Monday, July 18, 2011

"Too Big to Fail" Should Mean Reduced Freedom to Maximize Profits

I have said for some time that little of substance has changed in the global financial system that would prevent another financial crisis comparable to that of 2008--or worse.  The largest financial enterprises, with approximately six lobbyists for each member of Congress in the U.S., have diluted regulatory reforms that were intended to strengthen the financial system.  

That is wrong on multiple levels.  Firms that are so large that their financial distress would imperial the entire financial system must have to pay a price for the systemic risk they pose.  They must be constrained from seeking to maximize profits, either by splitting them into two entities--(regulated) banking and (unregulated) investment banking, as recommended by Paul Volcker, or being required to set aside greater loss reserves than smaller firms.

Despite the lobbying prowess of the biggest financial firms, global officials might be on the verge of major positive reforms that would strengthen the global financial system and make another crisis less likely or at least less calamitous.  International regulators have approved the Basel plans for firms that are considered "too big to fail" without causing a collapse of the entire system.  The reforms would require the largest firms to hold additional capital in reserve against unforeseen losses.  In addition, unlike the 2008 crisis, bondholders would be required to sustain losses and writedowns so as to protect taxpayers from having to bail out the largest firms. 

The rules also would attempt to bring under regulatory oversight the "shadow banking system," which was critical to inflating the housing bubble with reckless lending, inadequate loss reserves, and massive losses to taxpayers.

Not surprisingly, Jamie Dimon and other CEOs of the largest banks are objecting to the proposed rules.  They contend that the reforms would constrain bank lending and hurt the economy.  Government officials must hold firm against this pressure.  For far too long, the biggest financial firms have operated in an ostensibly market system which, in fact, allowed private interests to reap profits but which dumped massive losses on public taxpayers.

If The Financial Stability Board of finance ministers, central-bank governors, and regulators can persevere against the entrenched power of the largest financial firms, taxpayers will be much better protected, and the integrity of the global financial system will be enhanced.

Steve Lehman

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