federal bankruptcy system which “was simply not designed for large, systemically significant financial institutions.” Although Moss’s plan would provide a financial institution with capital infusions in times of general financial distress, “an individual institution would not be propped up or bailed out when it was on the verge of failure.” Rather, “it would be promptly taken over by a federal receiver and either restructured, sold, or liquidated – in much the same way the FDIC takes over (and, in many cases, promptly restructures and reopens) failing banks.”  

By the end of 2008, Moss wrote, “federal agencies had already disbursed more than $2 trillion in responding to the crisis and had taken on potential commitments in excess of $10 trillion.” They had also made it “absolutely clear that there was almost no limit to the resources they would devote to preventing or halting a systemic panic at a time of general financial distress.”

Without adequate reforms, Moss told Nieman Watchdog, there could be an even worse situation in the future when, once again, major financial institutions – such as was the case in 2008 of Bear Stearns, Fannie Mae, Freddie Mac, AIG and Citigroup – “are on the verge of failure and in a position to cause an avalanche, a cascade of failure” that would endanger not only the institutions and their stockholders but the entire economy. And once again, he said, the government would exercise an implicit obligation to come to their rescue.

Even former Federal Reserve Chairman Alan Greenspan has expressed concern about the implicit federal guarantees to large banks when they get into crisis situations. Greenspan recently deviated from his long-held anti-regulation philosophy and called for federal regulators to consider limiting the size of financial institutions deemed too big to fail.

According to Bloomberg News, Greenspan on Oct. 15 told the Council on Foreign Relations that the large institutions (in the reporters’ indirect quoting of Greenspan) “have an implicit subsidy allowing them to borrow at lower cost because lenders believe government will always step in to guarantee their obligations. That squeezes out competition and creates a danger to the financial system.” In calling for consideration of breaking up the large entities, Greenspan was quoted as saying, “If they’re too big to fail, they’re too big.” (While calling for limitations on size, Greenspan has opposed reinstituting provisions of the New Deal-era Glass-Steagall Act, which until 1998 prohibited commercial banks from engaging in investment banking.)

Other prominent economists have also weighed in to call for the breakup of large financial institutions. Last April, Nobel laureate Joseph Stiglitz, now a Columbia University professor, and former International Monetary Fund chief economist Simon Johnson, now an MIT professor, made such recommendations in Congressional testimony. Stiglitz said, “We have little to lose, and much to gain, by breaking up these behemoths, which are not just too big to fail, but also too big to save and too big to manage.” FDIC Chairwoman Sheila Bair has also called for Congress to look into limiting the size and complexity of systemically significant institutions.

Former Federal Reserve chairman Paul A. Volcker, chairman of President Obama’s Economic Recovery Advisory Board, has urged the Obama administration – unsuccessfully – to push for reinstitution of the Glass-Steagall provision separating commercial banks from investment banks. Volcker has argued that the linkage of commercial and investment banking “brought us to where we are today” and that regulation by itself will not work.

Moss takes a different tack on the breakup issue. If the financial institutions are tightly regulated in the manner he proposes – “if we get this right” – he said he envisioned some of them breaking up “on their own accord to get out from under the heaviest regulatory burden.”

The Obama administration, for its part, has recommended that the Federal Reserve, rather than a new entity, serve as the regulator of those systemically significant financial institutions that it refers to as Tier One financial holding companies. Among other things, the administration’s plan calls for substantially higher capital requirements for these financial institutions as well as compensation guidelines, and creation of a new agency to protect consumers from abusive lending practices relating to mortgages, credit cards and other transactions. Critics of the administration’s proposed new role for the Federal Reserve have cited its past oversight failures, easy credit policies “and the heavy influence that banks have on the Fed’s governance” as reasons why the Fed should not be given any new authority over large financial institutions.

Illustrative of the spread of opinion on the regulation of large financial institutions are the views of economist Alice Rivlin of the Brookings Institution and the Georgetown Public Policy Institute. In a briefing paper for the Pew Task Force on Regulatory Reform, Rivlin objected to any approach that designates specific institutions as “systemically important” (what Obama and Moss favor) or that establishes a new regulator for such entities (as Moss favors). Rivlin wrote that such approaches “will create a new class of GSE-like protected institutions,” a reference to government sponsored enterprises such as Fannie Mae and Freddie Mac which, prior to the recent financial rescue of other financial institutions, had been deemed to have a special claim on government protection.

In his Harvard Magazine article, Moss recognized that some economists are concerned that naming specific firms would possibly confer on them a special protective status. He rejected that argument, countering that “it is a fantasy to believe that the government’s implicit guarantee of all systemically significant institutions will magically disappear if (or even diminish meaningfully) if we simply stop talking about it. After more than a year of massive federal rescues and bailouts of major financial firms, that guarantee is now rock solid.”

Moss, an economist who provided research on financial regulation and regulatory reform for the TARP (troubled asset relief program) Congressional Oversight Panel, said the New Deal financial reforms were highly successful for almost 50 years in bringing about financial stability in commercial banking and financial innovation – until deregulation emerged in the 1980s, oversight was relaxed, and Congress repealed the Glass-Steagall provision separating commercial and investment banking. His proposal, Moss said, would update the highly successful New Deal regulatory strategy and apply it to regulating today’s biggest economic threat – “the growth of massive financial institutions outside of commercial banking.”

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