Lately, the "too big to fail" debate has intensified as if only now has an urgent need to find a scapegoat to slaughter emerged. Certainly, the numerous scandals and examples of gross mismanagement at financial institutions invite criticism and derision.
It is critical to have an intelligent and in-depth discussion about whether the top 12 U.S. banks, which make up 70% of all banking assets benefit from government subsidies and bailouts. If we really want to solve the TBTF problem, however, we need to think not just of banks, but of the entire financial sector since all participants – banks, securities firms, hedge funds, private equity firms, insurance companies and mutual and pension funds – are extremely interconnected. All of them can cause systemic risk and negatively impact the economy.
Firstly, all politicians, every type of financial institution, rating agencies, corporations, regulators, supervisors, economists and we as individuals need to admit our role in causing, abetting or ignoring factors leading to the 2008 financial crisis.
In the early 2000s, the Federal Reserve targeted the federal funds rate lower to stimulate the economy. The U.S., due to its large capital markets, benefitted greatly from all types of investors, including an unprecedented transfer of savings from growing emerging markets into a wide variety of U.S. financial instruments. Additionally, the chase for yield led to securitization which lubricated lending markets and enabled all of us to get mortgages at lower rates.
Did we collectively forget that greed is a cardinal, not a venial, sin? Did we falsify, withhold or ignore information when applying for a loan, when selling and securitizing loans or rating the mortgage-backed securities and collateralized debt obligation offspring? Did we read the prospecti to make intelligent decisions about investments or did we use the prospecti as placemats for our caviar and cocktails because we were going to use unregulated credit derivatives to transfer the credit risk to equally poorly supervised protection sellers like AIG? Did we push banks to make loans to people who were not creditworthy because all we think of is getting re-elected? Did we lobby for low capital requirements for banks and little regulation for shadow financial institutions? Enough of the finger-pointing already! It is nostra culpa. Recognizing our role in the crisis is critical or the same behavior will continue.
Secondly, the crisis had not even finished unfolding, and on both sides of the pond, we rushed to come up with regulatory frameworks so that the devastation would never happen again. As time passes, we are seeing that Basel III, Dodd-Frank and European Market Infrastructure Regulation may not address all the causes of the crisis, and certainly cannot incorporate predictions about what may cause the next one.
But, even though imperfect, we must remember most of these rules have not been finalized as lobbies and legislators tie the hands of regulators. These key financial regulatory frameworks all contain provisions including more capital and higher quality capital, liquidity, leverage and transparency requirements, an unfinished Volcker Rule, ring-fencing attempts and a whole host of derivatives regulations.
If finalized, implemented and properly supervised, it is possible that these unfolding regulatory frameworks will make enormous global banks smaller or at least keep them from getting larger. These frameworks can force banks to have better risk management if both shareholders and supervisors discipline banks.
It is also possible that predictions that world-wide disaster will inevitably result are self-serving fear mongering.