Federal Reserve Chairman Ben Bernanke recently told the Economic Club of New York that the U.S. faces “a very serious too-big-to-fail problem.”
As Bernanke described it, this means that the insolvency of one large company could threaten the global financial system. “There are too many firms that are, in some sense, systematically critical,” he said.
He knew this, of course, because the world financial system did collapse, or came pretty close.
About the same time that Bernanke spoke, a summit of the European Union, which had pledged more than $2 trillion to rescue banks, included a call from U.K. Prime Minister Gordon Brown for a restoration of the 1944 Bretton Woods Agreement. By this, he meant a globally coordinated effort to impose more stringent regulation on financial companies to avoid the excesses that plunge the world into economic turmoil every few years.
The stirring about an overhaul of the global financial system is likely to get more attention once President-elect Barack Obama takes office and a new economic team is appointed.
The danger seems to be that the process will become either overly politicized or rely too much on the public sector to control financial markets.
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Neither would be good. But we must recognize that taxpayers, who are guaranteeing the liabilities of so many banks, insurers and securities firms, have a right to be at the bargaining table when a regulatory system is established. It’s not too early to think about a framework for what a new financial regulatory system must do, and how it would perform. Here are a few components of the framework:
Any new system will need to be global, so the nations that have adopted the Basel Accord, hosted by the Bank for International Settlements in Switzerland, would be a good place to begin. The first Basel agreement in 1988, however, applied only to commercial banks and focused on bank-capital adequacy. The Basel system hasn’t served us well because it didn’t fully account for sudden losses of market liquidity. Plus, it was too tolerant of risks collateralized by mortgages and other assets.
Basel II, which went into effect in 2004, needs to be set aside in the immediate search for a replacement, which will have to address the shortcomings of the system that failed.
As Bernanke said, there are many large financial companies whose failure might place the entire system at risk. All of them — such as Goldman Sachs Groups Inc., Citigroup Inc., HSBC Holdings Plc and UBS AG — need to be included within the purview of a new, beefed-up regulatory framework.
Banks, thrifts, investment banks, insurance companies, hedge funds and asset-management groups must be included if they are judged too big to fail — those companies with $1 trillion or more in assets and that trade in global capital markets. There will be resistance from such companies, about 30 to 40 in all, but it must be done by all countries subscribing to the system.
Regulators need to agree on what they want to regulate: This should be all forms of risks that might threaten a company. The system will need to look at all risks that the regulators regard as appropriate, and they must do so on a forward-looking basis.
Roy Smith, the co-author of “Global Banking,” is a finance professor at New York University’s Stern School of Business