In his stunningly ambitious House testimony yesterday, Treasury Secretary Tim Geithner laid out three ways to fix finance. Large players -- be they banks, insurers or hedge funds -- must take less risk. A rejuvenated regulatory machinery must monitor the risks they do take, reining them in when they go too far. And if the first two measures do not prevent the failure of a major institution, the government must have the power to manage its collapse in an orderly fashion.
Geithner's success will depend on being clear that the first line of defense -- prohibiting excessive risk-taking -- is the most important. The financial industry, which makes money from risk, will no doubt argue the opposite. Yes, Mr. Secretary, the industry will say: We love your rejuvenated regulator and your orderly wind-downs. And because you are erecting a wonderful safety net, there's no need to mess with our trapeze act.
It would be nice to be able to agree with this pitch, because trapeze artists bring real benefits. By borrowing large sums, traders magnify the profits they get from funneling the nation's savings to the individuals and companies that use them best. This borrowing, or "leverage," is certainly risky. But it increases the incentive to allocate scarce capital intelligently. More productive capital means more jobs and growth.
Equally, the market for sophisticated derivatives is not just a dangerous casino -- though it certainly can be that. To the contrary, derivatives can actually make some risk vanish, freeing nonfinancial companies to grow. For example, a U.S. exporter might hold back from expanding a factory because of the danger that the dollar will rise, undermining his ability to sell abroad. A U.S. importer might hold back from expanding a store because of the danger the dollar will fall, making imports unattractively expensive. Thanks to currency swaps, these equal and opposing risks can be made to partially cancel one another. The factory and store can move forward with expansion. Again, jobs are created.
Because there are real benefits in sophisticated finance, it would be great to mitigate its risks without hobbling it. Geithner's proposals to eliminate gaps in the regulatory machinery and to shore up swaps trading by moving those transactions into well-capitalized clearinghouses point in the right direction. But regulation will never be perfect. There is no way to escape the basic dilemma: If you want to reduce the risk that finance poses to the real economy, you have to limit the amount of risk that financiers take in the first place.
Consider Geithner's proposal to eliminate overlaps and gaps in financial regulation. As Geithner himself acknowledged, the crazy risks that caused the crisis often occurred at institutions that were fully regulated. London had a unified financial regulator of the sort Geithner advocates; it failed miserably. The promise (both here and in Europe) of a new form of "systemic" regulation will be extremely hard to fulfill. Besides, it is not even clear that the most basic regulatory reforms are politically possible. Members of the congressional committees that oversee the Commodity Futures Trading Commission enjoy the campaign contributions that their power generates, so they have blocked its merger with the Securities and Exchange Commission, even though such a merger would make eminent sense.
What of empowering government to wind down failing financial firms in an orderly fashion? "Orderly" is in reality a euphemism for punishing private creditors in the way they deserve. Under existing rules, the government's takeover of AIG has been perfectly orderly; the problem is that the costs are borne by taxpayers rather than by AIG's traders, bond holders and swaps counterparties, which should have monitored their risks better. But even if the government had enjoyed wider authority, it's not clear that it would have forced private creditors to take losses. After all, government already has broad authority over bank failures. But it has shied away from punishing bond holders of busted banks lest other banks' bond holders panic.
So Geithner's ideas on regulation and wind-downs are sensible, but they won't prevent the next crisis or save taxpayers from the cost. That is why the financial industry must be forced to take less risk. Traders must use less leverage and hold more capital, even if this dulls incentives to allocate savings efficiently. They must be forced to pay a "risk tax" to compensate a public that will foot the bill if they blow up. Moreover, the risk-tax rate must rise as financial firms get bigger. A small hedge fund can blow itself up with crazy leverage and not destabilize the financial system: It should take as much risk as it likes. A big hedge fund, bank or insurer is a different matter. Over the past decade or so, Wall Street has concentrated risk in ever-larger behemoths. A central lesson from this crisis is that small is beautiful.
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