As Derek pointed out earlier, Treasury Secretary Timothy Geithner testified today before the House Financial Services Committee. I was pleasantly surprised to see that half of his prepared testimony involved the too big to fail problem. I was even more delightfully shocked to see that he offered a legitimate, tangible solution that could help with the problem. He suggests that firms will need to explain how they could be resolved in the event of their failure.
A Good, But Ultimately Inadequate Proposal
Before getting to his more novel idea, he first suggests a more well-known one:
Second, we will impose tough rules on our largest, most leveraged, and most interconnected firms. We will require these firms to hold more capital to protect the system in the event of the firm's failure. And we will make the financial markets more resilient.
We will require bigger buffers in the financial system to make it strong enough to withstand the failure of individual firms, and will reduce the threat of contagion caused by interconnections among major firms. This will include raising capital and liquidity requirements for all banking firms, and raising capital charges on exposures between financial firms. It will include comprehensively regulating over-the-counter (OTC) derivative markets, including by substantially increasing the use of well-regulated central clearing platforms. And it will include strengthening supervision and regulation of critical payment, clearing, and settlement systems
I support higher capital requirements for financial firms and securities, because it just makes sense. But those requirements alone cannot prevent the too big to fail problem. Let me explain why through an analogy.
Imagine you create a security pegged to some asset. Depending on how that asset's value changes, the security can turn a profit or loss on your initial investment. So you create a scenario where you assume that if things got as bad as they ever had, say like in the Great Depression, you figure out what would happen to that asset's value. You then structure the security in such a way, say with a large cash reserve, to withstand that shock to the underlying asset and at least break even. That's the story of mortgage-backed securities and rating agencies. We all know how well that turned out.
The point is that it's impossible to know how bad things could get, so no one can ever accurately predict the right amount of capital that firms would need to set aside in a catastrophic scenario. That capital may help and provide plenty of cushion most of the time. But it's not most of the time we're talking about -- we care about times that are unprecedented.
A Better Solution
So a better solution must be sought. Luckily, Geithner offers one. And it's a good one:
We will require our major financial firms to prepare and regularly update a credible plan for their rapid resolution in the event of severe financial distress. We will require supervisors to carefully evaluate the plan on an ongoing basis. This requirement will create incentives for a firm to better monitor and simplify its organizational structure and would better prepare the government - as well as the firm's investors, creditors, and counterparties - in the event the firm collapsed.