IN HIS WASHINGTON POST OP-ED, J.P. Morgan Chase CEO Jamie Dimon recently wrote, “The term ‘too big to fail’ must be excised from our vocabulary.” He allowed that “if some unforeseen circumstance should put this firm at risk of collapse, I believe we should be allowed to fail.” Crashes are often triggered by smaller events that of themselves do not pose a risk to the entire financial system, yet start a domino effect that does. Institutions from AIG and Citigroup to Merrill Lynch were saved only by state intervention, with taxpayers on the hook for footing the bill for some time to come.
The challenge for government is to know when to provide a safety net, without allowing bankers to believe that they will always be saved from their mistakes. The problem of moral hazard, as the 19th-century English philosopher Herbert Spencer put it, is “The ultimate result of shielding man from the effects of folly is to people the world with fools.” There are those who believe that more and better regulation, perhaps better coordinated internationally, will prevent such failures in future. As the Financial Times’ John Kay observed: “It is impossible for regulators to prevent business failure and undesirable to pursue that objective. The essential dynamic of a market economy is that good businesses succeed and bad ones do not.”
The problem is not so much that some firms are too big to fail but that they are too complex, too opaque and too interconnected. The 16 largest financial institutions control 2.5 times as many subsidiaries as the 16 largest nonfinancial firms. One of the most complex financial firms controls 2,435 subsidiaries, half of them chartered in other countries in order to minimize regulatory and tax burdens. Such complexity makes it difficult for anyone— including regulators and the companies’ own managers and directors—to fully understand all the risks the firms are taking, or how those risks might interact with ones other companies are taking.
The Obama administration proposes to create a “systemic risk regulator,” something like the Department of Homeland Security for financial markets. But even an omniscient regulator would not have prevented the financial meltdown. The proposal confuses the type of financial risk-taking that warrants clear, uniform limits with those that warrant discretionary attention and surveillance. Enterprise risk isn’t like pornography—you don’t always know it when you see it. Sometimes nobody sees any risk at all. In addition, investors would be lulled into a false confidence that government is looking out for them.
Instead of creating more bureaucracy, Washington can strengthen the system by using what Nicole Gelinas in her recently published After the Fall: Saving Capitalism from Wall Street—and Washington terms “the core principle of insulating money and credit from speculative excesses.” Many experts, for example, believe big firms should be required to maintain larger capital reserves, and that they should not be allowed to bet too much with borrowed money, a key factor in the recent crisis. In addition, boosting disclosure requirements, coupled with ensuring that some asset classes—such as derivatives and credit default swaps (CDS)—be traded on exchanges or clearinghouses, would at least reduce the opacity in critical markets.
When we look at the size of our current government debt as a result of bailing out entities that are TBTF and bailing out our economy on top of ever-increasing entitlements, we must ask the question whether even bigger bailouts after another cycle could take down the ability of the U.S. government to issue its own bonds affordably. In contrast to the 20th century where them U.S. was a creditor nation, America began the 21st century as a debtor country, and will likely remain so for the foreseeable future.