Central to the global meltdown were the financial industry?s distorted incentives, which caused bankers and investors to take enormous risks without due regard for their consequences. Imagine the following lucky situation. Say my father provides me the licence to go and gamble in Las Vegas and tells me that whatever profits I make will be mine. However, because I am so critical of his family system, he gives me this implicit assurance: even if I happen to lose my shirt in the city of sin, he will be there to pick up the tab and re-clothe me. Why would I, then, bother to keep a check on the risks I take? In a similar manner, being judged too important to the economy to fail is a financial institution?s (FI) sure bet.
Although much has changed in the wake of the crisis, this basic dynamic has not. In fact, the situation is worse today compared to that before the crisis. Those banks that were ?too big to fail? are now bigger. Government-sponsored mergers that resulted from the crisis have only made them larger. And the implicit guarantee that the government is not going to let these banks fail is now explicit.
In addition, the insurance offered to large banks by the ?too big to fail? policy tilts the field against the small banks and hampers their ability to compete, which, in turn, leads to greater bank concentration. This increases the power of banks at the expense of depositors and borrowers, and all but ensures that banks will be even bigger the next time a rescue gets called in. In 1998, the rescue of LTCM cost the major creditors $3.6 billion while in 2008 the government had to spend $700 billion to save the financial sector. What will the cost be from an ensuing crisis in 2018 if status quo is maintained?
Changing course, however, is not easy. The bailouts have been the most practicable response to very real threats to the financial system, and to the lack of options for assessing and restricting the risks taken by large financial players. But what the Obama administration has proposed as an alternative is hardly an improvement: its regulatory approach would throw the baby out with the bathwater.
What is needed is a better way to judge and restrain the risks taken by FIs, but without placing undue constraints on economic growth and the freedom of the market. Balancing these two crucial yet seemingly divergent aims will be no small feat.
If the ?too big to fail? syndrome is so unhealthy, what are the other options? One approach would be to make the alternatives to intervention more palatable. This is the logic behind the Obama administration?s proposal that FIs prepare so-called ?living wills??contingency plans for how to unwind their obligations in the event of failure. All market players will understand in advance what will be involved in the failure of a particular institution. Everyone will know that massive intervention would neither be required nor expected. Though the idea sounds good in principle, in practice, every institution would have a strong incentive to sabotage its own ?living will??designing it so that it would fail to protect the system from the shock of the firm?s collapse, and so requiring the government to step in and keep the firm afloat.
Instead regulators can try to avoid the circumstances that create the need for interventions, by restricting the risks that FIs can take. If neither the government nor the firms can be relied on to refrain from passing the costs of excessive risk-taking on to the public, then risk-taking itself should be prevented. This is the best option for changing the behaviour of large FIs and correcting the distorted incentives that produced such disastrous consequences.
The Obama administration has proposed prohibiting banks from owning, investing in, or advising hedge funds or private-equity funds, and prohibiting proprietary trading with bank funds. Such a policy would be very costly and doomed to fail: very costly because it would require prohibiting the involvement of large FIs in an enormous range of financial activities that now allow them to earn profit and compete; doomed to fail because such regulations are extremely easy to bypass.
Instead, the CDS-spread based mechanism suggested by Luigi Zingales of the University of Chicago and Oliver Hart offers a more sensible solution. A bankruptcy process for the FIs ensures that there is a firm commitment from the government that a failed FI will not be rescued. In turn, the existence of such a firm commitment ex-post will create the ex-ante incentives for the large FIs to avoid such risks in the first place. Second, since the triggers would be based on CDS-spreads, this market-based solution would act as canaries in coalmines, enabling the management of the FIs to take the necessary steps to avoid disaster.
The author is assistant professor of finance at Emory University, Atlanta, and a visiting scholar at ISB, Hyderabad
