In the Nation's Interest

Financial Regulatory Reform, Necessary but Not Sufficient

The Obama administration's proposal for regulatory reform includes necessary changes that will go a long way toward making the U.S. financial system safer and sounder. The federal government, like it or not, must guarantee the safety and soundness of the financial system. And as guarantor, the government needs the means both to prevent systemic financial crises and to cushion the cost of any failures that do take place.

As the Congress moves to consider financial regulatory reforms, many aspects of how the existing regulatory regime contributed to, or failed to head off, the financial crisis of 2008 remain unclear. But this much is clear: the former lender-of-last-resort policy known as ‘constructive ambiguity' is dead.

The policy of constructive ambiguity refers to the idea that the government, to encourage prudent risk taking among market participants, shouldn't signal whether it will come to the aid of foundering firms. It should avoid "moral hazard" by not being explicit about the government's willingness to come to the rescue of systemically important firms. In 2000, CED endorsed constructive ambiguity for the IMF, to maintain uncertainty among lenders that the IMF would rescue them, thereby maintaining their incentive to control their own risks, and thereby improve the functioning of markets.

Contrary to a literal reading of Secretary Geithner's statement about large banks that "...No one should assume that the government will step in to bail them out if their firm fails," it is unambiguously clear that the government will not allow systemically important banks to fail. The failure of Lehman Brothers, which was in part an attempt to maintain "ambiguity" about the government's commitment to large financial institutions, and the intolerable consequences proved to all that there would be "no more Lehmans." The government's actions subsequent to Lehman's failure make it clear that some financial institutions are indeed "too big to allow to fail." The proposed reforms seek in part to specifically authorize and streamline the steps required to "resolve" a major failed financial institution, and they thereby make the government's implicit guarantee much more transparent.

Now that the veil of ambiguity has been stripped away, we can easily see that the American taxpayer bears the burden of risk of the financial system. But a system that socializes the losses and privatizes the gains is neither stable nor sustainable - it is suffused with moral hazard, which inevitably will cause some institutions to take on excessive risk and to fail, leaving the taxpayer once again to pick up the bill.

Thus, the nation needs a tough new regulatory regime. The trick is to ensure both that "this never happens again," and that the financial system remains vibrant and healthy. A financial system that undertakes no risk will provide almost no benefit. The goal cannot be to achieve only safety and stability.

The Obama Administration proposed a number of reforms, including a greater focus on systemic risk, higher capital and liquidity requirements, resolution authority for regulators, stronger consumer protections, and new regulations for complex securitizations and derivatives. Though this effort is at the earliest stage, most commentaries seem to agree that the proposals strike a reasonable balance between safety and soundness on the one hand, and risk taking and financial innovation on the other. They take a stride forward by recognizing the need to identify and curtail systemic risk and to intercede in large financial institutions before they reach a point of failure. Of course, the results of the reforms depend on the details of the legislation that is signed into law and the execution of that legislation both by regulators and by those in private-sector financial markets.

That said, we should not think we have removed the risk of financial collapse because we have reformed our regulation of financial markets. Certainly, with reforms resembling those proposed, these markets are likely to be safer and better monitored. And yet the financial system did not cause the financial crisis by itself, and fixing the financial system, though necessary, will not by itself prevent future crises. Critical risks exist outside that system. The foundation for the current crisis included the combination of excessive public and private spending in the United States, insufficient spending and excessive export promotion in China and other countries, and high oil prices and the build up of financial surpluses in oil-exporting nations, among other economic forces. These imbalances provided the large capital inflows that spurred the rise in U.S. residential mortgages and the easy flow of credit to sub-prime borrowers, which are at the base of the financial crisis.

These economic imbalances still exist and are largely unaffected by the administration's regulatory reform, although the reforms are likely to moderate the provision of credit and, to an extent, risk-taking activities, thereby curbing U.S. overconsumption. Still, the probable answer to a question that is frequently being asked-If this plan were in place a year ago, would we have avoided a financial crisis?-is "no." The financial crisis likely would have developed because the underlying economic causes would still have been mostly the same. At best, had these proposed reforms been firm rules, the "crisis" might only have been a "problem" or about as severe as a "normal" post-World War II business-cycle recession.
In the current economic environment, a "normal" business cycle downturn doesn't look so bad. So let's work to implement these prudent proposals. But let's not forget about the other fundamental economic problems that contributed to the crisis. Because they are still here, and the policy of constructive ambiguity is forever gone.

Commentaries are the views of the authors and do not necessarily represent policies of the Committee for Economic Development.

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