Neil M. Barofsky, the Special Inspector General for the Troubled Asset Relief Program ("SIGTARP") released an "audit report" earlier this month entitled "Extraordinary Financial Assistance Provided to Citigroup, Inc." The report provides useful and interesting information about the use of TARP funds to help out Citigroup, but there are no surprising revelations. Policymakers were responding as best they could to a difficult situation under enormous time pressure.
I was, though, struck that both the Wall Street Journal editorial page and Simon Johnson, who offers frequent comments on the blog "The Baseline Scenario," used the report to comment on the issue of "too big to fail." The two come to this from different perspectives—Simon Johnson is a former chief economist of the IMF who favors making the largest banks smaller and the WSJ editorial perspectives on a myriad of subjects are well-known enough that it is unnecessary for me to characterize them.
Both the WSJ editorial, "The Ruling Ad-Hocracy" (subscription required), and Simon Johnson's Bloomberg article, "'Citi Weekend' Shows Too-Big-to-Fail Endures," mention Treasury Secretary Geithner's admission in the SIGTARP report that he could not rule out taking similar actions again if there were a comparable shock to the financial system. The WSJ editorial page and Simon Johnson are also both skeptical concerning the Dodd-Frank legislation's efficacy for making improvised bailouts in the future less likely.
Johnson has the more developed argument of the two. He focuses on the "big" in "too big to fail," advocating that a problem that should be addressed is the vast size of the biggest banks. He also believes, with some justification, that the resolution authority granted to the FDIC by the Dodd-Frank legislation will not work for these huge international financial institutions because of the global operations of these entities.
The point that the WSJ editorial page is trying to make beyond carping that the regulators have not done away with "too big to fail" and that they have not produced objective criteria as to what constitutes a systemically important institution is harder to discern. On the one hand, the editorial argues that "the time to tighten the rules on too-big-to-fail firms is when the market is calm, not amid a panic," which is a somewhat surprising statement from the editorial page editors given their usual anti-regulatory stance. They return to form at the end of the editorial in saying: "Any Republicans tempted to accept Dodd-Frank as settled law should dig into the details and work to restore the freedom to fail in American finance."
If it were possible to minimize the collateral damage from the failure of a financial institution, I would agree with that last sentiment. But that's the problem. Who can doubt that a sudden failure of Citigroup to meet its obligations would not have adversely impacted all of us? The failure experiment was run with the much smaller Lehman Brothers, and no one liked the results.
It is this issue that Johnson is trying to address by his tireless advocacy on his blog and in the book he coauthored with James Kwak, Thirteen Bankers, of limiting the size of financial institutions. While I think Johnson's ideas should be considered more seriously by policymakers than they have been, I would also point out that it does not solve all problems. Limiting the size of financial institutions does not necessarily get the government off the hook; for example, consider the savings and loan crisis of the 1980s and 1990s. To put it somewhat simply, the S&Ls ran into trouble because their business model of borrowing short and lending long could not survive a large increase in interest rates. Their regulator, the Federal Home Loan Bank Board, tried to paper over the problem by allowing S&Ls to pretend they were solvent by substituting "regulatory accepted accounting principles" for GAAP. The S&Ls could not grow out of their problem, and the George H.W. Bush Administration decided that, once and for all, they had to resolve this problem which had developed during the previous Reagan Administration.
(As an aside, Fannie Mae ran into the same problem as the S&Ls in the 1980s. Fannie was able, though, to grow out of its financial difficulties. A new management decided to embrace mortgage-backed securities, for which Fannie retained the credit risk but not the interest rate risk. This strategy, along with a better matching of the duration of liabilities with the duration of assets, worked. Also, of course, Fannie's strategy relied on its continuing access to capital markets due to the implicit federal government guarantee of its securities. After Fannie got a new regulator, the not very effective Office of Federal Housing Enterprise Oversight, its interest rate risk increased, but that is not what did it in. Fannie had no way of shedding the credit risk on mortgages it either had securitized or held in its portfolio. Freddie Mac ran into the same problem in the recent crisis, but in the 1980s it had a very small portfolio and minimal interest rate risk.)
As readers of this blog know, I have been concerned about the regulatory capture problem. Whatever structure we have for our financial institutions and markets and however the government is organized to regulate and supervise these institutions and markets, there will be heavy reliance on the quality of government regulation. There were regulatory failures that exacerbated the financial crisis; we need further thought on how to avoid such failures in the future. It is not an easy problem.
There will be a next time. One thing I learned from following these issues for over 30 years is that problems and crises in financial markets happen with a disturbing frequency. I don't think that can be prevented. The goal should be to minimize the severity of crises and particularly to limit the fallout. I am skeptical, as are the WSJ editorial page and Simon Johnson, about the efficacy of Dodd-Frank. It makes some improvements, but one does get the sense that what is happening now is a political process where the Treasury and the regulators are trying to address some issues while not offending financial institutions too much.
As far as when the next time will be, I have no idea. But if one wants something to worry about, one need only think about the continuing decrease in housing prices, the foreclosure mess, the high unemployment rate, the economic problems in Europe, the potential for Middle East conflicts, the increase in food and energy prices, the financial condition of state and local governments, etc. That is not an inclusive list. One can only hope that the optimism expressed by the stock market and the improved GDP growth rate are more important.
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