When Lehman Brothers went bankrupt in September 2008, Washington learned the hard way that some firms are just too tangled up in the global financial system to fail. The government has since doled out $5 trillion to keep the remaining players alive. But mostly policymakers have focused on treating the symptoms of the financial crisis rather than the underlying cause. They've been trying to find the perfect pharmaceutical cocktail, fashioning a mix of programs with offputting names like TALF, TLGP, and PPIP—and changing them on the fly. Some of these plans may relieve the pain, but that's all.
Unless President Barack Obama and other heads of state can figure out a way to bring the global giants of finance down to manageable sizes, taxpayers will surely foot the bill for more bailouts in the future. The task won't be easy. "We will not, in my judgment, eliminate too big to fail," says Gary H. Stern, president of the Federal Reserve Bank of Minneapolis. But he adds: "You want those circumstances to be as limited as possible."
The Obama Administration's main plan for attacking the too-big-to-fail problem calls for giving federal regulators expanded powers to seize and restructure all manner of financial institutions—not just traditional banks—when their failure would threaten the financial system as a whole. In particular, Federal Reserve Chairman Ben Bernanke wants the power extended to include diverse financial giants such as insurance-based conglomerate American International Group (AIG), as well as big holding companies such as Citigroup (C) and Bank of America (BAC), that own both traditional, deposit-taking banks and securities-trading units. But giving federal regulators a greater mandate won't be enough because the giant financial institutions' reach extends around the globe.
Lehman's collapse spotlighted the byzantine profusion of rules different nations have for handling failed financial companies. For instance, hedge funds that deposited money with Lehman in London are still trying to unfreeze their accounts because Britain doesn't have the same rules for unwinding a brokerage firm as the U.S. Without coordinated efforts, countries could find themselves pitted against one another. "There's a lot of work to do that just hasn't been done," says Sheila Bair, chairman of the Federal Deposit Insurance Corp.
Lehman's failure also revealed surprising cross-border connections between banks. For example, according to a March study by the Bank for International Settlements, in a few frenzied days after Lehman failed, European banks sufferedly badly from $175 billion in withdrawals from U.S. money market funds. The chain reaction was grave because the European banks had gone to the U.S. funds to borrow one-eighth of their dollars. Had the Federal Reserve not backstopped the money markets, a global meltdown almost surely would have resulted.
One solution to the too-global-to-fail problem is old-fashioned trust-busting. Regulators could break off chunks of banks—perhaps also insurers, hedge funds, and others—until those entities fit neatly inside national borders. "Banks that are too big to fail must now be considered too big to exist," says Simon Johnson, a Massachusetts Institute of Technology professor and a former International Monetary Fund chief economist.
A step toward that end would be to revive the Glass-Steagall Act, the Depression-era law that barred commercial banks from owning investment banks and other financial firms.
The 1999 repeal of the law permitted great risk to be concentrated in a handful of mammoth banks. Charles Geisst, a finance professor at Manhattan College and a noted Wall Street historian, says the repeal opened the door for an explosion in risk-taking with derivatives, not just in the U.S. but around the globe. "The original Glass-Steagall wasn't just a banking law; it was also a very good form of antitrust law," laments Geisst.
But beyond the formidable political hurdles to forcing healthy institutions to split up, critics argue that trust-busting might not even solve the problem. Many small institutions, for example, could fail just like the big boys did. "It sounds very easy and appealing; it won't be," says Ron J. Feldman, senior vice-president for supervision, regulation, and credit at the Federal Reserve Bank of Minneapolis. Trust-busting would also mean reversing actions taken during the heat of the crisis, such as allowing JPMorgan Chase (JPM), Bank of America, and Barclays (BCS) to grow even bigger by picking up assets from the sinking Bear Stearns, Merrill Lynch, and Lehman.
Another response to the problem would be to staff up the regulators and crack down on the firms' risky dealings by monitoring trades and the like. It's tempting, but it won't work, said Charles I. Plosser, president of the Federal Reserve Bank of Philadelphia, in a recent speech. Try to imagine regulators getting it just right—preventing catastrophic failures without stifling innovation, protecting poor performers, or leaving loopholes like those that contributed to the current crisis. "Failures are an inevitable consequence of a dynamic financial system," said Plosser.
Preparing for the End
Then there's what might be called the "living will" approach. Big institutions would be required to plan for their own orderly demise, much like many terminally ill people do. They would prepare to unwind derivatives, move assets to healthy institutions, and settle up their estates. If regulators knew such plans were in place, they could better judge the risk of a failure and then, perhaps, let some giants fall. Says Richard J. Herring, professor at the University of Pennsylvania: "You've got to make global companies think about how they can gracefully leave the scene if the worst should happen."