Sheila Bair argued to Congress last week that the government should "impose greater market discipline on systemically important institutions." Her rationale for the argument was that those large firms have been funded by the market as if they were too big to fail, while their management teams depended on faulty risk management practices; these circumstances, combined with ineffective regulation, created a the bulk of our current economic problems. Bair's commentary indicates that we will ultimately have much more regulation throughout the financial industry, simply because what happens to large institutions will trickle down to impact the smaller community banks.
Bair went on to say:
In a properly functioning market economy there will be winners and losers, and some firms will fail. Actions that prevent firms from failing ultimately distort market mechanisms, including the market's incentive to monitor the actions of similarly situated firms. The most important challenge now is to find ways to impose greater market discipline on systemically important financial organizations.
Shareholders, creditors to take losses
It is true that we need to create an effective, bailout-free system to unwind large failing institutions - and to do so without creating a financial tsunami that wipes out the rest of the economy. But the reality is that everyone will feel the impact of a large institution's failure. It is impossible that a CitiBank, Wells Fargo, Bank of America or Chase failure could result in only a slight ripple through the economy. Those closest to the institution will feel the pain the most and people on the far fringe, the least -- but it will be felt by all nonetheless. The government needs to stop trying to make our lives pain-free in all aspects of life. We simply cannot be shielded from ALL risks.
In the current meltdown, for example, shareholders felt the brunt of the financial crisis pain. Investing is an inherently risky enterprise, and to devise regulation that would soften the impacts of investment failure runs contrary to the tenants of our economic system. Because shareholders voluntarily took risks with the companies they invested in and supported, they should absorb the repercussions when those firms fail.
Bair agrees with this argument. She advises:
Under the new resolution regime, Congress should raise the bar higher than existing law and eliminate the possibility of open assistance for individual failing entities. The new resolution powers should result in the shareholders and unsecured creditors taking losses.
Bair also addresses the current priority given to secured creditors. Such creditors have, in the past, made credit decisions based on collateral value without thoughtfully considering creditworthiness as well. This puts the creditor at risk of default and forced liquidation, while encouraging lack of discipline in the market. Addressing this issue can help to minimize costs to receivership and spread out losses related to failures more broadly.
Other key points in Blair's testimony included:
The full text of Sheila Bair's testimony can be found at: http://www.fdic.gov/news/news/speeches/chairman/spoct2909.html