Manhattan Moment: Failure Should Be An Option For Financial Regulation

From his speech affirming that “we will rebuild” to his pledge to cut the deficit in half by 2013, President Obama is trying to soothe public fears over the economy and financial system.

In a high-profile week, one of his most important statements didn’t get as much attention as it should have. The president said that he wants to “strengthen markets so they can withstand ... the failure of one or more large institutions.”

Shouldn’t Obama be trying to prevent financial-industry failures?

In fact, he’ll try to do that, too. In the seven principles he unveiled last week to guide the White House and Congress in fixing the country’s system of financial regulations, the president said that he’ll aim to strengthen regulators’ oversight of big financial institutions and of financial instruments that can pose risks to the economy.

Part of this work means limiting borrowing and boosting capital requirements for big financial firms so that they can’t risk the world’s money as easily and recklessly as they did during the credit bubble.

It also means making sure that someone is responsible for the lightly regulated, exotic financial instruments that helped exacerbate the credit crisis – and for new instruments yet to be invented.

But no regulator will ever be smart enough to spot all catastrophic problems before they explode. As long as we have innovation, we’ll have failure, sometimes big failure.

In fact, we should remember that nearly two years into this financial crisis, it’s not the market that failed, but the financial industry’s business model. Global investors saw it coming before regulators did.

Unfortunately, our current system of financial regulation has no mechanism through which a big, failed financial company can cease to exist. Sudden bankruptcy is too destabilizing.

One reason we’re in this mess is that for more than a decade, lenders to big financial institutions assumed that the government would bail those institutions out if they ever did fail. Thus, the lenders were complacent about the type of risks those institutions were taking with other people’s money.

If we’re to remain a relatively free-market economy, though, we must allow bad companies to fail, even when—maybe especially when—they’re big or complicated. The government needs to protect the economy from those failing institutions, not protect the institutions from the economy by making zombies out of them.

Large, complex financial institutions, says Jay Westbrook, a business-law professor at the University of Texas at Austin, should be “too big to fail quickly”—not too big to fail at all.

The government should create a credible way in which big institutions or subsidiaries can collapse: a conservatorship structure for failed or failing firms, similar to what the White House did with Fannie Mae and Freddie Mac in September. The White House took over those institutions in an orderly fashion, eliminating existing management and letting shareholders suffer the losses.

A conservatorship for future failed companies should have two key differences, though. In order to ensure that companies and their creditors wouldn’t have an incentive to take ever more risks – expecting future government bailouts – creditors should not be protected from losses.

Among other things, these conservatorships would prevent some creditors from taking their collateral immediately and selling it in a crisis, as they can do now. Secured lenders to big investment firms would then demand higher interest rates for the new risk that their collateral could be indefinitely frozen.

This higher cost to big firms would make smaller, nimbler financial firms newly competitive against the lumbering giants, helping to remake our financial world into a healthier system of smaller firms competing against one another.

More importantly, it would reaffirm a key American principle: The worst companies go out of business – and someone more competent takes over.

This piece originally appeared in Washington Examiner

This piece originally appeared in Washington Examiner