Lowering risks from large, complex financial institutions

January 22, 2010

— Robert R. Bench, a former deputy Comptroller of the Currency, is a senior fellow at the Boston University School of Law Morin Center for Banking and Financial Law. The views expressed are his own. —

Financial institutions inherently are fragile.

As intermediaries, they are exposed to both exogenous and endogenous threats. The 2007-2008 financial crisis was caused by endogenous forces.  Simply, financial institutions were poorly governed, taking-on extreme liabilities and gambling them into high risk activities.  The meltdown of the financial system fed contractionary forces into the real economy, causing our “great recession,” creating negative exogenous loops back into financial institutions.

The roots of the financial crisis were poor underwriting of credit.  However, the crisis happened because that credit risk was amplified through abusive underwriting, distributing, and trading of debt-backed financial instruments.  The abuse was driven by “heads I win, tails you lose” compensation schemes.  Wall Street won, Main Street lost.

Reform of the financial system requires restoring the social utility of deposit-taking institutions while eliminating the casinos within them.  The Volcker-Obama proposals move in that direction, by limiting the degree of gambling at deposit-taking companies.  In essence, Volcker-Obama addresses the very basic question: What do we want the financial institutions to do for society?  We do not want them focused on fast profits through proprietary trading.  We do want them focused on how to finance the needs of households, commerce, and governments.

We need to separate the “financial markets industry” from the “financial services industry.”  The former complicates and confuses the latter when both are located in one financial services company.  Market trading makes for an active balance sheet and exponentially increases counterparty interconnectedness.  Unless walled-off or spun-off, regulating and supervising financial holding companies is difficult.  The financial services industry culturally  is a public utility, essential to our modern way of life, which is why we rescue it when trouble appears.  Unless we separate proprietary trading from the public utility, the high-roller financiers continue to free-ride the taxpayer.

But, even if we lower social risk by separating proprietary trading from deposit banking, we will still have very large financial institutions within and outside the deposit-taking sector.  We need large institutions because U.S. economic needs are large.  We need size so we are competitive globally. The taxpayer still will be on the hook for any systemic trouble — unless we develop a scheme to protect the taxpayer.

One way would be to create a “Systemic Resolution Fund” administered by the Federal Deposit Insurance Corporation.  Congress already is considering legislating to the FDIC authority to wind-up troubled non deposit-taking financial institutions.  Congress also could legislate creating a fund to do so through annual assessments on financial institutions identified as “systemically critical.”  Such an assessment would also lessen the implicit subsidy that large financial companies enjoy through taxpayer support.

It simply is time for an industry financed solution to the threat large financial institutions pose.  We chose an industry financed fund to create the FDIC and it has worked well for seventy years in dealing with deposit banks.  Why not consider this model for all systemically critical financial institutions?

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