Editor’s note: This is Part 3 of a multipart series. Read Part 1, "6 issues to steer financial reform," and Part 2, " ‘Wind-down’: a bailout alternative."

"Too big to fail" is used to describe companies that, if they collapse, would have such devastating effects on the financial system as a whole that government is forced to protect their creditors. Such rescues are costly to taxpayers, politically disruptive, and, by establishing a rescue precedent, pave the way for even more costly rescues in the future.

For reasons discussed last week, policies designed to convert too-big-to-fail (TBTF) firms into firms that are not TBTF are unlikely to be enacted. The alternative to rescuing such firms is to prevent them from getting into trouble in the first place by effectively regulating their risk exposures.

But our regulatory history is not encouraging. The savings and loan industry, rocked by a different kind of crisis in the early 1980s, was regulated by the Federal Home Loan Bank System (FHLBS), which Congress subsequently terminated because of its regulatory failures.

Some of the major banks and thrifts caught up in the recent crisis were also subject to extensive regulation. The Citibank and Bank of America holding companies were regulated by the Federal Reserve, while the banks themselves were regulated by the Comptroller of the Currency. WaMu, Indy Mac and Countrywide were regulated by the Office of Thrift Supervision, successor to the FHLBS, and it will probably be terminated in turn for its regulatory failures.

If we expect regulators to do better next time, we better understand why they struck out this time. Part of the reason is that major players contributing importantly to the crisis were, for all practical purposes, unregulated. These include investment banks, mortgage companies and AIG, an insurance holding company.

It is very difficult to rein in regulated institutions that must compete with unregulated firms, or are seduced into making attractive deals with unregulated firms. Furthermore, regulators tend to be jurisdictionally myopic: They ignore threats to financial stability that arise outside of the industry of firms over which they have legal jurisdiction.

Conclusion: Somehow the regulatory net must be made wide enough to cover all the firms that become important players in the next emerging bubble that can lead to a crisis. This is a major challenge, because the important players next time are unlikely to be the same as the important players in the most recent crisis.

The second cause of regulatory failure is the lack of adequate regulatory tools. The principal tool on which regulators rely to prevent excessive risk-taking is capital requirements. This is plausible because capital requirements focus directly on a firm’s capacity to bear loss.

If a firm has a capital ratio of 4 percent, for example, it means that the value of its assets could fall by no more than 4 percent before it is insolvent. If an 8 percent ratio is required, its assets must fall by 8 percent before it is insolvent, which means it is stronger. …CONTINUED

But capital requirements haven’t worked. Richard Herring notes that "the five largest U.S. financial institutions that either failed or were forced into government-assisted mergers in 2008 — Bear Stearns, Washington Mutual, Lehman Brothers, Wachovia and Merrill Lynch — were each subject to Basel capital standards, and each disclosed Tier 1 capital ratios ranging from 8.3 percent to 11 percent in the last quarterly report before they were effectively shut down" (see "Wind-down Plans as an Alternative to Bailouts," 2010).

Capital requirements are subject to a large margin of error because the valuation of assets can change sharply within a very short period. This is what happened to the firms cited above.

Capital requirements don’t discourage risk-taking during a bubble because firms can shift the composition of their assets toward greater risk without increasing their requirements. For example, the shift from prime into subprime mortgages did not increase capital requirements because both belonged to the same broad asset class.

Capital requirements do not increase the capacity of firms to absorb loss during a bubble unless the regulators increase the requirements. But this requires special insight into the economy by regulators, not to mention the political courage needed to remove the punch bowl from the party. This is too much to expect of regulators.

But perhaps the most serious limitation of capital requirements is that they apply only to firms in the industries to which the requirements have been applied. These are the industries that have been implicated in disturbances in the past, whereas the disturbances of the future may come from different sources.

The challenge is to find a regulatory tool that will a) automatically discourage risk-taking during a bubble, b) increase the capacity to bear loss of firms participating in the bubble, and c) apply to any systemically important firm, regardless of what industry they happen to be in. I will discuss this tool next week.

The writer is professor of finance emeritus at the Wharton School of the University of Pennsylvania. Comments and questions can be left at www.mtgprofessor.com.


What’s your opinion? Leave your comments below or send a letter to the editor. To contact the writer, click the byline at the top of the story.

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