Banks can’t be regulated against failure

Freedom New Mexico

Rep. Barney Frank, D-Mass, chairman of the House Banking Committee, and Sen. Christopher Dodd, D-Conn., chairman of the Senate Banking Committee, each have introduced sweeping bills to overhaul regulation of the country’s financial system.

Despite differences — Frank’s bill would expand the power of the Federal Reserve while Dodd’s bill would limit it — both have superficially attractive features, including consolidating the dizzying array of federal agencies with authority over various aspects of the financial industry.

Unfortunately, both bills reflect an inaccurate diagnosis of the causes of the financial collapse last year. The implicit assumption behind both is that the collapse was due to a lack of federal regulation.

In fact, the financial industry, pre-collapse, was among the most heavily regulated in the country. It collapsed in large part because it responded to incentives created by government policies — loose money from the Fed, an implicit guarantee that Fannie Mae and Freddie Mac would not be allowed to fail and thus otherwise risky loans appeared secure — that the two bills not only do not fix the situation, but would make matters worse.

Recovery from the collapse has been delayed in large part because the Bush administration took the short-term view that financial institutions, starting with Fannie and Freddie, were too big and/or too tightly interconnected with other firms to be allowed to fail. Thus we got the rescue of Fannie and Freddie and the Troubled Assets Relief Program (TARP).

A market system is a system of profit and loss. Profits tell a company it is satisfying consumer desires, while losses tell it that it is doing something terribly wrong.

When a company with losses is not allowed to fail, this interrupts the feedback loop that encourages the business to fix the problems. A bailout or rescue creates incentives to keep engaging in risky behavior because you know the government will bail you out.

One key to a healthy economy in the future, therefore, is to purge the term “too big to fail” from our vocabulary and our policy options. Both the Frank and Dodd bills expand and institutionalize the “too big to fail” mentality.

Both bills expand the definition of financial institutions, to cover all companies that include financial activities “in whole or in part,” which would include retailers that finance their own sales. These companies would be more closely supervised than they are now, but would be eligible for bailouts under a loose definition of “systemic risk” that includes (in the Dodd bill), having an adverse impact on “economic conditions in the United States.”

This makes no sense at all. A business typically goes through a cycle of growth and maturation. One can think of scores of companies that have faded from the scene because their leaders failed to respond effectively to an important customer or market change. It is not the government’s job to become a stop-loss protection for unhappy business decisions.

A proper economic system balances the tendency to take risks and the need for prudence by retaining a real risk of failure for those who take undue risks. Both the Dodd and Frank bills not only insert government more actively into the financial industry, they virtually eliminate failure as an option. That’s a formula for new financial meltdowns.