“Too Big To Fail” Reining In Large Financial Firms

This paper provides a well balanced perspective on banking regulation.

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Introduction (Via HBS)

Here’s a really scary thought. Now that the federal government has poured hundreds of billions of dollars into saving financial institutions deemed “too big to fail,” hasn’t it implicitly guaranteed similar largesse for all such institutions in the future? In its rush to help, has the government unwittingly created the mother of all moral hazards—implicit rescue guarantees as far as the eye can see?

No doubt about it, says HBS professor and economic historian David Moss. “The extension of implicit guarantees to all systemically significant institutions takes moral hazard in the financial system to an entirely new level,” he warns. But Moss has a fix: The federal government should slap tough new regulations on all firms that pose “systemic risk” —the risk that a failure of one institution could wreak havoc across the entire financial system.

Article Excerpts (Via HBS)

The Case For Regulation:

Looking at the historical record, Moss makes a strong case that targeted government regulation of financial markets has worked in the past to lower risk and instill consumer confidence.

It’s no accident that all these financial crises followed a concerted push by bankers, economists, and policymakers to deregulate the marketplace, says Moss. Although a deregulatory agenda was embraced by congressional Democrats and Republicans alike, President Reagan set the philosophical tone in his 1981 inaugural address when he famously observed: “Government is not the solution to our problem; government is the problem.” Thereafter, regulatory minimalism and a “market knows best” mindset took hold in Washington and on Wall Street and dominated decision-making for nearly three decades.

The Case Against Regulation:

“Before embracing more government regulation as the only answer, such advocates should consider the many ways in which government regulation itself can be part of the problem,” argue Hensarling and Sununu.

At the top of their list are Fannie Mae and Freddie Mac, the failed government-created mortgage giants. Despite repeated denials by congressional leaders, the marketplace understood that both mortgage behemoths enjoyed an implicit federal guarantee against failure, contend Hensarling and Sununu.

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