After this country's financial system was shaken to its very moorings, federal policymakers are about to make legislative prescriptions that we hope will ensure that the events of the past nine months are not repeated anytime soon, if ever.
As we all know, federal regulators were forced to make unpopular decisions based on the belief that weakened financial firms were so big and so interconnected that their failure would devastate the world economy. They were perceived to be, in a phrase, "too big to fail," and thus we bailed them out with tens of billions of dollars in taxpayer funds.
Just look at the events of last fall and the collapse of the credit markets after the Lehman Brothers bankruptcy filing. Hundreds of thousands of unresolved contracts illustrate the pain involved in a hands-off approach. By the time we were faced with the meltdown at American International Group, we were told a bailout to avoid the bankruptcy liquidation of credit default swaps around the globe was the only choice. AIG was simply "too big to fail."
It's my view that we would be much better advised if we simply dismantled gigantic, troubled firms instead of bailing them out. Currently, however, regulators lack the necessary tools to close large nonbank financial firms, and there is no easy way to dismantle a company the size of AIG. We must correct that oversight and provide for a meaningful resolution mechanism that can unwind, not prop up, failing firms.
A solution may be closer than we think if we simply look to the FDIC. We already have an effective process for closing banks, one that historically hasn't cost the American taxpayers any money when a bank needed to be shut down. We should build on this tried-and-true model to create consistency between bank and nonbank financial institutions. We need to update our laws to reflect the fact that nonbanks, as well as banks, create systemwide risks.
We should strongly consider establishing a resolution process for very large and complex financial firms that are troubled — one that recognizes the public interest, provides for financial continuity, and hits those responsible with financial losses. That would put us in a much stronger position in the event that we ever face this kind of crisis again.
How would it work? A systemic risk council should be formed and charged with deciding whether a troubled firm should be forced to close or allowed to stay open. Using a "good-bank/bad-bank" model, based on the FDIC's bridge-bank authority, we could maintain continuity, move the valuable operations to the "good bank" and leave troubled ones in the "bad bank." Shareholders and other creditors would bear the losses, as they should. And, finally, this process should be quick and decisive — and not make the firms wards of the state. The FDIC's model of selling assets quickly back to private buyers is the fastest way to recycle them into new loans, investments and jobs.
To be clear, this would not be a new bailout system or a blanket guarantee of the liabilities of systemically important firms. It should work much the same way as the FDIC now resolves a failed bank, and would be a way to inject accountability and responsibility into the process.
We cannot allow our regulatory system to continue to struggle because of anachronistic authorities that predate our changed financial landscape. The sooner we modernize our resolution structure, the sooner we can end the "too big to fail" mentality that has us all wondering what company will earn the dubious title next, and thus clear the way for a more stable economic future.