A central focus of financial regulatory reform has to be ending the implicit doctrine of too big to fail. It should be put to rest, but that's easier said than done.
The too-big-to-fail doctrine, which implicitly holds that a company's connection to the financial system is so great that its failure would put the entire system at risk, has itself put the system at greater risk by unintentionally encouraging ever greater risk taking under the belief the government would bail out errant actions.
Proposals for ending that doctrine include giving regulators the power and tools to break up companies whose significant interconnections and deteriorating financial condition put the entire financial system at risk.
If such proposals are to reduce the chance of massive financial failure and massive taxpayer-financed bailouts, they have to address key issues.
One issue is who will have the power to decide when to break up a financial company, and what metrics it will use to decide which company is too big and heading into dangerous waters.
Another is how transparent the metrics for determining systemic risk will be.
The metrics should be fully disclosed to the public to allow investors, and the market in general, to change their views of companies as the financial situation worsens or improves, by adjusting stock and bond prices.
Such price signals could serve to encourage companies to reduce their excessively risky positions. However, there is a danger disclosure could push them into greater difficulty, if investors perceive them as toxic and, therefore, withdraw capital.
But at least if the measures are made public, companies will have a better chance to adjust their actions to improve the situation before it deteriorates severely, or to make their case why their actions have been misperceived. Disclosure of a situation as it evolves also would give shareholders an opportunity to revise their views gradually, perhaps avoiding the devastating consequences a sudden price plunge triggered by an official warning could produce.
The government, for its part, needs to examine, disclose and correct its own policies that contribute to systemic risk — such as the Fed's easy money policies, or programs to encourage excessive low-quality mortgage financing, both of which were major factors in the recent financial market meltdown — or its fiscal policy with its now booming deficits.
The government, working with the Financial Accounting Standards Board and other expert groups, must begin to devise measures of systemic risk arising from individual companies, derivatives trading, excessive consumer credit and government policies. Such action would encourage more private firms as well as investors to examine risk more closely and devise their own measures to improve upon official data points. These efforts also would encourage more in-depth research on the issue of systemic risk and examination of historic causations and correlations.
Developing such measures is not just a matter of collecting a set of numbers. The problem is reminiscent of the concept of the efficient portfolio that led to Harry Markowitz's creation of the mean-variance of a portfolio by measuring the interconnection of one stock with another, and the contribution of William F. Sharpe, who simplified the process with the creation of beta to measure the risk correlation of each stock against that of the market. It will take a similar intellectual effort.
Another difficulty is determining how the potential impact on the market of new financial instruments, such as newly developed derivatives, will be assessed. Just putting a value on financial instruments that aren't widely traded is controversial. The FASB has been grappling with the issue for the last several years.
To their merit, the financial regulatory reform proposals — including the Restoring American Financial Stability Act discussion draft legislation, introduced Nov. 10 by Sen. Christopher J. Dodd — call for greater disclosure of over-the-counter derivatives.
Largely hidden from sight in terms of their financial statement impact, these derivatives also were out of sight and out of mind in terms of risk to the financial system as the crisis developed.
Better transparency also should extend to more disclosure of short equity positions. This disclosure, if imposed now, could be helpful to the market immediately while the broader and deeper systemic risk measurements are being developed.
As a Government Accountability Office report earlier in the year asserted, “A regulatory system should foster financial markets that are resilient enough to absorb failures and thereby limit the need for federal intervention and limit taxpayers' exposure to financial risk. Key issues include identifying safeguards to prevent systemic crises and minimizing moral hazard.”
Any government policy should encourage the market to devise its own approach to mitigating systemic risk. After all, it is the market that is most at risk, as the financial devastation of the last two years demonstrated. But government will find it hard to resist intervention in the economy and individual financial companies and other corporations, and that impulse will likely be the hardest obstacle to overcome in ending too big to fail.