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Authors of 'Too Big to Fail’ make case again
By MIKE MEYERS, Star Tribune
June 20, 2008
The best time to prepare for a crisis is before it happens. The second-best time is when the crisis is at hand.
As U.S. financial institutions tremble in the aftershocks of the subprime debacle, two prominent Minneapolis central bankers argue that the second-best time for bank regulatory reform has arrived.
"People may be more amenable [to reform] in that we've gone through a period of turbulence," said economist Ron Feldman.
The Bush administration this week promoted broader powers for the Federal Reserve to regulate the nation's financial system. But its appetite for more regulation of the financial system departs from the recent past.
In 2004, when U.S. banks were flush with profits, the book "Too Big to Fail" offered a list of ways for the government to avert the threat of a financial meltdown.
The warnings went unheeded. Congress passed no fresh legislation to shock-proof the U.S. financial system.
Only three months ago, the Federal Reserve put up $30 billion to ensure that J.P. Morgan would buy investment firm Bear Stearns. It was a New York powerhouse that was on the verge of going broke, but the Federal Reserve deemed it too interlinked with other financial firms to allow it to collapse.
Now the authors of "Too Big to Fail" are back, renewing their call for a revamping of banking regulation and oversight.
Gary Stern, president of the Federal Reserve Bank of Minneapolis, and Feldman, senior vice president, make their case in the cover article in the central bank's annual report, released earlier this month.
Their recommendations include:
• Use "failure simulations" to assess -- in advance -- the domino effect of individual bank failures. The process, they say, would give regulators early warning of which institutions to watch most closely to reduce systemwide vulnerabilities, and to show where the government can back away from offering banks "disaster" support.
• Adopt ways to minimize the spread of a crisis. "Augment policies that manage the losses one firm's failure imposes on [other financial institutions]," they wrote. "Closing firms while they still have some capital left is one example of this approach. ..."
• Find ways to improve the payments system -- where banks transfer money among themselves and others -- to reduce the risk that "one firm's failure puts the solvency of other firms in doubt."
Regulation resisted
Such remedies, first advanced by Stern and Feldman four years ago, proved to be a hard sell. Bankers were averse to more regulation. Some policymakers, until quite recently, thought "too big to fail" bailouts were unlikely.
In a speech in March 2007, only months before the latest credit crisis emerged, Sheila Bair, chairman of the Federal Deposit Insurance Corp., praised many of the ideas Stern and Feldman espoused in their book.
But she remained "deeply skeptical" of the book's underlying premise that some financial institutions were all but certain to win government bailouts in the event of serious money trouble.
"I am hard-pressed to envision a scenario where policymakers would choose a resolution that provided any significant protection to uninsured creditors," she said.
Although Bear Stearns investors and insiders lost billions despite Fed intervention, the unforeseen arrived when the investment bank hastily cut a deal with J.P. Morgan -- under Fed and Treasury supervision -- on a weekend.
"The manner in which Bear Stearns imploded certainly caught most observers and market participants by surprise," Stern and Feldman wrote in their recent article. "But it was no surprise that a failure of one of the largest U.S. investment banks posed spillover risks or raised too-big-to-fail concerns."
In an interview, Feldman said regulators should be prepared to protect the financial system rather than concentrate on the risks of individual banks.
He compared the problem to preparing for a flood.
"I don't know what's going to lead this levee to break," Feldman said. "It could be a big rainstorm. It could be snow. It could be a hurricane."
What's important, he said, is who would get flooded if it did break. "That's what we need to know," Feldman said.
Mike Meyers • 612-673-1746
By MIKE MEYERS, Star Tribune
June 20, 2008
The best time to prepare for a crisis is before it happens. The second-best time is when the crisis is at hand.
As U.S. financial institutions tremble in the aftershocks of the subprime debacle, two prominent Minneapolis central bankers argue that the second-best time for bank regulatory reform has arrived.
"People may be more amenable [to reform] in that we've gone through a period of turbulence," said economist Ron Feldman.
The Bush administration this week promoted broader powers for the Federal Reserve to regulate the nation's financial system. But its appetite for more regulation of the financial system departs from the recent past.
In 2004, when U.S. banks were flush with profits, the book "Too Big to Fail" offered a list of ways for the government to avert the threat of a financial meltdown.
The warnings went unheeded. Congress passed no fresh legislation to shock-proof the U.S. financial system.
Only three months ago, the Federal Reserve put up $30 billion to ensure that J.P. Morgan would buy investment firm Bear Stearns. It was a New York powerhouse that was on the verge of going broke, but the Federal Reserve deemed it too interlinked with other financial firms to allow it to collapse.
Now the authors of "Too Big to Fail" are back, renewing their call for a revamping of banking regulation and oversight.
Gary Stern, president of the Federal Reserve Bank of Minneapolis, and Feldman, senior vice president, make their case in the cover article in the central bank's annual report, released earlier this month.
Their recommendations include:
• Use "failure simulations" to assess -- in advance -- the domino effect of individual bank failures. The process, they say, would give regulators early warning of which institutions to watch most closely to reduce systemwide vulnerabilities, and to show where the government can back away from offering banks "disaster" support.
• Adopt ways to minimize the spread of a crisis. "Augment policies that manage the losses one firm's failure imposes on [other financial institutions]," they wrote. "Closing firms while they still have some capital left is one example of this approach. ..."
• Find ways to improve the payments system -- where banks transfer money among themselves and others -- to reduce the risk that "one firm's failure puts the solvency of other firms in doubt."
Regulation resisted
Such remedies, first advanced by Stern and Feldman four years ago, proved to be a hard sell. Bankers were averse to more regulation. Some policymakers, until quite recently, thought "too big to fail" bailouts were unlikely.
In a speech in March 2007, only months before the latest credit crisis emerged, Sheila Bair, chairman of the Federal Deposit Insurance Corp., praised many of the ideas Stern and Feldman espoused in their book.
But she remained "deeply skeptical" of the book's underlying premise that some financial institutions were all but certain to win government bailouts in the event of serious money trouble.
"I am hard-pressed to envision a scenario where policymakers would choose a resolution that provided any significant protection to uninsured creditors," she said.
Although Bear Stearns investors and insiders lost billions despite Fed intervention, the unforeseen arrived when the investment bank hastily cut a deal with J.P. Morgan -- under Fed and Treasury supervision -- on a weekend.
"The manner in which Bear Stearns imploded certainly caught most observers and market participants by surprise," Stern and Feldman wrote in their recent article. "But it was no surprise that a failure of one of the largest U.S. investment banks posed spillover risks or raised too-big-to-fail concerns."
In an interview, Feldman said regulators should be prepared to protect the financial system rather than concentrate on the risks of individual banks.
He compared the problem to preparing for a flood.
"I don't know what's going to lead this levee to break," Feldman said. "It could be a big rainstorm. It could be snow. It could be a hurricane."
What's important, he said, is who would get flooded if it did break. "That's what we need to know," Feldman said.
Mike Meyers • 612-673-1746