Saturday, April 4, 2009

Greenspan and Too Big to Fail

Last fall, I believe, Senator Bernie Sanders said something to the effect that a financial institution that is too big to fail is too big to exist. This position, though, is not confined to people on the left, and it is an issue that needs to be considered in the debate about financial regulatory restructuring that is coming.

In a March 26 article in the Financial Times (“We need a better cushion against risk”), Alan Greenspan argues that institutions that are too big to fail have “a highly market-distorting special competitive advantage in pricing their debt and equities. The solution is to have graduated regulatory capital requirements to discourage them from becoming too big and to offset their competitive advantage.”

That is an interesting idea and a reversal of arguments I heard when I was devising capital rules for a relatively small group of specialized government securities brokers and dealers that capital requirements for large firms should be less because their size and diversification made them less risky. Large banks are likely to fight Greenspan’s idea if it gains traction.

In addition to “too big to fail,” we also have to be concerned about “too important” or “too interconnected” to fail. For example, the clearing of government securities transactions for the major dealers is handled by only two banks – JPMorgan Chase and Bank of New York Mellon. There are not likely to be any new entrants anytime soon into this business because of its high barriers to entry. The clearing function of these two banks is vital to the functioning of the market for Treasury securities, which has enormous importance for fixed-income markets generally, as well as being essential to both the Treasury and the Federal Reserve. Whatever happens to these banks, this clearing function needs to continue. Moreover, neither banks is likely to want to have the entire market for clearing to itself, because of the risk this entails.

The issue of what to do about systemic risk is not easy. Simply stating that we will give the Fed unspecified authority to deal with it is not anywhere near a complete answer. If we are to change our regulatory system, there needs to be serious thought and debate about what kind of financial sector we should have and whether it is desirable to reverse the consolidation of financial institutions that has been facilitated by legislation, most notably in recent years by the Gramm-Leach-Bliley Act. It is interesting that Greenspan has entered into the fray on this subject with an idea likely to be opposed by the major banks.

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