Obama's Regulation Speech Thin On Too Big To Fail

On the one-year anniversary of the fall of Lehman, the President has decided it might be a good idea to visit New York and chastise Wall Street explain to Wall Street the regulation he believes necessary to avoid another financial crisis. But one area of reform where his speech is disappointing thin is dealing with the too big to fail problem. He has only three talking points that begin to touch on this problem. I'm unconvinced any of them will necessarily solve it.

First, you can find a copy of the full text here. I'm not sure how seriously anyone can take the President's supposed dedication to financial reform, given the low priority it's been given during his first year in office. At this point, he'll be lucky to get it during 2009. And by waiting so long, serious reform has become a more distant hope. In the speech, however, he promises new regulation will still happen by year's end.

Systemic Risk Regulator

The President spends a little time in the speech discussing the creation of a systemic risk regulator. I remain entirely unconvinced that such an authority would have any ability to prevent firms from becoming too big to fail. I'm cynical for two reasons.

First, I don't believe that the regulator will be particularly good at predicting sudden, unexpected risk. If it was, then that risk would be neither sudden nor unexpected.

Second, such a regulator might just function to bail out or prop up firms that should be failing, instead of actually fixing the problem. In the past I've expressed my fear that this is exactly what we'd get if the Fed is chosen as this regulator.

Higher Capital Requirements

Another proposal the President mentions is to increase capital requirements for banks, especially big ones. He says this should happen both in the U.S. and abroad. He says:

We'll also require these financial firms to meet stronger capital and liquidity requirements and observe greater constraints on their risky behavior. That's one of the lessons of the past year. The only way to avoid a crisis of this magnitude is to ensure that large firms can't take risks that threaten our entire financial system, and to make sure they have the resources to weather even the worst of economic storms.

For we know that abuses in financial markets anywhere can have an impact everywhere; and just as gaps in domestic regulation lead to a race to the bottom, so too do gaps in regulation around the world. Instead, we need a global race to the top, including stronger capital standards, as I've called for today.

I've extolled the virtues of this idea already, so I won't spend much time on it again here. It doesn't, at all, solve the too big to fail problem. It indirectly refers to it, however. Forcing bigger banks to have higher capital requirements merely attempts to lessen too big to fail's blow to competition by leveling the playing field. It's better than nothing, but it's no where near ideal.

I should mention, however, that the idea is good for its own sake. Some additional capital padding would surely have helped some of the banks avoid problems during the crisis. It would also serve to limit both risk and reward, two of the administration's other goals.

Resolution Authority

As far as I'm concerned, this is the closet that the President comes to offering a proposal that would help to solve the too big to fail problem. He says:

Even as we've proposed safeguards to make the failure of large and interconnected firms less likely, we've also proposed creating what's called "resolution authority" in the event that such a failure happens and poses a threat to the stability of the financial system. This is intended to put an end to the idea that some firms are "too big to fail." For a market to function, those who invest and lend in that market must believe that their money is actually at risk. And the system as a whole isn't safe until it is safe from the failure of any individual institution.

If a bank approaches insolvency, we have a process through the FDIC that protects depositors and maintains confidence in the banking system. This process was created during the Great Depression when the failure of one bank led to runs on other banks, which in turn threatened the banking system. And it works. Yet we don't have any kind of process in place to contain the failure of a Lehman Brothers or AIG or any of the largest and most interconnected financial firms in our country.

I've also mentioned my support of this in the past. Having a way to ensure that even gigantic financial institutions can fail would solve the problem at hand. I just have my doubts whether such a regulator can actually create a smooth resolution of gigantic interconnected financial institutions. I have my doubts, but the idea, in theory, sounds sensible. I'll be eager to see the nuts and bolts of how such a tidy resolution would work.

What Obama Didn't Say

What we entirely failed to hear was that there should be limits to how large financial institutions can become or that some of the biggest ones should be broken up. Maybe that's not surprising. There's an odd perception out there that firms should be able to grow infinitely, and that's good for the economy. That's not exactly true, as monopoly economics shows.

In a Joint Economic Committee meeting back in April, I heard it suggested by prominent economists Simon Johnson and Joseph Stiglitz that antitrust authority should be used to curb the too big to fail problem. That's clearly not something that the administration is taking seriously. Maybe it should. A firm becoming too big to fail creates a huge competitive advantage, since its borrowing costs will be lower than those smaller firms face. As a result, it will continue to grow faster and pose greater and greater risk to the system if it fails.