Failure Should Not Be Rewarded
FDIC Chairman Sheila Bair set forth guidelines today for establishing a Financial Company Resolution Fund (FCRF) to deal with the failure of systemically significant institutions. Regulations alone are insufficient to control risk in a complex and dynamic financial system. Events of the past two years have shown, despite extensive regulatory supervision, the current system failed to manage complex risks properly, resulting in the near failure of major financial institutions.
Even with increased regualtory supervision, given the complexity of modern financial institutions, it is inevitable that in the future a major institution will face failure. The role of the FCRF would be to fill the regulatory gap that exists by establishing a mechanism to effectively deal with a large banking failure without imposing the cost on the taxpayer.
Ms Bair noted that when an institution is mismanaged and takes on excessive risk it is important to let market disciplines apply. If a firm is no longer viable, then it should fail and there should be a sound regulatory plan in effect to deal with such an eventuality. Without the risk of failure and losses to management, creditors and shareholders, large institutions would become indifferent to risk, believing that due to their size, they would be rescued by taxpayer supplied dollars.
Ms Bair’s sound proposals for dealing with future large banking failures in an orderly manner are meant to reduce the possible systemic damage that the sudden failure of such a large institution might cause. Additional comments by Ms Bair follow:
We must find ways to impose greater market discipline on systemically important institutions. In a properly functioning market economy there will be winners and losers, and when firms — through their own mismanagement and excessive risk taking – are no longer viable, they should fail. Actions that prevent firms from failing ultimately distort market mechanisms, including the market’s incentive to monitor the actions of similarly situated firms. Unfortunately, the actions taken during the past year have reinforced the idea that some financial organizations are too big to fail.
The notion of too big to fail creates a vicious circle that needs to be broken. Large firms are able to raise huge amounts of debt and equity and are given access to the credit markets at favorable terms without consideration of the firms’ risk profile. Investors and creditors believe their exposure is minimal since they also believe the government will not allow these firms to fail.
If anything is to be learned from this financial crisis, it is that market discipline must be more than a philosophy to ward off appropriate regulation during good times. It must be enforced during difficult times. Given this, we need to develop a resolution regime that provides for the orderly wind-down of large, systemically important financial firms, without imposing large costs to the taxpayers.
The unprecedented size and complexity of many of today’s financial institutions raise serious issues regarding whether they can be properly managed and effectively supervised through existing mechanisms and techniques. Our current system clearly failed in many instances to manage risk properly and to provide stability. Many of the systemically significant entities that have needed federal assistance were already subject to extensive federal supervision. For various reasons, these powers were not used effectively and, as a consequence, supervision was not sufficiently proactive.
A strong case can be made for creating incentives that reduce the size and complexity of financial institutions. A financial system characterized by a handful of giant institutions with global reach and a single regulator is making a huge bet on the performance of those banks and that regulator.
Financial firms that pose systemic risks should be subject to regulatory and economic incentives that require these institutions to hold larger capital and liquidity buffers to mirror the heightened risk they pose to the financial system.
Even if risk-management practices improve dramatically and we introduce effective macro-prudential supervision, the odds are that a large systemically significant firm will become troubled or fail at some time in the future. The current crisis has clearly demonstrated the need for a single resolution mechanism for financial firms that will preserve stability while imposing the losses on shareholders and creditors and replacing senior management to encourage market discipline.
To be credible, a resolution process for systemically significant institutions must have the funds necessary to accomplish the resolution. It is important that funding for this resolution process be provided by the set of potentially systemically significant financial firms, rather than by the taxpayer. To that end, Congress should establish a Financial Company Resolution Fund (FCRF) to provide working capital and cover unanticipated losses for the resolution.